CHRG-111shrg57319--149 Mr. Vanasek," I am not aware of any particular limit that existed, but I could be incorrect. " CHRG-111hhrg56776--188 Mr. Garrett," Well, my understanding is, according to the examiner's report, the New York Fed required no action from Lehman in response to the stress test. Is that an incorrect understanding? " CHRG-111hhrg51592--193 Mr. Capuano," That's fair and reasonable, but that goes to Mr. Pollock's comment, which I thought was very good, of a cartel. Now, Mr. Pollock, you would agree that a cartel doesn't necessarily have to be just three or just 10, a cartel could be 100, if they operated as such; is that incorrect? " CHRG-111shrg57319--373 Mr. Beck," That is not what I said. No. I said I remember and recall this specific event because we did go out--because we securitized loans that were delinquent, which we represent that we won't do and we shouldn't do, and these were loans purchased from third parties and the loan servicing tape that we got from them was incorrect. It was wrong. And when we found that out, we went and purchased these loans back. Senator Levin. You notified everybody? " CHRG-110hhrg38392--177 Mr. Bernanke," Total inflation. Mr. Miller of North Carolina. The information that I have is that from November of 2001 until May of 2007, the wages of production workers, which is about 80 percent all workers, had increased 17.28 percent and total inflation had increased 17.22 percent, which is barely treading water. Is that an incorrect number? " FOMC20050809meeting--194 192,CHAIRMAN GREENSPAN.," You know, initial claims have not moved all that much since the last meeting, so it’s a little hard to make the case. And any word that we change now, since we’re changing so little, is going to be made more of than I think we’d want because there are so many people out there who are being paid to read this statement and interpret our meaning. So, I think we have to be a little careful of that. Unless something in the statement is obviously getting to be incorrect—clearly, we can’t have that—it’s probably better not to make a change." CHRG-111hhrg53245--256 Mr. Donnelly," One of the other things the investor, this fellow, talked about was, and he talked to all of us, was maybe what we ought to do is just throw a couple of cents on every tray and have in effect a quasi-public rating system so that we do not have to speculate on the opinion of Moody's or that they be part of in effect almost become like a public utility, that it is too important getting this right to our economy, to the global economy. We had the Fed chairman in today who said if we had let this get out of hand, the whole global economy would have collapsed. And so much of it was tied in to these incorrect ratings given by Moody's and others. " FOMC20081029meeting--106 104,MR. PLOSSER.," I just want to clear up the question. I think Tim and Nathan may have both answered this, but it's a question that President Lockhart raised earlier. In Mexico's case, for example, where almost all the major banks are foreign owned--EU banks, Spanish banks--those banks clearly have access to dollars through the ECB swap line. There's no reason that the dollar funding needs of those banks, to the extent that they can move these things around, can't be satisfied by access to dollars from the ECB. Is that a correct or an incorrect assumption? " CHRG-111hhrg53244--187 Mr. Hensarling," Okay. It has had some effect. Okay. Well, the chairman has said ``some.'' So I appreciate the chairman's distinction. Clearly, what you didn't mention, as far as positive impacts, was employment. We know that, since this legislation has passed, that unemployment is now at a quarter-of-a-century high, that 2 million jobs have been lost. Some believe that there is cause and effect on adding $1.1 trillion to the national debt. And on page 6 of your testimony, again you state, ``Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth.'' I have noticed, and please tell me if I am incorrect, the latest FOMC report indicates or estimates that we are looking at 9 to 10 percent unemployment not only for the rest of this year, but for the rest of next year, as well. Did I read that report correctly? " CHRG-111hhrg48868--92 The Chairman," Thank you, Mr. Chairman. And let me say to the gentleman from New Jersey, I apologize. I was looking at the transcripts of our previous hearing and the transcript, the official transcript, is probably incorrect. Looking at the official transcript, it cuts off the questioning. I should have wondered because, according to this transcript, the gentleman used far less than 5 minutes and most of us find 5 minutes too constraining. So I will have to correct the transcript. It began with covered bonds and I will have to check and see why transcripts were not better done. So we did have the hearing on July 10th well before they got involved again. The gentleman did ask if they planned to do it again and I guess he got his answer. They may not have planned to do it again, but they did it again. " CHRG-111shrg52966--22 Mr. Cole," I would indeed, and thank you for the opportunity, Senator. First of all, I would say that my understanding is that the report that the GAO has done is really based on review of one institution. Senator Bunning. That is incorrect, but that is fine. " Mr. Cole," OK, and that we received this report with reference to perspectives on risk just in the last couple days. So we would like an opportunity to go over these findings with the GAO, as we typically do in GAO reviews. We have not had that opportunity. But I will say this, that I think that what Ms. Williams quoted from is in the report, but unfortunately, there are other parts that were not quoted, and one in particular is, quote: The effects of a long period of easy liquidity and benign credit conditions have continued to weaken underwriting standards across all major credit portfolios. Finally, we note that investor demands appear to be encouraging large financial institutions to originate more assets and even greater volumes of low-quality assets, and in order to distribute them through the capital markets.In response to that, we took very firm actions, and that---- Senator Bunning. When? " CHRG-111hhrg55814--270 Mr. Tarullo," I think, Mr. Chairman, that Comptroller Dugan has summed it up. Surely we can keep the list private if that is what the Congress wants us to do, but through some combination of self-mandatory disclosures to shareholders and, frankly, just financial analyst observation of their behavior, capital, set-asides and the like for the firms, it is likely that most, if not all, of the institutions so identified would eventually be known to the public. And I think, as someone suggested, you may have a bit of a problem if an incorrect inference is drawn. So while again, there is a reason to try to avoid an increase in moral hazard, we should probably be realistic here about what will and will not be known. Mr. Moore of Kansas. Thank you, sir. Mr. Bowman and Mr. Sullivan, any comments? " FinancialCrisisInquiry--44 MURREN: Thank you. I have one final question, Mr. Chairman. CHAIRMAN ANGELIDES: Absolutely. You have—you have time. MURREN: I was struck, actually, by—you mentioned several times that your behavior, either individually or as a corporation, was really within the context of what is considered standard for the times. And given that we’re now in— in 2010 and we have unemployment at very high rates, foreclosures are high, many people are really suffering right now -- given that these are the standards of the times, could you please comment on your compensation and that of your senior executives? BLANKFEIN: First—you know, first as to the standards, I mean, I’m not—what I meant to convey is I’m not sure -- again, I haven’t surveyed what the standards of the time were. But let me say—and people will go back and test this, I’m sure, and look. I know the standards of times were different than what we are now. And so, the way I was asked that question, how do you rate yourself in terms of negligence of what you should have done—I’m just saying it would have to be compared to what the standards were. Those standards, when you look back in hindsight, should have been elevated. And, by the way, that could also be another source of—of incorrectness. Maybe we should have been a part of those who—who elevated those behaviors. But that’s what I meant to convey. I wasn’t saying that those were fine. I’m saying that when you asked me what the standards were, again, that’s how we—that’s how we would measure ourselves, in terms of what we were thinking. Now, you asked me a question—you asked me... MURREN: FOMC20070628meeting--363 361,MR. LACKER.," I like the statement as is. I was one of those who, when we considered accelerating the release of the minutes, thought that it would take some weight off crafting the statement, which we could shorten. Alas, I was incorrect, and that was sort of hopeless. So I’m giving up. I sort of like the length the statement is now. It does a reasonable job with what it does, with one exception—the last section, the so-called balance-of-risk assessment. I’ve argued this many times when we’ve talked about this. The intention is to convey the likely next direction of interest rate changes. Our general practice has been—there have been some exceptions—to describe the risks to the things we care about, and we invite people to deduce what we think of as the likely next direction of interest rate moves by inverting our policy reaction function somehow. I always thought that was problematic, needlessly obscure, and I liked the times when we crafted that statement fairly directly and explicitly with phrases like “policy firming.” About the balance-of-risk assessments, I hesitate to put something else on the table, but we ought to think about the directive, too, because the balance-of-risk assessment came into the statement because it was in the directive and there was a tilt statement in the directive that originated in the ’80s as a way of providing the Committee’s sense of constraint on the Chairman’s discretion to make intermeeting moves. That’s my understanding of how it arose. Then it came to be about the next meeting when we did intermeeting moves, and now it’s just sitting there in the directive, and I don’t know what good it does in the directive really. You know, we don’t make intermeeting moves. I don’t know what our understanding is about discretion about intermeeting moves. I think that we’re supposed to have a conference call with everybody. So I don’t know why we need this little directive in there, and it seems to me you could just take it out of the directive. About governance, I’m in favor of voting on the whole thing. I remember talking at one point with I think it was you, Mr. Chairman, and others about how it is backward for us to talk about the statement—to do negotiations about the statement—a week before we even talk to each other or read the Greenbook. But I don’t think that’s so problematic. It doesn’t end up putting our feet in cement really, and I think we’ve been able to have sufficient flexibility during the meeting despite what we said the week before. So I don’t view that as terribly problematic." CHRG-111shrg50815--75 Mr. Levitin," Also, the European Union's antitrust enforcement body has actually said that interchange fees are anticompetitive. That is being appealed, but we at least have a broad several countries that have recognized the problems with interchange fees. I think it is important to note, though, that what Professor Zywicki said is incorrect about interchange fees. There is a serious difference between interchange fees on credit cards and the cost of cash or checks or payment devices like that. If a merchant wants to charge more for cash, that is the merchant's prerogative. The merchant cannot surcharge for a credit card. If the merchant does so, the merchant is violating its agreement with its acquirer bank. Also, 45 percent of the cost of interchange fees, that is just going to fund rewards programs. Merchants don't get any benefit from that. That is going for frequent flyer miles for rewards junkies. So at least 45 percent of the cost of interchange has really no benefit for merchants. There is no evidence of ticket lift, contrary to what Mr. Clayton says. If you want to find out how happy merchants are when they have adopted credit cards, talk to McDonald's. McDonald's adopted credit cards thinking that they would get some ticket lift. Everything I hear is they have not been real pleased with it, but they have had to sink in a lot of money and that they are kind of trapped in that now. " CHRG-111shrg50815--51 Mr. Plunkett," Thank you for the question, Senator. A couple more areas we would like to see improvements. First, as we heard, fees have been growing faster than the cost of living. In many cases, penalty fees in particular seem to bear no relationship to the costs incurred by issuers if somebody pays late or goes over limit. So we like Senator Dodd's provision that fees should be reasonably related to the costs incurred by issuers. We like the provisions in that bill and others related to lending to young people. Two things there. Senator Dodd talked about extending credit responsibly to young people or having a cosigner with income who can pay for the loan and not offering the loan to young people without much income. The second issue in the bill, give young people a choice of whether they want to accept--a real choice--whether they want to accept credit card solicitations. So the bill has an opt in. You don't get solicited between 18 and 21 unless you affirmatively choose to allow it. A third issue is bringing down rates after somebody makes a mistake. In many cases, issuers appear to be reserving the right to charge those rates for a long time, you know, many, many, many months. What the Dodd bill says is after 6 months, if you have been on time, if you haven't violated your agreement, rates have to come back down again. Senator Johnson. I believe the time is incorrect. " CHRG-111shrg57322--587 Mr. Viniar," Chairman Levin, Ranking Member Coburn, and Members of the Subcommittee, good afternoon. My name is David Viniar. I have been Chief Financial Officer of Goldman Sachs since 1999. I am responsible for risk management, financial control and reporting, and financing our business, among other duties. I appreciate the opportunity to appear before the Subcommittee and I will comment here on our risk philosophy and our approach to risk management.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Viniar appears in the Appendix on page 216.--------------------------------------------------------------------------- As a global investment bank and financial intermediary, Goldman Sachs integrates advice and capital with its risk management capabilities to serve a broad range of largely institutional clients. In doing so, we often take on principal risk to help clients achieve their objectives. For example, we may facilitate block offerings, provide structured solutions, or extend credit. We routinely evaluate, price, and distribute risk across the spectrum according to the specific risk appetites of our institutional clients. We know that we will sometimes incur losses, but as a core part of our business model, we proactively manage our risk to minimize these losses. When we commit capital to buy or sell financial instruments, extend credit, or invest alongside our clients, we accumulate both long and short positions that give rise to liquidity, credit, and market risks. We deploy a range of risk management capabilities to price the risks of each transaction appropriately, keep the firm's overall exposures within risk limits, and establish offsetting positions, or sell and buy positions, as necessary to control overall exposure. Our approach is to understand the risks we are taking, analyze and quantify them, and keep a firm grip on their current market value. We carry virtually our entire inventory of financial instruments at fair market value, with changes reflected in our daily P&L. Such daily marking of our positions was a key reason we decided to start reducing our mortgage risk as market conditions were deteriorating at the end of 2006. I would like to give you a sense for how we managed our risk during the period leading up to the crisis. Through the end of 2006, we were generally long in exposure to residential mortgages and mortgage-related products. In that December, however, we began to experience a pattern of daily losses in our mortgage-related P&L. P&L can itself be a very valuable risk metric and I personally read it every day. I called a meeting to discuss the situation with the key people involved in running the mortgage business. We went through our positions and debated views on the mortgage market in considerable detail. While we came to no definitive conclusion about how the overall market would develop in the future, we became collectively concerned about the higher volatility and recent price declines in our subprime mortgage-related positions. As a result, we decided to attempt to reduce our exposure to these positions. We wanted to get closer to home. We proceeded to sell certain positions outright and hedge our long positions in an attempt to achieve these results. As always, the clients who bought our long positions or other similar positions had a view that they were attractive positions to purchase at the price they were offered. As with our own views, their views sometimes proved to be correct and sometimes incorrect. We continued to reduce our positions in these products over the course of 2007. We were generally successful in reducing this exposure to the extent that, on occasion, our portfolio traded short. When that happened, even if these short positions were profitable, given the ongoing high volatility and uncertainty in the market, we tended to attempt to then reduce these short positions to again get closer to home. This situation reversed itself in 2008, however, when the portfolio tended to trade long, and as a result, despite the fact that our franchise enabled the firm to be profitable overall, we lost money on residential mortgage-related products in that year. While the tremendous volatility in the mortgage market caused periodic large losses on long positions and large gains on offsetting short positions, the net of which could have appeared to be a substantial gain or loss on any day, in aggregate, these positions had a comparatively small effect on our net revenues. In 2007, total net revenues from residential mortgage-related products, both longs and shorts together, were less than $500 million, approximately 1 percent of Goldman Sachs's overall net revenues. And in 2007 and 2008 combined, our net revenues in this area were actually negative. For Goldman Sachs, weathering the mortgage market meltdown had nothing to do with prescience or betting on or against anything. More mundanely, it had everything to do with systematically marking our positions to market, paying attention to what those marks were telling us, and maintaining a disciplined approach to risk management. Thank you, and I am happy to take your questions. Senator Levin. Thank you very much. Mr. Broderick. TESTIMONY OF CRAIG W. BRODERICK,\1\ CHIEF RISK OFFICER, THE CHRG-111shrg54589--51 Chairman Reed," Thank you very much. Senator Bunning. Senator Bunning. Thank you. For the Chairman of the SEC, can and should the Securities and Exchange Commission require all reporting companies to disclose counterparties and reference entities and assets in their derivative portfolios? Ms. Schapiro. Require public disclosure? If their relationships are material and they have material contracts with counterparties, they should be disclosed--at the risk of saying something incorrect here--in their public filings if they are material to the company. Senator Bunning. I am talking--you are talking about someone to regulate these people. I am talking about---- Ms. Schapiro. For example, if Boeing were to enter into a customized---- Senator Bunning. Customized, or even--yes, a customized one. Ms. Schapiro. If they were regularly engaged in this market, I think that that should bring them under the umbrella of being regulated. But, otherwise, I believe our view would be that we could get at the information through the dealer's requirement to keep records about counterparties, an audit trail of the transaction, all of the terms of reference of the transaction. Senator Bunning. In other words, I am asking about any entities. Ms. Schapiro. Other than just dealers? Senator Bunning. That is correct. Ms. Schapiro. I believe that we think we can get the information through access to all the dealer information about who they were--who their counterparty was. Senator Bunning. I am worried about people slipping through, like we had for the last 10 years. Ms. Schapiro. I share that concern very much with you. I think to the extent anybody did not have a dealer as their counterparty, so a Boeing or another commercial company, and they were engaged in this market with any frequency at all, we could get at that directly. But I believe we could get the information very clearly through our regulation of the dealer and access to the complete books and records of the dealer, where they would show that they were transacting with Boeing. And, of course, if the information is in a trade information warehouse or the transaction is done through a central counterparty, we would have access to the information in that method, in that way as well. Senator Bunning. This is one for all of you. How do we prevent a clearinghouse or an exchange from being too big to fail? And should they have access to Fed borrowing? " CHRG-111hhrg48674--266 Mr. McCotter," Thank you, Mr. Chairman. People in my district woke up one day sometime late last year and found out that the world, as they knew it economically, was going to end because someone had done something wrong to seize up the credit markets. And since that time they have witnessed disorder in the sense of the government's response. They have perceived this to be an unjust appropriation of their money, spent on the very people who caused the problem, and they see a long-term loss of economic freedom due to government intervention. And most importantly, they don't see much benefit to their daily lives from all the things that the government has done. My concern in studying human nature is twofold: one, the concept of ``too big to fail.'' When you tell people they are too big to fail, they will, because they know there is no responsibility to be incurred, no accountability if they do. Where is the stigma for the people who failed and put us in this mess? Where are the measures taken to ensure that they pay a price for their problems that they have put onto us? I don't see any. I don't see any at this point. And the second part of my question is kind of that these people thought they could go on forever doing what they were doing, that it would just keep going, that the dot-com bubble was replaced by a housing bubble, and it would never end. Now we are talking about creating a government bubble to fix the housing bubble, but they never thought they were wrong. I asked you and Mr. Paulson once, ``What happened?'' The answer was, ``Mistakes were made.'' Well, I understand human beings are fallible. But the problem is, if people think they are too big to fail or they are too important, the hubris that enters into the prognostications that they make and the actions that they take leads them to make very, very big mistakes. So my question is this: If these people were wrong and we are suffering the consequences of their bad decisions; if people like Mr. Greenspan, who has admitted he was wrong, have caused us to suffer the consequences of his bad decisions; if--as you have written a book about the Great Depression--the people at the Federal Reserve were wrong and the people at the time had to live with their bad decisions, what in the odd chance happens if you are wrong? What is your worst-case scenario for the decisions and the actions that you have made and taken being incorrect, how will that affect the people who sent me here to work for them? " FOMC20060510meeting--169 167,MR. KROSZNER.," I agree with the 25 basis point move at this time. I think we have seen some beginnings of evidence of heightened inflation risk relative to six weeks ago, and I think it is also very important, as President Yellen mentioned, that looking back historically, we do not want to get too far out ahead and then have some regrets. But we also have to be concerned about how our actions will be interpreted by the market and to think about the longer-run expectations. We have to convey that we do have some uncertainty about where the economy is going, and I think that is well reflected in our discussion here and in alternative B. But it is extremely important to keep our powder dry. I really like the idea of saying that not only will we be looking at the data as we normally do in our due diligence but also we are going to be looking at things because there is uncertainty. We do not have an ideological view that we must make sure that every last concern about inflation is stamped out, without concern about growth, or vice versa. Also, as I said last time, it is hard to know exactly where we need to go to be at the right level. At best, we can be within 25 basis points of where we would hope things would be, but obviously, it is quite literally a moving target since the underlying economy is moving. That said, I think it is very important to emphasize in the statement what First Vice President Stone mentioned: If you look at what we say in line 4, we do specifically mention that some further policy firming may yet be needed to address inflation risks, which is not something that we had specifically singled out before and which I think helps offset the concern about the phrase “inflation expectations remain contained.” Although we have discussed that inflation expectations have moved up somewhat, I think that to say they are no longer contained is incorrect. We have seen a bit of tick-up of actual inflation and a bit of tick- up of some, but not all, measures of inflation expectations. As Vince mentioned, the most recent numbers coming from Blue Chip suggest that the professional forecasters are not saying that inflation expectations are moving up. I am concerned that, if we took out that phrase, which we have had for a while, we would be suggesting that we do think things are becoming unhinged and that might be a self-fulfilling prophecy moving in exactly the wrong direction. So I think the balance that we have now heightens our emphasis on inflation risk in number 4 but does not say that inflation expectations have moved too far beyond (and I do not think they have moved too far beyond) where they were before or that they have become unhinged. I like the balance that is there between the two. I also like keeping in the red phrase in the second part of line 4; but a small amendment to make it perhaps a bit easier to swallow and to make it seem not repetitive with the statement in number 5 is that, rather than saying “in any event,” we simply say, “The Committee thus will respond to changes in economic prospects as needed to support the attainment of its objectives.” Thank you, Mr. Chairman." FOMC20050503meeting--85 83,MS. YELLEN.," Thank you, Mr. Chairman. It has been less than a year since I returned to the policy table, but already there is a sense of déjà vu all over again. [Laughter] The recent pattern of higher inflation and softer spending seems remarkably similar to the May 3, 2005 42 of 116 prices. The latest data on employment, retail sales, and durable goods orders reveal unanticipated weakness on the real side of the economy. Readings on overall and especially core inflation have been uncomfortably and unexpectedly high. If the current situation persists or deteriorates further, we could face some difficult policy choices ahead, but I remain cautiously optimistic that the slowdown in growth and the uptick in inflation will both prove transitory. I believe we can draw some lessons for assessing current conditions and for calibrating policy going forward from last year’s experience. Last year’s jump in energy prices delivered a significant shock to consumers and businesses. For a time, the growth of consumer spending slowed and inflation increased. But after the initial jolt, the growth of consumer spending and economic growth overall rebounded. Higher energy prices again have hit consumers hard in the pocketbook and businesses on the bottom line, but there’s good reason to anticipate a similar recovery in spending this year, especially with oil prices having come down of late. So the lesson from last year’s experience is that we shouldn’t overreact to the present soft patch or short-run fluctuations in real-side data when the fundamentals for growth appear to remain relatively sound. I, therefore, find myself in agreement with the Greenbook’s perspective. Beyond the current quarter, the forecast has been revised only slightly, with the major components of demand projected to continue expanding at a fairly healthy pace. This forecast mirrors the perceptions of our Twelfth District business contacts who, outside of the Bay Area and Los Angeles proper, report that they remain quite upbeat about the economy. For inflation, last summer’s experience similarly advises a cautious policy reaction to the data. The recent uptick in core inflation probably reflects pass-through of cost pressures due to May 3, 2005 43 of 116 just like last summer, underlying pressures on core inflation appear to remain subdued. Several of the good fundamentals driving the outlook for inflation are worth highlighting. First, the data surveyed in Part 2 of the Greenbook suggest that at least some, and possibly considerable, slack remains in labor markets. Corroborating this view, our contacts, even in some of the most rapidly growing areas of the Twelfth District, report little trouble filling job openings except in some skilled trades that are in high demand in construction. I met recently with top executives of SBC West, a major employer in California and Nevada. They indicated no difficulties whatever in hiring at any skill level, with only a few exceptions, such as accounting. Like most of our contacts in the District, they also saw no significant wage pressures. Indeed, nationwide data suggest that labor cost pressures appear quite restrained. For example, as David noted, last week’s ECI data showed no sign of any acceleration in private compensation. The underlying trend in productivity is also solid, and, as I discussed at a previous meeting, I remain optimistic that it will remain so, in which case unit labor costs are likely to remain constrained. Our contacts report continued scope for productivity improvements. For example, the SBC West executives with whom we met explained how new technologies permit tasks to be performed via computers at headquarters that in the past required technicians to make service calls. Of course, “pricing power” is a phrase that is used frequently by our contacts, but the mention of pricing power is focused exclusively on pass-through of cost increases due to energy, materials, and transportation. In construction, agriculture, and transportation, firms report considerable success in passing these cost increases along. In other sectors, the experience has been more mixed. One director who runs a major clothing retailer reported only limited pass-through to consumer prices in the face of competitive pressures and continued gains in productivity. With May 3, 2005 44 of 116 Moreover, to the extent that these costs are being passed through to prices, they appear to provide only one-time boosts to the price level. In terms of policy, I support a 25 basis point increase at this meeting and retaining the “measured pace” description of the likely path for policy going forward, at least for today. Weak real-side data might suggest a pause to evaluate the extent and likely duration of the slowdown. But incoming inflation data could justify more aggressive action. Given the latest uncomfortably high readings on inflation, I think we have to remain vigilant. The constancy of long-run inflation expectations provides some reassurance, although I worry that if we had similar readings on such expectations in the early 1970s, they would have been slow to rise then as well, as bond markets had grown complacent about inflation. Last time, we adopted language that many of us thought made our balance-of-risk statement tautological. In fact, it turns out that the statement is not tautological, and I no longer consider it true. [Laughter] In my view, even with appropriate monetary policy action, the risk to the attainment of sustainable growth is unbalanced to the downside, while the risk to the attainment of price stability is unbalanced to the upside. It is the risk to our dual objectives, but not to each individual objective, that I consider balanced overall. Releasing an unchanged balance-of-risk statement might suggest to some that this Committee has ignored the palpable shift in economic conditions toward higher inflation and slower growth. Indeed, an uncharitable description of the current statement is that it has gone from not serving any purpose to potentially being perceived as factually incorrect. Rather than try to modify the balance-of-risk statement, I think it is perhaps time to retire it, for reasons that I will explain in more detail in the policy go-round. May 3, 2005 45 of 116" fcic_final_report_full--426 These facts tell us that our explanation for the credit bubble should focus on fac- tors common to both the United States and Europe, that the credit bubble is likely an essential cause of the U.S. housing bubble, and that U.S. housing policy is by itself an insufficient explanation of the crisis. Furthermore, any explanation that relies too heavily on a unique element of the U.S. regulatory or supervisory system is likely to be insufficient to explain why the same thing happened in parts of Europe. This moves inadequate international capital and liquidity standards up our list of causes, and it moves the differences between the regulation of U.S. commercial and invest- ment banks down that list. Applying these international comparisons directly to the majority’s conclusions provokes these questions: • If the political influence of the financial sector in Washington was an essential cause of the crisis, how does that explain similar financial institution failures in the United Kingdom, Germany, Iceland, Belgium, the Netherlands, France, Spain, Switzerland, Ireland, and Denmark? • How can the “runaway mortgage securitization train” detailed in the majority’s report explain housing bubbles in Spain, Australia, and the United Kingdom, countries with mortgage finance systems vastly different than that in the United States? • How can the corporate and regulatory structures of investment banks explain the decisions of many U.S. commercial banks, several large American univer- sity endowments, and some state public employee pension funds, not to men- tion a number of large and midsize German banks, to take on too much U.S. housing risk? • How did former Fed Chairman Alan Greenspan’s “deregulatory ideology” also precipitate bank regulatory failures across Europe? Not all of these factors identified by the majority were irrelevant; they were just not essential. The Commission’s statutory mission is “to examine the causes, domestic and global, of the current financial and economic crisis in the United States.” By fo- cusing too narrowly on U.S. regulatory policy and supervision, ignoring interna- tional parallels, emphasizing only arguments for greater regulation, failing to prioritize the causes, and failing to distinguish sufficiently between causes and ef- fects, the majority’s report is unbalanced and leads to incorrect conclusions about what caused the crisis. We begin our explanation by briefly describing the stages of the crisis. fcic_final_report_full--530 December 3, 2008, 151 in which he said in pertinent part: Only 6 percent of all the higher-priced loans [those that were considered CRA loans because they bore high interest rates associated with their riskier character] were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their assessment areas , the local geographies that are the primary focus for CRA evaluation purposes. This result undermines the assertion by critics of the potential for a substantial role for the CRA in the subprime crisis. [emphasis supplied] There are two points in this statement that require elaboration. First, it assumes that all CRA loans are high-priced loans. This is incorrect. Many banks, in order to be sure of obtaining the necessary number of loans to attain a satisfactory CRA rating, subsidized the loans by making them at lower interest rates than their risk characteristics would warrant. This is true, in part, because CRA loans are generally loans to low income individuals; as such, they are more likely than loans to middle income borrowers to be subprime and Alt-A loans and thus sought after by FHA, Fannie and Freddie and subprime lenders such as Countrywide; this competition is another reason why their rates are likely to be lower than their risk characteristics. Second, while bank lending under CRA in their assessment areas has probably not had a major effect on the overall presence of subprime loans in the U.S. financial system, it is not the element about CRA that raises the concerns about how CRA operated to increase the presence of NTMs in the housing bubble and in the U.S. financial system generally. There is another route through which CRA’s role in the financial crisis likely to be considerably more significant. In 1994, the Riegle-Neal Interstate Banking and Branching Effi ciency Act for the first time allowed banks to merge across state lines under federal law (as distinct from interstate compacts). Under these circumstances, the enforcement provisions of the CRA, which required regulators to withhold approvals of applications for banks that did not have satisfactory CRA ratings, became particularly relevant for large banks that applied to federal bank regulators for merger approvals. In a 2007 speech, Fed Chairman Ben Bernanke stated that after the enactment of the Riegle-Neal legislation, “As public scrutiny of bank merger and acquisition activity escalated, advocacy groups increasingly used the public comment process to protest bank applications on CRA grounds. In instances of highly contested applications, the Federal Reserve Board and other agencies held public meetings to allow the public and the applicants to comment on the lending records of the banks in question. In response to these new pressures, banks began to devote more resources to their CRA programs.” 152 This modest description, although accurate as far as it goes, does not fully describe the effect of the law and the application process on bank lending practices. In 2007, the umbrella organization for many low-income or community “advocacy groups,” the National Community Reinvestment Coalition, published a report entitled “CRA Commitments” which recounted the substantial success of its members in using the leverage provided by the bank application process to obtain trillions of dollars in CRA lending commitments from banks that had applied to 151 152 Randall Kroszner, Speech at the Confronting Concentrated Poverty Forum, December 3, 2008. Ben S. Bernanke, “The Community Reinvestment Act: Its Evolution and New Challenges,” March 30, 2007, p2. federal regulators for merger approvals. The opening section of the report states (bolded language in the original): 153 FinancialCrisisReport--294 The lack of performance data for high risk residential mortgage products, the lack of mortgage performance data in an era of stagnating or declining housing prices, the failure to expend resources to improve their model analytics, and incorrect correlation assumptions meant that the RMBS and CDO models used by Moody’s and S&P were out of date, technically deficient, and could not provide accurate default and loss predictions to support the credit ratings being issued. Yet Moody’s and S&P analysts told the Subcommittee that their analysts relied heavily on their model outputs to project the default and loss rates for RMBS and CDO pools and rate RMBS and CDO securities. (b) Unclear and Subjective Ratings Process Obtaining expected default and loss analysis from the Moody’s and S&P credit rating models was only one aspect of the work performed by RMBS and CDO analysts. Equally important was their effort to analyze a proposed transaction’s legal structure, cash flow, allocation of revenues, the size and nature of its tranches, and its credit enhancements. Analyzing each of these elements involved often complex judgments about how a transaction would work and what impact various factors would have on credit risk. Although both Moody’s and S&P published a number of criteria, methodologies, and guidance on how to handle a variety of credit risk factors, the novelty and complexity of the RMBS and CDO transactions, the volume and speed of the ratings process, and inconsistent applications of the various rules, meant that CRA analysts were continuously faced with issues that were difficult to resolve about how to analyze a transaction and apply the company’s standards. Evidence obtained by the Subcommittee indicates that, at times, ratings personnel acted with limited guidance, unclear criteria, and a limited understanding of the complex deals they were asked to rate. Many documents obtained by the Subcommittee disclosed confusion and a high level of frustration from RMBS and CDO analysts about how to handle ratings issues and how the ratings process actually worked. In May 2007, for example, one S&P employee wrote: “[N]o body gives a straight answer about anything around here …. [H]ow about we come out with new [criteria] or a new stress and ac[tu]ally have clear cut parameters on what the hell we are supposed to do.” 1143 Two years earlier, in May 2005, an S&P analyst complaining about a rating decision wrote: “Chui told me that while the three of us voted ‘no’, in writing, that there were 4 other ‘yes’ votes. … [T]his is a great example of how the criteria process is NOT supposed to work. Being out-voted is one thing (and a good thing, in my view), but being out-voted by mystery voters with no ‘logic trail’ to refer to is another. ... Again, this is exactly the kind of backroom decision-making that leads to inconsistent criteria, confused analysts, and pissed-off clients.” 1144 1143 5/8/2007 instant message exchange between Shannon Mooney and Andrew Loken, Hearing Exhibit 4/23-30b. 1144 5/12/2005 email from Michael Drexler to Kenneth Cheng and others, Hearing Exhibit 4/23-10c. In a similar email, S&P employees discuss questionable and inconsistent application of criteria. 8/7/2007 email from Andrew Loken to Shannon Mooney, Hearing Exhibit 4/23-96a (“Back in May, the deal had 2 assets default, which caused it to fail. We tried some things, and it never passed anything I ran. Next thing I know, I’m told that because it had CHRG-110shrg50418--214 Chairman Dodd," Senator Corker? You sure you don't want to move up a little bit? You are so far away. Senator Corker. I couldn't abandon my friend the cameraman here. [Laughter.] Senator Corker. Mr. Chairman, thank you for this great hearing. I appreciate all of you being here and understand the tremendous problems this is creating in all of our States. We have one of our most respected business people here tonight. That is one of your dealers who has 300 employees, and we understand about all the many workers and much employment. So I do have some tough questions, but I want you to know I do understand the turmoil that this is creating throughout our country. We have talked a lot about the TARP program and we talked about the fact that we were willing to, quote, ``bailout'' the financial institutions. But one of the things that is occurring in the TARP program that is not happening here is that the OCC that regulates these banks, or the FDIC if that is the case, has to certify to Treasury that these are strong institutions and they actually make recommendations to Treasury as to which institutions are the strong banks, the good banks, and should succeed. I find it really interesting that we, quote, have the big three here, if you will, because I know that all three of you are in different circumstances, and my sense is if the OCC was performing the same ordeal, if you will, on you all, some of you would not be recommended to get credit. My sense is that Ford has done a better job and is in a slightly stronger position, that GM has made some changes but is spiraling downward and in serious trouble, and my sense is, and I could be wrong, I know it is a private company and results aren't available, but that Chrysler just barely has a heartbeat. So I do wonder why we are talking to three companies in very different situations about all being treated the same way. It seems to me that that premise to begin with is very flawed. Now, obviously you all have created a pact. You wouldn't share with Senator Menendez how much each of you have asked. I know that one of you shared with us that you have given those numbers to Levin. But I would like to know exactly what each of you has asked for, and I think that is only fair, and I think dancing around that is incorrect. And then I would like Mr. Gettelfinger, if he would, since he says he went in and looked at these companies, to tell us which of these three should survive and which shouldn't. But I would like to have the numbers first. " CHRG-111hhrg56241--35 Mr. Bebchuk," Chairman Frank, Ranking Member Bachus, and distinguished members of the committee, thank you very much for inviting me to testify here today. I would like to devote my introductory comments to making four points. First, there is a growing acceptance, including among business leaders, that compensation structures have provided perverse incentives. They have encouraged financial executives to seek to improve short-term results even at the expense of an elevated risk of an implosion later on. Let me illustrate this problem with the example of Bear Stearns and Lehman Brothers, the two investment banks that melted down in 2008. Many commentators have assumed that the executives of these firms sold their own compensation, their own wealth wiped out together with the firms', and then inferred from this assumed fact that the firms' risk-taking could not have been motivated by perverse incentives created by pay arrangements. In a recent paper, my coauthors and I did a case study of compensation at those two firms between 2000 and 2008, and we find that this assumed effect is incorrect. We estimate that the top five executive teams of Bear Stearns and Lehman Brothers derived cash flows of about $1.4 billion and $1 billion, respectively, from cash bonuses and equity sales during 2000 to 2008, and these cash flows substantially exceeded the value of the executives' initial holdings in the beginning of the period. As a result, unlike what happened with the long-term shareholders, the executive net payouts for 2000 to 2008 were decidedly positive. The second point I would like to make is that we cannot rely solely on existing governance arrangements to produce the necessary reforms. To be sure, some firms have announced reforms of the compensation structures. For example, they indicated that bonuses would be subject to clawbacks. But firms have generally not provided information that would enable outsiders to determine whether the clawbacks would be meaningful and affect behavior or would be merely cosmetic. This is an area where the devil is in the details. Because the changes that firms adopt appear to be at least partly motivated by desire to appear responsive to outside criticism, there is a basis for concern that arrangements with details that are not disclosed might not be sufficiently effective. What else should be done? The point I would like to stress is to improve arrangements, pay arrangements in particular, in governance more generally. We have to strengthen shareholder rights. In addition to introducing say on pay votes, which H.R. 3269 would do, there are other things that need to be done to bring shareholder rights to the same level as the shareholders in the U.K. and other English-speaking countries enjoy. In particular, the following aspects of their existing state first deserves the Commission's attention. Many publicly traded firms still do not have majority voting. Shareholders still like the power to place director candidates under corporate bylaws. Many privately traded funds still have staggered boards, and many such firms have supermajority requirements that make it difficult for shareholders to change governance arrangements. Finally, in addition to strengthening shareholder rights, it remains important to have regulatory supervision of pay structures in financial firms, as the provisions of H.R. 3269 would require. Opponents of regulatory intervention argue that such regulatory supervision would drive a talent away. However, the regulation under consideration focuses on structure, not on pay levels, and firms would still be able to offer packages that are sufficiently attractive in terms of pay levels. One of the established insights in economics is that it is never efficient to compensate agents using perverse incentives; in the financial sector, an especially important context to apply this established insight. Thank you. [The prepared statement of Professor Bebchuk can be found on page 45 of the appendix.] " FOMC20080130meeting--294 292,MR. FISHER.," Well, Mr. Chairman, I've seen the discount rate tally. I've listened carefully to all my fellow Presidents and to Governor Kohn. I suspect I know what your fellow Governors are going to recommend. I'm in a distinct minority at this table. This weekend, by the way, I searched the newspapers for something to read that didn't have anything to do with either a rogue French trader or market volatility or what the great second guessers were blabbing forth at the chat show in Davos; and in doing so I happened upon a delightful article. I hope you saw it in the Saturday New York Times on the search for a motto that captures the essence of Britain. My favorite was nemo ne inclune lacet, which very loosely translated, I think, means ""never sit on a thistle."" [Laughter] Well, that's where I am. I'm going to risk sitting on the thistle of opprobrium for my respective colleagues by making the recommendation that we not change the funds rate and that we stay right where we are. Now, for the record, I would have supported last week's 75 basis point cut for the reasons that it would put us ahead of the curve and bought adequate insurance against a recession. I told you that directly, Mr. Chairman, and I mentioned it to Governor Kohn as well. Judging by the policy rules on page 21 of the Bluebook, as well as by the adjusted rule that our economist Evan Koenig has developed in Dallas, we are, indeed, ahead of the curve from the Taylor rule standpoint as we meet today with the rate of 3.50. As was mentioned earlier, we have not been docile. We have cut rates 175 basis points in a matter of months, and we've taken some new initiatives that I think are constructive and useful. I'd like to see more along the lines of the TAF. To be sure, in the discussion that we had in that emergency meeting, I had the same concerns that President Hoenig expressed in the call, but with the wording change that was put forward by Governor Kroszner I ended up where President Hoenig did. I regret not voicing my discomfort with the penultimate sentence in the statement--the one dealing with appreciable downside risk after the move we took--as I felt that it undercut the potential effect of our decision. During that call, you may recall that I pointed out the pros and cons. I began my intervention on that call by saying that there's a very fine line between getting ahead of the curve and creating a sense of panic. I also expressed concern of the need to be mindful of inflation, as many have at this table today. There are some critics who say we panicked in response to the market sell-off of that Monday. I do not believe that's the case, and I don't believe it's the case because I find it impossible to believe. As I've said repeatedly in this room, other than in theory, markets are not efficient, and on the banks of the Hudson or the Thames or the Yangtze River, you cannot in practice satisfy the stock market or most other markets, including the fed funds futures market, in the middle of a mood swing. When the market is in the depressive phase of what President Lockhart referred to as a bipolar disorder, crafting policy to satisfy it is like feeding Jabba the Hutt--doing so is fruitless, if not dangerous, because it simply will insist upon more. But attempting to address the pathology of the underlying economy is necessary and righteous, and that's what we do for a living, and I think we are best sticking with it. We're talking about the fed funds rate. I liken the fed funds rate to a good single malt whiskey--it takes time to have its ameliorative or stimulative effect. [Laughter] But I'm also mindful of psychology, and that's what I want to devote the remainder of my comment to, and then I'll shut up. My CEO contacts tell me that we're very close to the ""creating panic"" line. They wonder if we know something that they do not know, and the result is, in the words of the CEO of AT&T, Randall Stephenson, ""You guys are talking us into a recession."" To hedge against that risk is something to them unforeseen, even after they avail themselves of the most sophisticated analysis that money can buy. CEOs are, indeed, doing what one might expect. They are tightening the ship. They're cutting head counts to lower levels. They're paring back capex where they can beyond the levels they would otherwise consider appropriate after imputing dire assumptions of the effects of housing. I'm going to quote Tim Eller, whom I consider the most experienced and erudite of the big homebuilders, which is Centex, who told me, ""We had just begun to feel that we were getting somewhat close to at least a sandy bottom. Then you cut 75 basis points and add `appreciable downside risks to economic growth remain' in your statement, and it scares the `beep' out of us."" He didn't use the word ""beep."" These are his words, not mine. Imagine scaring a homebuilder already living in hell. The CEOs and CFOs I speak to from Disney to Wal-Mart, to UPS, to Texas Instruments, Cisco, Burlington Northern, Southwest Airlines, Comerica, Frost Bank, even the CEO of the felicitously named Happy State Bank in Texas, repeated this refrain, ""You must see something that we simply do not see through our own business eyes."" They do see a slowdown. They are worried about the pratfall, as I like to call it, of housing. They're well aware of California's and Florida's economic implosion and broader hits to consumer welfare across the national map. I recited some data points from those calls yesterday. But they do not see us falling off the table. They worry aloud that by our words and deeds we are inciting the very economic outcome we seek to cut off at the pass by inducing them to further cut costs, defer cap-ex, and take other actions to hedge against risk. They can't fathom it but assume that we can. Our Beige Book contacts and the respondents to the business outlook survey in Dallas say pretty much the same thing. One of those actions is to fatten margins by passing on input costs. Now, I mentioned the rail adjustment factor yesterday, and I'm troubled by the comment that I quoted yesterday from the CEO of Tyson Foods. ""We have no choice but to raise prices substantially."" I mentioned that Frito-Lay has upped its price increase target for '08 to 7 percent from 3 percent. Kimberly-Clark notes that it is finding no resistance at all to increasing prices in both its retail and institutional markets, and I mentioned that Wal-Mart's leaders confirm that, after years of using their price leadership power to deflate or disinflate the price of basic necessities-- think about this--from food to shoes to diapers, they plan in 2008 to apply that price leadership to accommodate price increases for 127 million weekly customers. This can't help but influence inflation expectations among consumers. I experienced a different kind of price shock two weekends ago, when I went to buy a television so I could watch President Rosengren's football team demolish President Yellen's. [Laughter] I was told that they had doubled their delivery and installation fees because of a ""fuel surcharge."" Well, I reminded the store clerk that I had been there about the time of the Army-Navy game, around Thanksgiving, and that gas prices had not doubled since the Army-Navy game, and he said, ""Mr. Fisher, we're selling less, and we will take what we can get away with however we can get away with it."" With one-year-forward consumer expectations, according to the Michigan survey, already above 3 percent, everyone from Exxon to Valero to Hunt Oil and our own economists in the Greenbook telling me that oil is likely to stay above $80, and the national average price therefore above $3, this mindset really worries me. I'm going to add one more very troubling little personal anecdote. Driving home from work last week I heard a commercial for Steinway pianos. The essence of the advertisement was that manufacturing costs had increased and that you could buy a piano out of their current inventory at the ""old price"" that was in place in 2007; but come February 1, there would be sizable price increases, so you'd better purchase your piano quickly. It has been thirty years since I have seen advertisements to go out and buy now before the big expected price increases go into effect. Now, this is an isolated, little bitty incident, but I fear this may be just the beginning of the more pervasive use of this tactic. Everyone in this room knows how agnostic I am about the predictive value of TIPS and the futures instruments comparing TIPS with nominals, like the five-year, five-year-forward. I've sent around an eye popping chart that shows the predictive deficiencies of the professional forecasters that were tracked by the Philadelphia Fed. I know that dealers are telling us that inflation is contained, but I have spent many years in the canyons of Wall Street, and I would caution against their disinterest in the predictions that they offer. When I see that every measure of inflation has turned up, learn from studying the entrails of the last PCE that 83 percent of the items therein experienced a price upswing, consider the shortcomings of the few tools we have for evaluating expectations of future inflation, and then hear from microeconomic operators of the economy that, by golly, we're going to take what we can while the getting is good, I can't help but feel that we cannot afford to let our guard down by becoming more accommodative than we have already become with our latest move. Mr. Chairman, you know because we've talked about this that I've anguished over this. In fact, to be politically incorrect in a government institution, I have prayed over it. It is not easy to go against the will of the people you have enormous respect for, but I have an honest difference of opinion. I truly believe we have it right at 3� percent right now. I think that, even with some important language changes, we risk too much by cutting 50 basis points at this juncture and driving the real rate further into what I perceive, even on an expectations-adjusted basis, is getting very close to negative territory. Mr. Chairman, I think we've gone as far as is prudent for now, and that 3� percent, together with the other initiatives we've taken to restore liquidity, is sufficient. So I ask for your forbearance in letting me sit on the thistle of recommending no change. I do want to say as far as the language is concerned, since obviously we're going to go with alternative B despite my vote against it, that I strongly recommend you consider the changes that were given by Presidents Plosser, Yellen, and Poole, and I would strongly advocate particularly at the end adding that we will act as needed to foster price stability and sustainable economic growth. I thank you for paring back alternative B, paragraph 3, in terms of getting away from discussing only energy, commodity, and other import prices. Thank you, Mr. Chairman. " CHRG-111hhrg58044--8 Mr. Price," Thank you, Mr. Chairman. Mr. Chairman, if the past 2 years have taught us anything, it is that risk is unavoidable and ever present. In order for the economy to work, businesses must be able to price their products for the risk that they incur. Risk-based pricing is especially important when trying to determine the reliability of the insured and the exposure of job creators. Credit-based insurance scores have proven to be the most predictive factor in determining the likelihood of a consumer filing a claim. This risk model enables insurers to more accurately underwrite and price for risk, and when this is done well, everyone wins. Democrats want you to believe that everyone should not be judged by their past actions. However, it is the American way to pull one's self up by working hard and making responsible decisions. What makes risk-based pricing and insurance scores important is the ability for people to improve their scores and lower their rates by paying their bills on time and taking responsibility for their financial decisions. What would happen if there was no risk pricing? Everyone would get the same price regardless of how much an insurer has to pay to cover a claim. This would result in significant and dramatic increases in rates to virtually all Americans, less credit available, more expensive credit, and more job destruction. This is clearly not the most wise avenue. I look forward to the testimony and hopefully our response in wisdom. I yield back. " FOMC20080318meeting--93 91,MR. MISHKIN.," Wouldn't you like to know! I believe that actually the Greenbook forecast of a mild recession is reasonable, but the possibility that we could have a severe recession is uncomfortably high, and I find the prospect pretty scary. The reality is that we are in this adverse feedback loop that I and others talked about. I think we're deep into it. The credit markets have been deteriorating. That's led to a sharp weakening of the economy's prospects. This is reflected in the very large change in the Greenbook forecast, with which I do strongly concur, so I don't think that it was out of line to put those in. Of course, that weakening has been feeding back to deteriorating financial conditions. So I think we're really in a tough pickle, and there are costs not just in terms of the economy. One result is that we've just expanded the safety net to a much wider set of institutions, and we are in a brave new world here, and it is very disturbing. So the ramifications in terms of the economy weakening and the adverse feedback loop go beyond just the fact that we might have unemployment. It may have major effects on the way markets work in the future, and that, I think, is something that we should be worried about and should be a consideration as well. The bottom line on real activity for me is that the prospects are very poor, and I find the downside risk just plain scary. That's the first part of my depression. The second part of the depression is that it's bad enough that we had these contractionary aggregate demand shocks from the financial sector, but we also have had very negative supply shocks that are both contractionary and inflationary. So we are getting hit by the double whammy. The news on inflation has generally not been good, even with the recent CPI numbers. But then, of course, they are reversed by the PPI numbers today. I don't put that much weight on the actual current numbers because, as you know, I take a view that the primary drivers of inflation and inflation dynamics are inflation expectations and expectations about future output gaps. So that's the framework in which I'd like to discuss what will happen on the inflation front. We have two problems in terms of inflation expectations right now. One is the supply shock, which I think is having some effects on inflation expectations, and also the view--although I believe it's incorrect, I do think that there's a problem that this view is widely held outside, and President Plosser mentioned this--that we on the FOMC are focused only on growth and are not at all worried about inflation. This is a communication issue that is hard to deal with because, even though I've been advocating being more aggressive in terms of easing, I do worry very much about the issue that we also have to indicate that, if necessary, we'll get out the baseball bat to keep inflation under control. That is not an easy thing to do. So when I look at inflation expectations, which I consider to be a key driver of inflation, I think that the evidence in the data is that we have had not a big increase but a slight increase in inflation expectations, on the order of about 10 basis points. There's a lot of uncertainty about that; it could be a little more than that, but I don't think a whole lot more. Also disturbing is that we certainly have had a big increase in long-run inflation uncertainty. That's reflected not only in terms of inflation compensation but also in the fact that people are buying inflation caps, TIPS are becoming very popular, and so forth and so on. In fact, one of the negative things that happened to me as a result of taking this job is that I had my entire TIAA-CREF in TIPS and unfortunately I had to divest all of it because they are government securities, and that turned out to be bad. But that's only one of the minor costs of being in this position. [Laughter] The issue here is that, although I don't think that inflation expectations have gotten unhinged at this point--and I think that we can say that the phrase ""reasonably well contained"" is okay--there is a greater risk that they could get unhinged. Now, I want to be clear. I'm not talking about the 1970s. It's not ""That '70s Show."" I have not been particularly happy with Allan Meltzer's comments about a bunch of things. The issue here is not that inflation expectations would go to that kind of level, but it could be that inflation expectations go up to 2� or maybe even a little higher and it would be costly to get that down. That's the concern we have to worry about. But let me talk about the other side because, when I think about the inflation dynamics, it's not just inflation expectations. I do not believe in the deus ex machina view of the inflation process. Something has to tie things down, and what ties it down is not current output gaps--which is why I think the standard Phillips curves don't predict very well--but expectations about future output gaps. On that score, I worry that there could be a lot of downside risk to inflation from that. If really bad things happen, which I think unfortunately is a seriously possibility, inflation could fall. A key fact, by the way, is that if you look at past recessions, you do find that inflation falls in the 12 months after recessions. In a couple of cases with supply shocks, there was a rise in inflation at the beginning of the recessions. Seven out of eight are in that category. Particularly if it's a severe recession, it's much more likely for inflation to fall. So it's not true that there's just upside risk; there is downside risk as well, and that's one reason that inflation uncertainty is not an issue just of potential upside. In fact, in the 2003 episode that President Lacker mentioned, the reason there was such a sharp rise in inflation compensation was not that people worried about inflation going up but that they worried that inflation would go down. Nonetheless, there's still a cost to the fact that longrun inflation expectations are not as solidly grounded as they were before. So my view in general is that we are facing an incredibly unpleasant tradeoff. We basically have the risk of the economy turning very sharply and the risk of inflation getting somewhat unhinged. I want to discuss that later. I wasn't going to discuss this, but I just really can't not react to the comments that you made, President Fisher. There's a view out there in the media that monetary policy has been ineffective. This was the statement that I think you made, and I think it is just plain wrong. So I want to discuss it because it's actually really important in thinking about a policy stance right now, and it's important to think about the economics of this. We have had a very nasty set of contractionary shocks from the financial sector, particularly the widening of credit spreads and the restriction of credit. So I want us to think about a counterfactual. Let's think about a situation in which we had what's happened and we did not lower interest rates. What would have been the outcome? Do you think that credit spreads would have lowered? I think credit spreads would have risen. In fact, when you think about what credit spreads are being driven by--I've argued this before--there's a valuation risk--the fact that we can't value assets, and that's this price discovery problem that we really can't do that much about. But there is also a macroeconomic risk, which is a lot of what's going on right now, particularly in terms of the housing market where people don't know where housing prices are going to bottom out. The view that they may keep on going down--and we had a very negative number on housing prices recently--means that even the AAA tranches now look as though they're very vulnerable, and therefore, the credit spreads on them go up a whole lot. My view is that monetary policy has been very effective because things would be much, much worse if we hadn't eased. On the other hand, we just had an incredibly nasty set of shocks as a result of what you described were the problems in these sectors. So I really think that this is very important. To finish up on this, the example of Japan is constructive because the Bank of Japan had a view very similar to the one that you've expressed, which is that they had all these problems in the banking sector, and the problems were not their fault. But they then took the view that they couldn't do anything about it. Monetary policy was not the source of the weak economy, so they were very slow to lower interest rates. The Chairman has talked about this. Every monetary economist who went to the Bank of Japan during this period--I did it when I was with the New York Fed in the mid-1990s--told them that their monetary policy was too tight. They basically said, ""Well, you know, it's not too tight, and it's not our fault that the banks are all screwed up because of poor regulation."" Well, the result was they ended up with deflation, and they lost ten years of growth. I'm being a little more blunt than usual, but I think that the economic arguments here are actually central in our discussion. " FOMC20070321meeting--15 13,MR. DUDLEY.," The distinction I’d make between fundamentals and risk reduction is that the latter occurs when people adjust their portfolios not because they change their view about the quality of a particular asset but because they are reducing the amount of risk exposure to the market that they want to have. So when you have a big event like February 27, obviously volatility goes up, and so value at risk goes up, and you may decide to reduce your risk. So you’re going to sell all sorts of things, and the prices of those things you sell will go down regardless of whether you’ve actually changed your opinion about them in any meaningful way. Why did corn prices on February 27 fall 2 percent? It was probably because corn prices had been in a big bull market, people had risk positions in corn, and so they wanted to get out of those positions." CHRG-111hhrg58044--74 Mr. McRaith," Congressman, we should always be concerned about unintended consequences and certainly the pricing of one risk in a company's pool affects the pricing of another risk in that same pool. However, we should not accept as gospel that 60 percent of people benefit from the use of credit-based insurance scores because we do not know what the baseline is. " CHRG-110hhrg41184--99 Mr. Bernanke," That is an excellent question. Part of what has been happening, Congressman, is that risk perhaps got underpriced over the last few years, and we have seen a reaction where risk is being now priced at a high price. It's hard to say whether the change is fully appropriate or not. Certainly part of the recent change we have seen is a movement towards a more appropriate, more sustainable, pricing of risk. But in addition, we are now also seeing concerns about liquidity, about valuation, about the state of the economy, which are raising credit spreads above the normal longer-term level, and those increased spreads and the potential restraint on credit are a concern for economic growth. And we're looking at that very carefully. " FOMC20050630meeting--119 117,MR. WILLIAMS.," I think that the Greenbook forecast, as I understand it—and maybe Dave June 29-30, 2005 43 of 234 prices and takes into account the kind of models that Josh was discussing. The staff looks at all the empirical evidence, just as they do for every equation on every aspect of the economy. So, monetary theory would tell you to come up with the best, most reasonable forecast and adopt a policy that is appropriate to that path but also consider, as you’re saying, all the risks and the distribution of the risks. It’s along the lines of some of the charts in the Greenbook, which show the distribution of risks and then contemplate the implications for the current set of policy options over that distribution of risks. I think the basic idea in the economic literature is that you first want to get a very reasonable path, and that would be more or less your baseline. It’s not a path, I should say, that just keeps housing prices constant or keeps any asset price constant. It should be the best forecast of these asset prices that you can come up with, but subject, of course, to the fact that these are very hard to predict." CHRG-110hhrg46591--163 Mr. Price," Dr. Stiglitz, private risk-taking? " CHRG-111hhrg52397--146 Mr. Price," Do you know what other governments are doing to determine their systemic risk in the derivatives market or act upon their systemic risk in the derivatives market? " CHRG-111hhrg51592--161 Mr. Joynt," Yes. We would take all market inputs, prices, CDS spreads, anything into account when trying to think about the risks that we analyzed. Individual analysts would receive market price information and spreads. Our central credit policy group would monitor CDS prices, and in fact go back to analysts and individual groups and say, ``Have you thought about and seen what's happening with these prices?'' So I would say we're aware of, it's an important factor, it's an influence, and just to respond to what you originally suggested, we see value in market prices for investors to reflect and think about the risk. I believe those are more volatile than fundamental analysis. They are influenced by market events, volatility, liquidity. And so I think they are complementary. So yes, we use them to help think about the fundamental analysis, as well. " FOMC20080310confcall--13 11,CHAIRMAN BERNANKE.," We would not be setting a price floor for the asset, but we would be trying to reduce the liquidity premium. If there were further deterioration in price associated with the credit risk, that would still show through. " CHRG-111hhrg53238--113 Mr. Zywicki," Sure. I think you point out more generally the fundamental problem here is that there are all kinds of tradeoffs. There are tradeoffs between the particular terms and the price of loans, between--as I talked about--prepayment penalties. Consumers pay an extra 100 to 150 basis points to get a fixed-rate mortgage. All these sorts of tradeoffs to think about price versus terms, accessibility versus risk, all the different sorts of things you are talking about are invariably and inevitably going to turn into political questions where there is no obvious answer. And it is precisely these sorts of tradeoffs between risk and price, for instance, why we have eschewed government central planning and dictating of credit terms in the past, because there is no right answer to these questions and they run the risk of being politicized. " fcic_final_report_full--376 Meanwhile, in the absence of a liquid derivatives market and efficient price dis- covery, every firm’s risk management became more expensive and difficult. The usual hedging mechanisms were impaired. An investor that wanted to trade at a loss to get out of a losing position might not find a buyer, and those that needed hedges would find them more expensive or unavailable. Several measures revealed the lack of liquidity in derivatives markets. First, the number of outstanding contracts in a broad range of OTC derivatives sharply de- clined. Since its deregulation by federal statute in December , this market had increased more than sevenfold. From June ,  to the end of the year, however, outstanding notional amounts of OTC derivatives fell by more than . This de- cline defied historical precedent. It was the first significant contraction in the market over a six-month period since the Bank for International Settlements began keeping statistics in .  Moreover, it occurred during a period of great volatility in the fi- nancial markets. At such a time, firms usually turn to the derivatives market to hedge their increased risks—but now they fled the market. The lack of liquidity in derivatives markets was also signaled by the higher prices charged by OTC derivatives dealers to enter into contracts. Dealers bear additional risks when markets are illiquid, and they pass the cost of those risks on to market participants. The cost is evident in the increased “bid-ask spread”—the difference be- tween the price at which dealers were willing to buy contracts (the bid price) and the price at which they were willing to sell them (the ask price). As markets became less liquid during the crisis, dealers worried that they might be saddled with unwanted exposure. As a result, they began charging more to sell contracts (raising their ask price), and the spread rose. In addition, they offered less to buy contracts (lowered their bid price), because they feared involvement with uncreditworthy counterpar- ties. The increase in the spread in these contracts meant that the cost to a firm of hedging its exposure to the potential default of a loan or of another firm also in- creased. The cost of risk management rose just when the risks themselves had risen. Meanwhile, outstanding credit derivatives contracted by  between December , when they reached their height of . trillion in notional amount, and the latest figures as of June , when they had fallen to . trillion.  CHRG-111hhrg58044--18 Mr. Garrett," I thank the chairman, and I thank the ranking member, and I thank the members of the panel who are here. Credit information has obviously become an essential and valuable tool in allowing various market participants to more accurately price for the risk. One of the areas we are examining today is how this information is used by property casualty insurance companies in determining the premiums they charge to their clients. There have been numerous actuarial reports that have studied this. By using consumer-based insurance or CBIS, in determining premium rates for P&C lines, insurance companies are basically more able to accurately price for the risk of the consumer and the rates have significantly decreased for a broad majority of the policyholders. Credit scores are really just one of a number of different data points that insurers consider when determining a consumer's premium. If we were to now limit or restrict certain types of information from being used to allow insurers to more accurately price for risk, two things are going to happen: One, more people will pay higher premiums; and two, fewer people will be able to purchase insurance. Neither of these things are good. In the wake of the recent financial crisis, instead of looking for ways to decrease credit availability and the accurate pricing of risk, I believe Congress should be considering policies that will help expand credit for consumers and small businesses and lower the cost of credit and insurance premiums for the majority of Americans. With our current unemployment rate around 10 percent, we really must work on initiatives to expand economic opportunities for all Americans, not ways for the government to micro-manage our Nation's small businesses and risk trying to restrict the aggregate price of risk. With that, I yield back the balance of my time. " FOMC20060920meeting--101 99,MR. STOCKTON.," The answer to that is “yes,” and I think there is some risk. One feature of our forecast is the fact that we are not projecting large declines nationwide in house prices. We are expecting a deceleration but not any outright declines. One could imagine that more of the adjustment could take place more quickly by a big drop in house prices that in some sense clears out that inventory through higher sales and maybe less production adjustment. On that side, you would probably get a quicker housing cycle than the one that we are projecting. However, it also brings with it some downside risk in that households would realize how much their net worth had fallen, which could have consequences for consumption both directly through the wealth effect and perhaps through sentiment. That correction could be quicker and maybe deeper, but then the rebound could be faster. That is a risk we have certainly contemplated. We were a little nervous about being too adventuresome on the house-price forecasting. We are not very good at forecasting asset values, we never understood how prices got as far out of alignment as we think they are, and we are not sure exactly what the process of correction is going to look like. So we have taken a middle stance between two models: one model that basically forecasts house prices off pure momentum and another one that takes seriously the analytical apparatus, which we showed you a year and a half ago at our special briefing on housing, that looks at the error-correction process of house prices to rents. The latter model actually does forecast outright declines nationwide in house prices by 2008. We are between a momentum model, which expects house prices to slow less than we are forecasting, and this error-correction model, which shows bigger declines." CHRG-110hhrg46596--223 Mr. Kashkari," Well, ultimately, it is the credit cards, and ultimately it is the borrowers who owe on the credit cards, or on auto loans. Similarly, these are consumer credit vehicles to start with. But what the Federal Reserve and Treasury are focused on is these are historically very low credit risk. They are not being priced where they are today because of credit risk; they are being priced where they are today because of illiquidity in the system. " CHRG-109shrg21981--205 RESPONSE TO A WRITTEN QUESTION OF SENATOR BENNETT FROM ALAN GREENSPANQ.1. In 2002, the Home Mortgage Disclosure Act (HMDA) regulations were revised to allow for additional data collection from the lending industry. On March 1, 2005, banks and other covered lenders will be required to submit data to the Federal Reserve that will include more loan-pricing data and new ethnicity data. Concerns have been raised that this new HMDA data, if taken out of context, might allow for misinterpretation. Can you explain what the intent of the new HMDA data is, the context of the data, and what some of the key limitations of that data are, that is, what the data might show and might not show?A.1. The new public disclosure of price information under HMDA is intended to ensure that the HMDA data set continues to be a useful tool to improve market efficiency and legal compliance with the fair lending laws. Since HMDA was last amended by the Congress, technological advances have made it possible for lenders to more accurately gauge credit risk. Lenders will lend to higher-risk individuals whom they previously would have denied credit, albeit at higher prices commensurate with the higher risk. Broader access to credit has been a largely positive development, expanding opportunities for homeownership and allowing previously credit-constrained individuals to tap the equity in their homes. However, expansion of the higher-priced lending market also has been associated with concerns about the fairness of pricing in the market. The price data newly required to be disclosed under HMDA can be used as a screen that identifies aspects of the higher-priced end of the mortgage market that warrant a closer look. Conclusive judgments about the fairness of pricing, however, must consider all of the legitimate factors that underlie pricing decisions, including risk-related factors. Risk-related factors include measures such as the borrower's credit history and debt-to-income ratio, and the loan-to-value ratio of the specific transaction. The expanded HMDA data do not include these factors, or many others that are potentially relevant to a pricing decision. Absent information about all relevant pricing factors, one cannot draw definitive conclusions about whether particular lenders discriminate unlawfully or take unfair advantage of consumers. Thus, any price disparities by race or ethnicity revealed in the HMDA data will not, by themselves, prove unlawful discrimination. Such disparities will, however, need closer scrutiny. In the case of depository institutions, for example, that scrutiny will be supplied by bank examiners, who will have access to information about all of the relevant variables. FOMC20070807meeting--158 156,CHAIRMAN BERNANKE.," Oh, I see what you’re saying. Well, actually the way I phrased it was intentionally not to say that risks have increased but rather to say that the price of risk has increased." CHRG-111hhrg52397--144 Mr. Price," And in that risk to American business, you believe that would drive businesses overseas? " CHRG-110hhrg41184--82 Mr. Castle," So Reg Z may be closer to the World Series, or something of that nature? Would that be a correct statement? Well, I think it's a matter of some concern to us. I hope you understand as your people go about their work, and they have to do their work correctly, how important that it that we have that in order to formulate legislation or determine where we are on legislation. Along those lines, let me ask you another question. In July of 2003, your predecessor, Chairman Greenspan, sent me a letter, which I will submit for the record, expressing deep skepticism about legislators' attempts to limit creditors' use of information regarding borrowers' payment performance with other creditors when pricing risk. Risk-based pricing, as this practice is commonly called, lowers the price of credit for some and provides access to otherwise unavailable credit to many. Mr. Chairman, do you share Mr. Greenspan's view of that? I quote from the letter, ``Restrictions on the use of information about certain inquiries or restrictions not considering the experience of consumers in using their credit accounts will likely increase overall risk in the credit system, potentially leading to higher levels of default and higher prices for consumers?'' " CHRG-111hhrg58044--160 Mr. McRaith," I would add, Congressman, that the companies pursued the profitable risks, and if in fact credit-based insurance scores identify prospectively less profitable risks, the pricing might be geared towards reducing the likelihood of that less profitable risk from enrolling with that company. " CHRG-111hhrg58044--201 Mr. Snyder," I think it is very important. I think the use of credit-based insurance scores in the personal lines of insurance has proven to be very important for the market. It has allowed a degree of objective and individually tailored decision making that more accurately assesses risk than was possible before. The risk assessment is good in and of itself because how else would you price an insurance product but to reflect the risk within that product, and the danger of moving away from that, I think we have seen perhaps too much of in other sectors. Secondly, it has had an overall positive availability impact on the market for personal lines. That would be true if you are an individual. In commercial lines, credit information has long been used because everyone understands that one of the first things that is reduced is maintenance of critical equipment and other things like that, and that leads to safety issues, which in turn leads to increased insurance risks. I think it is important up and down the line in terms of assessing for risk and then pricing for risk. " FOMC20081216meeting--459 457,CHAIRMAN BERNANKE.," There is an ongoing discussion about whether prices in markets are in some sense Pareto optimal prices or whether there is liquidity risk, other premiums, that the central bank could do something about. I don't know any way to resolve it. We have the same discussion each time. President Hoenig. " CHRG-111hhrg51698--369 Mr. Short," If I could add one point, the whole issue arises because there is a limit in the amount that a price can move in the cotton contract, and the situation that was faced by the exchange was we hit the limit and the OTC market and options markets were indicating that the real price was going well above that limit. From the standpoint of properly margining positions in the clearinghouse, we have to protect all market participants. We used the synthetic price indicated by the options price rather than where the futures price cut off. From our perspective we were trying to do what was right from the standpoint of risk management. " CHRG-111hhrg56241--61 Mr. Kanjorski," Thank you, Mr. Chairman. I will just open up first with some remarks to the panel, and I appreciate your opinions when I get to conclude. Very often, I have had the occasion over the last 6 to 9 months to make a speech in my district because I am trying to reach constituents to understand the overall complex problem of salaries and wages. Now, as a given factor in my congressional district in Pennsylvania, the average wage is about $13 an hour. And if you multiply that times 2,000 working hours a year, that comes to an annual income of, on average, $26,000. In the last 9 months or a year, I have had several witnesses who have appeared before my subcommittee, and we have gotten to this question of salary and compensation, and what we do about it. I, for one, am not certain that we put enough direct attention to the matter, and could get into difficulty if we start deciding that we are the final arbiter of what a fair salary is, because quite frankly, I will confess, I don't know. If hiring a brain surgeon, I guess, and I need brain surgery, there is no amount too excessive until after the success of the operation. Then I will be annoyed, whatever the bill. The reality is--that is not the topic of our discussion today--but in the hedge fund industry, they report--I remember one witness who was a little annoyed involving a cross examination: What did he make and what is his relationship? He earned about $2.5 billion a year, and I pressed him because I was offended that he only paid a tax rate of 15 percent because of the structure of his salary, putting him in capital gains as opposed to regular tax. After 15 or 20 minutes, with great annoyance, he finally put his hand in his pocket, leaned back and said, ``Congressman why are you picking on me? What did I do to you?'' I said, ``You did nothing; you happen to be a witness and I am trying to extract some information.'' He said, ``Well, I want you to know I am only the 51st highest-income person in this country.'' This astounded me. I thought we had located the highest-income person. I found out he actually was not and is not, and there are some who make a great deal more. I guess the first question that I would ask is, what is too much? What is too high? Is it $5 billion, or $50 billion? And now I pose that question, because we always use numbers, and I go back to my congressional district of $13 an hour wage. The gentleman who was testifying before me, his hourly wage is $1,300,000. That is what he makes every hour of the year. Now, when you do the mathematics of that, he makes 100,000 times the average wage of an average worker in my district. How do we get a sense? Regardless of what compensation we pass here or do on Fannie Mae, they are chickens; what do they get paid, $6 million a year? That is peanuts. I am wondering if we are approaching this from perhaps the incorrect direction. Should we be looking at, first of all, what do we need to get to a balanced budget? Because these people aren't just earning and taking corporate money or profits. These people are not picking up their burden in society in proportion to their income. And as a result now this year, we are ending up with a shortfall that we could make up if we didn't have these extraordinary ways of avoiding income. I am just wondering, should we approach this from changing the tax structure and perhaps get to a level field that way, as opposed to identifying particular people where we may be able to exercise power and those so that we cannot. And I am just curious. Let me throw that out there very quickly. " CHRG-111hhrg52397--312 Mr. Duffy," Congressman, it is important to have liquidity to get price information so you can do risk management and clearing. That normally comes from trading and then it goes into the clearinghouse once the price has been established, and then the risk management process goes on until that position is liquidated. I think that you can do some clearing without trading the product, but you need to have some relevant information from some of the providers that are out there today that are giving you price information as relates to this. There are margin requirements. There are twice daily mark-to-market requirements associated with clearing, so there are some things that are not a custom to the OTC world today that will burden additional costs but will also protect the taxpayer from additional liabilities like they had in the last several months. " FOMC20080430meeting--55 53,MR. STOCKTON.," Before explaining how the global developments that Nathan just described intersect with our domestic inflation forecast, I should briefly review some of the incoming information on prices. For the most part, the recent consumer price data have been running below our expectations. At the time of the March Greenbook, we were estimating that core PCE prices had increased at an annual rate of 2� percent in both the fourth quarter of last year and the first quarter of this year. We now are projecting increases of 2� percent and 2 percent in the fourth and first quarters, respectively. Although we are estimating that core PCE prices rose 0.2 percent in March--just a couple of basis points below our previous forecast--there were noticeable downward revisions to the data stretching back to late last year, principally for medical services and nonmarket prices. Just as we had discounted some of the earlier elevated increases in core PCE prices, we are now inclined to discount the recent more favorable readings. The small increases in medical service prices are not likely to persist. Moreover, some of the recent slowdown is attributable to nonmarket prices, which we view as both noisy and mean-reverting. Still, we don't think all of the good news on core PCE prices of late should be written off; and all else being equal, we would have taken down our forecast for the year as a whole in response to the incoming data. But, of course, all else was not equal. As Nathan has noted, there has been another sizable increase in crude oil prices; the prices of non-oil imports have increased more rapidly than we had expected; and more broadly, both imported and domestically produced materials prices have risen sharply thus far this year. In reaction, we have marked up our forecast for core PCE inflation for the remainder of the year, and that upward revision basically offsets the effects of the recent good news. For now, inflation this year looks likely to repeat the pattern of the past four years. Since 2004, headline PCE prices have risen at about 3 percent per year, and core prices have been up at a rate of about 2� percent. Due to a further steep rise in energy prices, large gains in import prices, and another above-trend increase in food prices, we are projecting headline PCE prices to rise 3� percent this year and core prices to increase 2� percent--similar to the averages over the preceding four years. Moreover, our forecast for 2009 bears a striking resemblance to the out-year forecasts that we have continued to make over the past four years. By now, in answer to the question of why inflation is expected to slow in the forecast, most of you could easily recite the staff's catechism of disinflation. Based on readings from the futures markets, we expect consumer energy prices to flatten out next year and food prices to slow to a rate close to core inflation. With the dollar not expected to fall as much as it has over the past year and other commodity prices expected to move sideways, import prices are projected to slow. Those more favorable developments in combination with a noticeable increase in projected slack cause headline inflation in 2009 to slow to 1� percent and core PCE inflation to edge back to 2 percent. Both of those figures are 0.1 percentage point higher than our March forecasts, reflecting the indirect effects of higher prices for energy and other imports. As we have noted many times, a key element in our projection is the assumption that oil and non-oil commodity prices will flatten out as suggested by the futures markets. To put it mildly, that has not been a winning forecast strategy in recent years, but I'm not sure that we have a superior one to offer you. Obviously, there are some big upside and downside risks to our forecast of domestic inflation. Nathan has already covered some of those related to prices for oil and other imports, so let me say a few words about the outlook for retail food prices. Our outlook for food prices remains relatively sanguine, but there would appear to be more pronounced risks to the upside than the downside. Although most of the value of what's in your morning cereal bowl is advertising, packaging, and transportation, some corn and wheat are in there also, [laughter] and those prices have been rising rapidly. Futures markets are predicting a leveling-out in crop prices, and that expectation is built into our forecast. But worldwide stocks of grains remain tight, and any serious shortfall in production could result in sharply higher prices. In that regard, while the growing season here is just getting under way, corn production is off to a slow start because unusually wet conditions have hampered plantings. Elsewhere, increasing supplies of livestock products and poultry have been a moderating influence on retail food prices in recent months. Again, while futures markets suggest relatively subdued prices going forward, there are a few worrying signs. Although cattle on feedlots have remained near record levels, new placements have fallen off of late, reportedly because of the higher cost of feed. In addition, the portion of feedlot placements composed of females was high last fall and through the winter, which points to a reduction in the size of the breeding herd this year and thus suggests some potential supply risks ahead. In recognition of the upside risks posed by both food and energy prices, we included in the Greenbook an alternative simulation in which oil prices climb to $150 per barrel next year and food prices continue to run at the elevated pace of the past three years. In this scenario, we also assume that another year of elevated headline inflation results in a further erosion of inflation expectations of about � percentage point. Under these conditions, headline PCE price inflation posts another year north of 3 percent, and core inflation moves a bit higher to 2� percent this year and next. It strikes me that this type of persistent upward creep to inflation, which would be difficult to positively identify in real time, is a more likely risk than a sudden upward surge in price inflation. There are, however, some downside risks to the inflation outlook as well. As you know, we upped our price forecast a bit in the last round because we saw the incoming readings on inflation expectations as suggesting that there had been some modest upward movement over the preceding few months. Some of that increase may have resulted from your aggressive easing of policy early this year. But going forward, the situation may be turned around. If our forecast over the next few quarters is in the right ballpark, and on our assumption that the easing of policy is coming to an end, you will be standing pat on policy even as payroll employment falls throughout the remainder of the year, the unemployment rate trends higher, and headline inflation begins to back down. It doesn't seem a stretch to me that in that environment, inflation expectations could come down somewhat, a development not embodied in the baseline forecast. More broadly, one place that inflation expectations might be expected to manifest themselves in a way that would be most damaging to inflation would be in labor compensation. Despite the elevated headline inflation of the past four years, there is little evidence of any noticeable step-up in wage inflation. If that was the case when the unemployment rate was 4� percent, it seems less likely that larger nominal wage gains will be secured when the unemployment rate rises to 5� percent. Indeed, increases in hourly labor compensation have been running well below our models for some time, pointing to some additional downside risks to our inflation outlook. For now, we see substantial risks to the inflation outlook, but those risks still seem twosided to us. Brian will complete our presentation. " CHRG-111hhrg56778--144 Mr. Royce," Let me ask you lastly, Mr. Greenlee, a question. If price controls were putting the solvency of a given insurance subsidiary at risk, would the Fed or the OTS have the authority to intervene and remove the price-fixing requirement on that subsidiary? " FOMC20080109confcall--24 22,MR. ROSENGREN.," Thank you, Mr. Chairman. My views are actually very consistent with your own. I would support lowering the fed funds rate 50 basis points, and, if it were up to me, I would support doing it right now. The employment report last Friday was weaker than I expected. In conjunction with the likelihood of several quarters of economic growth below potential, the risk that the economy is in, or could be going into, a recession is too high. Continued declines in housing prices and stock prices raise my concern that deteriorating household wealth will constrain consumption more than we anticipate. I am also worried that weaker labor markets are likely to exacerbate problems in the housing market. Should housing prices fall further and foreclosures rise more rapidly as a result of weak labor markets, financial markets may experience even more turmoil than we have experienced to date. Commodity and oil prices have risen, but I expect that the weakening in labor markets will be sufficient to restrain inflation. The downside risks to the economy are significant, and I think we should take aggressive action to mitigate that risk. Thank you. " FOMC20080130meeting--336 334,MR. PARKINSON.," Well, partly what I would say, in general, about the pricing of risk is that many, many people, including people in the Federal Reserve, were concerned about how narrow spreads were, were concerned about some of the slippage of practices, and were predicting that trouble lay ahead. But--and I'm certainly speaking for myself--I never expected this magnitude of trouble. What I've been focusing on are some of the factors that essentially made a bad situation much worse than we expected it to be. But there is no question that we entered the period with risk being priced very cheaply and a fundamental reassessment of risk. Again, I think that shouldn't have surprised anyone, but almost everyone except the most extreme pessimists has been surprised by just how much trouble that repricing of risk has caused. Some things that we have focused on certainly were not anticipated, and we think they made the situation markedly worse than we expected it to be. " CHRG-109hhrg31539--125 Mr. Bernanke," Well, Congressman, as you point out, there is uncertainty. We have a baseline forecast which assumes that energy prices don't do another big increase, that expectations remain contained, as they appear to be currently. We have talked about the cost side of labor costs, which seem not at this point to be a problem from a cost perspective. So from all that perspective, again, we have the baseline forecast that the inflation will gradually decline over the next couple of years. At the same time, we talk about risks, and we think there are some risks. The risk that I talk about in my testimony is that, given the tightening of markets, product markets in particular, that some firms may be better able to pass through those energy and commodity prices that you mention, and that that might become possibly embedded in the expectations of the public. So we do see some upside risks, and we have to take that into account as we make policy. " CHRG-109shrg26643--42 Chairman Shelby," Mr. Chairman, your testimony also notes the possibility of some risk which could add to inflationary pressures such as high energy prices feeding into the prices of nonenergy goods and services. Your testimony further notes the risk to our economy due to a slowing housing market you reference. What would be the impact on the economy if both of these effects materialize to a greater degree than is currently anticipated? How would the Federal Reserve be likely to respond to such a scenario if you found the pressure there from a double hit? " FOMC20080130meeting--210 208,CHAIRMAN BERNANKE.," However, there appears to be a law of nature that the turnaround in the housing market is always six months from the present date. We simply don't have any evidence whatsoever that the housing market is bottoming out. We have guesses and estimates about how far prices will fall and how far demand and construction will fall. The key issue is prices, and we are far from seeing the worst case scenario that you could imagine in prices. So long as we don't see any stabilization in the housing market or stabilization in house prices, then I don't think we can say that the downside risks to the economy or to the credit system have been contained. Until that point, I think we need to be very, very alert to those risks. Everyone has talked about inflation, as should be the case. I am also concerned. The pickup in core inflation is disappointing. There are some mitigating factors, such as the role of nonmarket prices, which tend not to be serially correlated. We haven't discussed owners' equivalent rent in this meeting for the first time in a while, but we know that it can behave in rather odd ways during periods of housing slowdowns. The hope is that energy and food prices will moderate; in fact, if oil prices do rise by less than the two-thirds increase of last year, it would obviously be helpful. Nominal wages don't seem to be reflecting high inflation expectations at this point. So I think there are some reasons for optimism; but as many people pointed out, there are upward pressures, including the point that President Fisher made that the lagged effects of the previous increases in energy, food, and other commodity prices have probably not been fully realized in core inflation. Furthermore, as we'll talk about more tomorrow, to the extent that we decide at this meeting to take out some insurance against downside risks, then implicit in that insurance premium might be a greater risk of inflation six months or a year from now. So we have to take that into account as we think about policy and about our communications, as President Plosser and others have pointed out. In particular, as Governor Mishkin and others have noted, we need to think about a policy strategy that will involve not only providing adequate insurance against what I consider to be serious downside risks but also a policy strategy that involves removing the accommodation in a timely way when those risks have moderated sufficiently. So my reading of the situation is that it's exceptionally fluid and that the financial risks, in particular--as we saw, for example, after the October meeting--can be very hard to predict. There are a lot of interactions between the financial markets and the real economy that are potentially destabilizing, and so we are going to have to be proactive in trying to stabilize the situation, recognizing that we have a confluence of circumstances that is extraordinarily difficult and that no policy approach will deliver the optimal outcome in the short term. We're just going to have to try to choose a path that will give us the best that we can get, given the circumstances that we're facing. All right. Any further comments or questions? We will reconvene tomorrow at nine o'clock. There is a reception and dinner, optional, available in the Martin Building. Thank you. [Meeting recessed] January 30, 2008--Morning Session " fcic_final_report_full--60 A sset - Ba ck ed Se cu r i t i es Ou tstand i ng In the 1990s, many kinds of loans were packaged into asset-backed securities. IN BILLIONS OF DOLLARS $1 , 000 Other 800 Student l oans 600 M anufactured hous i ng 4 00 200 0 Eq u i pment H ome e q u i ty and other res i dent i a l Cred i t card A utomob il e ’ 85 ’ 86 ’ 88 ’ 89 ’ 91 ’ 92 ’ 93 ’ 95 ’ 9 7 ’ 99 NO TE: Res i dent i a l l oans do not i nc l ude l oans secur i t iz ed by government - sponsored enterpr i ses . SOURC E: Secur i t i es I ndustry and Fi nanc i a l M arkets A ssoc i at i on Figure . these instruments became increasingly complex, regulators increasingly relied on the banks to police their own risks. “It was all tied up in the hubris of financial engineers, but the greater hubris let markets take care of themselves,” Volcker said.  Vincent Reinhart, a former director of the Fed’s Division of Monetary Affairs, told the Com- mission that he and other regulators failed to appreciate the complexity of the new fi- nancial instruments and the difficulties that complexity posed in assessing risk.  Securitization “was diversifying the risk,” said Lindsey, the former Fed governor. “But it wasn’t reducing the risk. . . . You as an individual can diversify your risk. The sys- tem as a whole, though, cannot reduce the risk. And that’s where the confusion lies.”  THE GROWTH OF DERIVATIVES: “BY FAR THE MOST SIGNIFICANT EVENT IN FINANCE DURING THE PAST DECADE ” During the financial crisis, leverage and complexity became closely identified with one element of the story: derivatives. Derivatives are financial contracts whose prices are determined by, or “derived” from, the value of some underlying asset, rate, index, or event. They are not used for capital formation or investment, as are securities; rather, they are instruments for hedging business risk or for speculating on changes in prices, interest rates, and the like. Derivatives come in many forms; the most com- mon are over-the-counter-swaps and exchange-traded futures and options.  They may be based on commodities (including agricultural products, metals, and energy products), interest rates, currency rates, stocks and indexes, and credit risk. They can even be tied to events such as hurricanes or announcements of government figures. Many financial and commercial firms use such derivatives. A firm may hedge its price risk by entering into a derivatives contract that offsets the effect of price move- ments. Losses suffered because of price movements can be recouped through gains on the derivatives contract. Institutional investors that are risk-averse sometimes use interest rate swaps to reduce the risk to their investment portfolios of inflation and rising interest rates by trading fixed interest payments for floating payments with risk-taking entities, such as hedge funds. Hedge funds may use these swaps for the purpose of speculating, in hopes of profiting on the rise or fall of a price or interest rate. CHRG-111shrg57322--822 Mr. Viniar," Sure. The same thing happened with leveraged loans in 2008. We were long in many leveraged loans, unfortunately, and the market clearly started to decline. We were marking things to market. We were marking them down and we sold them. We sold some at prices that people who bought them that continued to go down, and we sold some at distressed prices and since then they have recovered and they have made money on them. But we just felt our risk was just too big and our instructions were that we should reduce our risk, because that market was in very--ended up in severe distress. Senator Coburn. Now, there are some significant risk factors going on in commercial real estate. Do you all have big holdings in commercial real estate mortgages? " FOMC20070807meeting--166 164,MR. FISHER.," I would agree with that. Now, that doesn’t say that pricing has changed. Let me give you an example. Kimberly-Clark last week went to market on $2 billion in debt. They couldn’t move it unless they had a change-of-control provision. No price impact. So it is part of the risk premiums, but we’re not seeing pricing per se. I like the wording that President Geithner has suggested." FOMC20080430meeting--120 118,MR. MISHKIN.," But I do have a concern about the risk to inflation expectations because of the high commodity prices that we see. This is coming from the very adverse supply shock and the fact that we have had headline inflation so high for so long. The good news, by the way, is that it is actually quite remarkable, given how high headline inflation has been, how anchored inflation expectations have been. I think that has to do with confidence in this institution's doing the right thing. It is very important that we retain that confidence. We have to think about that when we decide what we are going to do regarding policy. About where I think inflation is going to be--I have been a 2 percent guy for a long time. I am not changing that. I think that inflation expectations are around 2 percent and that there is no expectation that we will have excess demand in the economy. If anything, it is the opposite of that. I see the risks as balanced--there are some risks on the upside, particularly because of what is happening with commodity prices. On the other hand, there are risks on the downside because of the expected slack and because there is some downside risk in the economy. So on that ground, I basically have the same story that I had before. Thank you. " FOMC20070131meeting--49 47,MR. DUDLEY.," You could think of the situation as credit availability to that sector diminishing, which could have feedback effects on price. That’s the risk." CHRG-109shrg30354--33 Chairman Shelby," Thank you Mr. Chairman. Mr. Chairman, your testimony notes the possibility of some risk which could add to inflationary pressures, in particular the possibility of higher energy prices feeding into the prices of nonenergy goods and services. Your testimony, Mr. Chairman, also notes the risk to our economy due to a slowing housing market. The question is this: What would be the impact, Chairman Bernanke, on the economy if both of these effects materialized to a greater degree than is currently anticipated? How would the Federal Reserve be likely to respond to such a scenario? These are not out of the question, either. " FOMC20050920meeting--141 139,MS. DANKER.," I’ll be reading the directive wording from page 27 of the Bluebook and the assessment of risk from exhibit 6 in the material that was passed out. For the directive: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 3¾ percent.” Now for the assessment of risk: “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to September 20, 2005 104 of 117 is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" CHRG-111shrg56262--28 Mr. Irving," I will make four comments. First of all, I think uncertainty about home prices and how borrowers behave when they are underwater on their mortgage, when the loan-to-value ratio is greater than 100, has increased the risk premium in the market. And the second facet of uncertainty which is causing skittishness about these securities is just uncertainty about Government policy. The Government in some sense has been in the position inadvertently of picking winners and losers in terms of which investments do well and which do not. Those that get the Government support perform better than those that do not, so it becomes less of an intrinsic relative value of the cash-flows and more an assessment of how the Government policy is going to go. The third would be the equity-like price volatility that we have seen exhibited in many of these marketplaces, again causes there to need to be an increased risk premium, that is, prices go down. And then finally, the complexity. We have sort of a rule of thumb on our trading room floor that for every additional sentence I need to describe to my boss the structure of the security I am buying, the price has to be lower by about a point, and---- " CHRG-111hhrg48867--185 Mr. Price," No, I understand that. But at some point there has to be a consequence for the decisionmakers here. We have determined, somebody has determined that there is an entity that is a systemic risk. So what ought to occur to that entity? It has to be something. " CHRG-111hhrg48867--183 Mr. Price," Anybody disagree with that being the outcome? So we all agree that systemic risk institutions no longer get explicit government support. Is that correct? " FOMC20060510meeting--122 120,MR. KOHN.," Thank you, Mr. Chairman. I agree with many of the rest of you that inflation risks rose over the intermeeting period, though I think I see a more limited rise than I sensed from some of the comments I have heard. Several factors do suggest higher inflation risk. Stronger growth than expected has left resource utilization a little higher than we thought—only a touch, I think, but still higher. The core CPI and PCE data were disappointing—were higher than anticipated. That, however, did follow several months in which those data came in lower than we had expected. And if you look at the Greenbook’s 2006 projection, it reverses a downward revision from last time. That is not to say it is not worrisome, but we were revising down for a while, and now we have had an upward revision. I think the commodity price increases are hard to understand, especially outside the energy area, where you can think about supply disruptions. Both the energy prices and the commodity prices could feed through to a limited extent into headline inflation. I think they do indicate, at the very least, that global demand has continued to be quite strong. In that regard, they would add to global inflation risks. The decline in the dollar is a bit worrisome. The pass-through to import prices has been very, very small over recent decades. But to the extent that the lower dollar is not passed through to import prices, it would be squeezing the profits of those people who are exporting to the United States, and I think, through either channel, this suggests at least a slight reduction in the competitive pressures on domestic producers— not big, but a slight reduction. We did have a small uptick in inflation expectations looked at through the markets or the Michigan survey. However, those expectations are still in the range of recent years, and I can recall a number of occasions post-Katrina and in the last few springs in which they have ticked up in similar situations and then come back down again, particularly after energy prices leveled out. None of these signs of higher inflation are very significant in and of themselves or if they were taken one by one; but taken together, they cannot be dismissed. They do suggest at least a small rise in inflation expectations and a small rise in inflation risk that could start pushing up underlying inflation further. That said, the data we have received over the intermeeting period should give us a little more confidence that conditions are being put in place or are in train to limit these risks and to keep the upside risk limited. The trajectory of information over the intermeeting period, especially on consumption and housing, points to quite a bit of moderation of growth in the second quarter. We are looking at 3-point- something, and the issue is what the point-something is; it is not 4-point-something or 5-point-something. Housing market information, I think, confirms that there is a slowdown in process that will restrain aggregate demand going forward. Sales have bounced around a lot, but inventories have risen substantially by any measure. That is going to be weighing on prices. The price data are ambiguous and hard to read. If you take a heroic leap and start seasonally adjusting the existing house prices on a month-by-month basis instead of a twelve-month basis, it looks as though they have been flattening out. But we will get better data later. If, indeed, prices are flattening out, we have not yet really seen that effect on consumption. So in that sense, the tightening of policy and the flattening-out of housing prices are still in the pipeline. Higher long-term interest rates: Some of that increase is an endogenous response to global growth and would require a higher path of short-term rates to keep inflation under control, but some of it is in the risk premium. The extent to which the risk premium has risen will damp demand for any given course of monetary policy. The energy-price increase will contribute to moderating growth of domestic demand, provided that we do not allow that energy-price increase to reduce real interest rates. Like some others here, I am kind of encouraged by the data on labor compensation. They are mixed, but I have interpreted them on balance to suggest that pressures on businesses from labor cost developments are muted. The ECI is certainly consistent with that, and so are four-quarter changes in compensation per hour and unit labor costs. The markup of price over unit labor cost actually increased from a very high level to an even higher level. I agree with President Poole that businesses will not voluntarily give up that markup, but we do have a recent experience if you look in the late ’90s. That markup peaked at the end of ’97, I believe, and dropped very, very sharply in ’98 and ’99, despite the fact that the economy was growing with some vigor. You can see that on page 39 of the Greenbook. So perhaps we need to think about that episode and how it happened. Certainly we have a precedent for vigorous growth and declining markup absorbing rising compensation costs. So where does that leave me overall? I agree with the staff. The most likely outcome—given the structure of interest rates, financial conditions, markets, and a flattening of energy prices—is for stable underlying inflation, core PCE to stay in the neighborhood of 2 percent, where it has been since early 2004. But I am a little more nervous about the stability than I was at the last meeting. Thank you, Mr. Chairman." CHRG-110shrg50409--94 Mr. Bernanke," Well, it depends which side of the transaction you are on. You have people on both sides who are trying to make a bet essentially on whether oil prices will go up or down. But, clearly, one of the major economic functions of futures markets is to allow those who want to lay off their risk, like an airline, the opportunity to sell or to buy forward the fuel so that they will not be subject to the risk of price fluctuations. And it is the activities of speculators in those markets that provides the other side of that transaction and makes those markets liquid and allows them to serve that function. Senator Crapo. The airlines are a good example. As you know, a number of the CEOs of a number of airlines have maintained that the price of their jet fuel is being forced unnaturally high because of market speculation in the futures market. Do you believe that they are correct in that? " FOMC20060328meeting--138 136,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Like all of you, we think the underlying trajectory of demand and inflation seems quite favorable, perhaps a bit more so than it did in January. We expect real GDP to grow at a rate slightly above the rate of increasing potential in ’06 and to slow to the range of potential in ’07. We expect the core PCE to rise at a rate in the neighborhood of 2 percent over the forecast period. Differences between our forecast and the Greenbook’s are minor. In our forecast, we assume that inflation expectations remain anchored and the term premium remains low and that we are now at a point where little or no resource slack is left in the domestic economy. The monetary policy assumption we adopt is the path currently priced into the futures markets. The major sources of uncertainty in our forecast are the size of the wealth effect we might see accompanying any slowdown of housing, the flexibility of profit margins, and the sustainability of this present configuration of low risk premiums. We view the risk to the growth forecast as roughly balanced, although the usual suspects provide a source of concern. The risk to our inflation forecast, in contrast, still seems slightly tilted to the upside. On the growth front, as I said, we think the underlying pace of demand growth is pretty strong, and we don’t see any signs yet that would point to evidence of a significant slowdown relative to potential in prospect. We think productivity growth is likely to remain quite high, rising perhaps a bit faster this year than in ’05. With the labor market growing on trend and some increase in labor’s share of national income, we expect consumption growth to remain reasonably strong. Stronger income growth offsets the expected deceleration in housing-price appreciation and the effect that might have on consumption. We expect a slight increase in the contribution of business fixed investment to demand growth, due principally to a rise in spending on equipment and software. We expect, of course, the contribution of residential investment to slow with the forecast period. World GDP growth seems stronger and more broadly based. We expect net exports to be a persistent drag, shaving about ½ percentage point off growth for each of the next two years. Despite this forecast of pretty strong spending growth and high levels of resource utilization, we believe core inflation is likely to remain moderate. Under the assumption of a relatively stable dollar and with the energy-price assumption taken from the futures curve, we expect headline inflation to slow to a rate closer to the core over the forecast period. But this forecast rests on three important foundations. The first is that we succeed in keeping inflation expectations reasonably well anchored. The second is that demand growth not only does not accelerate to a rate substantially above trend but also slows to potential over the forecast period. And the third is that the expected rise in compensation and unit labor costs results in a rise in labor share of income—in other words, that compensation growth accelerates but the increase is absorbed by some compression of profit margins and does not lead to a significant acceleration in core inflation. Now, the sources of potential upside risk to the inflation forecast are several. One, of course, comes from the interaction between our views about productivity growth, compensation, and profit margins. If the pace of productivity growth slows significantly relative to our assumption and if, at the same time, conditions in labor markets continue to improve, unit labor costs are then likely to accelerate. A rise in compensation, however, would not by itself portend a troubling increase in core inflation. The extent of this risk, as I said, depends on the degree to which rising unit labor costs are absorbed in shrinking profit margins rather than triggering output price increases as firms attempt to defend existing margins. And because the labor share of income seems somewhat low and, as historical averages suggest, there’s room for unit labor cost growth to be absorbed in profit margins rather than causing price increases, we need to be attentive to the risk that this process may produce a short-term increase in core inflation, perhaps also in inflation expectations. A second potential risk comes from what we think we know about the pace of demand relative to potential supply globally. A continued increase in commodity prices around the globe and, more recently, some modest increase in capital goods prices may suggest that global pressures on resource constraints are pushing up prices. This raises the risk that the recent weakness in core goods prices in the United States may not be sustained. Service price inflation in the United States has shown signs of slowing. Our central forecast, as I said, is conditioned on little movement in the dollar over the forecast period, but any sizable depreciation of the dollar would still carry the risk of some acceleration in core goods prices. For nearly two years, overall inflation, as what is measured by the PCE or the CPI would suggest, has been running substantially above core, and this is true for a range of alternative measures of underlying inflation. If the underlying inflation rate were closer to 1.5 percent than to 2 percent, we might view these potential sources of upward pressure with more equanimity. Although the probability seems low that these forces will act to produce a significant acceleration of core inflation or a significant deterioration in inflation expectations, we need to be careful about those risks. So with underlying inflation at the upper end of the inferred inflation preference of the Committee, we need to be more attentive to these risks. On the growth side, the most obvious sources of downside risk to growth are a substantial rise in energy prices from current levels, a slowdown in productivity growth, a sharp rise in risk premiums, and a more-adverse effect on saving and consumption from the expected adjustment in housing markets and prices. Like the staff forecast, we think it’s reasonable to expect household saving to rise a bit and consumption growth to slow, in part because of changing expectations about the pace of future appreciation in the value of home equity. But we believe that, absent some large, negative shock to perceptions about employment and earned income, the effects of the expected cooling in housing prices are going to be modest. Of course, this view may prove optimistic. We take some reassurance from the fact that the average growth forecast in the private sector probably anticipates a significant cooling in housing and a significant effect of that cooling on saving and consumption. Developments in asset prices and risk premiums over the past several months seem to support this picture of stronger confidence in the growth and inflation outlook because real rates seem to have risen. Equity prices and credit spreads suggest considerable confidence in the prospect for growth. Implied volatilities remain quite low. We don’t know how much of this is fundamental and how much will prove ephemeral. At the moment, though, overall financial conditions seem pretty supportive of the expansion. So with this forecast of growth in the vicinity of potential, core inflation at around 2 percent, and the risk somewhat to the upside for inflation, we think the principal responsibility of monetary policy remains to preserve the sense that we will act to keep long-term inflation expectations contained at levels consistent with price stability." FOMC20050630meeting--187 185,MS. BIES., The second question I have relates to the nature of the price decline risk. If some of these ARMs can’t be refinanced and foreclosures actually start to occur—where financial institutions take over the property—are there any studies out there that indicate how much foreclosure volume could hit the market before it had a material impact on local house prices? FOMC20050322meeting--150 148,CHAIRMAN GREENSPAN., You would just say: “The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability…” CHRG-111shrg50564--46 Mr. Volcker," No question about that. Senator Warner. You do not want to stifle innovation, but it seems to me that some of these instruments recently were more about fee generation than they were about appropriately pricing risk? " CHRG-111hhrg53244--161 The Chairman," Next--I have to apologize, I forgot that the seniority system here was designed by the choreographer of the Bunny Hop, and it goes this way. And I made a mistake. I told you I was getting old. So I am now at the gentlewoman from Wisconsin. Ms. Moore of Wisconsin. Thank you, Mr. Chairman. And thank you. I was really pleased to see in your testimony, under the regulatory reform section, that you realize that systemic risk is not just too-big-to-fail institutions, but activities and practices that provide systemic risk. Many of us--and, certainly, this article was given to me by Congresswoman Maxine Waters--have been reading the recent Rolling Stone article by Matt Taibbi, ``The Great American Bubble Machine.'' And while it is very critical of a particular firm, I think there are things that we all notice with respect to the housing bubble and the dot-com bubble and the oil bubble that all seem to be activities that seem to be systemic risks. For example, allowing an entity to sort of manipulate the price of an entity, of the housing prices, to ratchet the prices up and then just sort of hedge against their own products. So I guess I would like to ask your opinion about credit default swaps and also the practice of spinning, where executive compensation seems to be a systemic risk factor, as well. So can you tell us what we can do in our regulatory reform to prevent the creation of these bubbles? " FinancialCrisisReport--27 To ensure an ongoing supply of loans for sale, lenders created compensation incentives that encouraged their personnel to quickly produce a high volume of loans. They also encouraged their staffs to issue or purchase higher risk loans, because those loans produced higher sale prices on Wall Street. Loan officers, for example, received more money per loan for originating higher risk loans and for exceeding established loan targets. Loan processing personnel were compensated according to the speed and number of the loans they processed. Loan officers and their sales associates received still more compensation, often called yield spread premiums, if they charged borrowers higher interest rates or points than required in the lender’s rate sheets specifying loan prices, or included prepayment penalties in the loan agreements. The Subcommittee’s investigation found that lenders employed few compensation incentives to encourage loan officers or loan processors to produce high quality, creditworthy loans in line with the lender’s credit requirements. As long as home prices kept rising, the high risk loans fueling the securitization markets produced few problems. Borrowers who could not make their loan payments could refinance their loans or sell their homes and use the sale proceeds to pay off their mortgages. As this chart shows, over the ten years before the crisis hit, housing prices shot up faster than they had in decades, allowing price increases to mask problems with the high risk loans being issued. 36 36 See “Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends,” chart prepared by Paulson & Co. Inc., Hearing Exhibit 4/13-1j. CHRG-111shrg50814--66 Mr. Bernanke," Well, to the extent that there is more common put in, then depending on existing expectations and pricing, it may or may not affect the prices of the common. It depends on expectations where the price is today---- Senator Corker. But I guess--and I know my time is up, and I think you know I have a great deal of respect and I appreciate the way the interaction has been. So, in essence, we have decided that there are a number of institutions in our country that are too large to fail. We are going to stress test them--and really, to me, it is not so much about capital. It is our ability to calculate risk in the past, and I think we are going to look at that risk in a much different way. And then simultaneous to that, as a Government entity, we are going to be providing capital to these institutions on a go-forward basis. And so the signal to us and to the markets--and I am just clarifying--is that there are institutions in this country that absolutely will not fail, and we will go to whatever lengths necessary with public sector dollars to ensure that that does not occur. " fcic_final_report_full--78 As the scale, revenue, and profitability of the firms grew, compensation packages soared for senior executives and other key employees. John Gutfreund, reported to be the highest-paid executive on Wall Street in the late s, received . million in  as CEO of Salomon Brothers.  Stanley O’Neal’s package was worth more than  million in , the last full year he was CEO of Merrill Lynch.  In , Lloyd Blankfein, CEO at Goldman Sachs, received . million;  Richard Fuld, CEO of Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about  million and  million, respectively.  That year Wall Street paid workers in New York roughly  billion in year-end bonuses alone.  Total compensation for the ma- jor U.S. banks and securities firms was estimated at  billion.  Stock options became a popular form of compensation, allowing employees to buy the company’s stock in the future at some predetermined price, and thus to reap rewards when the stock price was higher than that predetermined price. In fact, the option would have no value if the stock price was below that price. Encouraging the awarding of stock options was  legislation making compensation in excess of  million taxable to the corporation unless performance-based. Stock options had po- tentially unlimited upside, while the downside was simply to receive nothing if the stock didn’t rise to the predetermined price. The same applied to plans that tied pay to return on equity: they meant that executives could win more than they could lose. These pay structures had the unintended consequence of creating incentives to in- crease both risk and leverage, which could lead to larger jumps in a company’s stock price. As these options motivated financial firms to take more risk and use more lever- age, the evolution of the system provided the means. Shadow banking institutions faced few regulatory constraints on leverage; changes in regulations loosened the constraints on commercial banks. OTC derivatives allowing for enormous leverage proliferated. And risk management, thought to be keeping ahead of these develop- ments, would fail to rein in the increasing risks. The dangers of the new pay structures were clear, but senior executives believed they were powerless to change it. Former Citigroup CEO Sandy Weill told the Com- mission, “I think if you look at the results of what happened on Wall Street, it became, ‘Well, this one’s doing it, so how can I not do it, if I don’t do it, then the people are go- ing to leave my place and go someplace else.’” Managing risk “became less of an im- portant function in a broad base of companies, I would guess.”  CHRG-111shrg50815--11 Mr. Levitin," Good morning, Mr. Chairman, Ranking Member Shelby, and members of the Committee. I am pleased to testify today in support of the Chairman's Credit Card Accountability, Responsibility, and Disclosure Act and other legislation that would create a more efficient and fair credit card market and would encourage greater consumer responsibility in the use of credit. Credit cards are an important financial product. They offer many benefits and conveniences to consumers. But credit cards are also much more complicated than any other consumer financial product, and unnecessarily so. Auto loans, student loans, closed-end bank loans, and all but the most exotic mortgages are relatively simple. They have one or two price terms that are fixed or vary according to an index. Not so with credit cards. Credit cards have annual fees, merchant fees, teaser interest rates, purchase interest rates, balance transfer interest rates, cash advance interest rates, overdraft advance interest rates, default or penalty interest rates, late fees, over-limit fees, balance transfer fees, cash advance fees, international transaction fees, telephone payment fees, and probably several other fees of which I am unaware. In addition to these explicit price points, there are also numerous hidden fees in the form of credit card billing practices. The card industry has been ingenious in creating tricks and traps to squeeze extra revenue out of unsuspecting consumers. These billing tricks cost American families over $12 billion a year. Credit card billing tricks make cards appear to be much cheaper than they actually are, and that leads consumers to use cards too much and to use the wrong cards. By disguising the cost of using cards through billing practices, card issuers are able to maintain uncompetitively high interest rates and to generate greater use of cards. That produces additional revenue from interchange fees for the issuers as well as over-limit fees, late fees, and penalty fee revenue. The complexity of credit card pricing makes it impossible for consumers to accurately gauge the price of any particular credit card, and unless consumers can gauge the cost of using a card, they cannot use it efficiently and responsibly. Markets cannot function without transparent pricing because demand is a function of price. The lack of transparency in credit card pricing has resulted in inefficient and irresponsible use of credit, and that has resulted in dangerously over-leveraged consumers, who are paying too much for what should be a commodity product with razor-thin profit margins rather than one with a return on assets that is several multiples of other banking activities. Consumer over-leverage is a factor that should concern all of us, especially today. There is nearly a trillion dollars of credit card debt outstanding. The average carded household owed almost $11,000 in credit card debt last year. That is a drop in the bucket compared with household mortgage debt, but even the most exorbitant subprime mortgage rate is rarely over 10 percent annually, whereas the effective APR on many credit cards--the effective APR--can easily be five times as high. And the harm to families is palpable. A single repricing due to a billing trick can cost a family between an eighth and a quarter of its discretionary income. These levels of credit card debt are not sustainable. Dollar for dollar, a consumer with credit card debt is more likely to file for bankruptcy than a consumer with any other type of debt. And to the extent that consumers are servicing high-interest-rate credit card debt, that is money they cannot use to purchase new goods and services from merchants. The money siphoned off by credit card billing practices does not create value. It cannot be spent in the real economy. The card industry's arguments that Congress should not interfere with their finely calibrated risk-based pricing are malarkey. Only a very small component of credit card pricing reflects risk. Almost all credit card pricing is a function of the cost of funds, the cost of operations, and the ability-to-opportunity price, not the function of risk. Moreover, to the extent that credit card prices reflect a risk premium, it is a pool-based premium. It is not an individualized risk premium. The card industry is not capable of pricing for risk on an individual basis. The technology is not there. This means that there is inevitably subsidization of riskier consumers by more creditworthy ones. Nor is there any evidence that connects the so-called risk-based pricing to lower costs of credit for creditworthy consumers. While it is true that base interest rates have fallen, that is almost entirely a function of the lower cost of funds, and the decline in base interest rates has been offset by increases in other credit card prices. According to the GAO, for 1990 to 2005, late fees have risen an average of 160 percent, and over-limit fees have risen an average of 115 percent. Since the 1990s, credit card pricing has been a game of three-card monte. Pricing has been shifted away from the up-front, attention grabbing price points, like annual fees and base interest rates, and shifted to back-end fees that consumers are likely to ignore or underestimate. The card industry's risk-based pricing story simply doesn't hold up on the evidence and is not a reason to refrain from much-needed regulation of unfair and abusive credit card billing and pricing practices that have had a deleterious impact on the economy and society. Legislation like the Credit Card Accountability, Responsibility, and Disclosure Act is a crucial step in restoring transparency and fairness to the credit card market and to letting American consumers responsibly enjoy the benefits of credit cards. Thank you. Senator Johnson. Thank you, Mr. Levitin. The panel should know that we will limit your remarks to 5 minutes in order to have a proper question and answer period. Mr. Clayton? STATEMENT OF KENNETH J. CLAYTON, SENIOR VICE PRESIDENT AND CHRG-109hhrg31539--190 Mr. Bernanke," It is a trick question. As I said in my testimony, our expectation is that core inflation will be moderating over the next 2 years for a variety of reasons. However, we do see some risks, and one of the risks would be that because product markets are tight, that there would be ability of firms to pass through energy and commodity prices into other goods. " CHRG-111shrg57322--204 Mr. Sparks," There is fee business, which I do not think is what you are talking about, and then there is market-making business. In this particular sector, typically you would have to do trades where you assumed risk. When that was not the case, there is an SEC markup rule with respect to a certain percentage, but that is for risk-free trades, and at this time in this market, that was not a typical thing where you would have a purely risk-free trade. The amount of bid-offer spread, which would be a term we would have used, would be very dependent on the product, the rating, the liquidity of the product, and the--if I did not mention liquidity, it was a huge issue. So, the bid-offer spread could vary at various times, but one of the things people expected us to do was to make a market and to have a bid-offer spread. The great thing about making a market is when you do that, clients can tell from your price relative to the prices that other people are making in that market on similar securities, if you are a better seller or buyer. And so, I actually--I am a believer in markets, and I think that is one of the nice things that price can affect, both your risk and it can also help people know where to go if they want to acquire risk. Senator McCaskill. OK. Let us talk about what people are betting on. And what I would like to ask a couple of questions about are the--you call them different things in different memorandums in here, whether it is Timberwolf or Abacus--the asset selector or the asset selecting agent. I think you called it a different term. Now, this is important because these are the folks that are figuring out what is going to be in the bet, right? What everybody is betting on. So the compilation of what is in this thing you create for people to bet on is done by these asset selectors. Who decides who the asset selector is for a deal? " FOMC20080805meeting--181 179,MR. MISHKIN.," Thank you, Mr. Chairman. Just let me talk a little about monetary policy, and I'll be brief there. But then I have to use my opportunity to raise some issues for the Committee when I'm not here. I do support alternative B. As is obvious from my earlier discussion, I believe that the risks are balanced. I have one modification to Janet's language because I think it is just simpler to say that ""the downside risks to growth and upside risks to inflation are of concern to the Committee."" I don't see the need for ""both,"" but we're actually on the same wavelength in terms of this issue. What I'd like to spend some time on--because I feel this is sort of my swan song, but maybe because I'm a classy guy, I'll call this my ""valedictory remarks""--are three concerns that I have for this Committee going forward. I'm not going to be able to participate, but I have a chance now to lay them out. The first is the real danger of focusing too much on the federal funds rate as reflecting the stance of monetary policy. This is very dangerous. I want to talk about that. Second is that I think it's absolutely critical that we keep our options open in the current circumstances, and so I want to talk about that. The third is on the communication issue, but it's not going to be on inflation objectives. I've already talked about that enough in public, so it's clear to you one way or the other. I hope you consider it, but that's something that I don't need to go into here. First of all, let me talk about the issue of focusing too much on the federal funds rate as indicating the stance of monetary policy. This is something that's very dear to my heart. I have a chapter in my textbook that deals with this whole issue and talks about the very deep mistakes that have been made in monetary policy because of exactly that focus on the short-term interest rate as indicating the stance of monetary policy. In particular, when you think about the stance of monetary policy, you should look at all asset prices, which means look at all interest rates. All asset prices have a very important effect on aggregate demand. Also you should look at credit market conditions because some things are actually not reflected in market prices but are still very important. If you don't do that, you can make horrendous mistakes. The Great Depression is a classic example of when they made two mistakes in looking at the policy interest rate. One is that they didn't understand the difference between real and nominal interest rates. That mistake I'm not worried about here. People fully understand that. But it is an example when nominal rates went down, but only on default-free Treasury securities; in fact, they skyrocketed on other ones. The stance of monetary policy was incredibly tight during the Great Depression, and we had a disaster. The Japanese made the same mistake, and I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me. I'm holding two houses right now. I'm very nervous. [Laughter] The second issue is that it's absolutely critical that we keep our options open. This relates to the points that I already made in my discussion--I argued that we don't know where this situation of financial stress is actually going to head and that the potential for shoes dropping and bad things happening out there is real. I think it's likely that it won't happen, but it's a significant probability with very serious negative consequences. In that situation, we don't know exactly the direction of where we have to go. I was actually very pleased with President Evans's comments. Charlie has been a good friend for a long time, and he is one of the people I have tremendous respect for as an economist. Although we had a disagreement in our view of monetary policy today, on the issue going forward I was pleased to see that you actually indicated that there is a possibility--we hope it doesn't happen, by the way--that things go south and that we actually have to be much more aggressive on monetary policy and on liquidity issues. I know that there have been some concerns on the Committee about that as well, but no option should be taken off the table if bad things happen, and we cannot get boxed in. I feel very, very strongly about that. I would also say that the same issue comes up in terms of inflation. I have argued very strenuously for nongradualism in a situation like the one we're in. We are in a different world when we are in a situation of financial stress, and it's very possible that we might have to raise rates very quickly. There's a good news case and a bad news case. The good news case is that housing prices stabilize. That could actually turn things around very quickly. I think, Bill, if I'm not incorrect, you mentioned that possibility, and I think you're absolutely right. In that kind of situation, our policy would become very accommodative. I do not think it's too accommodative at all right now. I think it's balanced; it's appropriate. But if the financial markets improve, it will become much too accommodative very quickly, and we then have to respond very quickly in order not to have inflationary consequences. I'd like to see that happen, by the way. The other case, which I would not like to see happen, is that inflation expectations get unhinged. I have seen no evidence that long-run inflation expectations have gotten unhinged, but there is substantial risk. If that happened, we would also have to move up very quickly. So I really implore this Committee to keep your options open. Do not get boxed in. Let's hope and pray-- let's all get around in a circle and hold hands--that oil prices fall, which will also help us not get boxed in. Don, I told you I was going to be a little colorful. He was waiting for this one. I should mention that Don was actually at a conference where he talked about constraints on people's behavior as a result of the transcripts being recorded, and he said, ""But not Rick."" [Laughter] The third issue is something about which I am less constrained, which is communications. I would not have talked about this earlier, but it really does worry me. We have a complicated governance structure in this Committee, which I actually think is the right governance structure. We have two types of groups that vote on this Committee. We have the people who are Presidential appointees and then confirmed by the Senate, who are Board members, and I will soon not be one of them. I'll be a civilian again. Then we have Bank presidents, who are much more tied into the private sector because your boards of directors, which are composed of private-sector people, recommend you. Then we do have some role, but they're the primary people who decide who becomes a Bank president. I think that's a very good framework. It actually serves us very well. I've been on both sides. I've been on the other side of the fence, not as a president but as an executive vice president. It serves us very well because we have a link to the private sector that we normally would not have; importantly, it keeps us real in terms of information; and there's a group of people out there who are not in Washington or New York (because people also have a hard time about New York) but who tend to be very important supporters for us politically. So this is a system that I would very much like to see preserved. It does have a problem because of the different roles here. What I have been very concerned about--and I have had people in the markets speak to me about this--is that recently I had a very prominent central bank governor say to me, ""What in the hell are you guys doing?"" The issue here is that we need to have a situation where Bank presidents and also members of the Board can speak their views. They may have different views, and I very much encourage that in terms of discussion, of where they think the economy is going, which is what we do inside; and I think that does need to be done outside the Committee because it shows that there are different views, that we're thinking about it, that we're trying to learn from each other, and so forth and so on. What is very problematic from my viewpoint are the speeches, discussions, and interviews outside, when people talk about where they think interest rates should head and where the policy rate should head. That's where the criticism has been coming from. I have to tell you that a lot of people whom I respect tremendously are saying to me that it's making us look like the gang that can't shoot straight. I think it's a really serious problem. I understand that we want to keep the priority of speaking our minds, but we have to work as a team, and I think that we're having a problem in this regard. Let me talk about why I think this is dangerous. It's dangerous in terms of policy setting. You can see this is very blunt. Clearly, if you were in a multi-period game, you wouldn't be this blunt. But now I'm not going to be here anymore, so you can hate me--I don't care. [Laughter] But this kind of cacophony on this issue has the potential to damage us in two very serious ways. One is that it weakens the confidence in our institution, and I have to tell you that I love this institution. It's very hard for me to leave this place, but it's something I have to do. If the institution is damaged in terms of the confidence that the public and the politicians have in us, it will hurt us deeply. It will hurt us in terms of policy because it will weaken our credibility, which actually will make it harder to control inflation. So I consider this a very serious cost. The second issue is on the political front. It is very possible that we're going to have a reopening of the Federal Reserve Act with the next Administration and the next Congress. The reason I think it is possible is that we have to restructure our regulatory structure. There's no way to get around it--we are in a brave new world on this. That could lead to an opening of this issue. The problem here is, in that opening, there are a lot of people in the Congress who are very uncomfortable having policymakers who are not Presidential appointees and confirmed by the Senate. Two outcomes could come out of that. One is that they could take the vote away from the presidents, which I think would be a disaster because then you're not going to have good people going into the System. We won't have boards of directors that will be good. We won't have all of the benefits that we think we have from the current system. The other alternative is that we then have presidents who are actually appointed by the President and then confirmed by the Senate. I think, again, that hurts the private linkage. So I feel very strongly about all three of these issues, but I think that you're going to come up with serious challenges in the future that could be very damaging to the System. So I hope you think about this and still like me for being blunt, and also miss me because there will be a little less amusement. Who else would have brought Monty Python into the FOMC? Thank you very much. " FOMC20061025meeting--23 21,MR. STOCKTON.," A little work has been done in this area, but it’s a bit like modeling the stock market. You wouldn’t take it very seriously in the sense that these are asset markets and they’re sometimes moving in ways that are very difficult to model on the basis of, for example, fundamentals—especially in a period when, by our assessment, prices have moved up significantly above what we think can be justified in terms of interest rates and rents. So now we have a situation in which that asset price misalignment is projected in our forecast to just barely begin to unwind but we’re really uncertain about what the timing of that process is going to be. One of the reasons we wanted to show the alternative simulation is that we’ve taken a fairly conservative approach here. Our slowdown in the growth rate of house prices, to roughly 1½ to 1¾ percentage points over the next two years, doesn’t make a big dent—if you remember from the briefing that we did one and a half years ago—in the price-to-rent ratio, which we plotted there and showed that that had increased very significantly. So our best guess is that, as in the past, those nominal prices will flatten out rather than actually decline. But the run-up was so large that we couldn’t rule out this time around that the adjustment of house prices could be more significant and more rapid than in the past. But I don’t know of any reliable empirical model or evidence. We’ve certainly done our share of work in modeling those house prices, and I know our colleagues at the New York Fed have as well. There’s a lot of controversy about whether there even is an asset price misalignment, much less, if there is, how it will unwind. So I don’t have a lot to offer you there, except that we’re going to try to present you with the range of possible outcomes in the sensitivity of our forecast to the baseline assumption that we’ve made. In that regard, I still see more downside risk there than upside risk to our house-price forecast." FOMC20080130meeting--110 108,MR. SHEETS.," Right. Just a word of background. The rationale for the falloff is the expected decline in these commodity prices and the expected slowing of global demand. Now, thinking about the risks, I am reasonably convinced that global demand is going to slow, which I believe will translate into reduced demand for many of these commodities that have driven up inflation. However, that says something only about the demand side of these commodity markets. There is also a lot going on on the supply side. At the last FOMC meeting, we talked about ethanol and the fact that many of these emerging-market countries are wealthier, that they want to eat better than they used to, that the relative price of energy has risen, and that it takes a lot of energy to raise these crops. So there are supply factors as well as demand factors at work in driving up these commodity prices. It is very hard for us to forecast the supply side of these markets. It is driven by things like weather and geopolitical developments and so on and so forth. On the commodities, my sense is that demand is going to shift in to some extent. As long as the supply doesn't shift in as well, we should be able to see a decline, or at least a slower rate of increase, in these prices. A very important point here is that, in order to get less of an impetus coming from commodity prices and inflation in these countries, we don't necessarily need oil prices to come down in level terms. We just need them to stop going up at such rapid rates. If we get slower rates of price increases, that will be disinflationary relative to where we have been. That is how I would characterize the risks around this forecast, mainly on the supply side of these commodity markets. " CHRG-109shrg30354--131 RESONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM BEN S. BERNANKEQ.1. I am very concerned about the potential efforts in this Congress to change the manner in which we regulate derivatives or to impact the manner in which derivatives operate in the economy. As you know, the President's Working Group on Financial Markets has explained why proposals we have faced in the last couple of years for additional regulation of energy derivatives were not warranted, and has urged Congress to be aware of the potential for unintended consequences. Do you share this view? Do you agree with the view of Alan Greenspan and others that derivatives have helped create a far more flexible, efficient, and resilient financial system? Are you aware of any evidence that additional reporting requirements or other regulatory actions would reduce energy prices and price volatility or are energy prices and price volatility determined by the market?A.1. I share the view that additional regulation of energy derivatives is not warranted. More generally, I agree that derivatives have created a more flexible, efficient, and resilient financial system. To be sure, as Chairman Greenspan recognized, derivatives pose a variety of risk management challenges that users must address. In particular, they must effectively manage the counterparty risks associated with derivatives. Thus far, with a few notable exceptions they have done so and, as a result, derivatives have produced the benefits that you have mentioned. I am unaware of any evidence that supports a view that additional reporting requirements or other new regulations would reduce energy prices or energy price volatility. Prices and volatility are indeed determined by the market, and as far as I am aware, energy prices and volatility recently have moved in ways that seem sensibly related to fundamentals.Q.2. Mr. Chairman, in your Sea Island speech in May on the subject of ``Hedge Funds and Systemic Risk,'' you noted that ``[t]he primary mechanism for regulating excessive leverage and other aspects of risk-taking in a market economy is the discipline provided by creditors, counterparties, and investors.'' You further observed that, in light of 1998's LTCM episode, the President's Working Group's ``central policy recommendation was that regulators and supervisors should foster an environment in which market discipline--in particular, counterparty risk management--constrains excessive leverage and risk-taking.'' You also noted that the PWG rejected so-called ``direct regulation'' of hedge funds, observing that ``[d]irect regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking but, in the case of hedge funds, the reasonable presumption is that market discipline can work. Investors, creditors, and counterparties have significant incentives to rein in hedge funds' risktaking. Moreover, direct regulation would impose costs in the form of moral hazard, the likely loss of private market discipline, and possible limits on funds' ability to provide market liquidity.'' Can you tell us a little more about what is involved in fostering market discipline in the hedge fund context and why you believe that is a superior approach to ``direct regulation?''A.2. The creditors and counterparties of hedge funds are regulated banks and securities firms. Banking and securities supervisors have been fostering market discipline by issuing supervisory guidance on counterparty risk management, by encouraging private sector initiatives to identify and promote best practices for risk management, and by undertaking supervisory reviews that assess whether banks and securities firms' practices are consistent with supervisory guidance and emerging best practices. As I indicated in my Sea Island speech, I believe that it is a reasonable presumption that market discipline can effectively constrain hedge funds' leverage. The banks and securities firms that provide hedge funds with leverage have strong incentives and capabilities to constrain their leverage so as to avoid counterparty losses. Supervisors of those banks and securities firms can and should take action if competition appears to be dulling those incentives in ways that threaten the counterparties and the financial system. Direct regulation of hedge funds could weaken market discipline if hedge funds' creditors and counterparties came to view direct regulation as an effective substitute for their own due diligence and monitoring of risks. Furthermore, development of an effective regulatory regime for hedge funds would be challenging in light of the diversity of hedge fund investment strategies and the speed with which their risk profiles tend to change. A regulatory regime that was insufficiently risk sensitive could impair hedge funds' ability to bear risks and provide liquidity to financial markets, which would make our financial system less efficient and less resilient." CHRG-111shrg57319--523 Mr. Killinger," I do not recall my exact timing. I do remember making public comments beginning in the middle part of 2005. I remember talking to the board from time to time about that there was growing risk because housing prices are growing faster than the rate of inflation. But also at the same time, I can remember everybody arguing of why that is going to be OK and it is unlikely to be a significant downturn in housing. We were kind of the front edge of trying to assess that there was a concern here. Senator Coburn. Well, that follows into my second question because in January 2005 is when you pushed forward a high-risk lending strategy for board approval. Only 2 months earlier, if you saw that prices would decline in the near future, why would you be pushing through a high-risk strategy on a market that you thought was a bubble? " CHRG-109shrg26643--59 Chairman Bernanke," Once again, of course, it cuts two ways. It would hurt the Iranians quite a bit to stop exporting their oil. It hurt the Russians quite a bit to stop exporting their natural gas. But I agree in the following general sense, that whereas there are substantial reserves of oil and natural gas in the world, a large share of them are in areas where there is geopolitical uncertainty or geopolitical risk, and that means that is a risk factor for the economy. We do not have a wide range of spare capacity in these energy areas so that a major change in the supply of energy available could make prices move a lot and that could have a major impact on the economy. That is a concern that we are going to have, I think, for a number of years. My view, in the long-run, is that with energy prices at current levels, over a longer period of time, there are going to be substantial new substitutes, alternative sources of energy, as well as new ways of conserving and reducing the use of energy. But over the next few years, our room for error is modest and we do face the risk that energy prices may fluctuate with changes in supply. Senator Bayh. Thank you. My closing comment, Chairman Bernanke, would be, you know, interdependence is one thing, increasing dependency is another, and it raises potential risks that we best think about in advance so that we do not face a potentially difficult situation at some point down the road. That is the underlying theme of my remarks. Thank you very much. " CHRG-110shrg50369--25 Chairman Dodd," That is a good additional point. I did not make that. Senator Shelby. Senator Shelby. Thank you, Mr. Chairman. Chairman Bernanke, as I noted earlier, wholesale prices rose by 1 percent in January and 7.4 percent over the past year. This is the fastest increase in 26 years. In your opening statement, you noted greater upside risks to both overall and core inflation than we saw previously. Additionally, the most recent minutes of the Federal Open Market Committee gave anecdotal evidence that in some instances these price increases were passed on to consumers. The FOMC also noted a risk that inflation expectations could become less anchored. Do you have any concern at all that the 225 basis-point cut to the Federal funds rate has limited the options that can be used to combat the upside risk of inflation? " FOMC20050322meeting--162 160,MR. GUYNN.," “Conditional upon the current path of policy, the risks to the attainment of both sustainable growth and price stability are roughly balanced.” To me it combines a number of things I heard around the table. Also, I want to say that I come out of the same cave as Cathy on the B4 cell. Although we didn’t have any quid pro quo when we voted for early release of the minutes, one of the effects that a lot of us hoped for was that we could simplify our statement. It seems to me that we have a chance to do that by dropping that whole last sentence in B4 about energy prices and March 22, 2005 81 of 116 flesh out that risk as well as others that we’ve talked about. To me it’s a great opportunity to simplify the statement a little." FOMC20050202meeting--227 225,MS. DANKER.," I’ll read the directive and the risk assessment language from page 29 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 2½ percent.” “The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal. With underlying inflation expected to be relatively low, the February 1-2, 2005 135 of 177 measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" FOMC20050322meeting--138 136,MS. MINEHAN.," I had similar concerns to Governor Gramlich’s about the “appropriate policy action” language. And given the length of your discourse, Vincent, which certainly was interesting in supporting the language, and the level of detail that you just went into in describing it, I think it’s going to be very hard to explain to others what the heck we’re talking about here. I really think all “appropriate policy action” is saying is that we can do our job. We’ve dealt with situations before where we’ve moved policy but continued to say that the risks were balanced. And with the “accommodative” language, I think we could continue to say that the risks are balanced and the whole statement would still flow logically. I’m also concerned in alternative B about the rise in energy prices not notably feeding through to core consumer prices. Core consumer prices are up a full percentage point on a year- over-year basis, and there has been some feed-through. We think it’s going to slacken, and maybe you want to put that reference in the future, but I’m not sure that this is what we want to say in this statement. I think we’d be better off leaving that sentence out and just going with “pressures on inflation have picked up in recent months and pricing power is more evident.”" FOMC20080805meeting--132 130,MR. KOHN.," Thank you, Mr. Chairman. Like others around the table, I made only small revisions to the central tendency of my forecast going forward as a result of the developments of the intermeeting period, maybe a slight reduction in the path of output and a quicker decline in headline inflation owing to the oil prices. But I think more important than any shift in central tendencies is the sense that the information tends to reinforce--to reduce the uncertainties around--the basic contours of a projection in which the economy operates with a wider output gap and a lower inflation rate on balance over the next 18 months or so than it has over recent quarters. About the output gap, the incoming information strongly suggests that we are on a trajectory that at least for some time will have the economy growing appreciably below the growth rate of its potential. The most obvious evidence is the persistence of a soft labor market--continuing declines in employment and no sign of near-term strengthening in the initial claims data. I agree that the declines in employment, as several of you have pointed out, are not consistent with a recession, but they're certainly not consistent with the economy growing close to its potential. You need another 150,000 or 200,000 jobs rather than minus 60,000, which is where we are now. So I think the economy is likely to grow below potential for some time. Even on the spending side, the decline in consumption in June, when rebate checks were continuing to hit bank accounts, and a further sharp drop in auto sales in July might be early signs that households are beginning to pull back under pressure from higher energy prices, job worries, declining house values, and reduced credit availability. To be sure, one month's consumption data along with auto sales, which are subject to all kinds of idiosyncratic influences, are not enough to justify a major change in outlook. But as President Lacker noted, household spending has for some time been a source of downside risk to the forecast. At some point, household spending could begin to reflect attitudes, and this information at a minimum seems to underline those risks as well as to point to sluggish growth of spending in the third quarter. Soggy economic news has extended to our trading partners, where actual activity and expected activity also have been marked down. The tone of news from abroad has been decidedly downbeat, as those economies feel the effect of weaker purchases from the United States, continuing financial strain, softening housing markets, and higher energy prices. Much as in the United States, attitudes abroad seem weaker than the data; but the euro area did report a record decline in retail sales in June this morning, and my sense is that our trading partners are facing larger downside risks to growth as well as a markdown of central tendencies. The dollar hasn't changed much on balance for four or five months now. With a stable dollar and weaker demand abroad, production in the United States will be getting a lot less cushion from net exports over the next few quarters than it did in the first half of the year. Finally, despite the downward movement in Treasury interest rates and in the expected federal funds rate path, financial conditions for households and businesses have tightened since the last FOMC meeting. Savers and intermediaries have become even more cautious amid concerns about deepening losses spreading beyond subprime mortgages, about the safety of uninsured deposits at regional banks, high volatility in markets, and the possible weakening of the underlying macro situation. Lenders are hunkering down to endure a long period of rising credit problems and great uncertainty. I don't think we need to rely on anecdotes here. Mortgage interest rates have actually risen on balance, as have corporate bond yields across many risk categories; and in many of these cases, the nominal interest rates are at least as high as or in some cases much higher than they were last August when the federal funds rate was at 5�. Banks continue to tighten terms and standards for nearly all categories of loans. Equity prices have fallen, adding to the downward pressure on wealth from declining house prices, and I think these developments underscore the very slow recovery likely in financial markets and the possible downside risks relative to even that very gradual improvement that many of us were expecting. The tightening of conditions is damping credit growth broadly defined and will constrain, at least to some extent, spending going forward, delaying the return to trend or above-trend growth. Thus although uncertainties remain quite elevated, I think we can be a little more confident that the economy will be subject to further quarters of below-trend growth and declining resource utilization. Furthermore, with housing prices still falling fast, inventories of homes still high, and financial markets quite skittish, the downside risks even to a slightly lower central tendency forecast remain high. Greater confidence that output will grow below potential for a time contributes to a little more optimism on my part that inflation will, indeed, come down substantially over the coming quarters. An environment of rising unemployment and declining capacity utilization is not one in which businesses or labor will find it easy to restore real incomes or raise profit margins after the increase in energy prices. With regard to that increase in energy and other commodity prices and how it affects headline inflation, I like to differentiate pass-through from spillover. I think we can expect passthrough. Pass-through to consumer prices of the higher energy and commodity prices is part of the adjustment process by which demand gets damped and by which consumers realize, unfortunately, the lower real income that they get from the adverse terms of trade. So the fact that businesses are able to pass through higher commodity prices and higher petroleum prices I don't find all that worrisome, provided that they're passing through a one-time increase in prices rather than a continuing rise. I think we have some further evidence that at least to date--things could change, I admit--what we are seeing is a pass-through of a one-time rise rather than some continuing increases. For one thing, commodity prices, as shown in Bill's chart, have flattened out or actually declined in the past few months. So presumably that pass-through is a one-time jump, if that's what they're doing, passing through those prices. Second, I think we saw in the GDP chain-type price indexes that the price of domestic value added increased at an annual rate of only 1.1 percent in the second quarter--which suggests to me that, at least through the second quarter, there was very little spillover from these higher commodity and energy prices to the stuff we produce here at home. Also, labor compensation growth, which could be a lagging indicator, at least to date hasn't increased. If anything, it has slowed a little further, which along with relatively robust productivity growth is holding down unit labor costs. Headline inflation--the goods and services that people purchase--has been high. Energy prices are being passed through, but I think to date there's no evidence or very little evidence that it's spilling over into other prices in the economy. So this is about the adjustment to relative prices. Obviously the decline in oil prices, if it holds, will be helpful on the inflation front, both in its direct effect on headline inflation and its indirect effect on inflation expectations. We finally have evidence of two-way risk in oil prices, and that should make us more comfortable with an assumption of stable prices as a reasonable basis for forecasting. Other recent contributors to higher price levels have also become less averse. As I mentioned, other industrial commodity prices have leveled out or declined, and the dollar has been relatively stable in recent months. Although I feel a little more confident about the expectation of lower inflation going forward, I agree that upside risks still prevail. Core inflation has ticked up. Headline inflation will be high for some time and could threaten to spill over through increases in inflation expectations. Oil and commodity price declines are largely an endogenous response to perceptions of weak growth, and if those perceptions turn around, so will those prices. Longer-term inflation expectations remain elevated by some measures and are probably less well anchored than they were a couple of years ago, before oil and commodity prices rose so much. In sum, I see upside risks to both the inflation gaps and the output gaps as having diminished over the intermeeting period, and we'll get to the implications of that for policy in the next part of the meeting. " CHRG-111hhrg51698--326 The Chairman," I have taken more time than I should, but if the Committee will bear with me. I know you guys are good at doing that, but one of the things that everybody brings up is this. These things are hard to price and figure out what the risk is and so forth. You guys believe you have the expertise to be able to do that? " CHRG-111shrg50815--110 Mr. Clayton," So as a practical matter, it is--they hold the risk, and if these trusts unwind, that comes back on the balance sheet. So there are real risks and checks and balances, which is what I think you are referring to, in this area. If the marketplace believes that this doesn't work, the cost of borrowing for that company goes up significantly. So there are real prices to be paid. " CHRG-110shrg46629--59 Chairman Bernanke," Our objective is to achieve enduring price stability and in particular we want to be sure that inflation remains under good control in the medium run. There are several elements of that. One is that I think it is important to recognize that the month-to-month inflation numbers are very noisy. And so a couple of good numbers does not, by itself, mean 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 would like to see it. The other is that as long as there are some very important risks out there to inflation, there is the possibility of inflation--even if it has come down some--there is the possibility that it will go back up in the future. 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 second, 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. Senator Bunning. Last week, you gave a speech and spoke at length about inflation expectations. You also said that expectations are ``imperfectly anchored.'' What in the world does ``imperfectly anchored'' mean? " FOMC20080805meeting--82 80,VICE CHAIRMAN GEITHNER.," I was just going to say this. I think that you can do crude estimates of likely total losses across the U.S. economy and credit markets in a scenario like the baseline scenario in the Greenbook, and if you use Nellie Liang's study or the stuff done in New York, there's a huge amount ahead still. Even though financial market prices now reflect an expectation for house-price declines that are not significantly more optimistic than David's baseline scenario, I don't think you can say with confidence now that financial institutions have already provisioned for or written down losses to accommodate that. Because the trajectory of house prices will depend in part on financial behavior--the availability of credit--as financial institutions catch up and adjust to that and adjust capital and asset growth, et cetera, there is some risk that you'll push that expected path of house prices down further from where it is. So if institutions have to prepare for the possibility that you're going to have a much weaker economic outcome because there's some probability around that, then there's a risk that they will produce that outcome through the combined effects of their behavior, which is why we're living with such a delicate balance. " FOMC20061025meeting--53 51,MS. PIANALTO.," Thank you, Mr. Chairman. For a while now, I’ve been somewhat more pessimistic than most of the Committee about the downside risk to the real economy. I was beginning to get worried that this might be the perpetual disposition of someone from Ohio. [Laughter] As a prominent member of our business community said to me not too long ago, it’s not the weather, it’s the climate. [Laughter] Since our last meeting, I’ve become more comfortable with the idea that substantially weaker-than-forecast growth is less probable—partly because we’re now a little further down the road without any signs that the worst-case scenarios are materializing and partly because my directors and my business contacts seem more positive about the economic outlook. Specifically, as I listened to some of my business contacts in construction, retail, and even real estate, the expectations that things will get substantially worse just aren’t there. Also, the demand for labor seems to be growing at a moderate pace. On the price side, my contacts are not indicating much of an impetus for higher final goods prices. Although projected compensation growth seems to be firming just a bit, my contacts are telling me that they think productivity gains will keep costs in check. With the declining energy and material costs, I don’t hear much about the potential for accelerating pressures on prices. When I combine what I’m hearing from my District contacts with the aggregate data that have come in since our last meeting, I sense that we have weathered the worst in softness on the real side for now. In September I noted that my biggest concern was the possibility that the inflation trend would worsen. It does not appear that this is happening at this point. However, we have yet to see lower rates of core inflation, and I’m sensitive to the fact that core measures of inflation are being held up by the contribution to owners’ equivalent rent from the rising rents and falling utility bills. Although more-stable energy prices will make the latter effect go away, it’s not clear that the rent part of the picture will quickly fade, as rents continue to converge toward still high housing prices. When we look at the distribution of prices in the CPI, excluding energy, food, and owners’ equivalent rent, prices seem to be either rising rapidly or falling. There isn’t much in the middle, and that makes the underlying movements in the inflation trend hard to interpret. It seems to me that the key risk on the real side of the economy has been that the housing market would decline much faster and more deeply than we had forecast and that the effect on consumption spending would be greater than we anticipated. So far, as others have commented, the collateral effect on consumption appears to have been contained. Furthermore, we expected that other forms of spending would hold up as the housing sector slumped, and those expectations appear to be on track for now. I recognize that we’re not out of the woods yet, but the downside risks to the real economy appear somewhat more benign than they did at both the August and the September meetings. In regard to the inflation risks, the probability of accelerating inflation has decreased, in my opinion, but the risk that inflation will remain higher than I personally desire hasn’t really changed. Thank you, Mr. Chairman." CHRG-110hhrg46593--350 Mr. Feldstein," It is very important and impossible to do as long as there remains this risk of continued defaults driving foreclosures, driving house prices down further. So if you looked at an individual mortgage-backed security or even an individual mortgage, it is hard to know what that is worth if there is a risk that, at some point in the future, that is going to default. And that is what makes it so important. " CHRG-110shrg50409--70 Mr. Bernanke," Well, there is speculation, but speculation under most circumstances is a positive thing. It provides liquidity and allows people to hedge their risks. It provides price discovery. It can help allocate oil availability over time, depending on the pattern of futures prices and so on. What is really a concern--what the CFTC, for example, is concerned with would be manipulation as opposed to speculation. Senator Reed. Well, I will use the term ``manipulation'' in the same situation. " CHRG-111hhrg53244--201 Mr. Bernanke," I think that could be addressed under the systemic risk regulation rubric that we have been discussing with the Council or with the Fed overseeing large financial institutions, that when you have an asset whose prices is rising quickly, you could require greater capital against it, for example, or greater downpayments. So even if you don't know there is a bubble or not, that still might be a prudent thing to do. So I do think that looking at asset price fluctuations in a supervisory context could be very helpful. " FOMC20051213meeting--84 82,VICE CHAIRMAN GEITHNER.," Our forecast for the national outlook has not changed substantially since the last meeting, and relative to the discussions so far, I guess we’re slightly at the stronger end. The recent data have been encouraging both here and internationally. The underlying pace of demand growth seems pretty good to us—good enough to raise the probability of the expansion continuing at a pace at or slightly above trend. The inflation news has also been reassuring, though December 13, 2005 51 of 100 We believe these conditions justify some further tightening of monetary policy, perhaps another 50 to 75 basis points. We are, therefore, comfortable with the expectations now built into the market. And with that monetary policy assumption, we think the risks to the forecast and to our objectives are roughly balanced. So, relative to September and October, we see somewhat less downside risk to growth, perhaps even some upside risk, and somewhat less upside risk to inflation. As this implies, our view is very close to the Greenbook. Let me mention a few other points. The apparent strength in productivity should make us more comfortable about the sustainability of the expansion and a bit less concerned about the near- term inflation risks because, of course, if the productivity growth stays stronger longer, we can be more confident that consumer spending will stay reasonably strong even if a more substantial slowdown in housing materializes. Scenarios in which more-moderate house price appreciation or some decline in housing prices leads to a sizable increase in the personal saving rate are probably less plausible or less troubling in an environment where consumers are more confident in the outlook for the economy or more confident in their future income growth. The productivity news, combined with continued moderation in the core inflation numbers and the moderation in measures of inflation expectations, make the inflation outlook somewhat more favorable. But against these factors there are others that justify some continued attention. Of course, overall inflation is still high, even though we expect it to moderate. Various measures of underlying inflation are still above what we would be comfortable with over time. There probably is still some energy cost pressure in the pipeline. And the TIPS-derived measures of inflation expectations over the medium term, if you adjust for the carry effect, have not really moved down that much. With compensation growth accelerating, we would expect eventually to see some upward pressure on labor December 13, 2005 52 of 100 surveys and anecdotal reports of pricing behavior, as we read them, suggest that businesses are able to pass on some share of their increased costs. So for these reasons, even with the additional tightening priced into the markets, we probably face some modest upside risk to our inflation forecast and to our objective, and we should continue to lean against this risk in what we do and what we say. We don’t see evidence yet to support a concern that the path of the nominal fed funds rate now priced into the markets risks going too far. Housing may be slowing a bit, but not really much. Other spending indicators look strong—probably stronger than we thought—and the strength is broader than it has been across the components of GDP. Expected real rates don’t suggest a high degree of concern, in our view. It’s just some concern, but not acute concern about the downside risk to future growth. If you try to take out expected inflation from forward rates, it looks as if real rates move up over the 2- to 5-year horizon. Equity prices, credit spreads, and the implied volatility of most asset prices don’t seem to suggest a lot of concern about significant deterioration ahead in the pace of the expansion. Although we don’t think the narrowing of the term spread itself or the low overall level of the yield curve offers clear guidance about monetary policy—clear guidance in terms of arguing for a softer or firmer stance than the other fundamentals might suggest—we’re somewhat more inclined to take the view that this change in the structure of term premia suggests we will have to do more than otherwise would have been the case. So all of this suggests to us that we should continue to tighten further and signal that we think we have still more to do." FOMC20050630meeting--321 319,MR. FERGUSON.," I’ll continue to plow that ground just for one minute. I’m struck a bit by the fact that the stories on the run-up in commodity prices and oil prices are all about China and India. You have a forecast here where China’s growth falls off fairly dramatically. Growth in the rest of the world I would describe as maybe more of a downside risk. You point out the uncertainty in Europe and Japan and you’ve even marked down economic growth in the United States. Yet your commodity prices tend to be rather flat. All this run-up was associated with China, India, and global growth. You have global growth dampening, but we don’t seem to recover much in the way of these commodity prices—oil being one, but others in general. I’m obviously missing something. What is it?" FOMC20080109confcall--19 17,MR. STOCKTON.," So, indeed, I think this combination of weaker economic growth and higher inflation is an unfortunate situation for you as policymakers. I do think there are some upside risks that you face on inflation, and the recent rise in oil prices probably intensifies those upside risks. We are taking some comfort from two other pieces of information in the constellation of the inflation data that the process isn't slipping away to the upside on inflation. One is, as Bill noted, that we haven't really seen any deterioration in the TIPS-based measures of inflation expectations. We have seen an uptick in the Reuters/Michigan survey of households in the last month or so, on both near-term and long-term inflation expectations. That does tend to happen in periods when gasoline prices are spiking up. I would hate to throw that observation out completely, but I guess as we look at this, we don't really see as yet convincing evidence that there has been a deterioration in inflation expectations. The other thing is that we haven't really seen anything in the way of serious deterioration on the labor cost side. So those two things combine, at least in my mind, not to eliminate but probably to limit some of the upside risks that you're facing on the inflation side. But, clearly, anecdotes are there--not just the data but also anecdotes--that suggest that businesses are facing some considerable cost pressures associated with higher energy and other commodity prices. " CHRG-110hhrg38392--89 Mr. Bernanke," Well, we think it remains a risk. It is important to understand that even should demand begin to stabilize--and it has shown signs at times of stabilizing--we have what you might call an ``inventory problem.'' That is, homebuilders have a large number of unsold homes. So, even if demand were to stabilize, homebuilders would have to continue to cut back on construction in order to eventually bring those inventories into line. So that would, of course, reduce economic activity. It might have some impact on the construction employment and so on. The related concern in terms of the downside risk is that, in order to clear out those inventories, we might start seeing falling prices, and for many people the equity in their homes is their major financial asset. So, the question is whether price declines, moderate price declines, have any significant impact on consumer spending? The evidence so far is that there really has been no spillover that we can see. We are certainly watching for any potential impact of changes in housing values on consumers and on their moods, attitudes, sentiments. It is part of what we are doing, and we are following that market very closely. " FOMC20051101meeting--227 225,MS. DANKER.," I’m reading the directive wording from page 24 of the Bluebook: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 4 percent.” And the assessment of risk, unchanged from the September statement, is: “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" CHRG-111shrg50815--120 M. AUSUBEL Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.1. There is no reason to expect that the new rules will result in the wholesale denial of access to credit cards for any group of consumers that currently has access to credit cards. As such, individuals who currently have access to credit cards are likely to continue to rely primarily on credit cards for their consumer finance needs. Q.2. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.2. There is no reason to expect that consumers will have significantly less access to credit or fewer choices because of the Fed's new rule. The principal effect of the new rule will be to limit penalty pricing of credit card consumers, not to limit access to credit or consumer choices. Q.3. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.3. It should be observed that consumer protection, as furthered by the Dodd bill, will help to contribute to the prudency of loans. Consumers will better understand whether they will be able to repay loans, and they will be more likely to avoid loans that they understand they do not have the reasonable ability to repay. Lenders will be unable to rely on penalty interest rates following delinquency, so they will be more likely to avoid making loans that are destined to go delinquent. It is difficult to state an opinion on prudential regulation more generally, without being provided some specificity about the form of prudential regulation being proposed. Q.4. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? A.4. If it is the case that banks are raising interest rates and limiting credit arbitrarily, this is probably due primarily to the financial crisis and the economic downturn. Under normal circumstances, credit card lending is highly profitable and there is little reason for banks to reduce credit lines. Banks do raise interest rates, but usually not across the board, as this would result in the loss of some profitable customers. There is no reason to expect that the new rules will lead to cross-subsidization of any particular group of customers. Q.5. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.5. No. There is no reason to expect that the new rules will lead to cross-subsidization of any particular group of customers. The principal effect of the new rules will be to limit increases in credit card interest rates following late payments. As documented in my written testimony, the typical increases in interest rates bear no reasonable relation to default risk. The penalties imposed on consumers are typically at least double or triple the enhanced credit losses attributable to these consumers. The terminology of ``risk-based pricing'' for the regulated practices is a misnomer; it is more accurately viewed as ``penalty pricing.'' Under the new rules, banks will still be able to charge higher interest rates (upfront) to riskier customers. That is, true risk-based pricing will still be possible within the rules. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM TRAVIS CHRG-109hhrg28024--105 Mr. Royce," Thank you. May it be that the rise in home ownership and the rise in housing wealth that went along with it over the past several years has enabled many consumers to dip into savings from current income, and thus, maintain spending even in the face of these high energy prices, as there are some signs that housing demand is slow, which you mentioned in your testimony, and the rise in home prices clearly are leveling off or starting to dip, in your view, how big of a risk to consumer spending from what might occur, a rapid downward adjustment in home prices, and are there possible offsetting factors in terms of how this will play out in the economy? " FOMC20050630meeting--419 417,MS. DANKER.," I’ll be reading the directive from page 30 of the Bluebook and the balance of risk assessment from the draft statement: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 3¼ percent.” And for the statement: “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" FOMC20060920meeting--142 140,MR. KOHN.," Thank you, Mr. Chairman. Whatever you want to call me is fine. [Laughter] I’m just glad to be here. [Laughter] I don’t think I can follow that up. Given the initial conditions—the doubling and more of energy prices over the past two years, the overexuberant housing market coming to grips with a renormalization of interest rates, a very low personal saving rate, and an uncomfortable increase in inflation this spring—a period of modestly below-trend growth and gradually ebbing inflation, as in the Greenbook forecast, is about as good an outcome as we can expect, as Dave Stockton noted. In that regard, several developments over the intermeeting period have made me a bit more comfortable with the plausibility of such an outlook. The weakness in housing has deepened and is more definitively leading to growth of output below potential. In fact, in my view the behavior of the housing market constitutes the main downside risk to sustained moderate economic growth. We’re in the middle of a housing adjustment, which has been hard to forecast, especially because it involves the unwinding of an unknown amount of speculative demand. With inventories rising and reports of price cuts getting greater prominence, the market isn’t yet showing signs of clearing and stabilizing. In the Greenbook forecast, residential investment, though weak, is supported by continued growth of income and relatively low mortgage rates, while house prices basically level out in nominal terms. As the Greenbook notes, however, this forecast leaves some aspects of the existing disequilibrium intact, most notably the high level of prices relative to rents. Also, the cutback in construction doesn’t completely offset the apparent excess building of the boom period. As a consequence, I see the housing forecast in the Greenbook as very far from the worst-case scenario that President Minehan characterized it as. And, we are just beginning to see the effect of the downshift in house-price inflation on consumption starting to play out. Outside of housing, however, recent developments should help to sustain continued economic expansion. Financial conditions remain quite supportive of both business and household spending. Long-term interest rates have fallen appreciably since midyear, and they are low in both real and nominal terms. Risk spreads are narrow, banks have not pulled back on business credit, and equity prices have risen on balance in recent months. Lenders and investors appear to remain confident that the economy will continue to expand at a decent pace. Higher levels of labor income in the first half of the year, along with a favorable effect on disposable income of a decline in energy prices, will help support consumer spending going forward. Economies elsewhere seem to be expanding at a solid clip. Moreover, they are probably less vulnerable to spillovers from a housing-led slowdown of growth in the United States than they were to weakness in 2001. That weakness was centered in a global market for investment goods and was reflected in global declines in equity prices. The less robust economy should present businesses with a more competitive environment in which it will be harder to pass through cost increases. In addition, the decline in energy prices, along with the leveling out of other commodity prices, will reduce cost pressures on businesses and should feed through in some measure to lower core inflation, especially as slower growth damps pricing power. The drop in energy prices has already restrained inflation expectations a bit. For all these reasons, I’m also a little more comfortable with the forecast of gradually ebbing core inflation. Nonetheless, I still see significant upside risk to such a path for inflation. In part, this reflects my uncertainty as to the reasons for the rise in inflation this spring and summer. Feed- through of energy and other commodity prices must have contributed to some extent, and we can see evidence of this in the greater price increases for some of the more energy-intensive sectors, such as for airfares. A portion of the pickup is in the rent-of-shelter category, likely from a shift to rental housing as expectations of house-price appreciation have been scaled back. But price increases have picked up in a number of other categories, and although energy costs probably accounted for some of this acceleration, we can’t dismiss the possibility that other forces were at work—for example, more general pressure of demand on potential output. A reduction of those types of pressures is still only a forecast. On the cost side, as many have commented, the compensation and unit labor cost data, while flawed in many respects, could be pointing to a risk that higher labor costs will persist, putting pressure on prices that might only be partially and reluctantly absorbed by profit margins. In sum, Mr. Chairman, I’m a bit more comfortable with something like the path for the economy and inflation in the Greenbook forecast, but uncertainties are quite high. They might even justify the “higher than usual” description. The downward path for inflation remains at risk, and as others have noted, the costs of exceeding that path could be disproportionate. Thank you." FinancialCrisisReport--386 In late February, Goldman’s Operating Committee, a subcommittee of its Firmwide Risk Committee, became concerned about the size of the $10 billion net short position. The Firmwide Risk Committee was co-chaired by Mr. Viniar, and Messrs. Cohn and Blankfein regularly attended its meetings. 1560 The concern arose, in part, because the $10 billion net short position had dramatically increased the Mortgage Department’s Value-at-Risk or “VAR,” the primary measure Goldman used to compute its risk. The Committee ordered the Department to lock in its profits by “covering its shorts,” as explained above. The Mortgage Department complied by covering most, but not all, of the $10 billion net short and brought down its VAR. It then maintained a relatively lower risk profile from March through May 2007. Attempted Short Squeeze. In May 2007, the Mortgage Department’s Asset Backed Security (ABS) Trading Desk attempted a “short squeeze” of the CDS market that was intended to compel other market participants to sell their short positions at artificially low prices. 1561 Goldman’s ABS Desk was still in the process of covering the Mortgage Department’s shorts by offering CDS contracts in which Goldman took the long side. The ABS Desk devised a plan in which it would offer those CDS contracts to short parties at lower and lower prices, in an effort to drive down the overall market price of the shorts. As prices fell, Goldman’s expectation was that other short parties would begin to sell their short positions, in order to avoid having to sell at still lower prices. The ABS Desk planned to buy up those short positions at the artificially low prices it had caused, thereby rebuilding its own net short position at a lower cost. 1562 The ABS Desk initiated its plan, and during the same period Goldman customers protested the lower values assigned by Goldman to their short positions as out of line with the market. Despite the lower prices, the parties who already held short positions generally kept them and did not try to sell them. In June, after learning that two Bear Stearns hedge funds specializing in subprime mortgage assets might collapse, the ABS Desk abandoned its short squeeze effort and recommenced buying short positions at the prevailing market prices. The Big Short. In mid-June 2007, the two Bear Stearns hedge funds did collapse, triggering another steep decline in the value of subprime mortgage assets. In response, Goldman immediately went short again, to profit from the falling prices. Within two weeks, Goldman had massed a large number of CDS contracts shorting a variety of subprime mortgage assets. On 1558 3/10/2007 email to Daniel Sparks, “Mortgage Presentation to the board, ” GS M BS-E-013323395, Hearing Exhibit 4/27-17. 12/13/2006 Goldman email, “Subprime Mortgage Risk,” Hearing Exhibit 4/27-2. 1559 1560 8/23/2007 email from Tom Montag, “Current Outstanding Notional SN ames,” GS MBS-E-010621231. 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined Comments, ” GS MBS-E-010135693-715 at 695). 1561 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Self-Review of Deeb Salem, GS-PSI-03157-80 at 72 (hereinafter “Salem 2007 Self-Review ”). 1562 Id. CHRG-109shrg26643--43 Chairman Bernanke," That would be a difficult situation because, on the one hand, higher energy prices would put pressure on inflation, but higher energy prices would also hurt consumer budgets and would probably or could possibly lead consumers to spend less. Together with weakening of the housing market, which might also lead to a higher savings rate and slower consumption spending, we would be in a situation with pressures in both directions, and I cannot really offer much more guidance other than to say that we would have to weigh the relative severity of the two risks. " CHRG-111hhrg49968--26 Mr. Bernanke," Well, of course, we always have to keep modifying our models and addressing new situations. But we have a lot of ways of checking on expectations, including monthly surveys of both businesses and households, the daily behavior of the TIPS market, the daily behavior of commodity prices, and other factors. And, in particular, you know, inflation expectations can only result in inflation if they actually affect wage and price setting. And what we are seeing in the markets is that prices of manufactured goods, for example, and wages in nominal terms are not showing any signs of a wage-price spiral. To the contrary, they are showing quite a slow rate of growth. So, first of all, I want to say that in the medium to longer term we are very focused on the price stability issue, and I understand your concerns about that. But, as best we as can tell within the uncertainties of the forecasting, we don't see any inflation risk in the near term. " CHRG-111shrg50815--118 STURDEVANT Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.1. Did not respond by publication deadline. Q.2. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.2. Did not respond by publication deadline. Q.3. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.3. Did not respond by publication deadline. Q.4. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? A.4. Did not respond by publication deadline. Q.5. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.5. Did not respond by publication deadline. Q.6. Transactional Users vs. Revolving Users: Mr. Zywicki has said in previous Congressional testimony that prior pricing mechanisms--which relied to a large degree on annual fees--forced transactional users of credit cards to subsidize the actions of consumers who carry revolving debts. I do not believe that the two categories should be treated in the same manner. The new regulations seem to limit the ability of lenders to use tools to distinguish between the borrowers characteristics. Do you believe that borrowers' rates and fees should be determined based on their own actions and not on those of others? Do you think that credit card offerings from the past, which had high APR's and annual fees for all customers were more consumer friendly than recent offerings that use other tools to determine fees and interest rates? A.6. Did not respond by publication deadline. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM TODD FOMC20080805meeting--12 10,MR. PLOSSER.," Thank you, Mr. Chairman. I want to follow up on that a little because it seems to me that, over a year ago now, there was a lot of discussion by various parties that had to do with risk premiums being very low. People were worried that the economy and the financial markets were underpricing risk. Now, all of a sudden, these spreads have increased. If you look at the OIS spread that you referred to, the one-to-two years out, is there a possibility that this is permanent--that in some sense the level of spreads in the pricing of the risk is just now higher and it is going to stay higher, maybe not as high as the peak but at some higher level? If that is true, then using those spreads as a measure of how distressed the market is could be very misleading. As a consequence, it would seem as though you would want to be asking questions not just about the prices and the spreads but also about volumes in these markets. Maybe, Bill, you can elaborate on what volumes are doing--certainly in the near-term, the overnight, and the one-month interbank funding markets? Are volumes back to their levels even though the spreads are higher? I think we have to be a little careful that, if this really is a permanent shift in risk premiums, looking at these things may be the wrong metric for assessing what is going on. If you have any observations about that, I would like to hear them. " FOMC20080625meeting--84 82,MS. PIANALTO.," Thank you, Mr. Chairman. The last two months have brought an interesting shift in my conversations with my business contacts. Their concerns have shifted from problems in financial markets to the rapid increase in input prices. Energy prices are the focus nationwide, but steel prices are also capturing the attention of the business people in my District. Several manufacturers and builders noted that the price they pay for steel has almost doubled since the beginning of this year. Clearly, businesses are worried about signs of growing price pressures, but their reactions to these price shocks tell a more complicated story. Many manufacturers have not been able to pass on price increases, resulting in a clear loss to profit margins. These businesses often report cost-containment or efficiency programs that will affect their hiring and capital decisions for months to come. Interestingly, the consumer price data show a similar dichotomy. My staff noted that our primary measures of core inflation are not providing a consistent story about the path of underlying inflation. In the May CPI report, roughly one-third of the weighted price changes increased at rates above 5 percent, and roughly one-third of prices changed by rates less than 1 percent. For example, while energy costs were up strongly and prices for a number of general service components have been drifting higher, large declines in apparel and vehicle expenses are imparting significant offsets. The 16 percent trimmed mean indicator showed an alarming 4 percent rise in prices, while the median rose just at 2.2 percent. The weight of price changes in the 1 percent to 5 percent range was unusually small, making it difficult to estimate the central tendency of the price change distribution with much confidence. So this makes it difficult to get a good read on where future prices are headed. My District business contacts remain pessimistic about growth prospects. District retail reports focused extensively on the likely effects of gasoline and food prices on the purchasing decisions of consumers. Many manufacturers, builders, and distributors are facing complicated output and investment decisions in the context of input price growth and weaker markets. Overall, most of the business people that I talk with are still quite cautious about their business plans, despite the fact that most of them have found sources of credit and terms that are not too elevated from what they have seen in previous years. In the economic projections that I submitted for this meeting, I raised my near-term forecast for output growth slightly and for headline inflation slightly more. Over the medium term, my outlook continues to be for modest growth because the housing market, in my forecast, recovers slowly, actually more slowly than in the Greenbook. My staff estimated a model for national housing starts that takes into account what has happened in the past in states that have seen major increases in foreclosures. The real estate difficulties that these states faced were much more persistent than anything that we have yet seen in the national data. The bottom line of this analysis is that, if the patterns of past housing cycles from the states that experienced the boom�bust cycles are repeated at the national level, then housing starts should remain relatively weak over the next couple of years. Supporting this analysis, three of the large regional banking organizations in my District are increasing their loan-loss provisions significantly in the second quarter based on the continued deterioration in the housing sector. Based on current projections, these institutions are projecting housing sector credit losses to accelerate in the second half of 2008 and to continue into 2009. Currently, the weak output growth contributes to my forecast of declining inflation rates, especially the core rate, but I also see evidence supporting that view in the ""less worker bargaining power"" scenario that is in the Greenbook. My contacts see very little price pressures coming from labor costs now or in the near future. Finally, implicit in my forecast for output growth and inflation is a fed funds rate path that includes increases later this year and into next year. Although additional risks to growth remain, the primary risk to my forecast concerns input prices and inflation expectations. If commodity prices continue to accelerate, they are going to put upward pressure on both headline and core inflation and downward pressure on output. That environment could lead to a highly undesirable increase in inflation expectations. On the positive side of risk to the outlook, I think that the fed funds rate actions that we have taken, in conjunction with the actions that we took in August to bolster market liquidity, have improved confidence, and I have substantially lowered the odds I had placed on financial market meltdown and on a severe recession. In that sense, since our meeting in April the downside risks to my outlook for economic growth have lessened somewhat, and the risks to my inflation outlook have moved up somewhat. Regarding the issue of providing longer-term forecasts, I have long supported efforts to clarify the underlying objectives of FOMC participants by providing our longer-term economic projections. Of the proposals that were offered by the Subcommittee on Communications, I favor reporting the average values for output growth, unemployment, and total inflation expected over a five-to-ten-year period--option 3. The features of these five-to-ten-year projections that I find attractive are that they indicate where the economy might converge and don't imply too much knowledge of the path to the long run. Thank you, Mr. Chairman. " CHRG-111shrg57923--32 Mr. Engle," Well, I think what I was going to say before is also related to this. The systemic regulator is going to have to use the incentives in the marketplace to achieve his goals. He is not going to be able to just legislate one thing or another, and our use of capital standards, capital controls, are ways of trying to nudge the institutions to take less risk or change their behavior in one way or another. Systemic taxes are very much designed to encourage institutions who have systemic risk to avoid the taxes by shedding the systemic risk if you can define and devise the systemic tax in exactly that way. The reason I think that making data public is useful is quite easily seen in the OTC derivatives market, where every time you enter a contract, you have a counterparty. And this counterparty has a risk that they will not perform. If the derivative turns out to have the value you want it to, then your counterparty may not perform. So we have to consider there being these extra risks, and it is very hard to assess the risk that your counterparty is going to be there if you don't know very much about what the counterparty is doing. So if we had more information on the health of counterparties, in other words, how much exposure they had to these same kinds of contracts, then the prices of the same deal with two different counterparties might not be the same. There would be a risk premium and you could decide whether you wanted to take the weak counterparty or the strong counterparty and you would get a different price in those contracts. That way, you would understand what risks you were taking and the weak counterparties would not be able to amass big positions. The poster child for this example is AIG, who, of course, wrote lots of credit default swaps but didn't have enough capital behind it, and investment bankers and final users bought a great deal of these contracts and insurance products without recognizing that actually they should have gotten a big discount on getting them because they weren't really so likely to pay off because AIG had such a big position. So if you could make public information on a basis which said, for each counterparty, how exposed is this counterparty--how many positions does this counterparty have maybe a week ago on these kinds of contracts? This would give the market a way of evaluating the risk that they were taking with each counterparty. I think it would also encourage trades to move toward exchanges or centralized counterparty where you might not have to produce this information. So I think that the transparency has a dual role in this case. It would encourage the migration of products to centralized clearing, which is something that we think would reduce systemic risk, and it would allow investors to understand the risks and price the risks they are taking better and thereby both of these would reduce systemic risk. Senator Corker. Professor Liechty, I have two more questions. Senator Reed. Go right ahead. Senator Corker. Professor Liechty, how long would it take--you know, we talked a little bit about this in the office, but let us say something like this became law in the summer of 2010. How long would it take before an entity like this was at least providing some of the basic information, not data, but information that would be useful to someone who is looking at systemic risk or other prudential regulators? " CHRG-111shrg50815--117 CLAYTON Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.1. It is likely that consumers perceived to have higher levels of risk--including those that are new to credit--will bear the brunt of credit reductions resulting from the rule. Thus, as noted in your question, the inability to price risk effectively may well mean less access to credit for very deserving individuals just because card issuers are unsure of the credit risk involved and will not be able to price for that risk as it becomes more apparent. As the credit needs of these individuals are unlikely to disappear--and, in fact, may actually increase due to exigent economic circumstances, e.g., unemployment--these consumers will likely be forced to turn to non-federally regulated lenders including payday lenders and loan sharks. Q.2. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.2. The new rule will affect every aspect of the credit card business, from how cards are funded, to how they are priced, to how they are marketed, and to how credit is allocated among customers of differing credit histories and risk. Because the rules are so strong, card lenders may have to increase interest rates in general, lower credit lines, assess more annual fees, and reduce credit options for some customers. The full impact of these changes will likely not be fully known for several years as business practices are changed and as the credit availability works its way through the economy. The new rule may also lead to higher interest rates or fees (such as annual fees) for all cardholders in order to compensate for the inability to price risk effectively. Thus, the least risky borrowers must now bear the cost for higher risk borrowers because the higher-risk borrowers will no longer bear the full cost of the exposure they pose to lenders. It may also be the case that payment allocation requirements will lead to the elimination of low-rate balance transfers that consumers and small businesses previously used to lower overall debt costs. Simply put, the sum total of all these rules will likely lead to reduced access to credit and higher prices to all consumers, in addition to many fewer choices on card products. We do not believe this is a desirable outcome for both consumers and the broader economy. Q.3. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.3. A system linking bank regulation and consumer protection forces more balanced supervision without the turf battles and inefficiency inherent in bifurcated jurisdiction. The two are highly integrated, and that one aspect cannot and should not be divorced from the other. This ensures that, for example, safe and sound lending would not be compromised by fee and rate restrictions envisioned by a consumer regulator only concerned with driving consumer costs down unencumbered by a need to consider the impact such restrictions may have on adequate return. Q.4. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? A.4. The rising interest rates and limitations on credit are due primarily to three factors. First, in the present challenging economic time, lenders are being more careful. Delinquencies on credit card accounts have significantly increased as a result of rising unemployment and uncertainty in the economy. This substantial increase in repayment risk affects the ability of lenders to make new loans, and requires companies to carefully evaluate and minimize their risk across the board so that they may stay in business and continue to make new loans. Second, funding costs have increased dramatically in the secondary market, which funds nearly half (or approximately $450 billion) of all credit card loans made by commercial banks. Investors are extremely sensitive to changes in the terms and conditions of the underlying asset, as has been evident in the current market, where investors have shunned nearly all forms of asset-backed securities over fears in the underlying economy. This drives up the cost of funding new credit, and leads to higher costs to consumers. Third, all businesses are concerned for the future, as borrowers' ability to repay may become severely compromised. This is particularly true with respect to credit card loans, which are open-end lines of credit, unsecured and greatly subject to changing risk profiles of borrowers. Banks need to ensure they will be paid for the risks they have taken in credit card loans; otherwise they will not be able to continue to make loans. As a result, many institutions must raise rates and reduce risk exposure in order to continue to lend. This results in all borrowers having to bear the cost of higher risk generally, a trend that will be exacerbated by the new regulations that limit the ability of lenders to price particular individuals for the risk they pose. Q.5. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.5. Reducing the ability of lenders to manage risk forces them to apply more general models to all account holders. The consequence of applying general models is that all account holders pay somewhat equally. Lower-risk borrowers at all income levels bear the brunt of this burden. Q.6. Role of Securitization: It is my understanding that during the height of the credit boom nearly half of all credit card debt outstanding was held in securitization trusts. Over the last 18 months much of the securitization market has been severely constrained. The Federal Reserve wants to revive the securitization markets through the Term Asset Lending Facility (TALF), but it is not yet operational. How important is a rebound in the securitization market to the availability of consumer credit? In other words, how much greater will the contraction be in the credit card space without securitization? A.6. The rebound in the securitization market is a critical component to the availability of credit in our economy. Credit cards are funded from two primary sources: deposits and secondary market funding, each accounting for about half--approximately $0.5 trillion dollars--of the total funding of card loans to consumers. Funding in the secondary market relies on investors' willingness to hold securities that are backed by credit card receivables. Any change in the terms of issuance can greatly impact the receptivity of investors to holding these securities. If investors perceive that there is greater risk, they are less likely to hold these securities, or may require significantly higher interest rates or other enhancements to compensate them for the risk. This means that less funding will be available, and if available, more costly. This translates into less credit available at higher cost to customers. It is hard to speculate as to the extent of greater contraction caused by a non-functioning securitization market, as lenders will have to turn to a limited number of alternative--and higher priced--funding mechanisms. However, we do believe the additional contraction would be very significant, and is reflected in the Administration's concern over this important aspect of the marketplace. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM JAMES C. FOMC20081216meeting--470 468,MR. KOHN.," A comment and a question. One comment, to follow up on your comment, Mr. Chairman, to President Lacker--I think there's pretty good evidence that there are liquidity strains in the market, beyond just credit strains, impinging on the price of these securities. One piece of evidence I would cite is the difference between on-the-run and the off-the-run Treasury security rates, which have gapped out by 40 or 50 basis points even from--well, I'm not even sure where they are relative to '98, but I think they're at record levels. The unwillingness of people--by ""people"" I mean market makers--to take positions and to do trades--their caution--is affecting the pricing of all kinds of securities well beyond the credit risk, and obviously there's no difference in the credit risk in on-the-run and off-the-run Treasury securities. " FOMC20080430meeting--87 85,MR. EVANS.," Thank you, Mr. Chairman. I was pleasantly surprised that we have not had any major downside surprises since our March 18 meeting. So while I still recognize the economy's downside risks, I've become less comfortable about signing onto the Greenbook's judgment that a nonlinear step-down in activity currently is in train. On balance, our projection still looks for weakness in the near term and then has growth picking up as we move through 2008 and into 2009. We see a noticeable output gap opening this year but not one as large as in the Greenbook. Under this forecast, it is possible that some portion of 2008 might eventually be labeled a recession, but it is not yet conclusive that it will be. Indeed, given the highly unexpected development that events have proceeded as expected, I think the downside risks to growth have abated some. Some of the stress in financial markets has been mitigated by our new lending policies as well as actions by banks in recognizing losses and raising capital. Neither the incoming data nor the reports from my business contacts seem to be consistent with the bleak downside scenarios that I feared might transpire after we saw the December employment report early this year. In this regard, I will simply note a couple of observations from my contacts. A national shopping mall developer reported that his tenants experienced a small improvement in April retail sales compared with March. He was not expecting that. Similarly, Manpower indicated a small improvement in billable hours for temporary workers over the past month and a half, also unexpected. Now, I am not saying that I will be surprised if the outlook deteriorates further. I am saying that the likelihood of that event seems to be smaller today than I expected at our last two meetings. Accordingly, I think that current real interest rates are appropriately accommodative relative to the baseline forecast for economic growth and the risk to that outlook. As seen in chart 6 of the Bluebook, the real funds rate is essentially zero. Of course, this uses a core PCE measure of inflation and thus may overstate the true real rate since headline inflation has been consistently running above this core measure. There is the additional accommodation that is being provided by the range of new lending facilities we had put in place. The extra accommodation is appropriate to offset the large degree of restraint still being exerted from financial markets, and our expansion of the swap lines and the TAF adds to this accommodation. Furthermore, in the event of a nonlinear step-down in economic activity, as in the Greenbook forecast, our policy responses can be adjusted appropriately because we're well positioned now for that. On the price side, on balance, the recent news has been good. My forecast has core PCE inflation falling to just under 2 percent in 2010 largely because of the increasing resource slack in the economy. However, I think there are substantial upside risks to this outlook. All of my business contacts have noted how high and rising energy and commodity prices are creating cost pressures that many are passing on to their customers. As Dave Stockton mentioned, with his inflation catechism, without reviewing the past transcripts I will speculate that we have been projecting a leveling-out of energy prices since the price of oil was $70 a barrel. Weak domestic demand may limit the degree to which producers can pass through these higher costs, but it is unlikely to prevent noticeable increases in some downstream prices. The depreciation of the dollar also imposes risks even beyond the effects operating through the commodity price channel. Now, I do agree that labor costs have not been cited as a problem for inflationary pressures, and so that does add somewhat to trimming out the risks there. Inflation expectations were also an issue. No matter how often we say that core inflation is a more reliable measure of underlying inflationary tendencies, I find it difficult to believe that the public's inflationary expectations will not be affected by large and persistent increases in food and energy prices. The past five years have been unkind on this score. On average over this time, higher food and energy prices have pushed total inflation above core about � percentage point, and it is also sizable over the past ten years. Another challenge for inflationary expectations comes from our policy focus on the downside risks to growth during a time of rising headline inflation. Rightly or not, this could make the public question our attitudes toward inflation. We are accepting considerable inflationary risks when we hope that these concerns will disappear quickly with future adjustments to policy that have not yet been signaled. How we balance these conflicting risks should be an important component of our discussion tomorrow. Thank you, Mr. Chairman. " CHRG-111shrg54533--33 Secretary Geithner," Our plan does not address a range of other causes of this crisis, including policies pursued around the world that helped produce a long period of very low interest rates and a very, very substantial boom in asset prices, housing prices, not just in this country but in countries around the world. And I think you are right to underscore the basic fact that a lot of things contributed to this crisis. It was not just failures in supervision and regulation. And as part of what the world does, major countries around the world, in trying to reduce the risk we have a crisis like this in the future, it will require thinking better through how to avoid the risk that monetary macroeconomic policies contribute to future booms and asset prices and credit bubbles of this magnitude. Senator Bunning. Your plan puts a lot of faith in the Federal Reserve's ability to spot risk and exercise its power to prevent the next crisis. However, if the Fed and other regulators have been doing their jobs and paying attention to what the banks and other firms were doing earlier this decade, they almost certainly could have prevented the mess. And the Fed has proven it is unwilling to use its power it has. Let me give you an example. Just look how slow it addressed the credit card abuses, and it took 14 years for the Fed to write one regulation on mortgages after we gave them the power to do that. So giving them the power and making them act are two different things. What makes you think that the Fed will do better this time around? " FOMC20050809meeting--218 216,MS. DANKER.," I’ll be reading the directive and the risk assessment from page 23 of the Bluebook: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 3½ percent.” The risk assessment portion reads: “The Committee perceives that with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill August 9, 2005 94 of 110" CHRG-110shrg50369--58 Mr. Bernanke," As you say, if it becomes entrenched, if inflation expectations were to rise and that were to lead to a wage-price spiral, for example, or, non-energy, non-food prices rising more quickly, that would be more of a concern. As I said, we are concerned. I do not wish to convey in any way that we are not concerned about it. We are trying to balance a number of different risks against each other. With respect to inflation, as I said, our anticipation is that inflation will come down this year and be close to price stability this year and next year. If it does not, then what we will be watching particularly carefully is whether or not inflation expectations or non-energy, non-food prices are beginning to show evidence of entrenchment, of higher inflation, as you point out. That would certainly be of significant concern to us and one that we are watching very carefully. Senator Menendez. Let me ask you, with consumers reluctant to spend and businesses reluctant to invest and lenders reluctant to lend and home prices going downwards, is the lower interest rates, do you believe, going to be enough to do the trick? " FinancialCrisisReport--67 Mr. Schneider told the Subcommittee that the numbers listed on the chart were not projections, but the numbers generated from actual, historical loan data. 172 As the chart makes clear, the least profitable loans for WaMu were government backed and fixed rate loans. Those loans were typically purchased by the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac which paid relatively low prices for them. Instead of focusing on those low margin loans, WaMu’s management looked to make profits elsewhere, and elected to focus on the most profitable loans, which were the Option ARM, home equity, and subprime loans. In 2005, subprime loans, with 150 basis points, were eight times more profitable than a fixed rate loan at 19 basis points and more than 10 times as profitable as government backed loans. The gain on sale data WaMu collected drove not only WaMu’s decision to focus on higher risk home loans, but also how the bank priced those loans for borrowers. In determining how much it would charge for a loan, the bank calculated first what price the loan would obtain on Wall Street. As Mr. Beck explained in his testimony before the Subcommittee: “Because WaMu’s capital markets organization was engaged in the secondary mortgage market, it had ready access to information regarding how the market priced loan products. Therefore my team helped determine the initial prices at which WaMu could offer loans by beginning with the applicable market prices for private or agency-backed mortgage securities and adding the various costs WaMu incurred in the origination, sale, and servicing of home loans.” 173 (5) Acknowledging Unsustainable Housing Price Increases In 2004, before WaMu implemented its High Risk Lending Strategy, the Chief Risk Officer Jim Vanasek expressed internally concern about the unsustainable rise in housing prices, loosening lending standards, and the possible consequences. On September 2, 2004, just months before the formal presentation of the High Risk Lending Strategy to the Board of Directors, Mr. Vanasek circulated a prescient memorandum to WaMu’s mortgage underwriting and appraisal staff, warning of a bubble in housing prices and encouraging tighter underwriting. The memorandum also captured a sense of the turmoil and pressure at WaMu. Under the subject heading, “Perspective,” Mr. Vanasek wrote: “I want to share just a few thoughts with all of you as we begin the month of September. Clearly you have gone through a difficult period of time with all of the changes in the mortgage area of the bank. Staff cuts and recent defections have only added to the stress. Mark Hillis [a Senior Risk Officer] and I are painfully aware of the toll that this has taken on some of you and have felt it is important to tell you that we recognize it has been and continues to be difficult. 172 Subcommittee interview of David Schneider (2/16/2010). 173 April 13, 2010 Subcommittee Hearing at 53. “In the midst of all this change and stress, patience is growing thin. We understand that. We also know that loan originators are pushing very hard for deals. But we need to put all of this in perspective. “At this point in the mortgage cycle with prices having increased far beyond the rate of increase in personal incomes, there clearly comes a time when prices must slow down or perhaps even decline. There have been so many warnings of a Housing Bubble that we all tend now to ignore them because thus far it has not happened. I am not in the business of forecasting, but I have a healthy respect for the underlying data which says ultimately this environment is no longer sustainable. Therefore I would conclude that now is not the time to be pushing appraisal values. If anything we should be a bit more conservative across the board. Kerry Killinger and Bill Longbrake [a Vice Chair of WaMu] have both expressed renewed concern over this issue. “This is a point where we should be much more careful about exceptions. It is highly questionable as to how strong this economy may be; there is clearly no consensus on Wall Street. If the economy stalls, the combination of low FICOs, high LTVs and inordinate numbers of exceptions will come back to haunt us.” 174 FOMC20061025meeting--191 189,MR. HOENIG.," Thank you, Mr. Chairman. My preference also is to maintain the rate at 5¼ percent. For the near-term outlook, I think an important recent development that has been noted is the decline in energy prices. As I said yesterday, lower energy prices do help cushion the effects of the housing slowdown, and they do reduce the downside risk to growth over the near term. At the same time, by lowering headline inflation, I think they help contain some of the inflationary expectations. So if that rate is maintained, I think we will, in fact, contribute to lower core inflation. By reducing both the downside risk to growth and the upside risk to inflation, the decline in energy prices makes it more likely that we can continue to maintain the fed funds rate at what I’ve described as its current moderately restrictive level until core inflation returns to more a acceptable level. At the same time, I continue to believe that the upside risk to inflation does remain. The recent monthly pattern in core inflation, while encouraging, does not firmly establish a downward trajectory, which I think is very important to establish. Consequently, I would be prepared to leave the fed funds rate at that level and have it naturally firm as mentioned by others, and I would support additional tightening should inflation reverse course. Let me very briefly talk about the statement. While downside risks to growth remain, I would not want to convey to the markets the impression that any near-term easing of policy is likely at all. As markets have only recently understood the message in the last press statement, I believe we can best accomplish this by updating the rationale section using the wording suggested in alternative B, section 2. I’m comfortable with the word “moderate.” I think Vince gave a good definition of it—at or slightly less than potential. I don’t think that word would be harmful at all. But then I would go alternative A for section 3, and I would maintain the wording of the assessment of risk that was used last time. I would not be in favor of modifying the language of the risk assessment in an attempt to get the markets to alter their current views of the expected policy path. Thank you." FOMC20080318meeting--101 99,CHAIRMAN BERNANKE.," Thank you very much. Thank you for all of your comments. Let me just briefly summarize and add a few points. To summarize the discussion, incoming data have been weak, and some view the economy as having entered recession. Housing demand and construction have continued to decline sharply, and house-price declines have been somewhat greater than expected. Housing weakness has implications for employment, for consumer spending, and for credit conditions. It also leads to 21 miles of empty boxcars. [Laughter] Financial conditions have worsened considerably, reflecting weakness in housing prices, and credit markets in particular are highly stressed and illiquid. Wider spreads have offset some or all of the decline in safe rates for many credit products, and credit conditions are tighter for most borrowers. Financial conditions are likely to be a significant drag on economic growth. Some noted the risk that continued financial turmoil could lead to a more serious and prolonged recession, implying possibly large downside risk to growth. With respect to households, consumption growth has flattened out, and there was generally greater pessimism about the labor market and economic prospects. Consumer credit quality may be worsening. Payroll employment growth has turned negative. There was little expectation expressed of strong help from the fiscal stimulus package. Firms are generally more pessimistic and cautious but also remain concerned about cost pressures. Inventories look to be in balance. Exports continue to be an important source of final demand and will continue to contribute significantly to growth, although it's possible that growth abroad may slow. Readings on core inflation have been mixed. Increases in energy and commodity prices are important sources of increased headline inflation, and some producers have adopted a cost-plus mentality. Agricultural prices, in particular, are up a good bit. Inflation breakevens are up somewhat, especially at the five-by-five horizon. The dollar has depreciated, potentially adding to longer-term inflation pressures and adding some risks. However, nominal wage increases are moderate, as are unit labor costs, and U.S. and global economic weakness could moderate gains in commodity prices and create domestic economic slack. Several members warned about the risk of losing inflation credibility. Any comments, thoughts? Let me make just a few comments. Again, I'm very sympathetic to what almost everyone has said around the table, in particular the fact that we're facing a three-front war, if you will, which makes this extraordinarily difficult and delicate. I thought in January that we were in recession. That was my view at that time, and I certainly believe it now. The Greenbook has done a good job of trying to factor in the data and the other types of evidence. I think I'm actually slightly darker on growth than the Greenbook is. The reason is that I don't see where the recovery is coming from in the beginning of next year. In particular, we won't have a recovery until financial markets stabilize, and the financial markets won't stabilize until house prices stabilize, and there is simply no particular reason to choose a time for that to happen. So I do think that the downside risks are quite significant and that this so-called adverse feedback loop is currently in full play. At some point, of course, either things will stabilize or there will be some kind of massive governmental intervention, but I just don't have much confidence about the timing of that. I would like to say a word. I would just agree with Governor Mishkin about the efficacy of our policy. I think that it has had an effect and it has been beneficial. We obviously affect shortterm rates, including commercial paper rates and the like, which have implications for financing and for borrowing. We affect the dollar, which has mixed effects, but on the growth side has some positive effects. It's true, as President Fisher pointed out, that medium-term and long-term rates have not fallen because lower Treasury rates have been offset by higher spreads, but again, the question is the counterfactual. Where would we be if we had not lowered rates? I think that lower rates have both lowered safe rates and offset to some extent the rising concerns about solvency, which have caused the credit spreads to widen. I think this argument can go either way. You can say that our policy is less effective and, therefore, we should do more of it. So there are two ways of looking at that. In addition, there may be some benefits for capital formation of low financing rates and a steep yield curve in keeping bank share prices from entirely collapsing. On inflation, I agree with much of what's been said, and I'm very concerned about it. Let me make one simple point, though, which I don't think has been adequately discussed. Ninety-five percent of the inflation that we're seeing is either the direct or the indirect effect of globally traded commodity prices--food, energy, and other commodities. What is happening is that there is a change in the relative price of, say, oil and the wage of an Ohio manufacturing worker. There's a relative price change going on. That has to happen one way or the other. It can happen either by overall increases in the nominal price of oil, which are reflected in overall increases in headline CPI inflation, or by lower or negative growth in nominal wages. Now, if we have temporary movements in these relative prices, I think all the theory tells us that the best way to let that relative price change happen is to let the shock feed through; let the prices of energy, commodities, and so on rise; accept a temporary increase in headline inflation; and focus on making sure that the increase in headline inflation doesn't feed through into domestic core inflation, say, through wages or domestic prices. A good response to that is, well, we've had a lot of ""temporary"" shocks here and they have gone on for a long time. That's certainly true. But again, it was very difficult to anticipate how these prices have moved. Looking forward, the futures markets have been wrong and wrong, but they are the best we have. In my view, if we think about the likely slowdown in the U.S. economy and the global economy, there are going to be some forces that will prevent commodity prices from continuing to rise the way they have been rising, which ought to take the pressure off the inflation process. That being said, I fully recognize that there has been a bit of movement in some of the indicators. I think I like the use of the index measure. It uses lots of different indicators. I don't think we should overemphasize inflation compensation. For example, the one-year inflation compensation three and four years out has moved up less than the five-by-five, and I think for good reasons. The five-byfive could reflect, again, general uncertainty. It could also reflect more volatility in the relative price changes of oil, for example. If we think there's more volatility in that, if it's up or down, that would create more uncertainty about headline inflation and would feed through into that spread. Frankly, in thinking about inflation, I am concerned about inflation expectations and the general psychology. I'm hopeful at least that it will moderate as commodity prices moderate although, of course, no one can know for sure. I agree with Governor Warsh that, from a financial perspective on the inflation side, the greater dangers are in the currency area. Exchange rates are very poorly tied down by fundamentals, except over very long periods of time--I think Ken Rogoff had a paper in which he said that over maybe 600 years or so the PPP finally works. [Laughter] So a lot of psychology is there. I think that it is an important issue. We need to think about what the Treasury will say and those sorts of things. That is a concern, and I consider that in some sense a greater risk at this point. So there are risks on both sides. I think that the downside risks, including the financial risks, at this point are greater--not to belittle inflation risks, which I think are quite significant. We are obviously going to have to make tradeoffs about how to deal with these. Using both our policy tools and our communication is very important. I agree with Vice Chairman Geithner that we need and I need--and I have a very important role here--to maintain clarity in communication about our attention to inflation, that we are not ignoring that side of the mandate. Finally, let me just say, as I said last night at the dinner with the presidents, that I think we are getting to the point where the Federal Reserve's tools, both its liquidity tools and its interest rate tools, are not by themselves sufficient to resolve our troubles. More help, more activity, from the Congress and the Administration to address housing issues, for example, would be desirable. We are certainly working on those issues here at the Board, and I will be talking to people in Washington about what might be done to try to address more fundamentally these issues of the housing market and the financial markets. So those are my comments. Why don't we turn now to Brian for an introduction to the policy round. " FOMC20080318meeting--86 84,MR. KOHN.," Thank you Mr. Chairman. I agree with the others around the table who have said that the prospects for economic activity have taken another sizable leg down over the intermeeting period. I think we have been, for a time, in that adverse feedback loop between financial markets and spending that everybody--Governor Mishkin and others--has been talking about. That is not an unusual kind of loop to be in during a soft economic period. I think it is probably characteristic of a lot of slow growth and recessionary periods. But certainly it has been more intense this time because the financial turmoil has spread well beyond housing and has intensified significantly over the intermeeting period. The incoming data on spending, employment, and production were weaker than expected. House prices are moving lower by more than we or the markets expected. All of these data have accentuated concerns about the creditworthiness of households and businesses and, hence, about the creditworthiness of the people who lend to them, especially those who lend in the mortgage market. As perceptions of risk and risk aversion rose, there was a flight to safety and liquidity. I think we see that a little in the growth of M2 over the past couple of months, which has been very, very strong and suggests that households are retreating to money market funds, probably the ones that hold government securities, and to insured deposits. In wholesale markets there has been unwillingness to take positions and rising concerns about an array of intermediaries. Bill described this process much better than I could--illiquid markets, extreme volatility, deleveraging, margin calls, forced sales, especially in mortgage-backed securities, wider spreads, equity prices falling, and lending and funding tenors collapsing toward the overnight, again. So financial conditions have tightened for everybody but the government--and some of the European governments have seen them tighten, I guess. Mortgage rates have risen, and business bond yields have risen as well, even with Treasury rates going down. Tighter credit and declining equity and house prices are reducing wealth, and all of this weakens spending further. Now, to this process, the staff has judged that the economy has entered a recessionary state in which we can expect household and business spending to fall short of normal levels, given income and interest rates. I am not sure how much weight to put on this. I am a bit uncomfortable with constructs that don't have a clear story behind them. But I must say that, looking at the sentiment indicators and listening to what I have heard around the table today from almost every Federal Reserve District reporting, I now put more credence in Dave's recessionary state than I did before the meeting started. Obviously, something is going on that is undermining confidence and making people much more cautious than you would think, given the exogenous variables. I do think talking about the recessionary state underlines the extraordinary uncertainty we are dealing with. President Stern pointed out the 1990-91 precedent. There are some precedents for some aspects of this, but we don't have many; and I think it is really difficult to know how financial markets will evolve and how that will feed through to the variables that affect household and business spending--the reaction of households, businesses, and state and local governments to tighter credit conditions. I agree with President Stern, President Evans, and others who said they thought that the financial stresses are deeper and will last longer than we thought and will, therefore, put more restraint on spending. Until markets stabilize on a sustained basis, the risk to satisfactory economic performance by the U.S. economy will remain skewed very much to the downside. Now, Federal Reserve liquidity tools that we have used are necessary to reduce the odds on even more-intense, downward-spiral crises and market liquidity feeding back onto spending. So I think our innovations here have been useful to reduce the downside risks a little and thereby to promote spending. But I agree with the others who say that they don't directly deal with the underlying macro risk, which is really a story about capital, solvency, wealth, and prices. I think monetary policy easing is a necessary aspect of addressing these macroeconomic risks. I agree with President Fisher, President Plosser, and others that there is more going on and that monetary policy easing may not be a sufficient way of addressing these risks. But I do think, as long as the economy is weakening the way it is and we have these risks, that easing monetary policy will be helpful. It will help bolster asset prices. It will make the cost of capital lower than it otherwise would be. It may not be sufficient to turn the thing around, but I do think that without the easing that we have done-- and that I hope that we do today--the situation would be far worse than it otherwise would be. We need to ease to compensate for the substantial headwinds that we are facing. Now, the forecast for inflation has not been marked down despite the greater output gap. As others have remarked, this output gap is offset, to a considerable extent, by the upward pressure on prices from oil and commodities and import prices as the dollar has fallen and prices have risen in our exporting partners--China, for example. I have to confess that I don't really understand what has been happening to commodity prices in recent months. I don't think the rise has been justified by the news on the underlying conditions of supply and demand. It is much larger than the dollar weakness has been, and the dollar�commodity price has always been a weak relationship. So, in fact, commodity prices are rising in a bunch of currencies. This isn't just a dollar weakness problem. I have to believe that there is a speculative element here. Partly as a consequence, I am comfortable with the forecast of a flattening commodity price picture in the future--it might even decline, but at least a flattening out. I do think a shift from financial assets, especially dollar assets, into commodities is going on, and mostly this has been triggered by concerns about the U.S. economy and financial markets. In some sense, that shift is okay. It is driving down the dollar, and that is helping to stabilize the economy. The decline that we saw in oil prices yesterday suggests that, when people get more confidence about where those financial markets are going, some of those commodity prices will actually fall as the concerns about the U.S. economy are alleviated. It is sort of an upside-down relationship, but I do think we saw a bit of it that way. But I also sense that some of the rise in commodity prices and the fall in the dollar reflects concerns about the inflation outlook here. It is not surprising to me, in a very volatile and uncertain environment, that inflation expectations are not as well anchored and that they fluctuate a lot in response to new information. I expect that inflation will come down as commodity prices level off; then the output gap will increase, and that in turn will keep inflation expectations down. Still, navigating this appreciably weaker economic outlook for the real economy and the threats to financial stability, on the one hand, and the tenderness of inflation expectations, on the other, will require some discussion in the next section of our meeting, Mr. Chairman. " FOMC20060510meeting--5 3,MR. KOS.," Well, as somebody said in another setting just the other day, risk premiums are something we don’t know a lot about, and they are difficult to disentangle. I haven’t done the exercise, but with energy prices rising, I don’t know that the carry effects have been huge." fcic_final_report_full--430 China and other Asian economies grew, their savings grew as well. In addition, boosted by high global oil prices, the largest oil-producing nations built up large cap- ital surpluses and looked to invest in the United States and Europe. Massive amounts of inexpensive capital flowed into the United States, making borrowing inexpensive. Americans used the cheap credit to make riskier investments than in the past. The same dynamic was at work in Europe. Germany saved, and its capital flowed to Ire- land, Italy, Spain and Portugal. Fed Chairman Ben Bernanke describes the strong relationship between financial account surplus growth (the mirror of current account deficit growth) and house price appreciation: “Countries in which current accounts worsened and capital in- flows rose . . . had greater house price appreciation [from  to ] . . . The rela- tionship is highly significant, both statistically and economically, and about  percent of the variability in house price appreciation across countries is explained.”  Global imbalances are an essential cause of the crisis and the most important macroeconomic explanation. Steady and large increases in capital inflows into the U.S. and European economies encouraged significant increases in domestic lending, especially in high-risk mortgages. The repricing of risk Low-cost capital can but does not necessarily have to lead to an increase in risky in- vestments. Increased capital flows to the United States and Europe cannot alone ex- plain the credit bubble. We still don’t know whether the credit bubble was the result of rational or irra- tional behavior. Investors may have been rational—their preferences may have changed, making them willing to accept lower returns for high-risk investments. They may have collectively been irrational—they may have adopted a bubble mental- ity and assumed that, while they were paying a higher price for risky assets, they could resell them later for even more. Or they may have mistakenly assumed that the world had gotten safer and that the risk of bad outcomes (especially in U.S. housing markets) had declined. For some combination of these reasons, over a period of many years leading up to the crisis, investors grew willing to pay more for risky assets. When the housing bub- ble burst and the financial shock hit, investors everywhere reassessed what return they would demand for a risky investment, and therefore what price they were willing to pay for a risky asset. Credit spreads for all types of risk around the world increased suddenly and sharply, and the prices of risky assets plummeted. This was most evident in but not limited to the U.S. market for financial assets backed by high-risk, nontradi- tional mortgages. The credit bubble burst and caused tremendous damage. Monetary policy The Federal Reserve significantly affects the availability and price of capital. This leads some to argue that the Fed contributed to the increased demand for risky in- vestments by keeping interest rates too low for too long. Critics of Fed policy argue that, beginning under Chairman Greenspan and continuing under Chairman Bernanke, the Fed kept rates too low for too long and created a bubble in housing. Dr. John B. Taylor is a proponent of this argument. He argues that the Fed set in- terest rates too low in – and that these low rates fueled the housing bubble as measured by housing starts. He suggests that this Fed-created housing bubble was the essential cause of the financial crisis. He further argues that, had federal funds rates instead followed the path recommended by the Taylor Rule (a monetary policy formula for setting the funds rate), the housing boom and subsequent bust would have been much smaller. He also applies this analysis to European economies and concludes that similar forces were at play. FOMC20070628meeting--105 103,MS. YELLEN.," Thank you, Mr. Chairman. Data relating to both economic activity and inflation during the intermeeting period have been encouraging. Economic indicators have strengthened considerably, and recent readings on core inflation have been quite tame. Although a portion of the recent deceleration of core prices likely reflects transitory influences, the underlying trend in core inflation is still quite favorable. I view the conditions for growth going forward as being reasonably solid. The main negative factors are tied to housing. The latest data don’t point to an imminent recovery in this sector, and I fear that the recent run-up in mortgage rates will only make matters worse. In addition, housing prices are unlikely to rise over the next few years and, indeed, may well fall, and the absence of the housing wealth gains realized in the past should damp consumption spending. I agree with the Greenbook that the recent run-up in bond and mortgage rates reflects primarily a shift in market expectations for the path of policy and, therefore, implies only a small subtraction to my forecast for growth in 2008. In my view, the stance of monetary policy over the next few years should be chosen to help move labor and product markets from being somewhat tight today to exhibiting a modest degree of slack in order to help bring about a further gradual reduction in inflation toward a level consistent with price stability. The stance of monetary policy will need to remain modestly restrictive, along the lines assumed in the Greenbook and by markets, in order to achieve that goal. My forecast is for growth to be around 2½ percent in the second half of this year and in 2008, slightly below my estimate of potential growth, and for the unemployment rate to edge up gradually, reaching nearly 5 percent by the end of next year. Under these conditions, core inflation should continue to recede gradually, with the core PCE price index increasing 2 percent this year and 1.9 percent in 2008. This forecast is predicated on continued well-anchored inflation expectations and the eventual appearance of a small amount of labor market slack. In addition, special factors such as rising energy prices and the sustained run-up in owners’ equivalent rent that have boosted inflation should ebb over time, contributing a bit to the expected decline in core inflation. In terms of risks to the outlook for growth, I still feel the presence of a 600-pound gorilla in the room, and that is the housing sector. The risk for further significant deterioration in the housing market, with house prices falling and mortgage delinquencies rising further, causes me appreciable angst. Indeed, the repercussions of falling house prices are already playing out in some areas where past price rises were especially rapid and subprime lending soared. For example, in the Sacramento metropolitan area east of San Francisco, house prices shot up at an annual rate of more than 20 percent from 2002 to 2005. Since then, however, they have been falling at an annual rate of 3½ percent. Delinquencies on subprime mortgages rose sharply last year, putting Sacramento at the top of the list of MSAs in terms of the changes in the rate of subprime delinquencies. Research by my staff examining metropolitan areas across the country indicates that the experience of Sacramento reflects a more general pattern. They found that low rates of house price appreciation, and especially house price decelerations, are associated with increases in delinquency rates even after controlling for local economic conditions such as employment growth and the unemployment rate. One possible explanation for these findings is that subprime borrowers, especially those with very low equity stakes, have less incentive to keep their mortgages current when housing no longer seems an attractive investment, either because prices have decelerated sharply or interest rates have risen. These results highlight the potential risks that rising defaults in subprime could spread to other sectors of the mortgage market and could trigger a vicious cycle in which a further deceleration in house prices increases foreclosures, in turn exacerbating downside price movements. The risks to inflation are also significant. In addition to the upside risks associated with continued tight labor markets, a slowdown in productivity growth could add to cost pressures. Although recent productivity data have been disappointing, I expressed some optimism at the last meeting about productivity growth on the grounds that at least some of the slowdown appeared to reflect labor hoarding and lags in the adjustment of employment to output, especially in the construction industry. Data since that meeting have reinforced my optimism concerning trend productivity growth. In particular, new data in the recently released Business Employment Dynamics report suggest that productivity growth may have been stronger than we have been thinking. This report, which includes data that will be used in the rebenchmarking of the payroll survey in January, shows a much smaller increase in employment in the third quarter of 2006 than is reported in the payroll survey; it, therefore, implies a larger increase in output per worker. A second risk to inflation is slippage in the market’s perceptions of our inflation objective. Although inflation compensation over the next five years is essentially unchanged since our last meeting, long-run breakeven inflation rates implied by the difference between nominal and indexed Treasury securities are up about 20 basis points. However, our analysis suggests that this increase reflects in good part an elevation in risk premiums or the influence of various—let me call them “idiosyncratic”—factors of the type that Bill Dudley mentioned, such as a possible shift in the demand by foreign central banks for Treasuries or special factors affecting the demand for inflation-indexed securities and not an increase in long-run inflation expectations. We base this conclusion on the fact that long-run breakeven inflation rates have also climbed in the United Kingdom—a country where inflation expectations have been remarkably well anchored over the past decade and where inflation has been trending downward. The fact that breakeven inflation rates rose in both countries, despite their different monetary policy regimes, suggests that a common explanation is needed rather than one specific to the United States. I think this conclusion is supported by the Board staff model that attributes about half of the movement in breakeven inflation to risk premiums. That said, our understanding and estimates of risk premiums are imprecise, so we must continue to monitor inflation expectations very carefully—of course, along with everything else. [Laughter]" CHRG-111hhrg52397--148 Mr. Price," Mr. Thompson, I have just a few minutes left. You mentioned that if we mandated a clearing companies would ``leave risks unhedged.'' What is the consequence of that? Mr. Don Thompson. The consequence of that is that a company which is an exporter and is exposed to fluctuations in currency risk may incur losses as a consequence of currency exchange rates that it otherwise might not incur if it were enabled to hedge them in the manner that it wanted to in the OTC markets. " CHRG-111hhrg51698--351 Mr. Neugebauer," Now you advocate for aggregate position limits for noncommercial traders. One of the things this body is struggling with is making sure that we don't push so many people out that we can't actually handle the appropriate amount of liquidity in the marketplace, so that our producers can use this as an effective price discovery and risk management tool. When I think about a bale of cotton in the 19th Congressional District, I think about all of the people who really have some commercial interest in that. All the way from the seed company to the fertilizer and the equipment company, the gins and merchants, and other people relying on the behavior of the cotton commodity price for their livelihood. So kind of two things begin to come to my mind there. When we start picking, who can and cannot participate in hedging a risk that they perceive, or putting together a business model where they can manage those risks? And, also, if we push too many people out of the marketplace, then if you have this many people trying to use a commodity as somewhat of a business hedge, that we don't have enough people to be on the other side. What is the right prescription of who you allow to play and who you don't allow to play? " FOMC20080625meeting--152 150,MR. ROSENGREN.," I support alternative B. At this time, there are significant downside risks to the economy and financial markets, as the collateral damage from the housing problems works through the economy and financial institutions. At the same time, continued increases in oil and food prices raise the risk that some part of these supply shocks will be incorporated into inflation expectations. In the absence of more-compelling evidence about which of these two risks will dominate, I would favor remaining on hold at this meeting. I hope that the economy picks up in the second half of this year and that the financial markets stabilize so policy can become less accommodative, but it is not clear that this will be the outcome. While the inflation outlook has been affected by continued energy shocks, the future path of oil prices remains uncertain, and recent history has many instances in which oil shocks are short-lived and have little effect on longer-run inflation expectations. Until we have more clarity on the path of the economy and inflation, policy should remain on hold, and our language should be consistent with that. " fcic_final_report_full--438 In effect, many of the largest financial institutions in the world, along with hun- dreds of smaller ones, bet the survival of their institutions on housing prices. Some did this knowingly; others not. Many investors made three bad assumptions about U.S. housing prices. They assumed: • A low probability that housing prices would decline significantly; • Prices were largely uncorrelated across different regions, so that a local housing bubble bursting in Nevada would not happen at the same time as one bursting in Florida; and • A relatively low level of strategic defaults , in which an underwater homeowner voluntarily defaults on a non-recourse mortgage. When housing prices declined nationally and quite severely in certain areas, these flawed assumptions, magnified by other problems described in previous steps, cre- ated enormous financial losses for firms exposed to housing investments. An essential cause of the financial and economic crisis was appallingly bad risk management by the leaders of some of the largest financial institutions in the United States and Europe. Each failed firm that the Commission examined failed in part be- cause its leaders poorly managed risk. Based on testimony from the executives of several of the largest failed firms and the Commission staff ’s investigative work, we can group common risk management failures into several classes: • Concentration of highly correlated (housing) risk. Firm managers bet mas- sively on one type of asset, counting on high rates of return while comforting themselves that their competitors were doing the same. • Insufficient capital. Some of the failed institutions were levered : or higher. This meant that every  of assets was financed with  of equity capital and  of debt. This made these firms enormously profitable when things were go- ing well, but incredibly sensitive to even a small loss, as a  percent decline in the market value of these assets would leave them technically insolvent. In some cases, this increased leverage was direct and transparent. In other cases, firms used Structured Investment Vehicles, asset-backed commercial paper conduits, and other off-balance-sheet entities to try to have it both ways: fur- ther increasing their leverage while appearing not to do so. Highly concen- trated, highly correlated risk combined with high leverage makes a fragile financial sector and creates a financial accident waiting to happen. These firms should have had much larger capital cushions and/or mechanisms for contin- gent capital upon which to draw in a crisis. • Overdependence on short-term liquidity from repo and commercial paper markets. Just as each lacked sufficient capital cushions, in each case the failing firm’s liquidity cushion ran out within days. The failed firms appear to have based their liquidity strategies on the flawed assumption that both the firm and these funding markets would always be healthy and functioning smoothly. By failing to provide sufficiently for disruptions in their short-term financing, management put their firm’s survival on a hair trigger. • Poor risk management systems. A number of firms were unable to easily ag- gregate their housing risks across various business lines. Once the market be- gan to decline, those firms that understood their total exposure were able to effectively sell or hedge their risk before the market turned down too far. Those that didn’t were stuck with toxic assets in a disintegrating market. CHRG-111hhrg53021Oth--29 Mr. Lucas," Thank you, Mr. Chairman. Mr. Secretary, OTC contracts are used to manage, of course, very real risks. And the OTC market's very purpose is to provide customized solutions that meet the individual needs of customers. Denying or effectively limiting access to these risk tools by eliminating, in effect, OTC contracts, which mandated clearing essentially does, jeopardizes the ability to hedge market risk, exposing customers to increasing price volatility. Why isn't reporting of OTC trades enough, sir? " CHRG-111hhrg53021--29 Mr. Lucas," Thank you, Mr. Chairman. Mr. Secretary, OTC contracts are used to manage, of course, very real risks. And the OTC market's very purpose is to provide customized solutions that meet the individual needs of customers. Denying or effectively limiting access to these risk tools by eliminating, in effect, OTC contracts, which mandated clearing essentially does, jeopardizes the ability to hedge market risk, exposing customers to increasing price volatility. Why isn't reporting of OTC trades enough, sir? " FinancialCrisisInquiry--376 DIMON: Well, there’s a consequence that you could lose your job. You could lose your reputation. But I do think that you raise an issue. The first way to correct it is that you actually risk adjust it, actually look at the capital being deployed and you make an evaluation. Did they do the right things for the right reason, for the client, et cetera? So you are constantly trying to evaluate are you doing the right things on trading debts. But it is a little one- sided that way. And the more senior the people become, the more stock they own in the company. So they are responsible for the well being of the whole company and they will pay a price if our company pays a price. I think that’s generally—you’ve seen that a lot of the companies that went belly-up their people did pay a price. January 13, 2010 FOMC20051213meeting--138 136,MS. DANKER.," I’ll be reading the directive wording from the Bluebook and the assessment of risks from alternative B in exhibit 2 from Brian’s presentation. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 4¼ percent.” And the wording for the assessment of risks: “The Committee December 13, 2005 90 of 100 attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.”" CHRG-111hhrg53021Oth--301 Mr. Murphy," Well, I don't want to discourage you from products that we may be able to drive to central clearing, because I think that does reduce systemic risk, that we not require be on an exchange if there is not enough volume for an exchange to want it, or for there to be any real price discovery there. " CHRG-111hhrg53021--301 Mr. Murphy," Well, I don't want to discourage you from products that we may be able to drive to central clearing, because I think that does reduce systemic risk, that we not require be on an exchange if there is not enough volume for an exchange to want it, or for there to be any real price discovery there. " CHRG-111hhrg48674--269 Mr. Bernanke," Well, some have raised the concern about inflation. If we don't get the balance sheet under control and the money supply under control in time, in an appropriate moment, we could risk having higher prices down the road. That is certainly a possibility. It is one that we are very aware of and doing our best to manage. But, you know, nothing is certain. So that is one risk that I see. The other risk I would point out would be just that the efforts that are being made, including our attempts to stabilize key credit markets, prove insufficient and the situation gets further--deteriorates further. Those are the things I can foresee. There must be things I can't foresee, but by definition, I don't know what they are. " CHRG-110hhrg45625--70 Mr. Bernanke," Certainly, Congressman. Thank you. Just to reiterate the Secretary's point, this is working capital, if you will. It is for purchasing these assets. It is a very large amount of money, but the risk to the taxpayer, although not trivial, is far less than the amount of money that is the purchase amount. With respect to protecting the taxpayer, I think that we should be using whatever possible market mechanisms that reveal the true value to the extent we can of those assets. One of the objectives of the program is to try to figure out what these things are worth. I think there is really a win-win situation possible here in that bringing the demand from the government into these markets will raise the price above the rock bottom fire sale distressed price that is currently prevailing from any of these assets, and yet that the taxpayer pays could still be well below what these assets would be worth in a normal market as the economy recovers. So I am not advocating that the taxpayer overpay. I think the prices should be determined by competitive market mechanisms--the more participation, the better. But I do believe that bringing liquidity into this market will help to clarify the prices and will bring the prices up from these rock bottom fire sale prices. " FOMC20080625meeting--99 97,CHAIRMAN BERNANKE.," Thank you, and thank you all. First, on the long-term projections, I think there's consensus that we should just go ahead and have a trial run. The staff should review the transcript and make gold out of straw there. We should consult with the subcommittee, and we should think about maybe even a couple of alternatives. Maybe we could try a couple of alternative ways of doing it in October. So let's go ahead and do something along those lines and keep thinking about how best to do it. Let me first, as I usually do, try to summarize the discussion around the table, and I'll add some comments of my own. Beginning with the summary, the incoming data were stronger than expected, notably for consumer spending but for some other components as well. As a result, economic growth in the second quarter, though not robust, was likely positive, continuing the pattern of weak but positive growth since the fourth quarter of 2007. However, to the extent that strength in consumption was transitory or due primarily to fiscal stimulus, some of the growth in the second quarter may have been borrowed from the second half. Participants generally saw growth continuing at a slow pace the rest of the year and improving in 2009. There was, however, some divergence of views, with some expecting a longer period of slow growth. Recent numbers on retail sales suggest that the consumer is holding up better than expected. Consumer finances may be better than feared, and the fiscal stimulus may already be having an effect. However, as many have noted, there are substantial drags on consumption going forward, including falling wealth and income, credit constraints, and the recent rise in energy prices. Sentiment has also fallen noticeably further. Weaker consumption may, thus, restrain growth later this year, particularly after the effect of the stimulus wanes. Labor markets continue to soften but at a relatively moderate pace. The peak in unemployment is projected to be between 5� percent and 6 percent. That's what I generally heard around the table. Prospects for housing continue weak, with falling prices, high inventories, and weak demand. Some saw a possible bottom forming but noted that the recovery of this sector is still some way off. As has been the case for a while, businesses are quite cautious, noting economic uncertainties and surging input costs, with one or two mentions of tighter credit, although that was not a dominant theme today. Real exports continue to grow and are partially offsetting weaker domestic demand, especially in the case of manufacturing. Financial conditions have been mixed since the last meeting, although the improvements from March have largely been maintained and the risk of systemic crisis may have receded to some degree. Funding markets are generally doing better. The concerns about credit losses have led the stock prices of banks, including regional banks and investment banks, to fall sharply. Capital raising continues, though at less favorable terms and with perhaps declining availability. As the economy continues weak and housing contracts further, more credit losses for banks may well be in store, adding to financial market stress and reducing the availability of new credit. Progress in the financial markets is likely to be slow as the deleveraging process will take a while. Stock prices in general are also lower. Financial conditions in the housing market remain important downside risks to growth, with the spurt in oil prices adding to those risks. Uncertainties about the growth prospects are great. However, tail risks may have moderated somewhat. Readings on core inflation have remained relatively moderate. However, the sharp rise in oil prices and some other commodity prices, in part reflecting flooding in the Midwest, is likely to lead to very high levels of headline inflation over the next few months. Gas and food prices have become perhaps the most important economic issue for consumers, and firms are feeling everincreasing cost pressures. Moreover, inflation pressures are global. There are increasing reports of firms being able to pass through these costs, which could lead to an increase in core inflation. On the other hand, slack may restrain core inflation increases. Measures of longer-term inflation expectations have been up a bit on net since April, depending to some extent on the measure chosen. Nominal wage growth is still slowing. Participants debated how much comfort to take from slow wage growth, some arguing that, by the time wages reflected higher inflation expectations, it would be too late. Most saw inflation risks as now to the upside, with the primary concern being the possibility that inflation expectations could rise further as headline inflation rises and more costs are passed through. That's my very, very quick summary. If anyone has any comments, I'd be happy to hear them. If not, let me just say a couple of words on my own views here. This may come as a surprise to some of you, but I am not a fine-tuner. I think that the objective of the Federal Reserve ought to be to avoid a very bad outcome, and so my concerns are primarily with tail risks on both sides of our mandate. I think that the evidence of the last month or so provides a bit of reassurance, on both the real side and the financial side, that the tail risks on the growth side of the mandate have moderated somewhat. That being said, I think they remain and are still significant. In particular, as I mentioned in the summary, I am at this point still suspicious of the strength that we saw in the second quarter. If we look at the fundamentals for consumption--including wealth, income, employment, and energy prices--and look at the plunge in sentiment, which is at remarkably low levels, I think there's a very good chance that consumers will weaken going forward and bring the rest of the economy along with them. In addition, of course, housing remains extremely uncertain. We are at best some distance from stabilization in that market. Even when residential construction begins to stabilize, we'll still see continuing declines in house prices, which will affect consumer spending and, importantly, will affect financial markets as well as the value of mortgages. With respect to financial markets, I agree certainly that the crisis atmosphere that we saw in March has receded markedly, but I do not yet rule out the possibility of a systemic event. We saw in the intermeeting period that we have considerable concerns about Lehman Brothers, for example. We watched with some concern the consummation of the Bank of America�Countrywide merger. We worried about a bank in the Midwest. Other regional banks are under various kinds of stress. We're seeing problems with the financial guarantors, with the mortgage insurers. So I think that those kinds of risk are still there, and we need to be very careful in observing them. Moreover, even if systemic risks have faded, we still have the eye-of-the-storm phenomenon--we may now be between the period of the write-downs of the subprime loans and the period in which the credit loss associated with the slowdown in the economy begins to hit in a big way and we see severe problems at banks, particularly contractions in credit extension. So I'm not yet persuaded that the tail risks are gone. I think it would be very valuable to have some more data, some more observations, to see how the financial markets and the economy are proceeding. But I want to say that I do agree that the developments in financial markets and the surprisingly strong data in the second quarter should lead us to feel somewhat better. I think we should take a little credit for our various efforts to support both the financial system and the economy. Now, what about tail risks on the other side--on inflation? The increase in oil prices that we've seen in the past six weeks is obviously very, very bad news. I think that the combination of the commodity price increases and what we're going to see as very ugly headline inflation numbers is beginning to generate a tail risk on that side of the mandate as well, and I am becoming concerned about that. Indeed, I think that it's now appropriate that we begin, as some of us already have, to move rhetorically toward acknowledging that risk and agreeing that it may be at the point where it even exceeds the risk that we see on the growth side, although I think we're very uncertain about that. Now, the concern I have is the following, which is that there has been a lot of talk about policy action. I don't think that a 25 basis point or even a 50 basis point move, if it's not viewed as being the start of a continued increase, is going to do very much on the inflation side, frankly. We had a good test of that over the intermeeting period. Partly because of our rhetoric and for other reasons, the dollar strengthened. The two-year rate rose 50 or 60 basis points, and oil prices went up $25. I do not think that with a small change in our stance we can do anything about commodity prices, and frankly, it's commodity prices that you're hearing about from your Board members and from people you talk to. It's the real change in the relative price of those commodities that is painful and the real change in the terms of trade coming through the dollar which is painful, and I don't think we can do very much about those in the short term. Our objective, of course, as everyone has noted, is to prevent that from becoming a sustained and persistent source of inflation. So the problem then is that a small amount of movement will not solve the problem. A small to moderate movement, however, might create some serious financial strains given the fragility of the system. I think what we need to do is to decide when we reach that tipping point. There will be a tipping point at which we're sufficiently confident that the system is stabilizing and that we can begin to turn in a serious way to the inflation concern. A partial one step, unless it signals a longer-term tightening program, could give us the worst of both worlds. We will just have to make the judgment about when we have reached the point of having to switch from our previous approach of supporting the economy and financial system to an approach that is aimed more at containing inflation. It's going to be a very difficult and delicate situation, but I want to express again my agreement with those of you who are worried about inflation and my belief that the time might be relatively soon. But it's going to be a very, very delicate decision and one that we have to make with great concern and consideration. A little anticlimactically, I would like to say just a couple of words about the 1970s because they keep coming up and I do think that these comparisons are a bit misleading. First, in the current episode, commodity prices--particularly oil prices--are basically most or almost all the inflation that we're seeing. That was not the case in the '70s. In particular, inflation rose considerably before the first oil price shock in 1973. PCE inflation was 5 percent in 1970, which prompted the wage� price controls, of course, which is an episode we're all familiar with; and in 1972, before the oil shock, average hourly earnings were growing between 7 and 8 percent. There was already a serious inflation problem before the oil price shocks came. Hence, credibility was already damaged at the time of the oil price shocks. That is not the case here. Second, the movement in wages and core inflation following the oil price shocks in the 1970s was very striking. From the time of the oil price shock right before the second quarter of 1973 until the first quarter of 1975, total inflation rose a little over 5 percentage points, reflecting the quadrupling of oil prices. During the same period, core inflation rose more than 6 percentage points. In other words, core inflation responded almost one for one to total inflation. Moreover, average hourly earnings rose more than 2 percentage points, and productivity and cost compensation rose 3� percentage points in that year and a half. So there was a very strong sensitivity of expectations and pass-through to these commodity price shocks. Obviously, we've been seeing oil price increases since 2003, and they have not yet shown anything like that effect on core inflation or on wages. The final observation I'd make about the 1970s is that we shouldn't forget that, even in that very bad situation with very poorly anchored inflation expectations, the slowing of the economy did do something to reduce inflation. In particular, core inflation fell 3� percentage points during 1975 following the 1973�75 recession. So while we cannot do much about oil prices, I do think that there is some hope that weakness in the economy is going to provide some restraint on core inflation, which of course will generate a more stable total inflation rate if and when commodity prices stabilize. So I've been very all over the map here. I apologize. I tried to organize my thoughts in the meeting. My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. I'm also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It's going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve. The last thing I'd like to say is on communications. Just talking about communications following this meeting, I'd like to advise everyone, including myself, to lean, not to lurch. That is, we are moving toward more concern about inflation, but we still have concerns about economic growth and financial markets. We should show that shift in emphasis as we talk to the public, but we should not give the impression that inflation is the entire story or that we have somehow decided that growth and financial problems are behind us, because they are not. So if we can convey that in a sufficiently subtle way, I think we will prepare the markets for the ultimate movements that we're going to have to make. Again, I very much appreciate your insights and your attention today. We have a dinner at 7:30, and for that reason I think we should probably bring this to a close. We'll start tomorrow morning with Brian's presentation of the policy options. The statement is essentially the same as the Bluebook's. There won't be any surprises there. So we'll begin with that first thing in the morning. Thank you. [Meeting recessed] June 25, 2008--Morning Session " CHRG-111shrg54589--3 STATEMENT OF SENATOR JIM BUNNING Senator Bunning. Thank you, Mr. Chairman. I appreciate all of our witnesses coming here today for this very important hearing. It is important for everyone to understand the financial nature of derivatives and, thus, the Banking Committee's interest in overseeing them. Let me say at the beginning that I do not know what regulations and restrictions we should put on these products. Figuring that out is the purpose of this hearing. But it should be clear to everyone that the current regulations are not enough. I understand the desire of firms to hedge their risks, whether those risks are interest or exchange rates, commodity prices, credit exposure, or something else. Genuine hedges that are accurately priced can provide the risk management that firms need. But it is not clear that all derivative products are genuine hedges or accurately priced. In fact, some look a lot more like a way to get around regulations and proper risk management, or just plain gambling. Regulators in the public need a better understanding of all the exposures of firms to eliminate uncertainty and the justification for further bailouts. Increased transparency and standardization of derivative contracts will help and must be accomplished. How far standardization requirements should go depends on whether there are true economic benefits to the custom products that outweigh the costs and risks associated with them. So far, specific and credible evidence on that point is thin. Credit derivatives may present the toughest questions. Should these products be treated as insurance with proper reserves? Should the buyer have an insurable interest and have to suffer actual losses or deliver the reference assets? How do we make sure credit protection does not undermine credit research or lead creditors to push debtors into bankruptcy? Should they even exist if not traded on an exchange? Someone has to bear the risk of every financial transaction so we must not allow the wizards of finance to pretend it has disappeared. Finally, just like with banks, we must eliminate the opportunity to avoid or choose favorable regulators or regulations. Similar activity must be regulated the same way by the same regulator. Otherwise, firms will be able to game the system, and regulators will not be able to effectively enforce the rules. Thank you, Mr. Chairman. " CHRG-111shrg57322--720 Mr. Viniar," And it is a risk-reward judgment question at the time. You look at what price you could sell that position. You make an assessment of that versus what it would cost you to put on an offsetting position, and understanding that putting on an offsetting position is never an exact hedge. Senator Kaufman. Right. " FOMC20070628meeting--122 120,MS. PIANALTO.," I also extend my heartfelt congratulations to the Spurs on their fourth and final NBA championship. [Laughter] Now, turning to inflation, I am hearing reports of upward price pressures across a handful of industrial commodities, and notably for metals. But wage pressures remain modest. Nevertheless, for the first time in more than a year, I am hearing from my business contacts that they are concerned about inflation. They are bringing inflation concerns up with me, and they are telling me that they concur with the Committee’s assessment that inflation remains a risk. To be sure, there were many positive signs in the May CPI report. The traditional core CPI beat expectations, and while the trimmed mean estimators that we produce in Cleveland were a little higher than the measure excluding food and energy, even those indicators were consistent with the moderation and the longer-term inflation trend we expect to see. Looking at the core measures enables me to be encouraged by the May CPI report. But that view is a rather hard sell to a public that saw headline CPI inflation rise 8½ percent at an annualized rate last month. Indeed, our readings of the underlying inflation trend and what people are feeling in their wallets have been at odds for many years now. I understand that our policies are not well advised or even equipped to address transitory price movements. But at some point, large and persistent price disturbances, such as we have seen in energy markets, warrant our attention. If these isolated price pressures become more generalized and enter into consumer and business decisionmaking, we could easily find ourselves living in the Greenbook’s “drifting inflation expectations” scenario. In summary, I think the housing market still presents a risk that the economy may not resume a more typical growth trajectory over the forecast period. Nonetheless, that concern is trumped by the risk that we may yet lose the public’s confidence that we are making sustainable progress against inflation. Therefore, I continue to believe that the predominant risk going forward is that inflation will fail to moderate as expected. Thank you, Mr. Chairman." CHRG-111shrg54589--121 PREPARED STATEMENT OF SENATOR MIKE CRAPO Recent events in the credit markets have highlighted the need for greater attention to risk management practices and the counterparty risk in particular. The creation of clearinghouses and increased information to trade information warehouses are positive steps to strengthen the infrastructure for clearing and settling credit default swaps. While the central counterparty clearing and exchange trading of simple, standardized contracts has the potential to reduce risk and increase market efficiency, market participants must be permitted to continue to negotiate customized bilateral contracts in over-the-counter markets. Many businesses use over-the-counter derivatives to minimize the impact of commodity price, interest rate, and exchange rate volatility in order to maintain stability in earnings and predictability in operations. If Congress overreaches and bans or generates significant uncertainty regarding the legitimacy of decisions to customize individual OTC derivatives transactions there will be enormous negative implications on how companies manage risk. At this time I would like to highlight a few examples from end users about what are the possible effects of severely restricting access to customized over-the-counter derivatives on companies' ability to manage risk and on the prices they charge customers.v David Dines, President of Cargill Risk Management: ``While margining and other credit support mechanisms are in place and utilized every day in the OTC markets, there is flexibility in the credit terms, credit thresholds and types of collateral that can be applied. This flexibility is a significant benefit for end users of OTC derivatives such as Cargill in managing working capital. Losing this flexibility is particularly concerning because mandatory margining will divert working capital from investments that can grow our business and idle it in margin accounts. While it depends on market conditions, the diversion of working capital from Cargill from margining could be in excess of $1 billion. Multiply this across all companies in the U.S. and ramifications are enormous, especially at a time when credit is critically tight.'' Kevin Colgan, Corporate Treasurer of Caterpillar: ``Our understanding of currently pending regulation in this area is that it would require a clearing function which would standardize terms like duration and amount. Any standardization of this type would prohibit us from matching exactly the terms of the underlying exposure we are attempting to hedge. This, in turn, would expose us to uncovered risk and introduce needless volatility into our financial crisis.'' Mark Grier, Vice Chairman of Prudential Financial: ``Without customized OTC derivatives, Prudential would be incapable of closely managing the risks created in selling life insurance, offering commercial loans, and proving annuities for retirement.'' John Rosenthal, Chief Hedging Officer of MetLife: ``Standardized derivatives cannot be used effectively to hedge all types of financial risk. Any increased risks would result in higher costs to offer and maintain these products. In either situation the increased costs of an inefficient derivatives market would be reflected in the pricing to our customers. To the extent the costs and/or risks associated with an inability to appropriately hedge these products became prohibitive; these products could be no longer available to customers.'' Janet Yeomans, Vice President and Treasurer of 3M: ``Not all OTC derivatives have put the financial system at risk and they should not all be treated the same. The OTC foreign exchange, commodity, and interest rate markets have operated uninterrupted throughout the economy's financial difficulties. We urge policy makers to focus on the areas of highest concern.'' At this time, I would like to submit into the record the complete letters. It is possible that I will receive additional letters in the next few days and I would also like to enter those letters in the record. While the derivatives market may seem far removed from the interests and concerns of consumers and jobs that is clearly not the case. Legislative proposals to alter the regulatory framework of over-the-counter derivatives is a very technical subject matter and the potential for legislation to have unintended consequences of legitimate transactions is considerable. We need to better understand the following questions: How do businesses use customized OTC derivatives to help stabilize prices and mitigate risk? What are the possible effects of severely restricting access to customized OTC derivatives on businesses ability to manage risk and on the prices they charge customers? What safeguards are in place to ensure that derivatives portfolios are a tool for hedging risk, rather than a source of risk? What does standardized mean, and how much of the OTC markets can and should be shifted on exchanges? ______ CHRG-111hhrg58044--137 Mr. McRaith," Congressman, the availability of data to any one insurance company at this point is so expansive, it is impossible to determine exactly what or to conclude what factors would replace a credit score. Some companies are using all of the sub-components of a credit score right now for pricing and not relying solely upon a credit score in and of itself. What we expect is that eliminating one rating factor will shift costs. There are some people who might pay more. Others might pay less. When you affect the price of one person in a risk pool, you are going to also affect someone else in that same pool. " FOMC20070807meeting--172 170,MR. KOHN.," Yes, I do. I see why you want to take out “volatile,” and I agree with that. Unlike President Lacker, I think it is important to keep credit conditions in there because it’s more than just price. So I was a little concerned that saying “risk premiums have increased and credit conditions have become tighter” puts it all on price. Suppose we didn’t have the phrase in red. We just had “owing to developments in financial markets, credit conditions have become tighter,” or “reflecting recent developments in financial markets, credit conditions have become tighter.”" FOMC20071031meeting--204 202,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. I think the economy is slowing. Even the nonhousing part of the economy is slowing a bit. Housing prices are still obviously sliding down. We don’t really claim to know much about where they’re going to end up or where we are in that process, but it seems that they are falling and probably at an accelerating rate. Our modal forecast—“our” meaning from the submissions—is for an economy that slows further and runs below trend over several quarters. But if you just look at the size of the bars on the submissions, the size of that bar about downside risk to growth is very high, much higher than the bar about upside risk to inflation. There is a huge amount of uncertainty about what equilibrium is and where short-term interest rates should be over time. But I think it is fair to say that we are now at the high end of, if not slightly above, most of those estimates of where equilibrium is. Therefore, it seems to me sensible that most of our submissions had a downward slope to the path of the fed funds rate going forward over this period. The question then is not principally whether to move but when and what signal of a change or no change should come. I think it is a very close call, and everything that I say I say with a lot of unease and discomfort. If the choice is to stay firm but to signal more explicitly than we did in September that we’re likely to move further, that seems to me just a bad choice. I think it is likely to amplify many of the risks that you are all worried about and it probably would make people more tentative about coming in and doing what they’re going to do to let this thing work through the markets because they will be living with our acknowledgement of substantial downside risk without action and uncertainty about whether we’re going to move. I think you might argue that a decision not to move with an explicit asymmetry in the balance of risks to growth would lower the path going forward and add to that uncertainty in some sense. I do not think that the markets are so fragile now that they could not take an adverse surprise of this magnitude, even though it is a very, very large adverse surprise relative to recent history. I don’t think that’s a good argument for moving. I think the best argument is that we’re still in the midst of what is a very delicate and consequential asset-price adjustment in the U.S. economy with a fairly dense, thick, adverse tail on the potential implications about the evolution in housing. The Chairman spoke eloquently early in the year—I think it was early in the year, but maybe it was late last year—about the pattern of history and the acknowledgement that weakness tends to cumulate, and you don’t really have a lot of experience with sustained periods of below-trend growth without falling into a more substantial rise in unemployment rates. Those risks have to be substantially greater when you have an economy going through this kind of asset-price adjustment. I found these charts discouraging, not reassuring, in the sense that we’re anticipating a slowdown in the rate of growth of credit for the economy as a whole that’s comparable to ’01. I think the pressure on bank balance sheets is probably—it’s hard to make these statements with any certainty—greater than it was in ’01. At least a reasonable expectation is that it’s going to be bigger than it was in hindsight in ’01, and I think you have a much more substantial impairment to the functioning of what Kevin calls debt capital markets—the industry around the design of securitization and structured finance, et cetera, which has been so important to the way credit gets originated and moved. That disruption could take a long time to resolve, and I think that just has to amplify the density of the adverse tail and the growth outcome, certainly with more uncertainty at this time. I think that it is hard, but the better course of valor is to move today, and I like the language in alternative A. Let me just go quickly through the arguments against it that I find most compelling. The best argument against is the fear that many of us spoke about—that even though the inflation numbers have been reasonably reassuring and we haven’t seen substantial erosion in inflation expectations that we can measure, there is a bit of deterioration in the feel, in the psychology. We have to be very careful that we don’t add to that through our actions or people’s expectations about how we’re going to behave going forward. But we should take some comfort from the fact that the market is pricing in more than 100 basis points of easing over the next two years. You have to believe that a fair amount of that is already reflected in breakevens, reflected in what people are willing to pay for insurance against adverse inflation outcomes, and reflected in the dollar. It doesn’t mean that if we validate part of those expectations you won’t see erosion, but we should take some comfort from that. Just one more thing. We have been through three years of very substantial relative price shocks in energy prices, commodity prices, and some other things. Those hit an economy that was growing over the period above most estimates of potential, and we have had pretty good performance of underlying inflation and inflation expectations in that context. So even though we look forward and we see what’s happening in commodity prices, energy prices, and the dollar as posing some potential risk of upside pressure on input costs, that is hitting the economy in a very different state. The experience of those last couple of years should give us a fair amount of confidence in the judgments we bring as to how we think about inflation going forward. I think we have less uncertainty around an inflation forecast than we would have had two or three years ago and still substantial uncertainty around the growth forecast inevitably given what the economy is going through. The balances suggest that it is better to move today because of that. As I said, I’m comfortable with the language in alternative A. I would be comfortable with Governor Mishkin’s amendment to A—I think that helps a bit. I have a lot of sympathy for all the arguments against the first sentence in alternative A in any form, but on balance, I would say that we just don’t want to take the risk that, by omitting some statement like it, we cause people to price in a steeper slope to that path going forward. It is something that we should try to avoid, and the best way to achieve that is the language in A. Thank you." CHRG-111hhrg51592--164 Mr. Neugebauer," I wonder what the difference of the analysis that the people who were taking on those risks for, you know, a relatively small amount of money. You have to be right on those, because they're taking a relatively small premium for a fairly large risk. I mean, so what did they know that you didn't know? " Mr. Joynt," I'm not sure how to react to that. There's--whomever was selling or buying protection, there would have been two people thinking two different things about that risk at that price. So one might have been thinking, ``That was a great trade, I'm glad I got this premium,'' and another was thinking, ``I'm glad I shed that risk.'' So--also, the CDS market is a synthetic and a derivative market. It's not physical securities. So the people who trade or act in that market aren't necessarily--they can act with leverage and volumes that might indicate they have much greater rewards than holding physical securities or risks. " CHRG-111hhrg53245--188 Mr. Johnson," Sir, if I could on the subordinated debt and the more general idea that the market can pick up the risk, I would point out that the evidence says the market pricing of risk, for example look at the CDS for Citigroup prior to the crisis, was going the wrong way. They thought Citigroup was becoming less and less risky. As we know, looking back, it was actually becoming more and more risky. So I am afraid, as one thing to look at, it is okay, but as a panacea or something to put a lot of weight on, I would do that with hesitation. " CHRG-110shrg50414--215 Secretary Paulson," Well, I would say in terms of bringing in the private sector, OK, along with it, I think we have looked at a number of initiatives. We started off, actually, with some initiatives with the private sector, some that got off the ground and others that didn't. I would say with the private sector as frozen as it is and as concerned as it is and with the overall system as fragile as it is, now is the time that we need to do something very strong as a government, and so that is why we have come up with this plan. Senator Bayh. Chairman Bernanke, many of my colleagues, Senator Reed foremost among them, have asked, and I think you put your finger on the essential point here, and that is how do we go about valuing the hold-to-maturity price versus the fire sale price, and I think you would acknowledge--you have acknowledged it is an inexact science at best. So the taxpayers do--there is some downside risk here. What do they get in exchange for bearing that downside risk? Why should they not be allowed to participate in the potential upside, and then that gets to the question once again of possible equity participation. " CHRG-109hhrg28024--32 Mr. Bernanke," No. I wish I had such a crystal ball. We're in a difficult period because, for the foreseeable future, we are operating close to the margins of available global supply of oil and natural gas. And as a result, prices are likely to stay high, and the risk exists, if there are significant disruptions of supply, that we'll get additional spikes or movements in energy prices. Now in the longer term, energy prices at the current level should be sufficient to bring forth a number of alternative sources of supply as well as induce significant conservation on the part of consumers and firms. So I'm actually fairly optimistic about 10, 15, 20 years down the road because these high prices will allow the economy to adjust. But over the next 5 or 10 years, we are in the zone of vulnerability without available alternatives to the extent we would like and with a relatively small margin of error in terms of global supplies. " CHRG-111shrg52966--55 Mr. Sirri," I think there is an element of accuracy to that, but I think there are tools available to us as regulators. Let me give you a specific instance. You are right, a particular complex financial firm will develop a model for risk, but they will have a process around that model for risk. And we care about the processes and the robustness of the processes and controls. So, for example, a model for risk is developed. Who validates it? Who verifies it? Who runs that model? If they report to the trading desk whose assets they are pricing, that is not helpful and that is problematic. If they report to an independent third-party that perhaps reports directly to the CFO or a risk officer, much stronger structure, gives you some comfort. Again, let me take a second one, a price verification group. You may have a firm that trades assets, but they have problems valuing assets, as you do when liquidity dries up. When valuations are struck, how are those valuations struck? There may be a model. Who validates the model? And how do you resolve disputes? If the trader says it is worth more than the risk person says it is worth, how do you resolve that? Is there a process where it could go up to the audit committee? And if it goes to the audit committee, does the After Action Report--the phrase you used--for that instance, does that go to the board of directors? Such processes, if they are in place, tell you that that firm is taking their job seriously. Senator Reed. I would presume, and correct me, that those procedures, those appropriate procedures you described, were not being deployed very successfully at Bear Stearns or Lehman Brothers. Were you aware of kind of those deficiencies contemporaneously with their---- " CHRG-111hhrg58044--143 Mr. Snyder," Well, in one sense it might force the industry to go back to larger classifications and rely more on those, such as territory and other factors which themselves were controversial. With the addition of credit-based insurance scores, you have added a degree of objectivity and individual tailoring that did not exist before, and it allows both not only accurate rating and underwriting of individuals but has improved availability in the market because the confidence companies have that they have the ability to price every risk and therefore, many more risks are being written in the voluntary market. " FOMC20061212meeting--73 71,MS. PIANALTO.," Thank you, Mr. Chairman. My outlook for the economy hasn’t changed much since our last meeting, but I have become more concerned about the risk to the outlook for real growth. So in my comments this morning, I’ll explain why my risk assessment has changed. The homebuilders with whom I spoke over the past several weeks told me that the low interest rates and the new financial products created an environment in which they did five years’ worth of business in the space of three years. They said that most homebuilders recognized that this pace of activity was unsustainable and so they planned accordingly. A few small builders have declared bankruptcy, and others still may do so; but for the most part, builders feel that they are financially prepared to make it through the next one or two years of poor business. So the financial condition of homebuilders is not my chief concern. However, I have become more worried about the potential spillover of housing conditions into consumer spending from wealth effects, income constraints, and creditworthiness. I think I’m going to give the counterpoint to President Lacker on these issues. The Greenbook points out that the OFHEO price index is still increasing a bit, but the builders I met with convinced me that the published prices for new homes don’t accurately reflect market conditions. Sellers are offering nonprice concessions, such as upgrades for appliances, carpets, fixtures, and so forth. Some builders are going to great lengths to keep published prices up. I’ve been told stories of builders in Arizona who have been giving buyers new Lexuses as part of the overall deal so that they don’t have to bring down the prices in their subdivision. Also, it seems as though owners of existing homes are not yet willing to reduce their asking prices by very much. With potential buyers still waiting for prices to fall further, traffic levels and transactions are low. It seems as though markets are not yet close to functioning smoothly, and homebuilders are telling me that it could take another year before buyers and sellers exhibit more confidence. I am concerned that we don’t yet have a good handle on where house prices are headed and how the uncertainties surrounding house prices might affect consumer spending. Second, the support to consumption provided by cash-out refinancing is not likely to be available going forward to the same degree that we’ve had during the past several years. Finally, the financial condition of some households has become pretty fragile, and we all know that rates on adjustable mortgages, including some subprime mortgage loans, continue to reset at higher rates. The adjustable rate mortgages are already causing some well- publicized problems for some households. Builders in my region report that the ability of potential homebuyers to qualify for home mortgages is becoming an issue. One homebuilder from Columbus told me that he is giving away new cars as well, but his motivation provides a twist on the Lexus story. Some of his customers are struggling to qualify for mortgage loans. So he’s giving them new cars so that they can get rid of their current cars and the payment obligations that go along with them. [Laughter] He’s not giving them a Lexus; he’s giving them a Kia. [Laughter] Now, if we could get these homebuilders to adopt a Buy American strategy, we might also be able to solve our domestic auto problem. As I said at the outset, I don’t have a major disagreement with the Greenbook baseline. I think that the outlook for near-term growth has deteriorated a little since October, and the Greenbook reflects that. I just think that there’s greater likelihood that the real economy could prove to be weaker than the baseline in the Greenbook in 2007, and the key risk in my view is the degree of spillover from the housing market into the rest of the economy. The Greenbook’s extended house decline alternative scenario represents this risk, although I have not yet heard stories that are quite as dramatic as the 20 percent decline in home prices in that scenario. Not much has changed, as many others have already commented, in the inflation outlook. The inflation trend continues to be hard to interpret, but I still expect core inflation to drift down gradually over the forecast period. Although there is still a risk that inflation will remain higher than I desire, I think that favorable compensation developments and declines in shelter costs could speed that rate of decline. Thank you, Mr. Chairman." fcic_final_report_full--172 The numbers were stark. Nationwide, house prices had never risen so far, so fast. And national indices masked important variations. House prices in the four sand states, especially California, had dramatically larger spikes—and subsequent de- clines—than did the nation. If there was a bubble, perhaps, as Fed Chairman Alan Greenspan said, it was only in certain regions. He told a congressional committee in June  that growth in nonprime mortgages was helping to push home prices in some markets to unsustainable levels, “although a ‘bubble’ in home prices for the na- tion as a whole does not appear likely.”  Globally, prices jumped in many countries around the world during the s. As Christopher Mayer, an economist from Columbia Business School, noted to the Commission, “What really sticks out is how unremarkable the United States house price experience is relative to our European peers.”  From  to , price in- creases in the United Kingdom and Spain were above those in the United States, while price increases in Ireland and France were just below. In an International Mon- etary Fund study from , more than one half of the  developed countries ana- lyzed had greater home price appreciation than the United States from late  through the third quarter of , and yet some of these countries did not suffer sharp price declines.  Notably, Canada had strong home price increases followed by a modest and temporary decline in . Researchers at the Federal Reserve Bank of Cleveland attributed Canada’s experience to tighter lending standards than in the United States as well as regulatory and structural differences in the financial system.  Other countries, such as the United Kingdom, Ireland, and Spain, saw steep house price declines. American economists and policy makers struggled to explain the house price in- creases. The good news was the economy was growing and unemployment was low. But, a Federal Reserve study in May  presented evidence that the cost of owning rather than renting was much higher than had been the case historically: home prices had risen from  times the annual cost of renting to  times.  In some cities, the change was particularly dramatic. From  to , the ratio of house prices to rents rose in Los Angeles, Miami, and New York City by , , and , re- spectively.  In , the National Association of Realtors’ affordability index—which measures whether a typical family could qualify for a mortgage on a typical home— had reached a record low.  But that was based on the cost of a traditional mortgage with a  down payment,  which was no longer required. Perhaps such measures were no longer relevant, when Americans could make lower down payments and ob- tain loans such as payment-option adjustable-rate mortgages and interest-only mort- gages, with reduced initial mortgage payments. Or perhaps buying a home continued to make financial sense, given homeowners’ expectations of further price gains. During a June meeting, the Federal Open Market Committee (FOMC), com- posed of Federal Reserve governors, four regional Federal Reserve Bank presidents, and the Federal Reserve Bank of New York president, heard five presentations on mortgage risks and the housing market. Members and staff had difficulty develop- ing a consensus on whether housing prices were overvalued and “it was hard for many FOMC participants . . . to ascribe substantial conviction to the proposition that overvaluation in the housing market posed the major systemic risks that we now know it did,” according to a letter from Fed Chairman Ben Bernanke to the FCIC. “The national mortgage system might bend but will likely not break,” and “neither borrowers nor lenders appeared particularly shaky,” one presentation ar- gued, according to the letter. In discussions about nontraditional mortgage prod- ucts, the argument was made that “interest-only mortgages are not an especially sinister development,” and their risks “could be cushioned by large down payments.” The presentation also noted that while loan-to-value ratios were rising on a portion of interest-only loans, the ratios for most remained around . Another presenta- tion suggested that housing market activity could be the result of “solid fundamen- tals.” Yet another presentation concluded that the impact of changes in household wealth on spending would be “perhaps only half as large as that of the s stock bubble.” Most FOMC participants agreed “the probability of spillovers to financial institutions seemed moderate.”  CHRG-111hhrg53021Oth--326 Chairman Frank," I have a proposal. We have a vote. There are three Members left on the Democratic side. I am wondering if Members could each do a minute and a half, pose a question and have the Secretary respond. Would that be acceptable. The gentleman from North Carolina, gentleman from Texas, gentleman from Illinois. Maybe we can shave it a little bit down to 1\1/2\ or 2 minutes for questions. Mr. Miller of North Carolina. Good morning, Mr. Secretary--or, good afternoon, Mr. Secretary. Most of what you have discussed, justifying derivatives--the purpose of derivatives is they are risk mitigation. They are like insurance. But it appears that there is no requirement with respect to derivatives that any party of the transaction actually have an interest in the underlying asset, the asset from which the derivative is derived. Obviously, if there is no risk to mitigate, it can't be risk mitigation. It doesn't appear to have anything to do with capital allocation. The only justification I have heard is it assists price discovery, and that the more transactions are based upon the value of an asset, the more accurate the price is. But that seems pretty thin given how huge the derivatives market is. Did you give any consideration to whether or not these products should be allowed at all, if they do anything useful for society? Do you think they---- " CHRG-111hhrg53021--326 Chairman Frank," I have a proposal. We have a vote. There are three Members left on the Democratic side. I am wondering if Members could each do a minute and a half, pose a question and have the Secretary respond. Would that be acceptable. The gentleman from North Carolina, gentleman from Texas, gentleman from Illinois. Maybe we can shave it a little bit down to 1\1/2\ or 2 minutes for questions. Mr. Miller of North Carolina. Good morning, Mr. Secretary--or, good afternoon, Mr. Secretary. Most of what you have discussed, justifying derivatives--the purpose of derivatives is they are risk mitigation. They are like insurance. But it appears that there is no requirement with respect to derivatives that any party of the transaction actually have an interest in the underlying asset, the asset from which the derivative is derived. Obviously, if there is no risk to mitigate, it can't be risk mitigation. It doesn't appear to have anything to do with capital allocation. The only justification I have heard is it assists price discovery, and that the more transactions are based upon the value of an asset, the more accurate the price is. But that seems pretty thin given how huge the derivatives market is. Did you give any consideration to whether or not these products should be allowed at all, if they do anything useful for society? Do you think they---- " FOMC20081007confcall--64 62,CHAIRMAN BERNANKE.," Thank you. Actually, going back to President Lacker and President Plosser, President Lacker made the point about the joint statement. The joint statement with respect to inflation says ""the recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability."" I would be content if the preference of others is to take out the word ""materially"" and just say ""have reduced the upside risks to inflation."" That would be perhaps more consistent, but I'm happy either way. So that's just a suggestion. Let me go on now to Bob Rasche. " CHRG-109hhrg22160--184 Mrs. Kelly," The GAO also released a report last year indicating that a functioning market for terrorism insurance would not exist if TRIA were allowed to expire. You further stated to me in this letter that if an efficient pricing mechanism for terrorism risk did not exist--and I am quoting you here--``some level of federal involvement in terrorism insurance may continue to be warranted.'' Without a functioning private market for terrorism insurance in the absence of TRIA, do you think government can replace market signals as an arbiter of terrorism insurance prices? " CHRG-111shrg57322--819 Mr. Broderick," This was entirely consistent with the strategy that--with the direction provided by David Viniar and other senior managers of the firm that we be less long in our mortgage business generally. Senator Coburn. OK. But as a risk manager, what are the inciting events for them to do that? You are sitting there looking at it as a risk manager. What caused them to make that turn? Was it, as testified in the first panel, we started seeing a deceleration and an increase in housing prices, or we started seeing subprimes not performing? What was it that led to that conclusion within your firm? " FOMC20081216meeting--453 451,MR. DUDLEY.," Yesterday we talked about AAA tranches of student loans, which are 97 percent backed by the Department of Education. They are selling at LIBOR plus 300 or LIBOR plus 400. It is hard to say that those securities are priced there because of credit risk. " FOMC20080805meeting--27 25,CHAIRMAN BERNANKE.," Thank you. I guess I would comment that there is an asymmetry here, which is the possibility of systemic risk. There are situations in which failures--major collapses of certain markets--can have discontinuous and large effects on the economy. We have seen that in many contexts across a large number of countries. These stresses do reflect the working out of equilibriums given fundamental losses, which we can't do very much or anything about. But they do create machinery that is less flexible and less able to respond to new shocks, and that raises systemic risk. That is the risk that we want to try to minimize, even as we allow the markets to work their way through and to price the changes we have seen. " CHRG-111shrg57319--521 Mr. Killinger," Again, I just do not recall the specifics of this at all. Senator Coburn. OK. Exhibit 78a,\2\ in this email exchange from March 10, 2005, with Jim Vanasek, you wrote, ``I have never seen such a high risk housing market as market after market thinks they are unique and for whatever reason are not likely to experience price decline. This typically signifies a bubble.''--------------------------------------------------------------------------- \2\ See Exhibit 78a, which appears in the Appendix on page 790.--------------------------------------------------------------------------- Is it accurate to say that you saw a bubble in housing prices as early as March 2005? " CHRG-110hhrg44901--3 Mr. Bachus," I thank the chairman. Chairman Frank, I am going to follow your lead and restrict my remarks to the real economy, which is the purpose of this hearing, and not some of the recent developments in the past week or two. Chairman Bernanke, looking at the economy, we had an overextension of credit. We had too easy of credit, it wasn't properly underwritten, and the risks were not taken into account. As a result of that, we have had, I think, massive debt accumulation in this country, and we are going through what is inevitable when people borrow more than they can repay. I think a second factor, and it may be in your remarks or questions, you can address this, but a tremendous amount of leverage and risk-taking and other risky and speculative investment practices and a lot of fortunes were made on the way up, but there is pain on the way down. As I see it, it is not an easy thing to go through, but it is a part of a market cycle. The third factor, and this is a factor that I think is the most important, is the high commodity prices, and particularly energy prices that have been a particular hardship on importing nations, and we are obviously an importing Nation. It has been a financial windfall to exporting countries. I have been to Abu Dhabi and Dubai, and the fabulous wealth that has been created out of really a desert society there in the past 40 years is just almost beyond belief. I think T. Boone Pickens, he is running a commercial right now, and he calls this, I think rightly so, the largest transfer of wealth in the history of the world. That, to me, and the effect it is having on Americans day-to-day, is our biggest problem. I believe it is the largest source of instability in our financial markets. I think that the consumers are stressed, they are paying high gas prices, high diesel prices, and they can't pay their other bills. They are even having trouble putting food on their tables. Finally, while we require the American people to live within their budget, we had deficit spending here, and have for some time, and there is a tremendous lack, I think, in Washington of financial discipline. The Federal Government has more obligations than it can fund today, but it continues to obligate itself, it continues to expand and create new programs, and it continues to assume responsibility for funding services that were traditionally in the province of local or State governments or families themselves. Obviously, all of these problems, the problem of tremendous mushrooming of extension of credit and debt accumulation, of overleveraging and risk-taking, of high energy costs, high food costs, high gas prices, and then a Federal Government that spent beyond its means, obviously there is no single approach we can take to getting ourselves out of this. I think the banks have repriced for risk. There has been a lot of--they have raised capital. I will state right here that I know there is a debate in this country on the overall financial stability of our financial system, but I, for one, think that we are well on our way to recovery in the financial system. I think the present stock prices of our banks don't accurately reflect the value of those banks. I think the stock prices are too low. The banks are sound, they are solid. I think the stock prices, right now you may have--I think there is a real--it is just a confidence factor. Anyway, we have had a retrenching and a correction, and I do worry about some attempts that we are doing to short-circuit the correction and the period of adjustment. I think long term they can deepen the damage. But, in contrast, there is something that I think we should do, and we can do now, and that is to address high energy prices. High energy prices mean higher production and transportation costs. Those increases are passed on to the consumers, and we saw that this morning, causing inflationary pressures. Particularly hard hit are those Americans, a million-and-a-half Americans, whose adjustable-rate mortgages are adjusting. Those families are facing a double whammy. To sum up, what I believe is needed now is a concerted bipartisan effort by Congress and the Administration to develop and implement a comprehensive energy and conservation initiative. It needs to be done now. It should have been last year or the year before that. I believe until we get a handle on our dependency on foreign oil, we are going to continue to have real severe problems. Thank you. " FOMC20050630meeting--137 135,MR. MOSKOW.," Thank you, Mr. Chairman. I wanted to make a few comments and then ask a question. First, I’d say that with all of the concerns about froth in housing markets, I found these presentations to be very informative, and I want to congratulate the people who spent a lot of time preparing them. I thought they were all very good presentations. But I also found the information comforting. We’ve all talked about the possibility of local housing bubbles and regional housing bubbles, and clearly there are some in the United States. But we never really looked at it on a national basis before. The net result for me was that I come away from the analysis not feeling any worse than I did before and probably a little better. First, I thought it was very helpful to see quantified—I think this was in Josh’s memo—the size of the potential bubble. He talked about a 20 percent drop in housing prices. But that was equal to only about 30 percent of GDP as compared to the drop in equity prices we had, which was more than twice that. Also, I had the feeling that appropriate monetary policy, as John said, could mitigate much of the distress that might occur. Moreover, the credit risk associated with home mortgages seems to be spread out across many institutions. Governor Bies said that a lot of analysis is being done now, and we’ll want to see the results of the analysis that the Board and the Comptroller are doing. But on the whole, the financial institutions seem to be in pretty good shape. The role of securitizing mortgages is to lay off risks to parties who are willing and able to bear the risks. Capital levels of the financial institutions are relatively high, so it appears that these markets are performing their roles well. And in the event of a sharp drop in housing prices, the odds of a spillover to financial institutions seem limited. And as I mentioned, it was helpful to hear the June 29-30, 2005 48 of 234 housing prices. So I come away somewhat less concerned about the size and consequences of a housing bubble than I was before. The question I had relates to what Governor Yellen was asking about—financial innovation. I was going to make a similar point. The fact is that there has been a great deal of financial innovation in housing markets in the United States. The average person can borrow very easily on his home these days. And I was wondering if there have been—or if it is possible to do—any international comparisons on this. I wondered whether the price-rent ratios in other countries that may not have had the same degree of financial innovation we’ve had differ substantially from ours." CHRG-111shrg50815--116 LEVITIN Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.2. I am unsure to which ``rules'' the question refers; I assume it refers to the recent unfair and deceptive acts and practices regulations adopted by the Federal Reserve, Office of Thrift Supervision, and National Credit Union Administration under section 5 of the Federal Trade Commission Act. If so, I strongly but respectfully dispute the premise of the question; the scenario that is presented is exceedingly alarmist. The question wrongly implies that all individuals with FICO scores of 620 or lower currently have access to ``traditional'' credit cards. They assuredly do not. First, nearly 10 percent of the United States adult population is ``unbanked,'' and that means almost by definition that they do not have credit cards; card penetration into the unbanked market is de minimis. Thus, at least half of the impact implied by the scenario is not possible. For the remaining 10 percent or so who have FICOs under 620, many do not currently have access to ``traditional'' credit. Instead, they have access to predatory new credit products like ``fee harvester'' or ``secured'' credit cards. Even if these non-traditional products were included in the term ``traditional,'' I think it is also dubious that all or even most of them would cease to be able to get ``traditional'' credit; nothing in the proposed regulations limits issuers' ability to protect against credit risk through either lower credit limits or higher interest rates or other fees. To the extent that these individuals are not able to get credit cards or choose not to accept them because of onerously high interest rates, the answer to where they would turn for financing needs depends on the particular circumstances of the individual, but I believe that many consumers would first cut down or eliminate non-essential expenses, which would reduce their financing needs. Demand for credit is not entirely inelastic. For these consumers' remaining financing needs, many would turn to family and friends for assistance. See Angela Littwin, Testing the Substitution Hypothesis: Would Credit Card Regulations Force Low-Income Borrowers into Less Desirable Lending Alternatives? 2009 Ill. L. Rev. 403, 434-35 (2009) (noting that borrowing from family and friends is the most frequent form of borrowing for low-income women). It is also important to note that empirical evidence suggests that ``credit cards are actually among low-income consumers' least-preferred sources of credit, meaning that there is no ``worse'' alternative to which they would turn if credit card access were reduced.'' Id. at 454. Beyond family and friends, there are also other legitimate, high-cost sources of credit besides credit cards--pawn shops, rent-to-own, and overdraft protection, e.g. There, of course, is a possibility that some low-income consumers will turn to illegitimate sources of credit, such as loan sharks, but this possibility could be tempered by community-based small loan programs. Indeed, given that the Federal Government is currently subsidizing credit card lending through the Term Asset-Backed Securities Lending Facility (TALF), it seems quite reasonable to support other forms of consumer credit lending. Indeed, in Japan, where there is a 20 percent usury cap, credit rationing and product substitution are significantly tempered by a government-supported small loan system. Nor is it clear that the terms on which ``loan sharks'' lend are actually worse than some subprime credit card products. As Woody Guthrie sang in the Ballad of Pretty Boy Floyd: Now as through this world I ramble I see lots of funny men Some will rob you with a Six gun And some with a fountain pen. But as through your life you travel As through your life you roam You won't never see an outlaw Drive a family from their home.Woody Guthrie, American Folksong 27 (1961). Finally, given the terms on which individuals with FICO scores of under 620 are able to obtain ``traditional'' credit, I think it is quite debatable whether ``traditional'' credit is in any way beneficial to them; fee-harvester cards and other subprime credit card products are as likely to harm consumers with poor credit ratings as they are to help them; these cards can improve consumers' credit scores over time, if the consumer is able to make all the payments in full and on time, but by definition a consumer with a FICO of under 620 is someone who is unlikely to be able to do that. Q.2. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.2. Again, I respectfully disagree with the premise of the question. The new uniform Unfair and Deceptive Act and Practices regulations adopted by the Federal Reserve Board, the Office of Thrift Supervision and National Credit Union Administration under section 5 of the Federal Trade Commission Act (``Reg AA'') do not prohibit risk-based pricing. Reg AA only prohibits retroactive repricing of existing balances. Card issuers remain free to increase interest rates prospectively with proper notice or to protect themselves immediately by closing off credit lines. That said, I would expect that Reg AA would likely reduce credit availability to some degree, although perhaps not to all consumers. This is not necessarily a bad outcome. Credit is a double-edged sword. It can be a great boon that fuels economic growth, but that is only when credit does not exceed a borrower's ability to repay. Credit can also be a millstone around the neck of a borrower when it exceeds the ability to repay. Overleverage is just as bad for consumers as it is for financial institutions. To the extent that Reg AA reduces credit availability, it might be a good thing by bringing credit availability more in line with consumers' ability to repay. Q.3. Consumer Disclosure: You state that the sheer number of price mechanisms make it difficult for consumers to accurately and easily gauge the cost of credit. You cite things such as annual fees, merchant fees, over-the-limit fees, and cash advance fees. You seem to suggest that credit cards should become much more plain vanilla because people simply can't understand the different uses and costs for those uses. Don't these different pricing mechanisms also provide more choices for consumers as they make purchasing decisions? A.3. That depends on the particular pricing mechanism. Many of them provide dubious choices or value for consumers. Consider over-limit fees, late fees, cash advance interest rates, and residual interest and double cycle billing. (1). LOverlimit fees. A consumer has no right to go overlimit and cannot assume that an over-limit transaction will be allowed. Moreover, overlimit can be the result of the application of fees, rather than of purchases. Therefore, overlimit is not exactly a ``choice.'' (2). LA late fee is no different than interest, just applied in a lump sum. I am doubtful that most consumers would prefer an up-front lump sum late fee rather than a higher interest rate. For the large number of ``sloppy payers'' who pay their bills a few days late, a higher interest rate is much better than a large flat late fee, but because consumers systematically underestimate the likelihood that they will pay late, they are less concerned about the late fee than the interest rate. (3). LMost cards charge a higher interest rate for ``cash advances.'' A cash advance, however, is not necessarily the payment of cash to the consumer. Instead, cash advances include the use of so-called ``convenience checks'' that card issuers send to consumers with their billing statements. (Incidentally, convenience checks present a considerable identity theft problem because they lack cards' security features and the cardholder has no way of knowing if they have been stolen. They expose issuers to significant fraud losses and should be prohibited as an unsafe and unsound banking practice.) Convenience checks permit cardholders to use their card to pay merchants that do not accept cards, like landlords, utilities, and insurers. This allows consumers to pay these bills even when they do not have funds in their bank account. But convenience checks carry the cash advance interest rate plus a fee (often a flat 3 percent with a minimum amount). These terms are usually disclosed on the convenience checks only partially and by reference to the cardholder agreement. It is doubtful that most consumers retain their cardholder agreement, so whether consumers understand the cost of using convenience checks is a dubious proposition. (4). LSimilarly, billing tricks and traps like residual interest or double cycle billing are hardly a ``choice'' for consumers; these are not product differentiations that are tailored to consumer preferences, as few consumers know about them, let alone understand them. Restricting card pricing could limit innovation in the card market, but it is important to recognize that not all innovation is good. There has been very little innovation in the card industry over the last twenty years, either in terms of technology or in terms of product. Cards still operate on the same old magnetic stripe technology they had in the 1970s. The card product still performs the same basic service. To the extent there has been innovation, it has been in the business model, and it has frequently not been good for consumers. Even things like the 0 percent teaser rate are hardly unambiguous goods. While 0 percent teasers are great for consumers who can pay off the balance, they also encourage consumers to load up on credit card debt, and if there is a shock to the consumer's income, such as a death, an illness, a divorce, or unemployment, the consumer is much more exposed than otherwise. I recognize that it is important to protect the ability of the card industry to innovate in the future, and that is why I believe the best solution is to set a default rule that simplifies credit card pricing, but to allow a regulatory agency, such as the Federal consumer financial product safety commission proposed by Senators Durbin, Kennedy, and Schumer and Representative Delahunt (S. 566/H.R. 1705, the Financial Product Safety Commission Act of 2009) to have the power to card issuers to introduce new products and product features provided that they meet regulatory consumer safety standards. Q.4. Bankruptcy Filings: As the recession worsens, many American families will likely rely on credit cards to bridge the gap for many of their consumer finance needs. Mr. Levitin and Mr. Zywicki, you seem to have contrasting points of view on whether credit cards actually force more consumers into bankruptcy, or whether credit cards help consumers avoid bankruptcy. Could both of you briefly explain whether the newly enacted credit card rules will help consumers avoid bankruptcy or push more consumers into bankruptcy? A.4. The newly enacted Federal Reserve credit card regulations will not have any impact on bankruptcy filings presently, as they do not go into effect until summer of 2010. When they do go into effect, their impact on consumer bankruptcy filings will likely be mixed. Credit card debt has a stronger correlation with bankruptcy filings than other types of debt. But this is not necessarily a function of credit card billing practices. Card debt reflects the macroeconomic problems of the American family--rising costs of health care, education, and housing but stagnant wages and depleted savings. The card billing tricks and traps targeted by the Fed's rules amplify this distress, but the Fed's rules will not solve the fundamental problems of the American family. To the extent that they limit the amplifying effect that card billing tricks and traps have on card debt levels, it will help some consumers avoid bankruptcy. If the rules result in contraction of credit availability, it might push consumers into bankruptcy, but that would have to be netted out against the number that are helped by a reduction in the amplification effect, and I am skeptical that there would be much contraction. I agree with Professor Zywicki that credit cards can help some consumers avoid bankruptcy. If a consumer has a temporary setback in income, credit cards can provide the consumer with enough funds to hang on until their financial situation reverses. But credit cards can also exacerbate financial difficulties, and even if the consumer's fortunes pick up, it might be impossible to service the card debt. Moreover, there are many consumers whose financial situations are not going to pick up, and for these consumers, card debt just adds to their distress. Q.5. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.5. Yes, but not by the same regulators. There is an essential conflict between safety-and-soundness and consumer protection. A financial institution can only be safe and sound if it is profitable. And abusive and predatory lending practices can often be extremely profitable, especially in the short term, and can compensate for the lender's other less profitable activities. The experience of the past decade shows that when Federal regulators like the Office of Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve are charged with both safety-and-soundness and consumer protection, they inevitably (and perhaps rightly) favor safety-and-soundness at the expense of consumer protection. These functions cannot coexist in the same agency, and consumer protection responsibilities for financial products should be shifted to a single independent Federal agency (which would not claim preemptive authority over state consumer protection actions) to protect consumer protection. Q.6. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? A.6. Banks are raising interest rates on consumers and limiting credit to cover for their own inability to appropriately price for risk in mortgage, securities, and derivatives markets has resulted in their solvency being threatened. Therefore, banks are trying to limit their credit card exposures and are trying to increase revenue from credit card accounts by raising rates. If banks are unable to competently price for risk for mortgages, where there is often robust underwriting, what confidence should we have in their ability to price for risk for credit cards where every loan is a stated income ``liar'' loan? The current financial debacle should cause us to seriously question banks' claims of risk-based pricing for credit cards. The original pricing failed to properly account for risk and the new arbitrary repricing certainly fails to account for risk on an individualized level. The only risk being reflected in the new pricing is the bank's default risk, not the consumer's. Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? Yes, it probably does because it is being done so arbitrarily. Q.7. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.7. No. The issue is a red-herring. As an initial matter, it is important to emphasize that the Federal Reserve's new regulations do not prohibit risk-based pricing. They only prohibit retroactive repricing of existing balances. In other words, they say that card issuers only get one bit at the risk pricing apple, just like any normal contract counterparty. Card issuers remain free to price however they want prospectively or to reduce or cutoff credit lines if they are concerned about risk. Second, it is important to underscore that to the extent that card issuers engage in risk-based pricing, it is only a small component of the cost of credit. I discuss this at length in my written testimony, but I will note that Professor Zywicki has himself written that 87 percent of the cost of credit cards has nothing to do with consumer risk; it is entirely a function of the cost of operations and the cost of funds. Todd J. Zywicki, The Economics of Credit Cards, 3 Chap. L. Rev. 79, 121 (2000). The remaining 13 percent represents both a risk premium and opportunity pricing. In many cases the opportunity-pricing component predominates. Therefore, there to the extent that credit card issuers do risk based pricing, it only has a marginal impact on the total cost of cards. As Professor Ausubel demonstrated in his written and oral testimony, a significant component of some credit card fees, like late fees, are opportunity costs. Likewise, in my written testimony, the section comparing my own credit cards, three of which are from the same issuer, but which have different rates that do not correspond with credit limits, indicates that there is significant opportunity pricing in the card market. Regulations that make cards fairer and more transparent would be unlikely to have much impact on consumer pricing. Third, it is not clear why cross subsidization should be a particular concern. It is a common fact of life. Consider flat-fee parking lots. Those consumers who park for 5 minutes subsidize those who park for hours. Similarly, at by-the-pound salad bars, consumers who eat only carrots subsidize those who eat only truffles. When cross-subsidization is regressive, it elicits additional concerns, but there are far more serious regressive price structures, not the least of which is the Internal Revenue Code. That said, I believe the cross-subsidization in the scenario to be unlikely because the risk that matters to card issuers is nonpayment risk, not late payment risk, and income and wealth generally correlate with low nonpayment risk. In sum, then, I think the cross-subsidization scenario presented is unlikely, and to the extent it occurs, the cross-subsidization will only be de minimis because of the limited extent of risk-based pricing. The problem presented by the scenario is a red herring concern and not a reason to shy away from regulating credit cards. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM KENNETH J. CHRG-111hhrg55811--269 Mr. Hixson," Thank you. My name is Jon Hixson, and I am director of Federal Government relations at Cargill. I want to thank you for the opportunity to testify today. Cargill is an international provider of food, agricultural, and risk-management products and services. As a merchandiser and processor of commodities, Cargill is an extensive end-user of derivatives on both regulated exchanges and in the OTC markets. Cargill's activity in offering risk-management products and services to commercial customers and producers in the agriculture and energy markets can be highlighted with the following OTC examples: We offer customized hedges to help bakeries manage price volatility of their flour so that their retail prices for baked goods can be as stable as possible for consumers and grocery stores; we issue critical hedges to help regional New England heating oil distributors manage price spikes and volatility on their purchases so that they can offer families stable prices throughout the winter season; and we offer customized hedges to help a restaurant chain maintain stable prices on their chicken so the company can offer consistent prices and value for their retail customers when selling chicken sandwiches. Chairman Frank's discussion draft is a positive step in addressing comprehensive market reforms of the OTC market. While we have some areas of concern, there are many well-supported elements included in this proposal. The discussion draft would improve transparency with dealer registration and audit trails, the proposal would create a regulated trade data repository and has a stronger focus on reducing systemic risk and more rigorous requirements for inter-dealer transactions. The bill also provides flexibility for end-users and traditional hedgers utilizing OTC risk-management products and clearly establishes regulatory authority to ban any swap deemed abusive. Cargill supports these provisions and appreciates the work of the chairman and other members of the committee in developing this discussion draft. The draft bill represents a significant improvement over many other proposals that, in our view, would overly restrict the use of OTC markets for hedging purposes. Our main concerns with the discussion draft relate to two areas of the legislation: first, the application of capital and margin requirements. The discussion draft gives regulators discretion in whether to impose margining requirements in traditional hedging and risk-management transactions. We appreciate this flexibility. However, we are concerned that, given recent regulatory statements and testimony, the imposition of mandatory margining for hedging transactions would still likely occur. This will make it very difficult, if not unlikely, that firms would be able to affordably and efficiently hedge their flour, heating oil, and chicken risks as described earlier. To ensure congressional intent, the legislation could include a list of factors and in a similar style as the provisions within the discussion draft that provide greater guidance on the clearing requirement. In addition, capital requirements should clearly recognize and reflect the risk-management processes utilized by dealers. When Cargill offers tailored risk-management products to our customers like the bakery hedge, we offset a substantial amount of that risk by taking positions on a regulated, centrally cleared exchange, margined for daily mark-to-market exposure. We also use margin agreements with most of our customers. These steps greatly reduce overall risks in the hedging transaction. Regulators should consider such prudent risk-management actions as they analyze and develop appropriate capital requirements to ensure that the charges are based on actual risk of loss. Regulators are also given much discretion in setting margin and capital requirements for non-bank dealers. The provisions often call for requirements as strict or stricter than those a prudential regulator would establish for a systemically significant financial institution. While we are very sensitive to the role played by a non-banking firm in last year's financial crisis, there should be some recognition that the bakery hedge, for example, did not cause systemic risks for the financial system. Excessive requirements on our segment will likely only result in less competition among dealers within the OTC segment. Surrogation of assets is our second area of concern. We are sympathetic to those who lost initial margin money last year and would like to work with others, including members of this committee, to address this issue. However, restrictions around variation margining will have the unintended consequence of curtailing sound business practices that would otherwise minimize the risks of a hedging transaction. We appreciate the opportunity to testify before the committee to offer examples of our use of OTC products in risk management and to highlight our areas of support and concern within the discussion draft. We look forward to working together as this legislation continues to develop. [The prepared statement of Mr. Hixson can be found on page 135 of the appendix.] Ms. Bean. Thank you for your testimony. We are going to proceed to the next witness, Professor Rene Stulz, chair of banking and monetary economics at the Fisher College of Business at Ohio State University. STATEMENT OF RENE M. STULZ, EVERETT D. REESE CHAIR OF BANKING AND MONETARY ECONOMICS, FISHER COLLEGE OF BUSINESS, THE OHIO FOMC20080430meeting--67 65,MR. STOCKTON.," I think that is a fair characterization. You know, one thing that we're struggling with--and I assume you are as well in giving your own views about the uncertainty and the skewness around your forecast--is whether things have changed. Is the skew large enough for us to argue that, in fact, the risks look unbalanced? We thought about that and about the potential upside and downside risks. Clearly, as I indicated, upside risks would be associated with ongoing increases in underlying prices for oil and other commodities that would probably feed through indirectly into core inflation over time. On the downside, we have been struck with how little upward pressure there has been on labor compensation and labor costs. Now, if you pinned me down and said draw a fine line on this, I'd probably say that, given the pattern of the past few years, it would look to me as though there's probably a little more upside risk than downside risk, but I don't see that skewness as being material in the forecast. " CHRG-111shrg56262--24 Mr. Davidson," Addressing the current illiquidity, I would focus sort of on two different areas. One is the area of uncertainty. We still have a tremendous amount of economic uncertainty and regulatory uncertainty, and that just takes some investors out of the market because they need the risks to know a little bit better. And the other area is just the lack of availability of leverage to certain types of instruments. Without leverage, many instruments have to trade at very discounted prices, and so the institutions who hold those now and do have leverage are not willing to transact at the all equity price as opposed to the leveraged price. And I think that is why some of the Government programs, like TALF, have been so effective is because they have reinstituted leverage into these markets. In thinking about the solutions, we have to consider what is the appropriate amount of leverage and make sure that that can be delivered through those markets because that will be an important part of their future success. " FOMC20080805meeting--17 15,MR. BULLARD.," Thank you, Mr. Chairman. I'm just following up here. I mean, as much as I love exhibits 14, 15, and 16--and I have used a lot of them myself when I talk about the economy--it is not really appropriate to look at these as measures of stress. You could just say that these are the equilibrium prices in an economy that is adjusting to a big shock. You could have a completely flat line here that would indicate stress in markets because these prices aren't moving around appropriately to the risks that have developed and opened up. So a lot of the concern around the table has been exactly that, when markets freeze up, you can't do any trade at any price; and for that the volume data would seem to be a much better indicator of the kinds of things that we are worried about. I think that this is conditioning a lot of our thinking about the economy--you look at this picture, and you naturally think it has to go back to 10 basis points before the crisis is over. That probably is not going to happen anytime soon and maybe never. Thanks. " CHRG-110shrg50369--40 Mr. Bernanke," Well, we are certainly aiming to achieve our mandate, which is maximum employment and price stability. We project that that will be happening. We are watching very carefully because there are risks to those projections. One of the risks, obviously, is the performance of the financial markets, and that again, as I mentioned before, complicates the situation. As events unfold--and certainly there are many things that we cannot control or cannot anticipate at this point--we are simply going to have to keep weighing the different risks and trying to find an appropriate balance for policy going forward. Senator Shelby. As a bank regulator, too--this will be my last question, Mr. Chairman--do you fear some bank failures in this country? I know there are big risks where they are heavily involved in real estate lending. Does that bother you as a bank regulator? " CHRG-111shrg57322--706 Mr. Viniar," What is the value? And then if we have bought something and we still have it and we want to sell it and we just think our risk is too big, we might have to cut the price and sell it at 80 cents on the dollar and the other purchaser may not think it is a great security, but they may think it is worth more than 80 cents. They may think it is worth 83 cents, which is still not 100 percent, but it is a price at which they want to buy it. Senator Coburn. Could you answer this question for me, and maybe you can't, but I would like for you to try because it concerns a lot of us. How is it that Goldman got 100 percent payback on this collateral dispute with AIG? " FOMC20080805meeting--117 115,MS. PIANALTO.," Thank you, Mr. Chairman. My outlook for economic growth and inflation over the next few years is broadly similar to the one that I held last meeting, although I think that the prospects for both inflation and economic growth in the near term have deteriorated since June. To a close approximation, my outlook ends up looking very similar to the Greenbook's baseline scenario. The most significant change I am making to my outlook is to mark down the prospects for business fixed investment this year and next, based on the reports that I am hearing from the manufacturers in my District. There is an interesting short-term/long-term dynamic taking place in the manufacturing sector. The manufacturing CEOs with whom I have spoken say that over the long term they are very bullish on America. The dollar depreciation, increased transport costs, and rising wages in China all favor more U.S.-based production. A senior executive from Alcoa told me that, in his 35 years of working in the manufacturing sector, he has never seen the fundamentals point so strongly toward the United States as a profitable location for manufacturing. The short term, however, presents a more mixed picture for manufacturers. Although some industries, such as power generation equipment and aerospace, are running flat out and expect to continue doing so, companies in other manufacturing industries have received or expect to receive order cancellations. In particular, the manufacturers that supply the automotive and commercial construction sectors are reporting a worsening outlook. Perhaps the best way to summarize the sentiments that I am hearing from manufacturers is to say that they see a bright future but they see challenging conditions over the next 12 months. We all know that housing markets are extremely weak. Housing prices began their decline earlier in Cleveland than in the rest of the country, and we are now seeing some stability in housing prices. Despite that hopeful glimmer, we have not seen any pickup in home sales. Based on this experience, it seems that we still have a long way to go nationally before we see any pickup in residential construction. In regard to financial markets, my chief concern is that lending is going to be constrained by lenders needing to maintain sound capital ratios in the face of asset write-downs and loan charge-offs. Balance sheet constraints and a declining risk appetite on the part of bankers mean that some worthy borrowers are going to be rationed out of credit markets, further restraining economic activity. Turning to inflation, I anticipate that price pressures will intensify further before we see some relief, just as the Greenbook baseline scenario depicts. Manufacturers are still raising their prices in response to rising prices for raw materials that they purchase. Some companies have had fixed-price contracts in place for five and ten years, and as these contracts mature, the companies are passing on huge price increases to their customers. Consequently, I think that even after a point at which energy and commodity prices flatten out, prices at the wholesale and retail levels are likely to adjust upward for a while longer. I just said that manufacturers are expecting some challenging times ahead. One reason is that many of them are caught between weakening demand conditions and soaring input costs. Sherwin-Williams represents an extreme case, but I think it illustrates the situation pretty starkly. The CEO of Sherwin-Williams told me last week that their business is down more than 20 percent in sales channels both to new construction and to existing homes. They have been in business for 126 years, and the last time this occurred was during the Great Depression. Despite these dismal sales, they are having to raise prices. The CEO told me that the company typically raises prices once a year, but in July they announced their third price increase this year. In the entire history of the company, they have never before had three price increases in one year. So I continue to see the risk to my projection for output as being to the downside for the reasons that we have been discussing for some time--high energy prices, severe financial stress, and a depression in the housing markets. The risk to my inflation outlook is weighted to the upside because I am concerned that inflation could remain elevated for too long, potentially destabilizing inflation expectations. The Greenbook baseline scenario expects the near-term inflation picture to worsen in the second half of this year before improving gradually over the entire forecast period. This pattern is a concern to me. In that environment, I worry that inaction on our part before next year could be seen as complacency on our part. So when I stack up the two risks against one another, I regard them as fairly equal right now. But my outlook is conditioned on a federal funds rate path that begins to increase about a quarter earlier than called for in the Greenbook baseline. I will speak to the relevance of this factor when we discuss monetary policy in the next go-round. Thank you, Mr. Chairman. " FOMC20060328meeting--76 74,MR. STOCKTON.," For my part, the most salient risk that I would note is housing, for a few reasons. One, it’s an asset market as well as a natural investment, and I just don’t know how to forecast those prices. I think that, in our presentation last June, we made pretty clear just what the uncertainties are there. Beyond that, I’m not sure what the effects will be if, in fact, there is a correction either on the construction side or on the price side. There are just so many uncertainties. As we’ve noted in the past, we use a standard wealth effect to calculate the consequences of that. But there could be bigger effects associated with equity extraction. There also could be confidence effects that are difficult to gauge. And so I see big risks on both sides. Obviously, I’d be more worried about the downside risk than the upside risk if we get another couple of years of things going on as they have been going. It means that for a while you’ll have to lean a little harder against the strength in housing, but it also means you’ll be dealing with potentially bigger consequences when the correction in housing markets occurs. So looking at the data, I’m feeling comfortable with our basic forecast—that things are tipping down. But as I indicated, we’re just really not sure what it’s unwinding to—whether it’s unwinding to the sort of benign soft landing that we’re forecasting. We think that forecast is reasonable. There’s nothing in the rate environment or in other factors that makes the forecast look far-fetched to us. On the other hand, one could certainly envision a more painful and bumpier adjustment that will cause bigger problems for the Committee." FOMC20080805meeting--119 117,MR. PLOSSER.," Thank you, Mr. Chairman. Economic conditions in the Third District remain relatively weak, but they are not materially different from what we and our business contacts have been expecting for the past several months. Manufacturing and residential construction sectors continue to show a slow decline. Payroll employment in our three states fell in June, but it is still above the levels of where it was three months ago and so has been performing somewhat better than in the nation as a whole. The pace of retail sales seems to have been softening, and commercial real estate firms indicate that most office and industrial markets have weakened slightly since the spring. My business contacts generally expect weak growth for a while. Manufacturers do expect a rebound during the next six months; but most other sectors, particularly retail sales, anticipate only soft or slightly improving conditions in the near term. Residential real estate is not expected to strengthen appreciably in the second half of the year. Banks expect somewhat sluggish growth in overall lending for the rest of the year, although compared with some regions, banks in our District are in pretty good shape. There are stresses, but they seem to be manageable. Credit, however, is generally available to businesses, and we hear only sporadic information from businesses that they are unable to obtain needed loans. For some time my business contacts have expressed concern about rising energy and commodity and transport prices. Our business outlook survey's prices-paid index rose yet again in July, and it is now at its highest level since March 1980. Although the prices-received index edged down slightly, it remains at a very, very high level relative to historical standards. The BOS's future prices-received index rose to 49.6 percent, which is the highest level it has been since January 1989. This indicates that roughly half the manufacturing firms that responded to our survey expect the prices they receive for their products to be increased over the next six months. To gauge the extent to which manufacturing firms have been able to pass on rising costs to their customers, we asked several special questions about product pricing in our July survey. More than 60 percent of our respondents indicated that, since the beginning of the year, they have been able to raise prices and pass along increased costs to their customers. About 26 percent said this took the form of increases in base prices. Almost half of them had increased base prices. The rest said they have used either surcharges or escalator clauses and, in some cases, combined those with base price increases as well. Surcharges and escalation clauses are not likely to go away anytime soon and may even become more widespread. About 56 percent of our respondents indicated that price escalation clauses and surcharges are likely to be a part of their pricing in the future. Further, since a large number of firms have already built cost increases into their base prices, it is not clear at all that prices will come down quickly, even if oil prices stabilize at a lower level. On the national level, the incoming data since our June meeting have been mixed but largely in line with my expectations for the near-term path of the economy. Real GDP growth for the second quarter came in somewhat weaker than many expected, although I will note that as recently as April many people were expecting negative growth in the second quarter and it is now almost 2 percent. But I think that the strength is a remarkable testament to the ability of this economy to weather shocks from financial market disruptions, a severe housing correction, and surges in energy and commodity prices. Nonfarm payroll employment has fallen an average of 66,000 jobs per month over the last seven months--a weak number to be sure but not nearly as severe as the job losses over the last three recessions, which averaged nearly 180,000 jobs a month. Since our June meeting, we have taken further steps to address fragile financial markets that were manifested by the difficulties surrounding the GSEs and the IndyMac takeover. On balance, my outlook for the economy is little changed, although the financial market developments since our last meeting have marginally increased the uncertainty surrounding my forecast. I do see near-term weak growth for the economy, but I continue to expect an improvement in output and employment growth next year as the economy rebounds closer to trend. Unfortunately, there has been a resurgence in financial market volatility, especially on the part of the banking sector and mortgage markets related to the problems of the GSEs. The liquidity in the interbank and primary dealer markets appears to have improved somewhat relative to the first quarter of this year. I read the conditions in the financial markets and the wide spreads on selected assets as having improved somewhat on net and the spreads we are seeing increasingly reflecting real credit risk as opposed to dysfunctional markets. As I indicated in my questions earlier, we should not use such spreads as the primary criteria for assessing the fragility of the financial markets. Moreover, we must be cautious in using monetary policy or other tools at our disposal as a form of forbearance that delays the necessary adjustments in the pricing of various financial claims. I think we need a high hurdle--that there are real market failures--before we intervene to stem liquidity desires on the part of traders or attempt to influence the price of specific asset classes. To agree with President Bullard's comments, we should begin to deemphasize and destress the importance of systemic risk because I think it is gradually dissipating as firms adjust to the more volatile and risky environment. The current state of the financial markets seems to me to bear some resemblance to the financial headwinds analogy that many people referred to during the early 1990s. Indeed, spreads on many forms of business and consumer loans are behaving now much in the way as they typically behave during recessionary times as credit risks rise. In the early '90s, monetary policy was less accommodative than it is now--at least the funds rate reached a low point of 3 percent from October 1992 to February 1994--and during that time headline PCE inflation ran about 2 to 3 percent. The real funds rate, measured by a one-quarter-ahead forecast of the CPI from the professional forecasters, was minus 0.1 percent over the six quarters from 1993:Q3 to 1994:Q4. Currently, the real funds rate using the same measure of one-quarter-ahead professional forecasters' CPI stands at minus 1.1 percent. The inflation outlook remains a cause of concern. Headline inflation is higher, and there is evidence of modest pass-through to core inflation measures. Inflation compensation on the six-to-ten-year horizon has risen modestly. Inflation compensation at the near term has fallen with recent declines in oil prices, but it remains volatile. The staff has suggested that a portion of the increase in the longer-dated inflation compensation measures may reflect an increase in inflation risk premiums. That is, markets are uncertain about the long-run path of inflation. This is not terribly comforting. It suggests that our credibility may be waning. Despite the recent drop in oil prices, I remain uncomfortable with the longer-term inflation outlook. Indeed, the focus of monetary policy must be on the intermediate to longer term, and we must resist the temptation to act as if our funds rate decisions can manage the outcomes over the very near term. Year-over-year inflation, headline CPI and PCE inflation, have now been consistently above 3 percent since October 1987. Year-over-year core PCE inflation has exceeded 2 percent every month but one since April 2004. That is four years. Businesses are reporting an increased willingness to pass on cost increases. Near term, we might get some moderation in headline inflation, if the recent drop in oil prices holds. This might result in less upward pressure on inflation expectations, at least in the near term. Of course, as has been pointed out, oil prices are notoriously hard to predict, and we may well see a resurgence in oil prices before the year's end; but we don't know. More important, a drop in oil prices will only temporarily mask what I view as the underlying inflationary pressures. Oil prices have clearly exacerbated the recent numbers and may mitigate them in the near term going forward. But my concern is that the real source of intermediate-term to longer-term inflationary pressures comes from our own accommodative policy, whose consequences for inflation will be felt only over time. We are unable to control the rise in oil prices and its consequences for inflation in the short term, but we must hold ourselves accountable for the longer-term consequences of our choices. Should we maintain our accommodative stance for too much longer, my view is that we are likely to see higher trend inflation in the intermediate term and a ratcheting up of inflation expectations. If that scenario unfolds, it will take a much more costly policy action to re-anchor those expectations than the cost of a preemptive move to raise the funds rate in the near term. To be sure, shifting policy to a less accommodative stance will be a difficult decision to make, given the continued volatility in financial markets and the projected near-term weakness in employment and output growth. However, what has been referred to as the tail risk of a very negative growth outcome has decreased since the start of the year, whereas inflation risks have increased. I think the enhancements we have made to our liquidity facilities should be sufficient to address any remaining dysfunctions in the financial markets, but they will not address the credit or solvency issues, nor should we expect them or desire them to do so. The markets will have to do that admittedly heavy lifting. I do not believe that we can wait until employment growth and the financial markets have completely turned around to begin to reverse course. But by our aggressive attention to short-term risk to growth and financial turmoil, we do put at some risk our ability to deliver on our intermediate- and longer-term goals of both price stability and sustainable growth. Thank you, Mr. Chairman. " FinancialCrisisReport--197 Resisting FDIC Advice. During the period 2004-2008, internal FDIC evaluations of Washington Mutual were consistently more negative than those of OTS, at times creating friction between the two agencies. OTS also resisted the FDIC’s advice to subject WaMu to stronger enforcement actions, downgrade its CAMELS rating, and solicit buyers for the bank. As early as 2005, the FDIC examination team expressed concerns about WaMu’s high risk lending strategy, even though the bank’s management expressed confidence that the risks were manageable. In an internal memorandum, for example, the FDIC team identified multiple negative impacts on WaMu’s loan portfolio if housing prices were to stop climbing. The memorandum stated in part: “Washington Mutual Bank’s (WMB) single-family residential (SRF) loan portfolio has embedded risk factors that increase exposure to a widespread decline in housing prices. The overall level of risk is moderate, but increasing. … A general decline in housing prices would adversely impact: a) The SRF loan portfolio; b) The home equity loan portfolio; and c) Mortgage banking revenue. … In January 2005, management developed a higher-risk lending (HRL) strategy and defined company-wide higher-risk loans as … sub prime loans … SFR loans with FICO scores below 620, … consumer loans with FICO scores below 660, and … [the] Long Beach … portfolio. Management intends to expand the HRL definition and layer additional risk characteristics in the future. … Management acknowledges the risks posed by current market conditions and recognizes that a potential decline in housing prices is a distinct possibility. Management believes, however that the impact on WMB would be manageable, since the riskiest segments of production are sold to investors, and that these investors will bear the brunt of a bursting housing bubble.” 752 751 See, e.g., April 16, 2010 Subcommittee Hearing at 61 (testimony of OTS Director Reich: “[F]irst of all, the primary regulator is the primary Federal regulator, and when another regulator enters the premises, when the FDIC enters the premises, confusion develops about who is the primary regulator, who really is calling the shots, and who do we report to, which agency.”) 752 Undated draft memorandum from the WaMu examination team at the FDIC to the FDIC Section Chief for Large Banks, FDIC-EM_00251205-10, Hearing Exhibit 4/16-51a (likely mid-2005). In an interview, when shown the draft memorandum, FDIC Assistant Regional Director George Doerr, who was a member of the WaMu examination team, told the Subcommittee that this type of analysis was prepared for a select group of mortgage lenders, including WaMu, to understand where the mortgage market was headed and how it would affect those insured thrifts. He did not have a copy of the final version of the memorandum, but said the FDIC’s analysis was discussed with OTS. Subcommittee interview of George Doerr (3/30/2010). FOMC20051213meeting--88 86,MR. FERGUSON.," Thank you, Mr. Chairman. The concept of the known unknown came to the national consciousness about a year or two ago, and I sense that it’s very much in this room today. The baseline forecast calls for a very nice, soft landing to potential growth with contained inflation if we just tighten our policy one or two more turns. I’m certainly prepared to accept that forecast for the purpose of today’s meeting, but the uncertainties or the known-unknown factors around it are to me quite obvious. To me the risks are clearly to the upside with respect to growth, but surprisingly may be more balanced with respect to inflation. It is easier to see an upside growth risk than a downside one, in large part because the incoming data have been surprisingly robust, making a slowing just a quarter or two away seem a little bit of a stretch. Much of the waning wealth effect on which the baseline is built is due to a slowing in the housing market. It is true that some of the indicators suggest some moderation there, December 13, 2005 56 of 100 when lined up against the actual strength shown in home sales themselves, both existing and new— and also prices, which have continued to appreciate at a double-digit pace through the third quarter— it is hard to say that the housing market is anything but robust. A second element of the wealth effect that the Greenbook assumes is that the equity price appreciation will be no more than needed to keep the current level of the equity risk premium about stable. But again, it is easy to see some upside potential here. The equity risk premium is now above average. The recent run-up in equity prices, coupled with sustained high levels of productivity growth, an attractive profits outlook, and healthy corporate balance sheets all make it perhaps a little more likely that equity prices will rise rather than fall, and indeed, rise more than expected. If this were to occur, the earnings-price ratio would decline and the equity risk premium would return to the normal range, and in doing so would provide more equity wealth impetus to the economy than perhaps the baseline assumes. Finally, global growth is a surprise to the upside. As Dino indicated, equity prices have shown remarkable strength globally. Monetary policy itself has in many cases been somewhat stimulative and generally financial conditions have been supportive of growth. All of this suggests a bias toward faster global growth due to accommodative financial markets broadly. On inflation, I judge that the risks to the baseline forecast are perhaps a little better balanced. While the upside growth risk would certainly pressure resources with inflationary consequences, that is not the entire story. For one thing, inflation has come in a little softer recently than we had expected. Secondly, energy prices seem to have flattened, and market participants expect them to moderate even further, providing a rapid diminution of the upward momentum to headline inflation. December 13, 2005 57 of 100 pass-through has been relatively low. Finally and importantly, longer-term inflation expectations are moderate. I would also add in this regard something that has not been much discussed here: Labor compensation itself has been on the weaker side, even as resource utilization has tightened. And finally, the productivity growth story, I think, has shown continued robustness. In this regard I’d point out that we talk a great deal about the upward adjustment to the structural productivity growth in the staff forecast, but all they’ve really done is just to maintain what has happened from 2001 to 2004. So maybe we’ve put too much weight on the temporary downward movement as opposed to just recognizing that things haven’t changed very much. So given this view of the risks around the forecast, why do I propose that we accept the baseline for purposes of today’s decision and communication? First, I am mindful that policy works with long and variable lags. While the risks for us are not totally balanced, the greater weight of the evidence, I think, is still for a good outcome, given that we have moved rates up quite considerably. And with inflation expectations still well contained, I think there’s no reason to adjust market perceptions of what we’re likely to do going forward. If those two facts did not adhere, my judgment might be different. Secondly, one would have to say that while the housing sector story is yet to come, there are, as we’ve heard around this table, a large number of anecdotes all pushing primarily in the same direction—supporting, I would think, the baseline. Third, I take some comfort in the fact that the baseline forecast is shared roughly by most outside forecasters. The Greenbook does not seem to be out of the trend. The Blue Chip consensus is that after more than two years of above-trend growth, activity in 2006 is likely to moderate to its trend December 13, 2005 58 of 100 underlie the Blue Chip are not distinguishable dramatically from the Greenbook forecast. President Moskow has already talked about what happened in Chicago at their outlook symposium. Again, the consensus seems quite consistent with our forecast from the staff. And the NABE members we met with in this room not too long ago also expect growth to be in the range of 3.25 to 3.5 in 2006. Finally, I am willing to take the baseline as the basis for policy today because I recognize that our language will convey the proper sense of caution to reflect the risks and leave us with the flexibility to respond to other changes. I will delay any further comment on that, as you have suggested, until the second part of our discussion." CHRG-111hhrg48867--174 Mr. Bartlett," Dr. Price, I would share the one that we have come up with, and this is about our 18th draft: ``Systemic risk is an activity or a practice that crosses financial markets or financial services firms and which, if left unaddressed, would have a significant material and adverse effect on financial services firms, markets, or the U.S. economy.'' " FOMC20061025meeting--83 81,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Our view of the national outlook hasn’t changed much since September. If monetary policy follows the path that’s laid out in the Greenbook, and it’s flat for the next few quarters, then we expect growth to return to a level close to 3 percent in ’07 and for inflation to moderate gradually from current levels. However, we still face the basic tension in the forecast—the combination of relatively high core inflation today and an economy that has slowed significantly below trend—and we still face the same basic questions: Will inflation moderate enough and soon enough to keep inflation expectations reasonably stable at reasonably low levels? Will weakness spread beyond housing and cumulate? Relative to September, we see somewhat less downside risk to growth and somewhat less upside risk to inflation, but as in September, I think inflation risks should remain our predominant concern. Relative to the Greenbook, we expect somewhat faster growth in ’07, but we have a higher estimate of potential. The difference is really mostly about hours and trend labor force growth. We expect more moderation in core PCE and expect it to fall just below 2 percent in ’07, but this difference is mostly the result of different assumptions about persistence. With these exceptions, our basic story about the contour of the expansion is fairly close to the Greenbook, and the implications for monetary policy are similar. The markets do seem relatively positive, a little more optimistic about the near-term outlook. Equity prices, credit spreads, and market interest rates all reflect somewhat less concern about both recession and inflation risks. Some of this, however, is probably the result of the exceptional factors supporting what the markets call liquidity. What is liquidity, and what’s behind it? I don’t know that we have a good answer to that. Most people would cite a combination of the facts that real interest rates are fairly low in much of the world still, that reserve accumulation by the countries that shadow the dollar is still quite large, that a big energy-price windfall is producing demand for financial assets, particularly in dollars, and that there is confidence in the willingness and ability of the central bank, particularly this central bank, to save the world from any significant risk of a recession. I don’t think all of this, therefore, is the result simply of confidence about fundamentals, so we shouldn’t take too much reassurance. But it still is a somewhat more positive constellation of asset prices, of market views about the outlook. Someone wrote this week that the fog over the outlook has lifted. I don’t think that’s quite right. It’s true that the economy still looks pretty good except for housing, and I do think it’s fair to say that core inflation is moderating and that expectations are behaving in ways that should be pretty reassuring to us. But it is too soon to be confident that inflation is going to moderate sufficiently soon enough with the path of monetary policy priced into markets today, and it is too soon to be confident also that the weakness we see in housing, in particular, won’t spread and won’t cumulate. So I think that overall the balance of risks hasn’t changed dramatically, and as in September, I still view the inflation risk as the predominant concern of the Committee." CHRG-110hhrg41184--89 Mr. Bernanke," Congressman, I think I'll let my testimony speak for itself in terms of the monetary policy. I just would say that we do face a difficult situation. Inflation has been high, and oil prices and food prices have been rising rapidly. We also have a weakening economy, as I discussed. And we have difficulties in the financial markets and the credit markets. So that is three different areas the Fed has to worry about--three different fronts, so to speak. So the challenge for us, as I mentioned in my testimony, is to balance those risks and decide at a given point in time which is the more serious, which has to be addressed first, and which has to be addressed later. That is the kind of balancing that we just have to do going forward. " FinancialCrisisReport--391 Goldman began marketing Hudson 1 securities in October 2006, soliciting clients to buy Hudson securities. It did not fully disclose to potential investors material facts related to Goldman’s investment interests, the source of the CDO’s assets, and their pricing. The Hudson 1 marketing materials stated prominently, for example, that Goldman’s interests were “aligned” with investors, because Goldman was buying a portion of the Hudson 1 equity tranche. 1581 In its marketing materials, Goldman did not mention that it was also shorting all $2 billion of Hudson’s assets – an investment that far outweighed its $6 million equity share and which was directly adverse to the interests of prospective investors. In addition, the marketing materials stated that Hudson 1’s assets were “sourced from the Street” and that it was “not a balance sheet CDO.” 1582 However, $1.2 billion of the Hudson assets had been selected solely to transfer risk from ABX assets in Goldman’s own inventory. Goldman also did not disclose in the materials that it had priced the assets without using any actual third party sales. The absence of arm’s length pricing was significant, because the Hudson CDO was designed to short the ABX Index using single name RMBS securities, and there was a pricing mismatch between the two types of assets. 1583 Goldman not only determined the pricing for the RMBS securities purchased by Hudson 1, but retained the profit from the pricing differential. The marketing materials did not inform investors of Goldman’s role in the pricing, the pricing methodology used, or the gain it afforded to Goldman. In addition, the marketing materials stated Hudson 1 was “not a balance sheet” CDO, without disclosing that Hudson had been designed from its inception to remove substantial risk from Goldman’s balance sheet. The Hudson 1 Offering Circular contained language that may have also misled investors about Goldman’s true investment interest in the CDO. The Offering Circular stated: “[Goldman Sachs International] and/or any of its affiliates may invest and/or deal, for their own respective accounts for which they have investment discretion, in securities or in other interests in the Reference Entities, in obligations of the Reference Entities or in the obligors in respect of any Reference Obligations or Collateral Securities ... , or in credit default swaps ... , total return swaps or other instruments enabling credit and/or other risks to be traded that are linked to one or more Investments.” 1584 This provision seems to inform investors that Goldman “may invest” for its own account in the CDO’s securities, reference obligations, or CDS contracts, while withholding the fact that, by the time the Offering Circular had been drafted, Goldman had already determined to take 100% of the short position in the CDO, an investment which was directly adverse to the interests of Hudson securities investors. 1581 10/2006 Goldman Sachs report, “Hudson Mezzanine Funding, 2006-1, LTD.,” at 4, GS MBS-E-009546963, Hearing Exhibit 4/27-87. 1582 1583 1584 Id. For more information on this pricing mismatch, see the Hudson discussion, below. 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS- E-021821196 at 251 (emphasis added). CHRG-111hhrg58044--28 Mr. Snyder," Good morning. Chairman Gutierrez, Ranking Member Hensarling, Mr. Price, and members of the subcommittee, my name is Dave Snyder, and I am vice president and associate general counsel for the American Insurance Association. In the midst of the financial turmoil and its related chaos, the U.S. property and casualty insurance sector is stable, secure, and strong. There are good reasons for this. We, you and the States never lost sight of our fundamental shared goals, reduce risk where possible, accurately assess and assume the remaining risk, and provide effective coverage to the American people. As a result, auto and homeowner's insurance markets are by every measure financially sound, competitive, and affordable. Claims are being paid daily by solvent companies. The market is very competitive by any measure and insurance is taking less of a bite out of household incomes than in the past. This is good for the economy because this maximized competition forces prices down to the lowest feasible level so people have money to spend on other things. Insurance scoring has played a major role in creating this positive market for all concerned. By empowering more effective risk assessment and pricing, the majority of the population pays less. Insurance is more available and more people can receive reasonably priced coverage, instead of being relegated to the high-risk pools, because insurers have a cost-effective tool to assess and price for risk, giving them the certainty they need to provide coverage to nearly everyone. You have asked us to address certain issues relating to insurance scoring. In summary, it is race and income blind, and has repeatedly been proven to be an accurate predictor of risk, indeed, one of the most accurate. The States have actively regulated it and insurance commissioners have full access to all the information they desire. In response to your request for recommendations, we suggest that all States adopt the National Conference of Insurance Legislators' model law. Second, the States should make sure they capture and analyze all of the credit complaints they can and communicate with insurance companies about them, individually, and any trends. We note, for example, from Director McRaith's testimony, that the rate of complaints under the existing system for credit-based insurance scores is about 1 complaint out of every 1.5 million policies issued or renewed. In addition, we all need to work together more effectively on financial literacy to help the American people understand how insurance scores are used by insurance companies to provide them with coverage. There is one other recommendation we did not emphasize in our written statement, that is to make it more possible to innovate on a pilot basis. For example, to introduce more direct measures of driving performance, such as the ability to assess risk, based not only on mileage, but how, when, and where those miles were driven. One other factor in the strength of the personal lines insurance market is that we have collectively reduced risk. Thanks to your leadership and that of safety groups, the insurance industry, and the States, far fewer Americans are injured and killed on our highways than ever would have been expected. Using fatality rates of 1964, last year alone, we have collectively saved 120,000 lives and prevented millions of injuries. This has created a solid foundation of the healthy auto insurance system we have today. The insurance industry is focused on building safety as never before through advocacy of smoke detector laws and codes requiring sprinklers and disaster resistant buildings, and the eminent opening of a building construction test center with wind turbines powerful enough to test the structural integrity of buildings. We hope to see a pattern of positive change similar to that which we helped bring about in auto safety with your cooperation and assistance. Thank you for inviting me to speak with you today. I would be pleased to answer any questions you may have. [The prepared statement of Mr. Snyder can be found on page 147 of the appendix.] " FOMC20051101meeting--140 138,MR. KOHN.," Thank you, Mr. Chairman. Unlike President Geithner, I view the incoming information over the intermeeting period as having mixed implications for what might be required from us to keep inflation in check. On the one hand, demand and output, as he noted, appear to be continuing to grow at a pace that over time is likely to gradually put added pressure on resources. Apparently, the tightening of monetary policy, the rise in energy prices, and the appreciation of the dollar in the first half of the year were not enough to slow growth to trend in the third quarter. And the September employment report and October data on initial claims suggest that the underlying pace of job creation has been maintained going into the fourth quarter. Moreover, demand over the next few quarters, as many of you pointed out, should be boosted by the ramping up of rebuilding efforts. Still, conditions do seem to be in place for a moderation in growth over the intermediate term. Financial conditions have tightened. Interest rates have moved higher; in response the exchange rate has firmed and stock prices have dropped a little. All of the increase since the last meeting was in real interest rates, and most of the rise didn’t seem to be in response to data, but rather to our own speeches, making it unambiguously restraining. In addition, volatilities have backed up a little and risk spreads have widened just a little since the middle of the summer, suggesting that investors are a bit less confident about the future, even if they’re still too confident. Data and anecdotes on housing markets hint at some moderation, and that began even before the recent rise in rates, perhaps as a consequence of the earlier increases in interest rates as well as the elevated level of house prices relative to incomes. Home equity loans at banks actually fell last month, suggesting that equity extraction is no longer so attractive. But as best we can tell, without a November 1, 2005 66 of 114 slowed, while price increases for condos have moderated very little and remain quite high. All in all, we seem to have reached an inflection point in the housing market, fortunately. And house price increases, working through the wealth channel and as an inducement to construction, should be less of a stimulus to demand in the future, though how much and how fast is a very open question. Higher energy prices could take something off of consumption, even after gasoline prices decline in coming months. Natural gas prices will be elevated through the winter heating season. And the negative results of consumer sentiment surveys—which persisted into October, even as gas prices declined—could be suggesting a more marked response than we’ve seen over the past few years of increases. In the staff forecasts these forces slow the economy to a rate of growth slightly below its potential, even with a slight easing of financial conditions as policy firms less than the market has built in. It’s as good a guess as any and better than any forecast I might make. Given the range of uncertainty, however, the important point for us at this meeting is that growth is likely to slow to closer to the rate of growth of potential, but it’s probably going to take at least a couple more policy firmings. The news on prices and costs has been more favorable for the inflation outlook. Core inflation has been damped, despite substantial increases in energy prices before the hurricanes. Because the increases in the prices of petroleum and petroleum products have been large and sustained, they are more likely to show through to core prices than at any time since 1980. But I’m encouraged by the lack of much response so far this year. And energy prices themselves have eased off much more than expected when we last met. Pass-through effects of past increases in energy prices in the staff forecast are magnified and November 1, 2005 67 of 114 results of the Michigan Survey are cautionary, but long-run forward measures of inflation compensation in the market have risen only modestly, and they do remain well below their levels of last year and the early part of this year. I suspect that household inflation expectations will ease back if gasoline prices retreat, as they are expected to. Business labor costs are probably not putting much upward pressure on prices. The trend in ECI compensation continues to be favorable, including wages and salaries increasing at a 2½ percent rate for several quarters now. The lack of upward pressure is especially noteworthy in the face of huge increases in consumer energy costs, and it seems inconsistent with tightness in labor markets that might begin to escalate costs at prevailing levels of resource utilization. And productivity growth in the third quarter was strong, holding down the rise in unit labor costs. In the Greenbook, compensation and core prices accelerate noticeably over coming quarters. In my view, incoming price and compensation data raise the odds that the pickup could be a bit smaller, with inflation settling at a slightly lower level if output follows the Greenbook path. On attitudes, we’ve had competing anecdotes at this meeting. Most of you—I think the majority of you—seem to suggest that businesses are sensing some increased pricing power. That would, if it’s true, support the staff forecast; but it hasn’t shown through in actual prices paid by consumers as of yet. Because the economy seems to have a good deal of forward momentum at a time when resource utilization is high, and because higher energy prices do threaten to feed through to core prices and inflation expectations, we need to continue firming until we have some better indications that conditions are in place to keep inflation restrained. Underlying trends in output and employment will be obscured by the effects of the hurricanes, including the onset of rebuilding efforts, and this circumstance probably amplifies the already November 1, 2005 68 of 114 neutral federal funds rate, will be in reducing the risk of overshooting. They do provide a rough guide that we’re in the neighborhood, but I don’t think they’re a very precise measurement. In that regard, I myself am not uncomfortable retaining the “accommodative” language until we decide we don’t need to tighten anymore. I’ve defined accommodative for my own purposes as too low [laughter]—too low to accomplish my objectives. I think we can mitigate the risk of overshooting in policy by keeping our eyes on the underlying drivers of resource utilization and demand—such as housing prices and household reaction to energy prices, as well as cost pressures and inflation expectations. And I do think the “measured pace” of tightening has been helpful in this regard as well, in contrast to 1994 and 1995 when tightening picked up at the end and I think the risk of overshooting increased. I’m comfortable with tightening again at this meeting and signaling that we do not think we are finished removing accommodation. But just what we should signal about our expectations for the future will require a fresh look at each meeting, and I support the general sentiment that we need to look at our language very, very carefully going forward. Thank you." CHRG-111hhrg51698--178 Mr. Buis," All right. Thank you, Congressman. That farmer, that soybean farmer in Albert Lea, what this really means to them is their ability to price their product when they can get a decent return out of the marketplace. That doesn't occur after harvest, because you generally have a lot of product coming onto the market. So they look for opportunities at other times during the year, after harvest, on when they are going to deliver that product and get the best price. When they are precluded from the marketplace, like this time, in many cases--my friend, Mr. Damgard, got $7\1/4\ for his corn, but not everyone did--then they have to accept a price after harvest. If you look at all the spring crops this year, in Minnesota and elsewhere, they all collapsed before harvest; and so those producers were put at even a greater risk. I would remind the Committee this is--the original derivative is farmers selling their products after harvest into the future, and that sound financial instrument was taken out of their hands this year. " FOMC20071211meeting--43 41,MR. STOCKTON.," Food is important. In fact, we devote, I would imagine, a surprising amount of resources to it. We have an agricultural economist whose job is to follow those developments and report on them. It is his view—and based on both the futures prices and some of the modeling that we have done—that we will see a deceleration going forward in retail food prices. As you know, futures prices basically are projecting a flattening-out. I assume that is part of what is in Nathan’s forecast as well. We are not trying to outguess the markets in that regard, and the reports that we have received on agricultural production look relatively favorable for the coming year. Now, most of that is a bit of winter wheat at this point and not much more in terms of production, although we have seen some significant rebuilding of both flocks and livestock herds that suggests that we are on the right track in terms of an output response to the higher prices that we have seen in the past year. Markets are tight, and I think there probably is some asymmetry in the risk surrounding the food price forecast, in that it is easier to see some possibility of stock-out problems if there is any shortfall in production over the coming year, than that there would be some massive boom in agricultural production that will depress prices sharply. But I do think—and in the Greenbook Part 2 quite often, especially in the autumn, when we are actually doing a more careful accounting of the harvest—we devote a fair amount of attention to resources to it. We can certainly do even more going forward." CHRG-109shrg30354--89 Chairman Bernanke," Senator, the two interact because if there was just a one-time pass-through and the public were completely convinced that the Fed would keep inflation low and expectations were low and the Fed were perfectly credible, then that inflation would be just a temporary thing and would come back down. So the risk is the interaction of the two. The risk is that inflation will go up because of energy prices, because of greater pass-through, and that will feed into inflation expectations, which then will feed into a round of additional price increases and the like. You really cannot get a permanent increase in inflation unless people increase their inflation expectations. That is why the Fed's credibility is, I think, such a major asset of the United States. Senator Sununu. It seems to me to the extent that you are in the midst of a little bit of a dilemma it is as follows. Right now, inflation is above what has been stated in different ways your target range. We have still got high energy prices. So that would suggest that the absolute level of inflation remains a concern. On the other hand, you have a forecast for moderating growth. You have a slowdown in the housing industry. So while the inflation numbers may push you toward a rate increase, the moderating growth that has been forecast might encourage you to pause or to forgo further rate increases. That is a dilemma. I think we all understand that. To what extent is the fact that you now find yourself in this dilemma the result of a slowness or a delay to action in beginning this cycle of rate increases? " CHRG-110hhrg44903--79 Mr. Hensarling," Thank you, Mr. Chairman. Mr. Geithner, in my opening comments I asked a rhetorical question; now I would like to ask a direct question. And that is, just how will the Federal Reserve think about the balance between price stability, financial stability, consumer protection, full employment, and taxpayer protection? I am curious about how you, as head of at least the New York Fed, would think about this balance. And what would be the risk associated with increasing the charge to the Fed with more responsibilities, particularly at a time when at least many of our constituents, when they look at price stability, might not give you an A-plus? " FOMC20080625meeting--92 90,MR. KOHN.," Thank you, Mr. Chairman. My forecasts for both economic growth and inflation are within the central tendency of the rest of you and a little stronger than the staff's outlook. In fact, my 2008 projections for economic activity for the second half of the year were revised very little from two months ago. Growth turned out to be stronger than I expected in the first half, and that carries some weight going forward; but financial conditions are tighter with higher bond rates and lower equity prices, and of course oil prices are a lot higher and that will damp demand going forward. So I expect slow growth in the second half followed by expansion around, maybe a little above, the rate of growth of potential in '09 and '10, with the same basic story that everybody else has: drags on activity from declining housing activity, decreasing wealth, tight credit conditions, and higher petroleum prices. All of those drags will abate over time, allowing the natural resilience, with slightly accommodative financial conditions, to show through, and I assume a gradual tightening of monetary policy beginning next year. Incoming information on prices and costs has been mixed. Oil and food price increases will raise headline inflation, but core has been stable and has come in a little to the soft side of expectations, and labor costs as yet show no signs of accelerating. Going forward, I see a sharp decline in headline inflation later this year with the assumed leveling-out in oil prices and a gradual decrease in core as economic slack inhibits wage and price increases, offsetting the pass-through from oil prices. Now, that's my central tendency. I consider the odds on that being realized to be even lower than usual, and the usual odds are disappearingly small. It seems to me that the defining characteristics of the current situation are uncertainty and risk. We're facing multiple shocks, many of them unprecedented in size and persistence, in the housing market, financial markets, and commodities. The outlook is full of puzzles, and in my mind anyone who thinks he or she understands what's going on is either a lot smarter than I am or delusional--or both. [Laughter] I class the risks for both output and headline inflation as greater than usual, and let me tell you about some of the things I wrestled with. Financial conditions, are they accommodative? I continue to believe that the 2 percent nominal funds rate is not indicative of a highly accommodative financial condition, given the current state of financial markets. That is, in my view we have limited insurance. Spreads have widened sufficiently over the past 10 months both for long-term and short-term credit, and bank terms and conditions for loans and lines of credit have tightened enough that only a small part of the drop in the fed funds rate is showing through to the cost of capital for median households and firms. The staff's flow of funds estimates show a marked deceleration in the growth of both household and business debt in the first half of this year, from 10 percent for households last year to 3 percent in the first half of the year and from 12 percent for businesses to 7 percent in the first half of the year. A 2 percent fed funds rate will become accommodative as spreads narrow and financial functioning returns more toward normal, and that's one reason I assumed a gradually rising federal funds rate over 2009 and forward. The evidence about improving financial markets over the intermeeting period was decidedly mixed. Some spreads did come in from late April. Investment-grade businesses tapped bond markets in size, but almost all spreads remain unusually wide. We were reminded of the fragility of the evolving situation, especially in the financial sector, with the worries about continuing credit problems resulting in sharp declines in equity prices on financials and an uptick in their CDS spreads, which had narrowed the previous month or two; the downgrading of monolines and investment banks; and the increasing attention to the problems of regional banks. It would be surprising if these were not reflected in even greater caution by banks and other lenders in their lending practices. Also the securitization markets, especially for non-agency mortgages, are not functioning in a way to replace bank intermediation. This is going to be a prolonged process of reintermediation, deleveraging, and building liquidity with an uncertain endpoint. Like the staff, I assume that the conditions return to something approaching normal over the next 18 months, but the risks are skewed toward an even longer recovery period. The second topic is household spending. Households are facing a huge number of adverse shocks: higher oil prices, tighter credit, declining house prices, and rising unemployment. It's not surprising that confidence is at recessionary levels. It is surprising that spending is so resilient. I assumed that the saving rate would rise very gradually once the tax rebate effects wore off, but I think a more abrupt and sizable increase in household saving is a distinct downside risk. What about housing? Some sales measures have shown a few tentative indications of leveling off. I was encouraged by President Lockhart's report from Florida, but I'm also struck by renewed pessimism about housing in the financial markets. Equities of construction firms and builders have declined after stabilizing, actually rising, earlier this year. ABX indexes have turned down, reversing earlier improvements; and perhaps underlying the previous two developments, the Case-Shiller futures indexes remain in steep decline, though today's information was less weak than expected. The view of the financial markets, anyhow, is that the light at the end of the housing tunnel is receding, and declines in expected house prices must be an important reason for the erosion in market confidence in financial intermediaries. In sum, although the incoming data may have reduced the threat of a sharp drop in spending, in my view there remains a very pronounced downward skew around my outlook for modest growth in H2 and a strengthening next year. However, that downward skew around output did not translate into a downward skew around my forecast for headline inflation. In fact, I saw the risks on headline inflation as tilted to the upside, though roughly balanced around the gradual decrease in core. I think the upside risks result from two additional areas of uncertainty. One area is commodity prices, though the trend increases in commodity prices over the past few years can be attributed to rising demands from emerging market economies relative to sluggishly responding supplies. Despite Nathan's best efforts, I really don't think we have much of a clue about the cause of the spike in oil prices this year. It has been especially striking to me over the intermeeting period, when the prices of industrial commodities have been falling on balance. Presumably prices in these markets already incorporate expectations of reasonably strong global growth outside the United States as in the Greenbook. Absent any surprises, futures market quotes ought to be the best guide, but what we don't understand can fool us, especially when so much of the relevant information involves emerging market economies, where data are sparse and of questionable value. Given our experience over the past few years, I think continued increases in commodity prices would seem to be an upside risk. The other area is inflation expectations. I assume that as headline inflation comes down, both short- and long-term inflation expectations, especially in the survey data, will reverse their recent increases based a lot on the kind of information that President Yellen was observing about how the household survey has tended to follow contemporaneous inflation. I'm encouraged by the relatively flat readings on core inflation and labor compensation increases. Higher expectations have not so far become embedded in prices and costs, despite all the talk of passing along cost increases. But headline inflation is going to rise before it falls. Real wages will be further eroded by higher energy costs. Although this is a necessary part of an adjustment to an adverse terms-of- trade shock, it will be resisted. Hence, a further rise in inflation expectations and a stronger determination by households and businesses to act on those expectations will be a risk over coming months. With that further rise in oil prices, it's a bigger risk than it was a couple of months ago. In terms of the long-term projections, Mr. Chairman, I think I'm fine with something like your proposal. Our objective for adding a year was to give the public a better sense of where we're going over the long term. Given the shock to the economy, that's not as informative as it was before. I think we're close to where most people would say their inflation objective was, but not for the growth rate of potential or the NAIRU. I could live with option 3 or President Bullard's alternative to that--to state exactly what our long-term expectations are instead of talking about five to seven years or five to ten years. I don't think we'll gain a lot. I don't think the costs or benefits are very large on either side of this. Our problems now are not that people don't understand where we're going in the end. I think they have a pretty good idea that we want inflation to be a lot lower than it has been. But I think they don't really understand how we're going to get either to full employment or to price stability, given where we're starting. So I think the uncertainty about our objectives is a very small problem relative to the other problems now. But if we can reinforce what those objectives are, it might help a little around the edges. I do worry, as President Lacker said, that what we say about output and employment not be interpreted as goals but rather as a judgment about the state and the structure of the economy. I am hopeful that we could take care of that in what we say about what we're publishing. Thank you, Mr. Chairman. " FOMC20070131meeting--32 30,MR. DUDLEY.,"1 Thank you. In terms of market developments, I would like to focus on three major topics. First is the sharp adjustment in market expectations concerning monetary policy since the last FOMC meeting. Second, I will talk about the persistence of high risk appetites in credit markets, with a focus on what may be the most vulnerable market in the United States—the subprime mortgage sector. Third, I want to discuss the possible factors behind some of the sharp shifts we have seen in commodity prices since the last FOMC meeting, in particular whether these price movements reflect a shift in risk appetite among noncommercial investors or fundamental developments in supply and demand. First, there has been a sharp shift in market expectations with respect to interest rates since the last meeting. At the time of the December meeting, the consensus view among market participants was that the FOMC would begin to lower its federal funds rate target this spring and that this easing process would continue into 2008, with cumulative rate cuts of about 75 basis points. As you can see in chart 1, which looks at the federal funds futures market, and chart 2, which looks at the yield spreads between the March 2008 and the March 2007 Eurodollar futures contracts, expectations have shifted very sharply over the past month. There is now no easing priced in through midyear 2007 and a residual of only about 25 basis points of easing priced in beyond that. This shift in expectations can also be seen across the Treasury yield curve. As chart 3 shows, the Treasury yield curve is now slightly above where it was at the time of October FOMC meeting. Since the December FOMC meeting, there has been a rise of about 35 to 40 basis points in yields from two-year to thirty- year maturities. The shift in expectations is reflected predominately in real interest rates. As can be seen in chart 4, breakeven inflation rates have not changed much since the last FOMC meeting—the decline in breakeven rates that occurred early in the intermeeting period has been reversed more recently, and so we are at or slightly above where we were at the December meeting. This upward shift in real rates appears to reflect a reassessment by market participants not only about the near-term path of short-term rates but also about what level of real short-term rates is likely to prove sustainable over the medium and longer term. The buoyancy of the recent activity data may have caused some market participants to reassess what level of the real federal funds rate is likely to prove “neutral” over the longer term. Regarding the issue of risk appetite, there appears to be no significant change since the last FOMC meeting. Risk appetite remains very strong. Corporate credit spreads remain very tight—especially in the high-yield sector (as shown in chart 5)— and implied volatilities across the broad market categories—equities and interest rates (see chart 6) and foreign exchange rates (see chart 7)—remain unusually low. Moreover, the turbulence in some emerging debt and equity markets experienced 1 Material used by Mr. Dudley is appended to this transcript (appendix 1). early this month was mostly transient and has subsided as well. So things appear calm. But what are the areas of greatest risk? In the United States, the subprime mortgage market appears to be a particularly vulnerable sector. The vulnerability stems from four factors. First, this market is relatively new and untested. Chart 8 shows the overall trend of first residential mortgage originations and the share of these mortgages by type—conforming, jumbo, subprime, and alt-A, which is a quality category that sits above subprime but is not quite as good as conforming. As can be seen in this chart, subprime mortgage originations have climbed in recent years, even as overall originations have fallen. In 2006, subprime mortgages were 24 percent of total originations, up from a share of about 10 percent in 2003. The second factor is that credit standards in this market appear to have loosened in 2006, with the proportion of interest-only loans and low- documentation loans climbing as a share of the total. As a result, there are some signs that strains in this market are increasing. As chart 9 shows, delinquency rates have moved somewhat higher. In contrast, charge-offs remain low, held down by the rapid house price appreciation that we saw in recent years. Most noteworthy, as shown in chart 10, the most recent 2006 vintage of subprime mortgages is showing a much more rapid rise in delinquencies than earlier vintages showed. The third factor is that most outstanding subprime mortgage loans have adjustable rates. There is significant reset risk given the rise in short-term rates in 2005 and the first half of 2006 and the fact that many of these loans started with low “teaser” rates. Fourth, housing prices are under some pressure, and this could contribute to further credit strains. I see some risk of a vicious cycle. If credit spreads in the securitized market spike because loan performance is poor, a sharp downturn in lending could result as the capital market for securitized subprime mortgage products closes. This constriction of credit could put downward pressure on prices and lead to more credit problems among borrowers. The result would be additional credit quality problems, wider credit spreads, and a further contraction of credit. Fortunately, to date the news is still fairly favorable. The strong demand for the credit derivatives obligations created from subprime mortgage products has restrained the rise in credit spreads. As can be seen in chart 11, spreads are still well below the peaks reached in late 2002 and early 2003. Thus, the economics of making such loans and securitizing them into the capital markets still work. But this situation could change very quickly, especially if the labor markets were to become less buoyant and the performance of the underlying loans were to deteriorate, leading to a surge in delinquencies and charge-offs. Let me now turn to the commodity markets. The issue I wish to examine here is whether some of the sharp movements in commodity prices that we have observed since the last FOMC meeting represent shifts in the risk appetite among noncommercial investors who have put funds into commodities as a new asset class versus the contrasting view that these price movements predominantly represent changes in the underlying supply and demand fundamentals. To get a sense of this, let’s look briefly at three commodities that have moved the most and are representative of their classes—copper, corn, and crude oil. As chart 12 shows, the sharp decline in copper prices appears linked to the large rise in copper inventories at the London Metal Exchange. If anything, the price decline appears overdue. For corn, the rise in prices also appears consistent with declining stocks both in the United States and globally (see chart 13) as well as the growing demand anticipated for corn in the production of ethanol. For crude oil, the decline in prices is more difficult to tie back to inventories. Although U.S. inventories remain high relative to the five-year historical average (as shown in chart 14), this situation has persisted for some time without having a big effect on prices. Instead, the shift in oil prices appears to be driven mostly by longer-term forces. This can be seen in two ways. First, as shown in chart 15, the change in oil prices has occurred in both spot and forward prices. The oil curve has shifted downward in mostly a parallel fashion, which also calls into question the role of unseasonably warm weather as the primary driver. If weather were the primary factor, then the decline in prices should have been reflected much more strongly in the spot and very short-end of the oil price curve. Second, as shown in chart 16, OPEC spare production capacity has been increasing and is expected to continue increasing in 2007. This growing safety margin reflects both slower growth in global demand and the expansion of non-OPEC output. The improved safety margin may be an important factor behind recent developments in the energy sector. Finally, there were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the December FOMC meeting." FOMC20061025meeting--246 244,MS. DANKER.," I’ll be reading the directive wording and the risk assessment for alternative B from page 29 of the Bluebook: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” Then the risk assessment: “Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”" CHRG-109shrg30354--72 Chairman Bernanke," I think it is the risk that we are considering, and again it is just a risk, that inflation might move up and might force us to be more aggressive, which we do not want to do, because we hope that inflation will stay under control or come down as we expect it to. I think that is a risk. We also have the geopolitical issues. We have seen the latest in the Middle East, for example. Oil prices are a risk and a concern, and we are paying very close attention to that situation as well. Senator Menendez. And last, I had asked you in a written question which you answered about paying down publicly held debt and the importance of that. Now we see where CBO tells us we are headed to $12 trillion worth of debt by 2011. How much importance do you place on paying down that publicly held debt in the context of long-term economic health? " CHRG-111hhrg52397--12 Mr. Price," Thank you, Mr. Chairman, I appreciate it. In a free market, over-the-counter derivatives provide an essential function by allowing companies to customize the way that they address their risks. Many companies have successfully used OTC products to help their consumers save money and to create jobs, including 3M, which is testifying today, as an end user of derivatives. A market-based economy allows institutions to succeed and to fail. And they fail for a number of reasons: The business takes on too much risk; it may be under bad management; or it may have an ineffective business model. Despite the fact that credit default swaps have come under fire lately because of AIG's remarkable over-exposure, when they are used appropriately, they can be a very effective risk management tool. Thus, we need to be extremely cautious and careful as we decide how to appropriately regulate derivatives. In fact, the market has already begun addressing some of the concerns that credit default swaps and OTC derivatives posed. So I look forward to hearing from the witnesses about what they are doing to make OTC and CDS trades more transparent. In the end, however, regulation must not be a one-size-fits-all system. Such a system stifles innovation, raises prices for consumers, punishes entrepreneurs, and destroys jobs. Thank you, Mr. Chairman. " CHRG-111hhrg53021--130 Mr. Scott," Thank you very much, Mr. Chairman. I am over here, Mr. Secretary, over here in the corner. I would like to see if I could squeeze in a couple of questions. First of all, I have a concern that your proposal could very well force non-financial dealers to meet capital requirements in order to provide legitimate managed risk. But, given that these non-financial dealers do not have depositors, unlike large financials, and a low or no systemic risk profile, is it possible that such a requirement could unintentionally create a bank monopoly in the over-the-counter derivatives market? And wouldn't that reduce competition, reduce liquidity, raise prices, and increase systemic risk by consolidating the markets? " CHRG-111hhrg53021Oth--130 Mr. Scott," Thank you very much, Mr. Chairman. I am over here, Mr. Secretary, over here in the corner. I would like to see if I could squeeze in a couple of questions. First of all, I have a concern that your proposal could very well force non-financial dealers to meet capital requirements in order to provide legitimate managed risk. But, given that these non-financial dealers do not have depositors, unlike large financials, and a low or no systemic risk profile, is it possible that such a requirement could unintentionally create a bank monopoly in the over-the-counter derivatives market? And wouldn't that reduce competition, reduce liquidity, raise prices, and increase systemic risk by consolidating the markets? " FOMC20070509meeting--16 14,MS. JOHNSON.," The basic message from the rest of the global economy is that economic conditions are favorable and appear likely to remain so through the end of next year. Although small variations in the basically optimistic outlook are present, real GDP growth in the foreign economies seems poised to continue at an average annual rate of about 3½ percent throughout the forecast period. Inflation risks are present as slack has been reduced in several foreign economies. However, we anticipate that central banks abroad will respond further as needed such that inflation abroad will edge up only slightly through the end of 2008. In this forecast round, the staff had to contend with a move back up in global crude oil prices and further increases in nonfuel commodities prices—shocks common to the whole global economy. In addition, for the U.S. outlook, we needed to take account of the depreciation of approximately 2 percent in the foreign exchange value of the dollar over the intermeeting period, as Dave discussed. We have recently revisited the question of whether we could improve upon the forecast for crude oil prices embedded in market futures prices and have convinced ourselves based on empirical evidence that we cannot. As a result, our projections for future WTI spot oil prices and the average oil import price are shifted up and down over time by fluctuations in spot and futures oil prices. This has been an “up” forecast round. After reaching a peak around August of last year, global oil prices fell through very early this year and then reversed to trend back up, but not smoothly. The upward move of oil prices over the intermeeting period was apparently a response to the surprising degree of continued production restraint from OPEC and heightened concerns about supply from Iran, Iraq, and Nigeria. The strength in global demand for energy, too, no doubt provided support for continued elevated prices. In this forecast we also had to take into account a deviation in the usual price spread between West Texas intermediate and other grades of oil. Reduced refinery activity has led to an unusually large accumulation of crude oil stocks in the Midwest, the delivery area for WTI, and depressed its price relative to that for other grades. When we were finalizing the baseline forecast, spot and futures prices implied an increase to our projection for WTI crude oil in the current quarter of about $4.50 per barrel relative to the projection in the March Greenbook; however, this change understates a bit the upward shift in overall oil prices because of the change in spreads. These considerations led us to revise upward the average oil import price in the Greenbook for the current quarter about $6.50 per barrel. We expect that over the forecast period the relative prices of WTI and other grades will gradually move back toward normal, so our upward revision narrows somewhat in future quarters, particularly by the second half of 2008. The baseline forecast reflects the consequences of these higher oil prices for the U.S. economy and the rest of the world. Turning points in the ups and downs of oil prices have an uncanny way of happening at the time that we are finishing the Greenbooks, and such a turning point might have happened again. Since the Greenbook path was set, crude oil prices have moved back noticeably. If we were concluding our forecast today based on yesterday’s futures prices, we would show an upward revision in the near term of only about half that in the Greenbook. For 2008, our upward shift would be about two-thirds of that in the Greenbook. The effects of this more benign level for oil prices would be slightly positive for real GDP growth both in the United States and abroad. Such a lower projected path for oil prices would also slightly lessen the pressures on headline inflation rates that are a feature of the baseline forecast. Another element in the forecast worth a brief mention is the upward revision to both core import price inflation and core export price inflation for the second quarter, to annual rates of 4.5 percent and 5.5 percent, respectively. Prices for core imports and core exports accelerated in the first quarter as prices for food and industrial supplies, particularly fuels and metals, surged. Metals prices have continued to rise in recent weeks, and the increase, along with the recent depreciation of the dollar, led us to revise up our current-quarter projections. In constructing our forecast for these trade prices, we base our projection of the commodity-price component on market futures prices. Again, we have done recent work to see if a better alternative is available, but we have concluded that none is. Despite rapid increases in prices of various traded commodities over the past few years, the futures markets are implying a path through the end of 2008 that is about flat for an index of nonfuel commodities. In combination with our projection for only modest real dollar depreciation and no major changes in overall inflation rates here and abroad, such an outlook for commodity prices yields a deceleration in both core import prices and core export prices. Our forecast for the increase in these prices in 2008 remains low, at 1.3 percent. Although oil prices have been revised up this time, their projected path flattens in mid-2007. This outlook and the flat projected paths for commodity prices and the dollar imply a waning of the upward push to consumer prices that has resulted from rising oil and commodity prices. Consequently, in the Greenbook forecast, only limited further tightening by some foreign central banks is required to contain inflation. That events in these markets may surprise futures traders and us for yet another year with additional commodity-price increases is a major risk to our outlook for inflation. David and I will be happy to take any questions." FOMC20060328meeting--132 130,MR. STONE.," Thank you, Mr. Chairman, and welcome back. And welcome to the new Governors. First, I’d like to make a couple of comments on the region before I talk about the national economy. The Third District didn’t see a fourth quarter as weak as the national economy, nor is our first quarter as strong. But we’re seeing solid growth, which our indicators tell us will continue at current rates for the foreseeable future. Payroll employment is a particular issue in our District. With the benchmark revisions that were made, our employment growth has been stronger than we originally estimated. Our three-state unemployment rate fell to 4.4 percent in January, and businesses report an increasingly difficult time finding qualified workers. Indeed, more than half the respondents to a special question on our manufacturing survey said that they were having trouble filling openings because of the lack of qualified applicants. That’s an increase from 40 percent when we asked that question two years ago. Firms report the greatest difficulty in finding production workers and computer-savvy employees, but I would go on to point out that one of our directors, who heads a temporary employment agency, has been reporting for the past two years a continuing difficulty in finding workers with even limited skills to deploy. Manufacturing in our area continues to expand at a moderate pace. After a temporary dip in January, the index in our survey has rebounded to the level consistent with last summer, and that level is consistent with moderate expansion in activity. Retail sales in our District are rising only modestly, but retailers tell us that weaknesses in February were weather-related and that they expect a pickup in April. Demand for nonresidential office space in the District is growing, and that’s unusual for our market. The office market absorption rate is rising in the Philadelphia metropolitan area, and the office vacancy rate is declining in both the city and the suburbs. We had some office building in the last couple of years, which is the first office building we’ve had in downtown Philadelphia in a decade. We are seeing a few signs of modest slowdown in housing markets, with permits, home sales, and mortgage lending softening in recent months. Finally, we have received some further welcome news of moderation in price pressures in the District. Our manufacturers’ survey measures of prices received and prices paid have fallen sharply over the past two months. Expectations of future price increases remain subdued, and several respondents told us that, in their view, input price pressures have settled down and that their inflation concerns have subsided. Turning to the national economy, our economic outlook is broadly consistent with the Greenbook baseline. All signs point to a strong rebound of growth this quarter, after the temporary weakness in the fourth quarter. Employment, business spending, and manufacturing remain strong, and consumer spending continues to increase at a solid pace. There are emerging signs that the housing market is beginning to cool off, but no signs of a sharp retrenchment at this point. The economic fundamentals remain solid, and after the rebound this quarter, we expect growth to settle down to a range of 3 percent to 3½ percent, near potential growth. The economy is expected to remain near full employment, with labor markets tight. We expect hourly compensation growth to accelerate somewhat over the forecast period, but not dramatically. Now, in my view, the risks to growth are roughly balanced. A sharper decline in the housing market than that built into our forecast poses some downside risk, but it’s also possible that housing will not turn down as much as or as soon as forecasted. The extent to which we see an improvement or further deterioration in exports is another risk that could go either way. In fact, there appears to be a considerable divergence of views on the path of net exports among private- sector forecasters. In my view, the inflation risks are tilted somewhat to the upside. It’s true that the data on core inflation and inflation expectations and our own recent decline in survey measures of prices paid and received are encouraging. The acceleration of core inflation at the end of 2005 has been reversed in the first months of 2006. So far, firms have had a remarkable ability to absorb cost shocks via new-found productivity gains, and increased global competition has limited their pricing power. Both have helped keep inflation in check. On the other hand, oil prices remain at high levels and continue to be volatile. The ability of firms to maintain low pass-through in the presence of continued higher costs is a question. With inflation running near the top of the range that I consider consistent with price stability and with the economy operating at high levels of resource utilization, there is a risk that strong inflation pressures could emerge. Several times in the past we have seen core inflation quickly rise by a sizable amount when the economy was operating at high levels of resource utilization following periods of accommodative monetary policy, even when oil prices did not rise sharply. So in my view, the inflation risks remain at least moderately on the upside, even though the recent data have been benign. That said, on the whole I think the economy and the economic outlook are very positive. Thank you." CHRG-111hhrg74855--111 Mr. Gensler," Congressman, hedging is a very important part of our economy. We are promoting that in this bill. We are lowering risk to the American public allowing utilities and energy companies to hedge customized risk but those risks that are standard enough, for instance a 2-year risk on natural gas pricing, standard contract, we want to move that onto the clearinghouses to lower risk and very importantly on the transparent trading venues. And if I might note, I don't think the transparency costs end users. If you didn't know what an apple cost when you walked in the store, does it help you if you have to pay an extra nickel or 10 cents for that apple because you don't know what it cost the prior person walking in the store? I don't think so. We bring every securities transaction and every futures transaction to transparent markets. Why shouldn't we do that in natural gas and electricity over-the-counter markets? " CHRG-111hhrg52397--108 Mr. Pickel," Well, primarily because if you want to be able to have a product there for those who do need to hedge a risk, it is important to have a market there where people are willing to take a view on whether the pricing of that is cheap or expensive, so providing that liquidity. Furthermore, you have the traditional bond or loan holder, but you have other individuals, including the dealers who sell the protection to those people who hold the bonds and loans who will also need to manage that risk. So it is a complicated issue of many different types of risks even though the underlying bond and loan may be only held by 10 or 15 percent of the users. Mr. Miller of North Carolina. I probably do not have enough time to ask another question, so I yield back. " FOMC20050322meeting--102 100,MS. PIANALTO.," Thank you, Mr. Chairman. Conditions in the Fourth District have been gradually improving across a broad range of industries this year, and business confidence appears to be strengthening as well. Actually, it feels good to no longer be a Beige Book outlier. [Laughter] As it turns out, I am also not a Greenbook outlier. I find myself in broad agreement with the staff’s baseline projection. I know I should feel comfortable being in such good company, but I view the projection as the result of competing risks. Both the Greenbook and my business contacts are bringing to my attention the positives associated with productivity growth and the negatives associated with price increases. Although the rate of structural productivity growth might slow somewhat over the next few years, in my view the decline in the Greenbook multifactor productivity projections seems a little steep. The productivity growth surprises of the last couple of years may persist a bit longer. Business executives that I talk to tell me that they are still very focused on looking for opportunities to enhance productivity and that their capital investments are designed to achieve that goal. The drive for efficiency has become even more pronounced for those companies that are grappling with large increases in energy prices and in the prices of other raw materials. And, of course, many companies continue to experience large increases in medical care costs, adding to the incentives to wring out labor costs and other costs. The prospect that productivity growth may exceed the Greenbook baseline gives me some optimism about the inflation outlook at a time when the headline inflation numbers keep escalating. Yet the factors driving the price level up do not seem to be going away. Energy prices, as we’ve commented, have ratcheted up again. And, as multiyear contracts with energy suppliers roll off, many companies continue to face increases in the prices they have to pay. The same situation exists, March 22, 2005 37 of 116 and also intermediate products. In addition to these factors, there is also the possibility that past dollar depreciation could show up in the form of higher prices of both imported and domestic products. The anecdotal information that I have been receiving about pricing has taken on a different tone from last year. Last year, retailers like Wal-Mart and Home Depot would not accept price increases from their suppliers. But the dam seems to be showing some cracks. Recently, I heard from the CEO of a global company that supplies the big-box retailers with adhesive products, such as duct tape. He told me that during a recent meeting with Wal-Mart he explained that he was requesting a price increase. He was told that they weren’t accepting any price increases and that they would go to his competitors. Three days later he received a call from Wal-Mart saying that they were going to purchase these supplies from him at the price increases he requested because his competitors had also asked for a price increase. Also, a large manufacturer of capital equipment who supplies the adhesive industries, among others, told me that he can get price increases for his equipment even though his costs are not rising that dramatically. But because the businesses he is supplying are able to pass on price increases, they are willing to take a price increase from him. So it seems that, at least in this industry, it’s more than the adhesives themselves that are beginning to stick. [Laughter] All things considered, I do think that the pricing environment over the next year or so will be very challenging for companies. I see some evidence that price pressures have been building, yet, if businesses are successful in maintaining strong productivity growth, these pressures might be held in check. The Greenbook illustrates the tension between these two factors and, as I said, I can find March 22, 2005 38 of 116 I think our strategy of gradually removing our policy accommodation has convinced the public that we are determined to keep inflation in check over the long term. It will be important for us to earn that same degree of confidence as we go forward and as resources in the economy become more intensely utilized. Although I’m concerned that the possibility of inflation creep over the next year is there, the risks still seem balanced to me as long as we continue to remove our policy accommodation at a measured pace and do so for the foreseeable future. Thank you, Mr. Chairman." CHRG-111shrg57322--193 Mr. Swenson," We bid on--our requirement for our desk is to bid on ABS securities. When clients come to us, we try to give--we give the market value bid or the offer for that security. Senator Coburn. So you are a true market maker. So even if it is the worst possible combination of securities, there is a price at which the risk is worth taking. Is that correct? " CHRG-111hhrg55811--105 Mr. Gensler," The advantages that economists for decades have noticed is that end-users then get the benefit of seeing that price discovery function. If you are a small hospital in any State, and you are thinking about hedging an interest rate risk, you can see what happened even a half an hour earlier on a standard interest rate hedging transaction. " FOMC20060131meeting--110 108,VICE CHAIRMAN GEITHNER.," I’d like the record to show that I think you’re pretty terrific, too. [Laughter] And thinking in terms of probabilities, I think the risk that we decide in the future that you’re even better than we think is higher than the alternative. [Laughter] With that, the economy looks pretty good to us, perhaps a bit better than it did at the last meeting. With the near-term monetary policy path that’s now priced into the markets, we think the economy is likely to grow slightly above trend in ’06 and close to trend in ’07. We expect underlying inflation to follow a path close to current levels before slowing to a rate closer to 1.5 percent for the core PCE sometime out there. Relative to the Greenbook, we’re a little softer on growth in ’06 and a little stronger in ’07, but our inflation outlook is similar. The uncertainty around this forecast still seems considerable, perhaps more than the market has priced in. On the positive side, consumer and business confidence still seems pretty high, with employment growth solid and compensation growth likely to pick up. We think that household income growth is likely to be pretty strong. Investment may be strengthening, and it could surprise us with more strength. The tone of the anecdotal to us seems more positive, less cautious than it has been. And just to cite our Empire survey, the six-month-ahead numbers show a fair amount of optimism. Overall, financial conditions, of course, still seem quite supportive of continued expansion. Global growth has strengthened. And like the staff, the market seems to have looked through the negative surprises in the fourth-quarter numbers and priced in a bit more, rather than less, confidence about the strength of demand growth going forward. On the darker side, we have the familiar concerns about potential adverse shocks, energy supply disruptions, terrorism, et cetera. But even in the absence of these events, we face a fair amount of uncertainty about key elements of the forecast. The prevailing expectation of a gradual moderation in housing prices and a relatively small increase in the saving rate could prove too optimistic. Private investment growth could slow further, productivity growth could disappoint, risk premiums could rise sharply. And, of course, that could happen even in the absence of a major deterioration in the growth or inflation outlook. But this, on balance, still leaves us with what looks like a relatively balanced set of risks around what is still a quite favorable growth forecast. The inflation outlook still merits some concern—I think modest concern—about upside risk. Underlying inflation is still somewhat higher than we would be comfortable with over time. The core indexes are running above levels said to define our preference over time. Other measures of underlying inflation are running above the core rates. The behavior of inflation expectations at longer horizons has been reassuringly stable in the face of the elevated headline numbers, but the levels are still at the higher end of comfort. With the economy near potential, unit labor cost growth should accelerate. And, of course, although profit margins still show ample room to absorb more unit cost increases, their behavior suggests continued pricing power. The strength of global demand, the continued rise in commodity prices, other input costs, and the latest increase in energy prices all suggest a possibility of further upward pressure. With this outlook and this set of risks, we believe some further tightening of monetary policy is necessary with another small move today and a signal that some further tightening is probable. We’re comfortable with how the market’s expectations have evolved over the past few weeks and with the present forecast of perhaps one—maybe slightly more than one—move beyond today. It’s hard, though, to understand why the market attaches so little uncertainty to monetary policy in the second half of the year. And this underscores the fact that one of our communication challenges ahead is to make sure we convey enough uncertainty about our view of the outlook and its implications for monetary policy. In this regard, I want to compliment the recent innovations to the Bluebook presentations and hope that they persist." FOMC20050503meeting--167 165,MS. DANKER.," I’ll be reading from page 28 of the Bluebook the language for alternative B: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the May 3, 2005 102 of 116 the federal funds rate to an average of around 3 percent.” “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" FOMC20060808meeting--8 6,MS. JOHNSON.," From the perspective of the global economy, one of the important revisions in this forecast from last time is the projected path for crude oil prices. We have incorporated into the baseline forecast a path for both West Texas intermediate (WTI) prices and the U.S. oil import price that is more than $5 per barrel higher in the fourth quarter of this year and nearly $7 higher by the fourth quarter of next year than was the case in the June Greenbook. It is still true, however, that the projected path, based as usual on market futures prices at the time the forecast was made final, is quite flat. The sizable jump in oil prices this time reflects the volatility that we have seen in market prices for oil since late June, when the previous Greenbook was being finalized. Spot prices for WTI moved from below $70 per barrel at that time to a recent peak of $77 in mid-July and again yesterday, following BP’s announcement that pipeline repair in Alaska will shut in about 400,000 barrels per day of crude oil. Price fluctuations during the intermeeting period reflected market concerns about the potential effect on supply of ongoing events in the Middle East, some disruptions to production in Nigeria, and a slight reduction in output by Saudi Arabia, as well as an awareness that hurricane season has arrived. No doubt the underlying strength of the global economy is contributing by maintaining overall demand as well. As of close of business yesterday, the futures path for WTI oil prices during the remainder of this year and next year was about $2 per barrel above the Greenbook baseline path. Clearly, further moves in oil prices are a risk to the forecast. Another important element in the foreign outlook is the continued elevated level of nonfuel commodity prices, especially the industrial metals. Metals prices are down from their highs in May, but they are also up from their near-term lows in June. During the intermeeting period, spot prices for copper and zinc rose through mid-July and then partially reversed their recent increases but since have moved up again. On balance, metals prices are modestly higher since the time of the June Greenbook, but prices of other primary commodities are somewhat lower. As a result, our projected path for nonfuel commodity prices in this forecast is very similar to that of last time. The elevated level of these prices means that they will continue to have lagged effects on U.S. import and export price inflation for a time. The flatness of the path going forward means that we anticipate that the implications for import price inflation will abate noticeably in 2007, contributing to a sharp drop in the rate of inflation for core imports. Further fluctuation in the prices for these global commodities is also a risk to our baseline forecast. These developments in global commodity prices, both fuel and nonfuel, along with other data released over the intermeeting period, led us to revise up some our forecast for inflation abroad through mid-2007. We expect that the upward pressures on inflation in the industrial countries will be felt in the near term, particularly this quarter, whereas those in the emerging market economies will be evident later this year and into next. The revisions are small, in part because foreign industrial countries have to date been very successful at containing the inflation consequences of higher crude oil prices and several have tightened monetary policy and in part because emerging market economies have continued to suppress domestic energy prices, delaying their effects in the process. Some monetary policy tightening has also been implemented by a number of Asian central banks. We continue to read the evidence for foreign real GDP growth as indicating a solid pace of expansion, with the possible exception of Canada, where output growth slowed in the second quarter. We have fine-tuned our outlook for expansion abroad a bit—strengthening last quarter and this quarter and lessening the pace just a little next year; but the overall path for foreign real GDP is about the same as in June. Indicators from most of our important trading partners—for example, from Japan, the euro area, and China—suggest considerable momentum in foreign economic expansion at the present time. Global financial markets confirm a generally favorable climate for continued strong growth, and many of the signs of increased risk concerns and heightened volatility from earlier in the year have faded. Over the intermeeting period, stock prices in many of our trading partners have risen. Equity price indexes in emerging market countries, in particular, have rebounded from the lows of mid-June but generally have not returned to the levels reached in early May. Other than in the United Kingdom and Japan, yields on ten-year sovereign bonds have moved down 10 or more basis points in the major foreign industrial countries since your June meeting, and spreads on dollar-denominated emerging market sovereign debt have partially retraced previous increases and are not far above the lows observed in early May, with the exception of spreads for Turkish debt. On balance, the dollar is down just a little over the period. The bottom line is that the staff’s picture of the global economy implies an essentially neutral effect of the external sector on U.S. GDP growth over the forecast period, although one must remember that there are risks on both sides to that picture. The arithmetic contribution of real net exports to GDP growth for the rest of this year and next year is essentially zero—with a small positive contribution over the second half of this year, unusual for us, followed by a small negative contribution in 2007 as a whole. Exports of both goods and services are expected to grow strongly, supported by steady expansion of real GDP growth abroad. The step-down in U.S. real GDP growth should restrain import growth somewhat over the next six quarters. The nominal trade deficit on goods and services is projected to widen about $75 billion from the estimated figure for the second quarter to that for the fourth quarter of 2007. The change in the non-oil nominal trade balance accounts for only one-third of that $75 billion. This change in the overall trade balance is sufficiently small that the projected ratio of the trade deficit to GDP is steady at about 6 percent. Nevertheless, the current account deficit is projected to exceed $1 trillion at the end of 2007, and the ratio of the current account deficit to GDP rises from 6.5 percent to 7 percent next year. A growing net deficit in investment income flows largely explains the further deterioration in the current account balance. That change, in turn, is accounted for by a substantial widening of the deficit on portfolio income that more than offsets a gain in the balance of direct investment income. The financing requirements of our external deficit remain large and will continue to grow as long as the level of the trade balance remains far from zero. David and I will be happy to answer any questions." FOMC20060510meeting--132 130,CHAIRMAN BERNANKE.," At this point I would normally try to summarize the remarks around the table. But since you have all just heard them and since my own views are not terribly different from many who have spoken, I think in the interest of time I will just go ahead and talk briefly on my own behalf about what I see the economy doing, and then we will turn to the policy go-round. 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. I would also note that there are going to be some offsets to the decline in residential investment. We’ve noted increases in nonresidential construction, which is about half the size, as a share of GDP, of residential construction and, in terms of contribution to GDP, could make up something like a half of the direct impact of a decline in residential spending. We also have gotten a sense that capital spending is relatively strong, and world growth is also strong, which may enhance our exports. So there are some countervailing factors to help cushion the presumed decline in the housing market. But as we talk about the housing market, which is 6 percent of GDP, or nonresidential construction, which is 2.7 percent of GDP, we have to pay very close attention to consumption, which is 70 percent of GDP and which really is the center of the forecast for the rest of the year. The soft landing scenario viewed in the Greenbook requires that consumption grow the rest of the year at something around 3.4 percent, which is roughly what it has been doing in the last year or so on average. I think that is broadly plausible. There are factors on both sides of it. Supporting consumption, obviously, are some increases in compensation likely coming forward both in terms of hourly wages and in terms of hours worked, job availability, and to some extent maybe increases in stock prices. On the negative side, many people have pointed out the effect of rising interest rates and softening in housing prices. Energy is actually a bit of a mixed bag. Energy prices are obviously a negative for consumption in level terms, but we have had a big drag on consumption for the past two years from increasing energy prices, and so if energy prices do stabilize, the drag will actually be less in 2006 than in previous years. So, again, I do think that the slowdown that has been forecast by the Greenbook is plausible, but like a number of people around the table, I would note that so far it is largely a prospective slowdown and that the data have only begun to support that development. On the inflation side, I have somewhat more concern, like a number of people. Core inflation has been remarkably stable, and I do not think it is going to rise very much; but to the extent that there are risks, they are very largely to the upside. And I also have some concerns about the possible emergence of some inflation psychology, which is a very negative thing for our policymaking. The factors that support higher inflation are well known. First, energy and commodity prices. I would point out that, rather than being transitory, they have now undergone a long, sustained increase, which evidently must at some point get into the cost structure of firms. Second, the weakening dollar over the past month or so may be sufficient to add some pressure. Third, the effect of compensation, I understand, is a little ambiguous. There are some factors working in the other direction, including markups and productivity, but clearly the sense around the table is that compensation is beginning to move up somewhat, and the risks there I think are also to the upside. Finally, it is worth noting that, at a technical level, some of the components of the inflation indexes are moving upward—in particular, owners’ equivalent rent. It economically makes sense that, if house prices have risen so much, rents will begin to rise. Since that is a very large share of both the CPI and the PCE core measures, that is going to be an upside risk for us. Now, again, I do not want to overstate the problem. I think that core inflation will remain contained, to use our language, but I am concerned about those risks. Clearly, the markets have seen a strengthening of the economy and increased inflation risk. Despite all of our communication and language, it is summarized by an increase of about 25 basis points in where they think the federal funds rate is going to end up later this year. We have seen and already discussed the increase in inflation compensation and in other measures of inflation expectations. Much of our confidence that the pass-through from energy, from the dollar, and from labor costs to final goods inflation will be low is predicated on the view that inflation expectations are low and well contained. When that premise begins to break down, then all the other elements of the analysis also begin to come under pressure. Finally, as a number of people have noted, although we do not have an official definition of price stability, we are at the upper level of what might plausibly be called the region of price stability, and further increases will be difficult and potentially costly to reverse. So looking forward to the policy discussion, I think we are going to have to take into account the emerging inflation risk. At the same time, there is an awful lot of uncertainty about what is going on in the economy. It is going to be a difficult balancing act to try to maintain as much flexibility as possible so that policy can respond to new data as they arrive. At this point I would like to turn over the floor to Vincent, who will talk about the policy options." CHRG-111shrg52966--33 Mr. Polakoff," Senator, I would say they understood the risk for the period of time that they were operating in, but failed to---- Senator Bunning. In other words, what I am trying to get at, there is a reasonable rate of return on equity that everybody expected at a given point in time. Somehow, that got out of kilter, and instead of being happy with a 7 or 8 percent return on equity, people were leveraging from--and I don't blame anybody, but regulators ought to be looking at the rate of return on equity and not giving permission for these firms to get into mischief, and that is what happened. That is why we are here today asking you these questions. The regulators should have stopped the risk takers taking undue risk with taxpayers' money or with equity that has been invested. Now the taxpayers are paying the price. So go ahead, finish your answer. " FOMC20080805meeting--115 113,MS. YELLEN.," Thank you, Mr. Chairman. Developments during the intermeeting period have heightened my concern about downside risks to economic growth and slightly allayed my concern about upside risks to inflation. Let me begin with growth. The moderate growth rate registered in the second quarter was disappointing, especially because it benefited from the temporary effects of the fiscal stimulus package. Moreover, the pattern of consumer spending during the quarter, with weakness in June, is worrisome. With all the publicity surrounding the rebate checks, households may have put them to work earlier than usual, especially since they were facing significantly higher prices for food and gasoline. This interpretation does not bode well for activity in the current quarter. Assuming no change in the funds rate this year, we have lowered our forecast for real GDP growth for the second half of the year about percentage point, to just � percent, and project a correspondingly higher unemployment rate. Our forecast for weak second-half growth reflects not only the unwinding of fiscal stimulus but also adverse financial sector developments. The credit crunch appears to have intensified since we last met. Evidence of tighter financial conditions abound. Risk spreads and the interest rates charged on a variety of private loans, including mortgages, are up noticeably, and lending standards have tightened further. Credit losses have risen not only on mortgages but also on auto loans, credit cards, and home equity lines of credit. As a consequence, the list of troubled depository institutions is growing longer. IndyMac and First National will not be the last banks in our region to fail. Indeed, the decline in broad stock market indexes is partly a reflection of the market's concerns about the health of the financial sector. Many financial institutions are deleveraging their balance sheets and reducing loan originations. For example, a large bank in my District has begun now in earnest to cancel or cap outstanding home equity loans and lines of credit, despite an ongoing concern about alienating consumers. Tighter credit is affecting demand. Anecdotal reports suggest that the plunge in July car sales partly reflects a tightening of credit standards for auto loans and leases. A large bank reports a substantial drop in demand for mortgage credit in response to the recent rise in mortgage interest rates, and the anecdotal reports that we hear support the Greenbook's negative view of the effect of credit conditions on investment in nonresidential structures. The housing sector is of considerable concern. House prices have continued to fall at a rapid rate, and futures prices suggest a further decline of around 10 percent over the next 12 months. This forecast seems reasonable given the overhang of homes for sale, the recent rise in mortgage rates, and the tightening of credit. Unfortunately, the risk of an adverse feedback loop from tighter credit to higher unemployment, to rising foreclosures, to escalating financial sector losses, to yet tighter credit remains alive and well, in my opinion. Indeed, stress tests conducted by some of the large financial institutions in our District reveal an exceptionally high sensitivity of credit losses to both home-price movements and unemployment. The ""severe financial stress"" simulation in the Greenbook illustrates my concern. It is not my modal forecast, but it certainly seems well within a reasonable range of outcomes. The probability of such a scenario has risen, in my view, since we met in June. One partially mitigating factor that should help to support consumer spending is the drop in the price of oil since our last meeting. But to the extent that the decline in oil prices partly reflects reduced expectations for global growth, the net impetus from stronger domestic spending will be offset by weaker export growth. Continued declines or even stabilization in oil prices will, however, be good for inflation. We have revised down slightly our forecast for core inflation as a consequence. Moreover, the fact that we were not once again surprised on the upside by oil prices has had a small favorable effect on my perception of inflation risks going forward. That said, inflation risks obviously remain. Even with the recent decline, energy prices are well above year-ago levels and are not only pushing up headline inflation but also spilling, to some extent, into core. Higher headline inflation could undermine our credibility and raise inflation expectations. If the public concludes that our implicit inflation objective has drifted up, workers may demand higher compensation, setting off a wage�price dynamic that would be costly to unwind. Fortunately, the reports I hear are consistent with the view that no such dynamic has taken hold. My contacts uniformly report that they see no signs of wage pressures. They note that high unemployment is suppressing wage gains. Growth in our two broad measures of labor compensation are low and stable; and taking productivity growth into account, unit labor costs have risen only modestly. I tend to think of the chain of causation in a wage�price spiral running from wages to prices, but it is certainly possible that the causation also, or instead, runs in the opposite direction. Either way, though, faster wage growth is an inherent part of the process by which underlying inflation drifts up, and at present we see not the slightest inkling of emerging wage pressures. Growth in unit labor costs also remains at exceptionally low levels. I would also note that I have looked for evidence of some increase in the NAIRU due to sectoral reallocation by examining the Beveridge curve, thinking that if there were sectoral reallocation we might see an outward shift in the Beveridge curve. I have detected no evidence of such an outward shift. These facts provide me with some comfort. Moreover, various measures of longer-term inflation expectations suggest that they remain relatively well contained. When we met in June, the Michigan survey of inflation expectations five to ten years ahead had recently jumped a couple tenths of a percentage point. I argued then that the respondents to that survey typically overrespond to contemporaneous headline inflation. Since that meeting, oil prices have come down a bit, and so have the Michigan survey measures. Assuming that the funds rate is raised from 2 percent to 3 percent in 2009, my forecast shows both headline and core PCE inflation falling to about 2 percent in that year. So, in summary, during the intermeeting period, my forecast for economic growth has weakened, and that for inflation has edged down slightly. I consider the risks to our two policy objectives pretty evenly balanced at the present time. " CHRG-111hhrg53246--69 Mr. Gensler," And our mission is to make sure that the markets are fair and orderly and provide the risk management for those hedgers. But through position limits, Congress gave us the authority many years ago to set position limits to protect those markets, so that they are fair and orderly and they represent the price discovery that you are so--so I think we are aligned on that, and it is whether this promotes market integrity along that front. " FOMC20060920meeting--60 58,MS. JOHNSON.," In the international economy, the striking development over the intermeeting period has been the rapid and substantial drop in crude oil prices and in prices for some nonfuel commodities. The spot price of WTI crude reached a recent high of about $77 per barrel on August 7, following news of problems with the BP pipelines at Prudhoe Bay. Since then, it has declined to less than $62 in trading yesterday, decreasing about $15 per barrel. The far futures price is down somewhat less, nearly $10 per barrel, leaving a barrel of WTI crude for delivery in 2012 priced about the same as a barrel of crude in the current spot market. As has been our practice for many years, we have assumed for the Greenbook baseline forecast that oil prices over time will match those contained in the futures price curve that held when we finalized the forecast last week. The timing of our forecast this Greenbook and last and the smoothing from quarterly averaging results in our forecast path for the oil import price shifting a bit less than did the spot price of crude. The downward revision in the oil import price amounts to nearly $12 per barrel in the near term and narrows to somewhat more than $8 per barrel by the end of 2007. Some other commodity markets were remarkably volatile over the intermeeting period as well. The spot prices for gold declined more than $60 per fine ounce since the time of the August FOMC meeting. Many of the industrial metals also moved down sharply in the past week or two, but in some cases these declines merely retraced run-ups earlier in the intermeeting period and resulted in only small net changes. Regarding the implications of the lower oil prices for our forecast, it is helpful to remember that our assumed price for WTI crude in the fourth quarter is near, but still more than $1 per barrel above, the average price that prevailed in the first quarter of this year, when we regarded oil prices as very elevated. In addition, the forecast path for WTI now rises into 2007 and then is about flat at close to $70 per barrel through the end of 2008. It also is relevant for constructing the forecast to ask why oil prices have come down as they have. The new developments that triggered the reaction in market prices seem to be importantly about the risks attached to future supply. Some aspects of geopolitical tensions, such as the conflict in Lebanon and the ongoing dispute with Iran over its nuclear program, seem to have eased. The Atlantic Ocean hurricane season has pleasantly surprised, with fewer storms than previously expected and none so far threatening the Gulf of Mexico. One factor that likely influenced the price reaction to the apparent lessening of risks to supply is the high level of inventories of crude oil at the present time. Current demand and supply plus market expectations of future demand and supply combine to determine spot and future prices plus desired inventories. With inventories already high, news that future supply is less uncertain sharply lowered the price required to clear the spot market and the premium that buyers are willing to pay to ensure future access to oil. Nevertheless, the positive slope to the futures curve over the forecast period suggests that, on balance, market participants are not expecting future supply to be as abundant relative to demand as is the case currently. With respect to the implications for our forecast of foreign growth and inflation, we needed to consider the direct effects of lower energy prices and also to ask whether actual or prospective slowing of global economic activity and, hence, demand for oil and other primary commodities have contributed to the downward shift in these prices. On balance, our outlook for real GDP growth abroad generally remains quite strong. However, we do expect a decrease in the average rate of growth of foreign real GDP from about 4 percent at an annual rate in the second quarter to 3¼ percent in the second half of this year and over the remainder of the forecast period. In both the industrial countries and the emerging-market economies, the pace of real growth was particularly vigorous during the first half of this year and contributed to continued strong demand for oil and other commodities. Monetary policy has been tightened in response to concerns of inflation and overheating in many countries, measures to tighten fiscal policy have been passed in some cases, and officials in China have imposed additional administrative measures to restrain growth. Prospective moderation of the rate of foreign growth was a feature of our forecast in August. Data from Canada and Japan already provide evidence of a lessening in the rate of growth in those countries. However, available data on activity in the euro area, China, and Mexico continue to be buoyant. In putting the pieces of the forecast together, we have concluded that the lower oil prices are consistent with overall foreign growth remaining moderately strong and will help to ensure that it remains so. At the same time, the projected pace of global economic activity is consistent with oil prices remaining quite elevated and rising somewhat into next year. We judged that the implications for foreign growth of the downward revision to the outlook for U.S. real output growth were partly offset by some boost to foreign growth that we otherwise would have incorporated in response to the reduced energy costs, although these factors differ across countries. As a result and given data received since the August forecast, the path for foreign real GDP growth was little revised on balance from that in the previous Greenbook. We have revised down our forecast for headline consumer price inflation abroad a few tenths for the second half of this year and next as a consequence of the lower path for energy prices. We project that in the industrial countries other than Japan inflation will move down somewhat over the forecast period. In contrast, Japanese inflation is expected to edge up but to remain below 1 percent. Some emerging-market economies in Asia still have controls on or subsidies of domestic fuel prices, which delays any pass-through of higher energy prices into domestic inflation. Accordingly, we project that increases in global oil prices earlier this year will push inflation in emerging Asia temporarily above 3 percent during the first half of next year. We look for inflation in Latin America to remain contained near present rates. We see the risks to this forecast in many respects as balanced. We have been surprised on the upside by the strength in foreign real activity during the first half of the year, and strong domestic demand in some regions could push off into the future some of the slowing that we are projecting. Alternatively, foreign activity may be more sensitive to the U.S. slowdown than we currently envisage. We feel especially uncertain with respect to the outlook for oil prices, given market reaction to recent events; the sharp change in prices caught us and the futures market by surprise. Although we are once again assuming that oil prices will follow the path implied by futures prices, we recognize that a much larger move up or down is quite possible. David and I will be happy to answer any questions." fcic_final_report_full--481 PMBS are Connected to All Other NTMs Through Housing Prices But this does not mean that only the failure of the PMBS was responsible for the financial crisis. In a sense, all mortgages are linked to one another through housing prices, and housing prices in turn are highly sensitive to delinquencies and defaults on mortgages. This is a characteristic of mortgages that is not present in other securitized assets. If a credit card holder defaults on his obligations it has little effect on other credit card holders, but if a homeowner defaults on a mortgage the resulting foreclosure has an effect on the value of all homes in the vicinity and thus on the quality of all mortgages on those homes. Accordingly, the PMBS were intimately connected—through housing prices—to the NTMs securitized by the Agencies. Because there were so many more NTMs held or securitized by the Agencies (see Table 1), their unprecedented numbers—even in cases where they had a lower average rate of delinquency and default than the NTMs that backed the PMBS—was the major source of downward pressure on housing prices throughout the United States. Weakening housing prices, in turn, caused more mortgage defaults, among both NTMs in general and the particular NTMs that were the collateral for PMBS. In other words, the NTMs underlying the PMBS were weakened by the delinquencies and defaults among the much larger number of mortgages held or guaranteed as MBS by the Agencies. In reality, then, the losses on the PMBS were much higher than they would have been if the government’s housing policies had not brought into being 19 million other NTMs that were failing in unprecedented numbers. These failures drove down housing prices by 30 percent--an unprecedented decline—which multiplied the losses on the PMBS. Finally, the funds that the government directed into the housing market in pursuit of its social policies enlarged the housing bubble and extended it in time. The longer housing bubbles grow, the riskier the mortgages they contain; lenders are constantly trying to find ways to keep monthly mortgage payments down while borrowers are buying more expensive houses. While the bubble was growing, the risks that were building within it were obscured. Borrowers who would otherwise have defaulted on their loans, bringing an end to the bubble, were able to use the rising home prices to refinance, sometimes at lower interest rates. With delinquency rates relatively low, investors did not have a reason to exit the mortgage markets, and the continuing flow of funds into mortgages allowed the bubble to extend for an unprecedented 10 years. This in turn enabled the PMBS market to grow to enormous size and thus to have a more calamitous effect when it finally collapsed. If the government policies that provided a continuing source of funding for the bubble had not been pursued, it is doubtful that there would have been a PMBS market remotely as large as the one that developed, or that—when the housing bubble collapsed—the losses to financial institutions would have been as great. PMBS, as Securities, are Vulnerable to Investor Sentiment In addition to their link to the Agencies’ NTMs through housing prices, PMBS were particularly vulnerable to changes in investor sentiment about mortgages. The fact that the mortgages underlying the PMBS were held in securitized form was an important element of the crisis. There are many reasons for the popularity of mortgage securitization. Beginning in 2002, for example, the Basel regulations provided that mortgages held in the form of MBS—presumably because of their superior liquidity compared to whole mortgages—required a bank to hold only 1.6 percent risk-based capital, while whole mortgages required risk-based capital backing of four percent. This made all forms of MBS, including PMBS, much less expensive to hold than whole mortgages. In addition, mortgages in securitized form could be traded more easily, and used more readily as a source of liquidity through repurchase agreements. FOMC20050202meeting--147 145,MR. HOENIG.," Thank you, Mr. Chairman. For the economy, growth currently remains above trend and, as we all know, is likely to remain above trend several quarters forward. As a result, we are systematically approaching long-run potential GDP for the economy. I expect growth will be near 4 percent this year—above trend. There are obvious reasons for this: monetary policy remains accommodative, consumer spending on goods and housing is strong, and business equipment spending is strong. While fourth-quarter growth was below expectations, final sales to domestic purchasers were at a robust 4.3 percent pace. And I think the labor market continues to improve. Evidence from our District is very much in line with this outlook. Most retailers we contacted said that holiday sales were moderately higher than a year ago, and many said that sales were above their plan. In addition, many ski resorts in our region reported sharp increases in hotel occupancy and a near-record volume of ski visits, many from foreigners. Job growth picked up in December. Hiring announcements since the last FOMC meeting exceeded layoff announcements by a margin of two to one, and a substantial fraction of small and midsized manufacturers said that they plan to increase employment in the coming months. District manufacturing continues to expand at a brisk pace; production, new orders, and employment all rose in December, and firms remained upbeat about future activity. Capital spending plans for 2005 are reported strong. We all know where the price indexes are right now but, looking to the future, I would expect to see further increases in core inflation. With the federal funds rate below the lower bound of most estimates for the neutral rate, I remain alert to the greater or increasing risk of inflation. In addition, there are several other reasons to think that this upside risk may be rising. First of all, as others have said here today, we are hearing more about the return to pricing power. Further, a greater pass- through of higher commodity prices seems to be occurring. The possibility of continued dollar depreciation is strong, as is a greater pass-through of higher import prices. And slowing productivity February 1-2, 2005 101 of 177 Evidence from the District supports these observations. For example, the fraction of businesses reporting labor shortages was 53 percent in January, up significantly from last quarter and last year. As a result, wage pressures in the District have also increased. About 26 percent of the employers contacted in January said that they had to boost wages more than normal as compared to 17 percent last quarter and 11 percent a year ago. In addition, our manufacturing survey showed evidence of greater pricing power. For example, among respondents reporting higher input prices, the share who also reported higher output prices has risen markedly, from 40 percent in the fourth quarter of 2003 to 60 percent in the fourth quarter of 2004, the same as before the recession. Similarly, among those who expect to pay higher input prices going forward, those who also expect to charge higher output prices has risen markedly from 41 to 51 percent. In summary, the outlook for the nation and our region is certainly good. Growth is robust, and we are hearing increasingly that there is a lot of money looking for opportunity. I would submit that the risk of higher inflation, therefore, is now large enough that we should at least be thinking about raising rates more aggressively toward neutral than we have in the past. Thank you." FOMC20080805meeting--104 102,MR. EVANS.," Thank you, Mr. Chairman. Overall there has been little change in the sentiment of my business contacts since our last meeting. Most are still reporting sluggish domestic demand with little evidence of any improvement over the near term. On the price front, everyone continued to cite cost pressures. Manufacturers have long lists of materials cost increases, while retailers note large increases in wholesale prices of imported consumer goods. Everyone discusses how they are planning to continue passing these costs along to customers in second-round effects. Undoubtedly weak market conditions will limit their efforts, but I suspect that many will be successful in raising prices significantly. Turning to the financial situation, to start I should note that I did hear some good reports with regard to liquidity in Chicago financial markets. A contact at the Chicago Mercantile Exchange told us that they conducted extensive liquidity reviews for their largest clearing members, with special scrutiny of firms that had substantial volumes of hard-to-value assets on their books. The clearinghouse was very pleased with the results, finding that these firms had good access to liquidity. Overall, however, my financial conversations this round were relatively downbeat. I did hear some interesting details, though, about the dynamics of the restructuring of credit intermediation. With commercial-mortgage-backed securities markets effectively shut down, a highly rated owner-developer of high-end shopping malls described his increasingly difficult attempts to find funding for his regular flow of balloon payments on mortgage properties. He has gone from restrictive loans from life insurance companies to attempting to put together his own structured-debt securitization. They want to issue bonds backed by the revenues generated from a pool of their high-quality properties and sell them to major fixed-income investment funds. This is one example of what economists like Kashyap and Shin estimate will be a reduction of at least $1 trillion in lending to nonfinancial institutions due to mortgage-related losses at U.S. financial institutions. It is also an example of how firms are trying to find workarounds for the functions that intermediaries used to do for them. But such restructuring must be raising the cost of financing in ways that are not obviously amenable to mitigation through liquidity policies. Turning to the national outlook, the information we have received over the past several weeks has contained many crosscurrents, but overall our forecast for output growth is little changed from our June projections. With regard to prices, I am concerned that inflation risks continue to grow. The most recent news on core prices has not been good. Oil prices may be coming off the boil, but they are still scalding. Prices are still down only to where they were in May. My impression from my contact calls is that the ultimate pass-through to final product prices of earlier increases could take a disconcertingly long period of time. Furthermore, I continue to think that the current funds rate in conjunction with our enhanced lending facilities represents a quite accommodative monetary policy stance, even given the disruptions in financial markets. If the policy path remains as accommodative as futures markets expect, then improvement in inflation will most likely require fortuitous favorable developments in inflation expectations and more restraint from resource slack than we might have otherwise expected. This brings me to three considerations that I would like to highlight as we evaluate the riskmanagement positions underlying our views on appropriate policy and our economic projections. The first factor is that, according to many econometric estimates, the 5� to 6 percent unemployment rate envisioned in the projections would provide only very modest restraint on inflation. In addition, costly reallocation could lead to less resource slack, perhaps temporarily driving the NAIRU above 5 percent. You know, when I talk to my staff, they assure me that there are very good reasons, demographically based, to believe a NAIRU under 5 percent. But I tend to think I've read a few too many papers on policy and policy mistakes where that's exactly the issue--when you think the sustainable unemployment rate is lower than it actually is. So that's a risk, I think. The second factor is that many individuals and businesses see the large relative price changes in oil, food, and commodities as precursors to more-persistent inflation. Whether or not their assessments are analytically correct depends on their expectations of our policy response. A substantive response may be necessary to prevent self-fulfilling price increases and keep inflation under control. Words can take us only so far. The third consideration is the potential diminishing returns through our efforts to mitigate distressed financial market conditions. It is my interpretation that our current accommodative monetary policy and suite of lending facilities are set to mitigate severe downside risks and the systemic risks that you mentioned earlier, Mr. Chairman. This is helpful under the assumption that reducing liquidity strains will assist financial markets to return to normal operations and prevent a permanent impairment of our financial infrastructure. But financial conditions seem unlikely to return to our previous perceptions of normal, at least for some time. Thus, I see a risk that extra accommodation intended to grease the financial wheels could be left in place too long and prove counterproductive for price stability. Indeed, the old perception of ""normal"" likely is not the correct benchmark for us to use in looking for whether we are experiencing structural changes in the intermediation process in which new liquidity providers are playing enhanced roles in the lending process and in which risk standards are changing. So when thinking about market functioning, it would be useful to discuss this within a longer-term framework of what we can feasibly expect from market functioning and what central bank liquidity has the ability to usefully and appropriately influence. Thank you, Mr. Chairman. " FOMC20050322meeting--240 238,MS. SMITH.," I’m reading from page 25 of the Bluebook. The wording would be: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 2¾ percent.” And then B modified is: “The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”" FOMC20061212meeting--201 199,MS. DANKER.," I’ll be reading the directive and risk assessment from page 23 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” Then: “Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”" FOMC20080625meeting--118 116,MR. EVANS.," Thank you, Mr. Chairman. I'd like to start by saying that I agree with your comments yesterday about how we should proceed with the Committee approach and think very collaboratively about the policies and delicate strategies that we're facing. Although we disagree on a number of the elements of the outlook, I think that bringing everything together is a very important part of this. I have fully endorsed funds rate cuts that we have taken so far in large part as insurance against tail risks to growth. I think that policy last summer was much too restrictive given what we were facing and that, along the way, a lot of these cuts have been motivated by tail risks to growth. The funds rate at 2 percent is pretty ample insurance to my mind--more so given the improvement in the outlook for growth that we've seen as second-quarter growth has been marked up so much and even more so given the inflation risks that we're facing, the risks to inflation expectations, and the potentially very low real interest rates that we might be looking at, depending on the measure. If we had the opportunity to recalibrate things a bit, I probably would prefer something more like a 2� percent fed funds rate to be positioned against the different risks that we're facing, but I understand that we're at 2 percent, and no change seems like the right move for today. I do have a few concerns about the way we're thinking about this, more in the line of risks. One is that, as we take insurance against tail risk, we're positioning the funds rate against an event that we think is not the most likely and is negative compared with where we are. Unless and until that event happens, policy is somewhat accommodative because it hasn't happened, and we're thinking that it is closer to where it ought to be if that should happen. Unless you think that we haven't taken out insurance, then I think that we have more accommodation than we might like. The second concern is whether it is possible to be more precise about what we mean by this tail risk. I mean, it's really a catch-all. Nobody is very comfortable with all of this. What are the markers that we could look at for improvement if we could quantify this somehow? Is it that financial markets should be functioning better? I think surely that is the case. Is there a way that we could describe that? I'm sure we'll disagree on many elements of this. Labor market improvement--we should expect that, if the labor market does better than we were thinking, then that would tend to bolster consumption spending a bit better in the face of all the shocks that we're looking at. So the extent to which the labor market doesn't continue to deteriorate, at least in line with some of the recession scenarios and the tail risk scenarios that we were thinking about, is a potential marker. As we keep pushing out our expectation that the economy is going to weaken--and we've done this a number of times--and if we're looking at the third quarter being revised up--and I agree that we're facing a lot of risks there--but if we start marking that one up, I think that's a marker that we have to be concerned about. Obviously, if oil prices and commodity prices were to decline and free up purchasing power for consumers, that would help out, too. So these are just some of the things that come to mind. Is there a way to think about the details a little better, with a bit less of a SWAG? Another risk relates to financial markets. Here I'm thinking about the really influential work of yours, in 1983, on nonmonetary influences on the Great Depression. A lot of the actions that we have taken are defenses against those types of issues, right? In the 1930s, when the economy was doing very badly and banks were failing--I'm telling this to you, and you've described it to everyone--then the knock-on effect was that the banks weren't there anymore and important resources for evaluating credit were lost, and so it was more expensive and very difficult to do. We have some of that going on now, right? We've moved from the banks making mortgages and holding them to the ""originate to distribute"" model. Those resources have been dispersed, and now that securitization market is closed. I heard that very clearly yesterday. Those important resources aren't there to originate mortgages, so if we get to the point that buyers are willing to purchase these houses, that could be a concern. What happens if there's a true impairment to the financial capital stock, and real resources aren't there anymore to help out with this? We're probably looking at a reallocation of resources from that sector of the financial market either back to banks or to somewhere else. But as we see those resources reallocated and as we think about unemployment being higher, we can talk ourselves into thinking that a lot of slack is in the economy when, in fact, there may not be so much slack. At some point it may be slack, and at other times it won't be, until those resources are reallocated most efficiently. I think this could reduce potential growth rates and have structural elements to it, not just cyclical elements. So there's not a slam-dunk for this. There is just a risk that an element of that is playing out throughout this, and other factors are superimposed on that. But it's something that I worry about. In a robust type of policy development, I think we should be considering things like that. It's just the case that, in the current situation that we're looking at, there might be a limited role for monetary policy to repair real capital stocks. Another concern is that anytime we've engaged in substantial risk-management policies, there has always been difficulty in taking them back. That's part of the delicate strategy that you are referring to, I think. That's how I heard it. So we have to be very careful. There's a lot of art to this clearly, but it would be good if we could offer a few more bright lines about how we'll approach that. Still, I certainly agree. I think we need to seek consensus. It's our role to raise these issues and then come to the best judgment. So I'm quite comfortable with no change today. I'm quite comfortable with the language in alternative B, although in the third paragraph we say, ""However, in light of the continued increases in the prices of energy,"" and I think it would be better if we didn't say ""continued."" I think it's enough to say ""the increases."" In part, I don't know if this is a marker that, if prices level out, we'd still be comfortable with the inflation risk. I think that there will be a lagged effect of all the very large increases that we've seen for oil as they work their way through. If prices just level out, we still have risks to inflation expectations. So I prefer taking that out. Thank you, Mr. Chairman. " FOMC20081007confcall--39 37,CHAIRMAN BERNANKE.," All right. I'm going to read the joint statement by central banks, which has been negotiated with the other central banks. So we really can't edit this one because of the negotiations that have already taken place. However, you should already have the FOMC statement. So here's the joint statement by central banks: ""Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets. Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability. Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions."" So that would be the joint statement. Then we would issue separately on our website the FOMC statement. Let me stop there and open the floor for comments on the action, on the general situation, on the statement, or whatever you would like to talk about. Would anyone like to speak? President Yellen. " FinancialCrisisInquiry--448 BASS: Sure. First of all, I’ll—in the interest of full disclosure, I was a senior managing director at Bear Stearns for five and-a-half years from 1996 to 2001. So a lot of the people at that firm are very good friends of mine. And a lot of the people that ran the firm are very good friends of mine. In—in September of 2006, I went to Bear Stearns to meet with a guy named Bobby Steinberg, who at the time was their chief risk manager at the firm. He congregated a meeting in a conference room at their headquarters for me with the head of mortgage trading, the head of fixed income trading, the head of mortgage risk, fixed income risk and himself. And I went through my entire presentation as to what I saw building in the housing market where I— where I thought mortgage credit was going to go. And—and—and, you know, a couple points that I’ll make. Someone—someone in this morning’s hearing said did you ever contemplate housing prices ever dropping. They didn’t even have to drop for losses to show up. OK? If housing prices just went flat, they would have lost 9 or 10 percent on these securitizations, which would have wiped out everything up to close to the AAs. So to put it into perspective, I—I went through my presentation with their risk committee and said do you realize that if I’m right—and— and by the way, I’m one data point from Dallas, so I realize that they can discount what I had to say. But the presentation’s fairly compelling. If I’m right, do you realize what’s going to happen to this firm, knowing how—the firm’s position? And he said-- he said, Kyle, you worry about your risk management, and we’ll worry about ours. And that was the last time I spoke with them. Again, it’s—it’s one data point. And with regard to the Federal Reserve, I met one of President Bush’s staffers and—and went through it with him. And he suggested I go talk with the Federal Reserve here in D.C. And I met with one of the Federal Reserve board members and went through my— my presentation again, just a data point from Dallas—meeting at the Federal January 13, 2010 Reserve here in D.C. It’s—it’s not a large data point. However, their answer at the time was—and—and this was—this was also the thought that was—that was homogeneous throughout Wall Street’s analysts—was home prices always track income growth and jobs growth. And they showed me income growth on one chart and jobs growth on another, and said, “We don’t see what you’re talking about because incomes are still growing and jobs are still growing.” And I said, well, you obviously don’t realize where the dog is and where the tail is, and what’s moving what. But again, it was my opinion which, you know, they intended—or they—disregarded. FinancialCrisisReport--525 Goldman senior executives closely followed Hudson’s development and sale. Hudson was discussed, for example, at five different Firmwide Risk Committee meetings attended by senior Goldman executives. 2271 Mortgage Department executives also sent progress reports to the senior executives on Hudson 1. On October 25, 2006, for example, Mr. Sobel sent an email to COO Gary Cohn and CFO David Viniar alerting them to Hudson sales efforts and the pricing of its securities. 2272 During discussions over the best price at which to market the CDO’s equity tranche, a senior executive emailed Peter Ostrem and others: “keep in mind the overall objective - this is not about one trade - having said that, I agree that [the proposed price] may be too low.” 2273 On October 26, 2006, Mr. Jha, a Goldman risk officer, circulated a Mortgage Department Risk Report to a number of Goldman executives, including CEO Lloyd Blankfein and COO Gary Cohn, noting in the forwarding email: “Risk reduction [in the Mortgage Department] is primarily due to pricing of $2bn Hudson Mez synthetic CDO.” 2274 Selling Hudson. Once the Hudson CDO was ready for sale, the Goldman sales force had difficulty selling Hudson securities to investors due to its reliance on BBB and BBB- rated subprime RMBS securities. Allied Irish Bank (AIB), for example, apparently referred to the Hudson securities as “junk.” 2275 One Goldman employee emailed the CDO team and asked: “[D]o we have anything talking about how great the BBB sector of RMBS is at this point in time ... a common response I am hearing on both Hudson & HGS1 is a concern about the housing market and BBB in particular? We need to arm sales with a bit more.” 2276 2271 Firmwide Risk Committee meetings were often chaired by David Viniar and frequently attended by Lloyd Blankfein and Gary Cohn. See 9/20/2006 Firmwide Risk Committee Minutes, GS MBS 0000004472; 9/27/2006 Firmwide Risk Committee Minutes, GS MBS 0000004474; 10/4/2006 Firmwide Risk Committee Minutes, GS MBS 0000004476; 10/11/2006 Firmwide Risk Committee Minutes, GS MBS 0000004478; 11/1/2010 Firmwide Risk Committee Minutes, GS MBS 0000004484. See also 10/11/2006 email from Arbind Jha to Joshua Birnbaum, GS MBS-E-012695030 ( “Sobel this morning in the firmwide risk committee mentioned that we have circled up the junior and some of the equity tranches ”). 2272 2273 2274 10/25/2006 email from Jonathan Sobel to David Viniar and Gary Cohn, GS MBS-E-009757821. 10/12/2006 email from Thomas Cornacchia to Peter Ostrem and others, GS MBS-E-0000066413. 10/26/2006 email from Arbind Jha, “MarketRisk: Mortgage Risk Report (cob 10/25/2006),” GS MBS-E- 0000056041, Hearing Exhibit 4/27-89. That same day, October 26, 2006, Mr. Swenson also described the risk transfer to Goldman executive Bill McMahon when updating him on the trading desk ’s ABX position: “In addition to $2bb of risk that was placed into the CDO , we have sold to retail since 4pm yesterday $2bb of BBB- risk.” 10/26/2006 email from Michael Swenson to Bill McMahon, others, GS MBS-E-0000054856. 2275 10/11/2006 Goldman internal email, “FW : Hudson Mezz, ” GS MBS-E-017502610, Hearing Exhibit 4/27-170c. (A Goldman employee asked a sales associate: “what specifically did AIB say was ‘junk ’ about the hudson mezz deal? ” The employee then forwarded the email to M r. Herrick saying: “You may want to ask [the sales associate] about this when she ’s there tomorrow and Friday. ... She said ‘AIB are too smart to buy this kind of junk.’”). 2276 10/19/2006 email from Mitchell Resnick to Jonathan Egol, Darryl Herrick, and David Rosenblum, GS MBS-E- 009557391. “HGS1 ” refers to Abacus HGS1, a CDO 2 where Goldman, as in Hudson 1, held 100% of the short interest. CHRG-109shrg30354--55 Chairman Bernanke," Senator, I agree that there is more of a problem in the product markets than in the labor markets. In the product markets they are sufficiently tight that firms are developing pricing power and they are passing on their energy and materials costs. It still is an inflation problem because if inflation rises, it is still going to have the same adverse affects. It is going to get into expectations. I am not saying that is going to happen. Our forecast is for inflation to decline over time. But it is a risk. And nevertheless, if it is coming from product markets more than labor markets, it is still a risk to inflation. Senator Sarbanes. Thank you, Mr. Chairman. " FOMC20050630meeting--9 7,MR. LEHNERT.," As Josh noted, everyone’s talking about house prices; but they also seem to be talking a great deal about mortgages. The popular consensus appears to be that homebuyers, especially in hot housing markets, now make token down payments and can just scrape into their homes by resorting to interest-only mortgages; in this view, borrowers and lenders alike are vulnerable to any fall in house prices. In my prepared remarks I will address each of these issues. An obvious measure of the vulnerability of a borrower to a decline in his house price is the ratio of the current mortgage balance to the current value of his home; this ratio is known as the current loan-to-value, or LTV, ratio. The top panel of your first exhibit compares the distribution of the estimated current LTV as of September 2003 (the black bars) with the distribution as of March 2005 (the red bars). June 29-30, 2005 8 of 234 The middle left panel uses the same data to concentrate on the most leveraged borrowers. For a given drop in nominal house prices (the horizontal axis), the vertical axis gives the percent of borrowers who would have negative equity. As before, the black line reflects data from September 2003 while the red line reflects the most recent data. As shown by the red line, following a house-price drop of 10 percent, an estimated 4 percent of borrowers would have negative equity, while a drop of 20 percent would leave about 18 percent of borrowers in negative territory. The middle right panel summarizes average LTVs at origination for homes purchased in 2004, by state, relative to price appreciation in that state over the previous four years. States with lower-than-average appreciation, such as Utah, Texas, and Oklahoma, are at the left, while states with faster-than-average appreciation, such as California, Massachusetts, and New York are at the right. As shown, LTV at origination in 2004 was actually lower in states with more appreciation. Thus, homebuyers in California and other high-appreciation states made larger down payments relative to the price of their house than homebuyers in low-appreciation states such as Oklahoma. Increasing home equity, mainly driven by rising house prices, has supported mortgage credit quality in recent quarters. The bottom left panel plots delinquency rates for loans held on banks’ books (the black line) as well as for the broader MBA [Mortgage Bankers Association] measure (the red line). Both have fallen significantly in recent years. The bottom right panel summarizes the vulnerability of borrowers to house- price shocks. The average LTV on mortgages has declined over the past 18 months, and most households currently have substantial equity in their homes. In the past few years, borrowers have benefited from rapidly rising house prices, which have kept mortgage delinquencies at extremely low levels. However, an estimated 4 percent of borrowers are highly leveraged and could lose all of their home equity if house prices were to fall 10 percent. As I noted earlier, recent anecdotal reports have highlighted a second potential risk lurking within mortgage markets—the sudden popularity of interest-only mortgages. These are the subject of your next exhibit. June 29-30, 2005 9 of 234 Turning to the data, line 1 of the top left panel shows that the dollar value of RMBS pools has nearly doubled over the past two years. Moreover, as shown in line 2, RMBS pools backed by interest-only, or IO, mortgages have increased almost sixfold, and now amount to nearly $300 billion. However, total home mortgage debt, line 3, has also increased over the past two years. As shown in the memo line, interest-only RMBS pools now account for 3.6 percent of all home mortgage debt, up from less than 1 percent two years ago, but still a small share of all mortgages. As their name implies, interest-only mortgages do not require the borrower to make principal payments, at least during an initial period. Borrowers willing to use IO mortgages could qualify for a larger mortgage and thus be able to buy a more expensive house. The top right panel gives some idea of the relationship between price appreciation and the popularity of IO mortgages. The vertical axis shows the fraction of IO mortgages used to purchase houses, by state, in 2004. Again, I should emphasize that the IO shares are calculated within the RMBS world, and so are probably overstated. The horizontal axis gives state-level house-price appreciation from 1999 through 2003. As you can see, IO mortgages are somewhat more popular in states that saw more appreciation, although, as seen in the inset box, the correlation is not particularly strong. While the principal value of an IO loan doesn’t decline, if the initial down payment is large enough, the borrower may have a substantial equity cushion against price shocks. The middle panel reports the LTV at origination for IO loans made over the past three years. As shown, most IO mortgages had LTVs below 80 percent, although the trend over time has been away from the very lowest LTVs. That said, lenders have continued to make relatively few IO loans with LTVs above 80 percent. Those higher LTV loans now account for about 15 percent of all outstanding IOs. Finally, anecdotes often emphasize that IO loans are extended to borrowers with lower credit quality. The bottom panel shows the distribution of credit quality, measured by FICO scores, among IO borrowers. As a rough approximation, most lenders define prime quality borrowers as those with FICO scores of 660 or above. The leftmost set of bars thus represents subprime borrowers. As shown, between 8 and 10 percent of IO loans have been extended to these borrowers. Moving to the right, the next two sets of bars show that the great majority of IO borrowers had solid credit scores between 660 and 779. As shown by the rightmost set of bars, about 10 percent of IO borrowers had credit scores above 780. On the whole, therefore, the credit quality of borrowers using interest-only loans does not appear particularly risky. June 29-30, 2005 10 of 234 exclusively hold or guarantee conforming mortgages with fixed rates. Private mortgage insurers, line 2, insure the component of mortgage principal that exceeds 80 percent of the property’s value and so are effectively exposed to the credit risk associated with high-LTV loans. RMBS pools (line 3), as well as banks and thrifts (line 4), hold a wide variety of different mortgage types, including traditional fixed- rate mortgages as well as variable-rate and junior liens. The top right panel emphasizes that the housing GSEs hold very little credit risk. As shown on line 1, the average LTV at origination of GSE-guaranteed mortgages was 70 percent; based on regional house-price appreciation, the estimated current LTV of these mortgages (line 2) has fallen to 57 percent. The average credit score of the underlying borrowers (line 3) is also solidly in the “prime” category. Obviously, these average values mask some variation in the borrower population, which no doubt contains some higher-risk borrowers. However, as shown on line 4, 19 percent of the mortgages guaranteed by the GSEs carry some form of credit enhancement. If one of these mortgages defaults, the GSE receives a payment from the insurer, usually a private mortgage insurance, or PMI, company. The middle left panel examines the health of the PMI industry. As shown by the black line (left axis), the ratio of total insured mortgages to capital, the risk- capital ratio, has declined steadily over the past 10 years, indicating that PMI companies have historically high capital on hand relative to the risks they insure. The red line (right axis) shows net underwriting income—that is, income from premiums less losses and expenses, relative to capital. After suffering large losses in the late 1980s, PMI companies have consistently recorded positive underwriting income. In sum, PMI companies appear to have built up a historically large cushion to absorb the losses that might be associated with a widespread drop in real estate values. The middle right panel analyzes the risks posed to investors in RMBS pools. These pools contain some of the riskier outstanding mortgages. However, they are structured so that investors can choose their risk exposure. Further, RMBS pools are exceptionally transparent, so investors have extensive information on each mortgage in the pool. In principle, investors should have understood, and appropriately priced, the risks inherent in these mortgages. In practice, however, investors price these mortgages using loss models, which are estimated using relatively little data from major house-price declines. June 29-30, 2005 11 of 234 account for more than 40 percent of assets. Residential mortgage credit risk is more concentrated at these institutions than at the institutions in the lower quartiles. The panel to the right shows the average size and capital-to-asset ratio of institutions in each of the quartiles. Reading down the first column, which gives average institution size, one can see that smaller institutions are concentrated in the first two quartiles, which have relatively little mortgage exposure. Reading down the second column, which gives average tier 1 capital ratios, institutions in all quartiles are extremely well capitalized. Thus, institutions with large amounts of mortgage credit risk on their portfolios are well positioned to handle severe losses. To sum up, neither borrowers nor lenders appear particularly shaky. Indeed, the evidence points in the opposite direction: borrowers have large equity cushions, interest-only mortgages are not an especially sinister development, and financial institutions are quite healthy. Nonetheless, even the most sanguine analyst quails when contemplating a historically unprecedented drop in nationwide nominal house prices. Such a drop will obviously hurt both borrowers and lenders and will also no doubt expose weaknesses that will only be obvious in hindsight. Thus, perhaps it would be best simply to venture the judgment that the national mortgage system might bend, but will likely not break, in the face of a large drop in house prices. That concludes my prepared remarks." FOMC20060629meeting--116 114,CHAIRMAN BERNANKE.," Thank you. If I could try your patience for a few more minutes at the end of a long afternoon, I’d like to summarize what I’ve heard today and then just add a few comments of my own. While I’m doing that, Brian, would you distribute table 1? Table 1 in the Bluebook shows the three alternative suggestions for the statement. Since the Bluebook, we have received some suggestions, and we’ve done some wordsmithing—we’ve actually responded to a few things we heard today. The general tone of the three statements is the same, but we wanted you to see where it was today, so that you could think about it overnight and so that it would help you for your discussion tomorrow. That’s going to be coming around. Let me just briefly summarize what I heard. Certainly, a central theme of the speakers today was the increase of uncertainty and risk in the environment. It’s getting more and more difficult to forecast, and there are certainly risks both to the upside and to the downside. The central tendencies with respect to output seem to be that output is slowing to something close to potential. Some felt growth would be stronger than the Greenbook suggested; others, like the Greenbook, thought it would be falling somewhat below potential. A few people saw downside risks from previous tightening. There was some disagreement on the extent to which financial conditions are supportive of the economy, and some disagreement on consumption, although there was a view that lower-income consumers were going to do worse than higher-income consumers. Housing is certainly slowing. Some took the view that it was slowing more or less as expected, whereas some thought the slowing was somewhat worse than expected—certainly that’s a source of downside risk. The view of the labor market is that it remains reasonably healthy, that it’s difficult to find skilled workers, but there are still few signs of wage pressures in the economy. The business-sector evaluations were much more upbeat, with ongoing expansion, good sentiment, and capital investment. Finally, there seems to be considerable unease about recent inflation developments. Everyone considered these recent developments to be unwelcome. Some felt that the recent increase in inflation might be temporary. Others saw it as more persistent. But there certainly was a sense that it’s a risk to the economy. Let me add just a few thoughts about the situation. The situation is, I think, exceptionally complicated because at least three different things are going on. First of all, there’s a cyclical transition from a period of above-trend growth to what we would hope would be a period of trend growth, the normal soft-landing problem. Second, we essentially have a supply shock. It’s not exactly a supply shock because it has complicated elements to it, but oil prices and commodity prices are rising significantly, and that is creating a worsened tradeoff. Third, we are having a housing cycle that has a certain autonomous component to it because it’s like any other asset-price correction taking place on its own schedule, so to speak, and it is interacting with the other two forces. So given these three things occurring at the same time, the situation is obviously very complicated. Now, the ideal situation would be for us to move to a steady, sustainable pace without inflation. Right now, the biggest risk to that steady pace seems to be the pickup that we’ve seen recently in inflation. The main point I want to make about inflation—many points have already been made—is that it really is quite broad-based. I think there are good reasons to downweight, to some extent, owners’ equivalent rent. It is arguably a cost of living; however, the effects of monetary policy on this kind of cost of living are somewhat ambiguous. So we could get ourselves into a bad situation if we focus on it too much. But having said that, if you slice, say, core PCE in any other way—if you look, for example, at core PCE prices excluding OER, at core goods, at core PCE services excluding OER, at market-based core PCE less OER, at any of these ways of slicing inflation—you get a similar pattern in terms of the three-month, six-month, and twelve-month averages, which suggests a broad-based acceleration and one that I think we should be concerned about. We should also note that the three-month total PCE inflation rate is 5.2, which is significant because it influences inflation expectations overall. Now, a concern that we all have—and many people expressed—is that we don’t fully understand why this sudden acceleration is taking place. Some of the possibilities are, first, the supply-shock increases of energy prices; second, the tight product markets; and third, changes in inflation psychology, perhaps related to headline inflation. I guess I would just raise the possibility that these three things are interacting. Perhaps with tighter product markets it’s easier to pass through your energy costs or your commodity costs. That pass-through interacts with higher inflation psychology, and there’s maybe a vicious cycle there. The thing we should be concerned about is whether those higher prices then lead to higher wage pressures in an inverse kind of spiral. So I do have concerns about inflation, although I don’t want to exaggerate. I think we’re still looking at numbers that are historically not extremely high. The other big issue is the housing cycle. I’m going to give us a bit of perspective. It is a good thing that housing is cooling. If we could wave a magic wand and reinstate 2005, we wouldn’t want to do that because the market has to come back to equilibrium. The level of activity now is about a third bigger than it was in during the boom in the late 1990s. The housing construction industry is large, bigger than historically normal, and a controlled decline in housing obviously is helpful to us at this stage in bringing us to a soft landing in the economy. But as people have pointed out, the cooling is an asset-price correction. Like any other asset-price correction, it’s very hard to forecast, and consequently it is an important risk and one that should lead us to be cautious in our policy decisions, as we’ll talk about tomorrow. Another potential nonlinearity is in financial markets, as we’ve seen recently. We don’t have a good understanding of how changes in interest rates are affecting risk reduction and positions in financial markets right now. Just a bit of commentary on consumption: A lot of our uncertainty—I guess you’d call it model uncertainty—is the question about how a decline in housing prices will affect consumer spending. The range of views is wide, some arguing that, because of equity withdrawal and so on, the effect would be very large. I don’t know the answer to that question, obviously, but I think there are some positive factors that will support consumption going forward. To name a few, the job market remains good, unemployment insurance claims are low, unemployment is low, and I suspect that wages and incomes will start to rise sometime soon. Consumer confidence is not that bad. Gasoline prices are likely to come down. In part, they are reflecting high ethanol prices, which will come down over time. We’ve seen before that consumer confidence can be very sensitive to gasoline prices. Balance sheets remain reasonably healthy. Even if housing prices flatten out, people have accumulated a lot of equity, and the implication of that is that they can smooth their consumption through rough times, if necessary, by drawing on that equity. Finally, Kevin and Randy, I think, gave different sides of the surge in tax collections, but on the whole it is probably a positive sign. It probably suggests there is more economic activity than we are capturing. So let me just conclude by reiterating that we find ourselves in an extraordinarily complicated situation because we have these different themes—the cyclical turning point, the supply shock, and the housing cycle. The implication is that, whatever we do, we’re going to have to be very deliberate and careful; but I think we cannot ignore the inflation side of this equation. Any other comments? Well, thank you again for your patience in a long afternoon. I’m glad this is a two-day meeting. [Laughter] Everyone should have table 1; I don’t expect significant changes before tomorrow. I’ll see you tonight at the British Embassy, and we will reconvene tomorrow morning at 9:00. [Meeting recessed] June 29, 2006—Morning Session" CHRG-111hhrg53234--37 Mr. Adler," Thank you, Mr. Chairman. Mr. Vice Chairman, you a moment ago articulated Congress' mandate to the Federal Reserve with respect to maximum employment and to price stability. To what extent, if any, do you think additional responsibility as a systemic risk regulator would in any way distract the Federal Reserve from its 1977 congressional mission? " FOMC20080625meeting--129 127,MS. YELLEN.," Thank you, Mr. Chairman. I favor alternative B with the proposed wording. Given the forecast and the risks around it, our next move on the funds rate is likely to be up, and the question is when. Assuming that the data on growth and inflation come in roughly as I and the Greenbook expect, I would envision beginning to remove policy accommodation toward the end of this year, similar to the assumption in the Greenbook. As I mentioned, I'm not very confident that the outlook for growth and employment has improved as much as the Greenbook assumes. I'm concerned that households and firms are in a python squeeze of an intensifying credit crunch and a continuing decline in housing wealth as well as pressures from surging food and energy prices. I think the economy has shown resilience so far, and that's reassuring, but I don't think it's assured for the future. The aggressive policy actions that we have put in place since January are actually working to cushion the blow, and that's part of the reason that we haven't seen a greater unraveling so far. I mentioned yesterday that, with respect to inflation, the behavior of both core inflation and wages thus far makes me optimistic that headline inflation will come down if commodity prices finally level off. But I think there's no doubt that the risks with respect to inflation are not symmetrical at this point, and they have definitely increased. I still see inflation expectations as reasonably well anchored, but there's no doubt that a wage�price spiral could develop, and dealing with it would be a very difficult and very painful problem for the Committee. So while I feel that we are essentially credible now, I wouldn't want to take absolutely for granted that this is something that we can count on going forward. At this point, the federal funds rate remains well below the recommendations of most versions of the Taylor rule. I have viewed this as appropriate, not largely as insurance against downside risk but simply in refection of the unusually severe pressures from collapsing wealth and tight credit and financial constraints. But it does seem to me to be appropriate going forward to at least take out some insurance against the development of a wage�price spiral mentality, and that could take the form of gradually removing that discrepancy from what, for example, a Taylor rule recommends. But before we begin to do that, it does seem to me that we should wait to get a somewhat clearer picture of where the real side is going. " FOMC20070807meeting--89 87,MR. ROSENGREN.," The Boston staff forecast is broadly consistent with the Greenbook forecast, with export-led growth being significantly offset by weakness in residential investment, resulting in a gradual increase in the unemployment rate and core PCE inflation settling around 2 percent. The Boston staff forecast is somewhat more optimistic on residential investment but also has somewhat higher potential than the Greenbook forecast. My own view is that residential investment is likely to be as weak as in the Greenbook forecast but that potential may be closer to Boston’s estimate. Taken together, weak residential investment and somewhat stronger productivity, along with the possibility that construction employment will be more depressed going forward, may result in more of an upward drift in unemployment, helping to reduce some of the concerns with labor market pressures on inflation. However, given the similarities in the forecasts, well within standard errors, at this time it is probably more important to highlight the risks to the forecast. It is notable that the rather benign outlook of the forecasters is in marked contrast to the angst I hear when talking to asset and hedge fund managers in Boston. The angst is new and reflects heightened concerns with the financial ramifications stemming from subprime mortgages. Recent developments in residential markets are of potential concern. They have been raised by many around the table. Over the past several years, large homebuilders have been able to increase their market share. Given the use of subcontractors and with little obvious economies of scale, the primary advantage of large homebuilders would seem to be access to external finance, which allows them to purchase large tracts of land. When housing and land prices were rising, particularly in fast growing areas of the country, this access provided a significant advantage over the small builders that could not tie up significant resources in land. However, what provided a competitive advantage in the first half of this decade now places a significant strain on large homebuilders. A large investment in land whose price is falling is aggravating the problem these builders have with unsold inventory and depressed prices for new homes. Not surprisingly, the largest homebuilders, which account for nearly a quarter of homes sold, have equity prices trading lower than at any time in the past year, and recent earnings announcements have highlighted significant write-downs in land values. The low equity prices of homebuilders seem broadly consistent with residential investment remaining quite weak well into 2008. Financial market disruptions are likely to be a further impediment to the housing market and potentially provide a channel for problems to extend beyond residential investment. A number of financial instruments, such as the 2/28 and 3/27 mortgages that were widely used last year, are no longer readily available. Furthermore, the originate-to-distribute model has been disrupted by the heightened uncertainty surrounding CDOs and CLOs that we heard about earlier this morning. There seem to be two significant developments. First, the liquidity of these instruments has declined, making valuation assessment difficult. As lenders have made margin calls, forced liquidation of collateral in illiquid markets has further depressed the market. While of concern, I would hope that this is only a short-run effect. The second development of concern is that many investors have been relying on rating agencies to evaluate credit risk but the underlying credit risk is relatively opaque and the correlations between tranches may not have been fully appreciated. If investors have lost confidence in the rating agencies to accurately assess credit risk for structured products, the market could be impeded until confidence is restored. Since similar structures are used for financial instruments besides mortgages, getting secondary market financing for a broader range of financing needs could be difficult, and external financing for some borrowers could be affected. This has been reflected in the widening spreads for riskier corporate bonds, where the spreads have widened from unusually low levels and are still relatively narrow compared with earlier periods of significant financial disruption. While recent problems are not compelling enough for me to have a significant disagreement with the forecast presented in the Greenbook, the risks surrounding that forecast on the downside have increased. I remain concerned that higher oil prices, a falling dollar, and tight labor markets pose upward risks to the forecast of inflation, but recent events have significantly raised my estimate of the risk of a slower economy than I would have predicted a few weeks ago." FOMC20080805meeting--130 128,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Like the Greenbook, our modal forecast shows weaker real activity and slightly higher core inflation over the forecast period. Downside risks to growth remain substantial, in my view, and have probably increased relative to what we thought in June. Risks on the inflation front remain weighted to the upside, perhaps somewhat less than in June, but this is hard to know with confidence. The adverse growth risks are worse for several reasons. The labor market and labor income are weakening more quickly than expected. Although there were some tentative signs of stabilization of housing demand in the spring, demand seems to have fallen further since. Credit conditions are tighter and are expected to be tighter longer, and this seems likely to produce a further deterioration in overall demand--note, of course, the reduction in credit for autos, the rise in mortgage rates, and the more conservative lending standards for consumer and corporate credit. Growth outside the United States seems likely to slow further. Of course, fundamental to this dynamic, as has been true for 12 months, each shift in perceptions that the bottom in overall economic growth is further away produces additional stress for financial institutions and markets, adding to the intensity of prospective financial headwinds and to concerns about downside risks to growth. Now, the adverse tail on the inflation front remains significant. Many measures of underlying inflation suggest a broad-based, if limited to date, acceleration in the rate of underlying inflation. Market- and survey-based measures of long-term expectations are high. Surveys suggest that firms are able to pass on some part of the acceleration in energy and materials costs. On the more positive side, energy, commodity, and materials prices have declined significantly, principally it seems because of expectations of slower growth in global demand. Growth is moderating significantly around the world, and it's going to have to moderate further in the most populous parts of the world as central banks there get monetary policy tighter. The growth of unit labor costs has been and is expected to be very moderate here. Profit margins still show plenty of room to absorb cost increases, and as David reminded us, you can have a relatively benign outlook for the path of core inflation without margins narrowing very dramatically. Inflation expectations have not deteriorated meaningfully here, even with the flatter expected path of monetary policy in the United States. Of course, it's very important that inflation expectations and pricing power moderate from current levels. If some of the downside risks to growth materialize, this will happen, and inflation risks will moderate. If, however, the economy continues to prove to be resilient to these downside risks, then we will face higher inflation. On balance, the rate of growth in underlying inflation suggests that growth in demand in the United States will have to be below potential for a longer period of time if inflation expectations are to come down sufficiently. This means that we will have to tighten monetary policy relatively soon compared with our previous behavior in recoveries--perhaps before we see the actual bottom in house prices and the actual peak in unemployment. However, at this point, the risks to real growth remain critical. In my view, we need to have more confidence that we have substantially reduced the risks of a much sharper, more protracted decline in growth before we begin to tighten. I think it is unlikely that we will be able or will need to move before early next year. Short-term market expectations for monetary policy in the United States seem about right at present. I don't see a strong case for trying to alter those expectations in either direction at this point. To try to pull forward the expected tightening would risk adding to the downside risk to growth and magnifying the risk of a much more severe financial crisis. On the other hand, if we avoid some of these downside risks to growth, then policy will need to tighten more quickly, perhaps, than the expected path now priced in the markets. The evolution of monetary policy expectations and of inflation expectations since May illustrates how uncertain the markets are about what path of policy will be appropriate. But the pattern of changes in both of these measures of expectations suggests that the markets believe we will get this balance right--that we will do enough soon enough to keep underlying inflation expectations from eroding materially. Thank you. " FOMC20060131meeting--116 114,MR. KOHN.," Thank you, Mr. Chairman. The projections I submitted for this meeting reflected expectations of an economy that probably is operating in level terms somewhere in the neighborhood of its long-run, sustainable potential and will continue to do so over the next two years with growth broadly in line with the growth of potential and inflation basically stable. My forecasts for 2006 are very close to those I submitted last January and June. That’s partly a product of innate stubbornness. [Laughter] But it also reflects the fact that 2005 came in largely as expected—after allowance for hurricanes and an energy shock last year that elevated core inflation and damped growth somewhat compared with our forecasts last January. This is encouraging in that it suggests that we are not looking at major unexplained and unanticipated forces acting on the economy. At this point, our focus appropriately is on keeping inflation contained. I see several reasons for optimism in this regard. One is the performance of core consumer prices and price measures, which continue to suggest that the pass-through of higher energy prices will be limited. Core inflation was roughly stable last year. It picked up a bit in the fourth quarter, but that was from unusually low readings in the third quarter. Declining consumer inflation expectations in the most recent Michigan survey, along with the failure of market-based inflation compensation readings to respond significantly to the substantial run-up in oil prices and higher core readings over the intermeeting period, just reinforce my assessment that any pass-through should be small and limited in duration. As we noted at the last meeting, perhaps the greater threat to sustained good inflation performance comes from possible increases in pressures on resources. The critical question is whether growth in output close to trend is a reasonable expectation with only modest further policy firming, given the low level of long-term rates, reduced drag from energy prices, and a boost from rebuilding. I thought it was a reasonable expectation, for a number of reasons. First, after smoothing through the fluctuations caused by auto incentives and hurricanes, private domestic final demand already showed signs of moderation last year. Growth in private domestic final sales slowed from 4¼ percent in the first half of the year to 3 percent in the second half of the year, with every element—consumption, business fixed investment, residential housing investment— moderating. The staff estimates that about 0.3 of this was due to hurricane effects, but that still leaves underlying private demand slowing to an annual rate of about 3¼ or 3½ percent. This moderation did not reflect the full effects of our policy tightening, especially on the housing market. Even well-anticipated increases in the short-term rates seem to be having a significant effect on housing markets, which have become more dependent on adjustable rate mortgages to maintain affordability. We are just beginning to see the anticipated slowdown in this sector. With growth in consumption and sales constrained by a leveling-out of housing wealth, businesses are unlikely to see the need to step up the pace at which they are adding to their capital stock. As a consequence, investment growth could slow, at least slightly, over the next few years, reflecting reduced impetus from the accelerator. Finally, although foreign economies are strengthening some, foreign investment and consumption remain subdued relative to income. And given our continuing outsized appetite for imports, net exports are unlikely to be putting added impetus to demands on domestic production. I think there are several upside and downside risks around this picture of growth near potential, as a number of you pointed out. I agree that the housing market is the most likely source of a shortfall in demand. I don’t think we can have much confidence about how the dynamics of this market will play out now that it has begun to soften. My suspicion is that, as little bubbles in the froth are popped, the risks are tilted more toward quite a sharp cooling off than toward a very gradual ebbing of price increases and building activity. On the other side, it seems to me global demand would be a major upside risk to growth and to price stability. The extraordinarily rapid rise in commodity prices and upward movement in global equity prices may indicate a very fundamental turnaround in foreign demand and attitudes beyond just a stepwise strengthening of growth. For now, these remain risks that we’ll need to monitor. In making my forecast, I assumed we would tighten at this meeting, and likely at the next as well, to gain greater assurance that inflation will remain contained over time, consistent with my forecast of a 1¾ percent increase in core prices in 2007. However, I do see action in March as dependent on the readings we get in coming months. There is, as usual, considerable uncertainty about the precise nature and magnitude of the risk to the outlook, but we’re dealing with an economic picture that overall is remarkably good and expected to remain that way for the foreseeable future. Reflecting on this situation, among many, many aspects of the past, I end my remarks as I began them: Thank you, Mr. Chairman." CHRG-110hhrg46591--162 Mr. Price," Right. Thank you. I think we all are interested in appropriate regulation, not an absolute unregulated system. I want to touch, in my remaining few moments, on a concern that I have that much of the criticism of what has gone on I believe to be an attack on the capitalist system of markets and the ability to take risk and realize reward. I wonder if you might comment briefly on whether or not financial regulators should try to reduce systemic risk by setting limits on private risk-taking. Ms. Rivlin? Ms. Rivlin. I think we need limits of various kinds on leveraging. I think we were overleveraged in many respects. And in respect to the derivatives, I think--or even the credit default swaps--was the basic problem that we had credit default swaps or was it the people who were trading them were way overleveraged? And I would worry about the overleveraging. " FOMC20070509meeting--186 184,MS. DANKER.," I’ll be reading the directive and the risk assessment from page 23 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” The risk assessment: “In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”" FOMC20080625meeting--125 123,MR. HOENIG.," Thank you, Mr. Chairman. Recognizing, as I do, where we're coming from and its dangers, I think more-recent data suggest that the downside risks to growth have diminished, and in my judgment the current stance of policy is much more accommodative than necessary to address these risks. I continue to believe that the two most recent policy actions of this Committee were more than sufficient, and we really need to think about reversing them sooner rather than later. Inflation risks have risen, and we have seen erosion in longer-term inflation expectations. As I noted in my previous remarks on the outlook, if we do not begin to remove policy accommodation soon, I think we risk having to tighten policy more aggressively in the future to reestablish our credibility. A couple of things. It struck me in looking at some of the major economies besides the United States--the European Union, Japan, and China--if you look at the real interest rates, they're low. I mean, they are 1 percent or less or negative. So this is a lot of stimulus coming into the world economy. And to make my point again, I don't think you can have a sustained recovery with a sustained inflationary environment, which we're in danger of encountering if we continue on this path. Over the past several weeks, markets have significantly altered their expected funds rate path to remove policy accommodation, and therefore, I don't know that doing something today would be that big a surprise. The current funds rate path built into the market rates is closer to what I believe is desirable to maintain price stability over the long run, but I would prefer moving somewhat faster--3 percent by the end of this year and perhaps 4� percent by the end of '09. Thus, in my view, we should begin the process of removing monetary policy accommodation by increasing the fed funds rate target by 25 basis points at this meeting. I think this action would perhaps be somewhat unexpected, and I recognize that there is some risk that markets would react by moving the funds rate path up more dramatically than some might desire. However, taking this action would move us beyond merely talking about inflationary risk and would help us contain inflation expectations by reaffirming our commitment to maintaining price stability. I think it would quickly have a positive effect on the economy as these expectations begin to shift. Now, assuming that's not the majority view today, I would then encourage us to set the stage in our language for stronger actions coming in the future. That is an important issue especially, as you mentioned yesterday, in terms of remarks that we might make following this meeting, in speeches and so forth. Finally, let me just say that I think policy is currently accommodative, perhaps very accommodative. The insurance policy taken out earlier this year to guard against the tail risk of spillovers of the financial distress to activity is less necessary, perhaps far less necessary, and it is potentially even harmful to the efforts of maintaining price stability. Therefore, I encourage action sooner rather than later. Thank you. " FinancialCrisisInquiry--272 HENNESSEY: Just—just 15 seconds. There is a significant difference between an increase in the perception that your firm will fail and whether or not a put option exists. They may both be the case. It may be the case that your spreads increased significantly after Lehman failed, but there might still be— investors still might be pricing in the risk the possibility that the government would step in and rescue your firm. Thank you. FOMC20081007confcall--28 26,MR. FISHER.," Mr. Chairman, I just want to add to Nathan's discussion but join it with the credit road. I spent this afternoon with the National Retail Federation. These are CEOs of Home Depot to JCPenney's to Ann Taylor, et cetera. One thing that I've been concerned about has been Chinese pressures in terms of their selling prices. As you know, these were being elevated--for example, in women's wear, 8 percent across the board. What is interesting is that, in the past two weeks, it has completely changed. They will deal only with those they consider to be creditworthy buyers, and they've now negotiated that price all the way back to last year's levels, as long as you are creditworthy. If you're not creditworthy in their opinion, they won't sell to you, period. So these two things are beginning to join, and I think this adds to the points that Nathan made. It's not just a matter of slack. It's a matter of unwillingness to deal with certain opposite parties--a counterparty risk of its own kind, so to speak--and it at least mitigates the concern I've had about the pass-through risk that we've talked about quite a bit. Thank you, Mr. Chairman. " FOMC20050630meeting--378 376,MS. BIES.," Thank you, Mr. Chairman. I thought I’d focus my remarks today on the topic we discussed yesterday—the housing markets. And then I’d like to talk a little bit about some of the liquidity issues in housing markets and relate that to monetary policy. Let me start by saying that overall I agree that there is not a major risk of significant problems in the housing markets. But there is momentum building in the housing area that is raising some issues about which I am not as sanguine as many of the staff who gave the presentations yesterday. But I want to compliment the staff from both the Board and the Reserve Banks. I thought they did a fantastic job in pulling all of the information together While inflation overall is apparently well contained, I, too, am generally concerned about the continued ratcheting up of our expectations. The one thing that stands out is how much housing prices have jumped relative to overall price levels. We know that the average price for new homes in May was up 8 percent from a year ago. Existing home prices were up 10.2 percent, as was said yesterday. But inventories remain relatively lean, even though the supply has risen by about half a month since the beginning of the year. When I look at the jump in housing prices, I’m trying to see if consumers are saying, “We have good, strong income growth and we’re able to afford more.” Or are they seeing these price increases and trying to jump in while they still can afford a house, before home prices get totally out of their range? Are they viewing real estate as an alternative for investment purposes, after being stung in the stock market drop of a few years ago? Really, all of these factors may be at the heart of the strong demand for housing. But I also think that the financing markets are sending different signals in these areas. I know Mark is going to talk about some of the specifics but I want to discuss some of the macro June 29-30, 2005 149 of 234 customers going to banks to refinance and take advantage of low, long-term fixed interest rates. So most of the mortgage originations in the 2001-2002 period were predominantly fixed-rate loans or they were ARMs that had fairly long fixed-rate periods before becoming adjustable. What is striking is how this has been changing in the last 12 months. ARMs of all types have jumped from about 16 percent of originations in 2001 to about one-fourth in 2002 and 2003, to over half of mortgage originations last year. This is happening in a period when short rates are rising and long rates are flat to down. If bankers are really working to the benefit of their customers, why aren’t they locking in long rates in this environment? It is also the case, when we look at the mix of products, that more of the mortgages are subprime products. Subprime originations have climbed to over 18 percent of total originations. In terms of where these mortgages are being parked—whether they are on the books of banks and other financial institutions or are being securitized—about two-thirds of originations continue to be securitized. So the use of the markets is about the same. But the types of mortgages being securitized are changing. Again, these are predominantly ARMs, and more of them tend to be option ARMs—the higher-risk kinds of structures. As we saw in the information presented about the real estate mortgage pools that are being created, the risk profile in those pools is changing. Interest-only mortgages were basically nonexistent in those pools two years ago; they are now running over 3.6 percent of them. Whereas a lot of these IO mortgages had very conservative loan-to-value ratios—under 80 percent—more and more of them now have loan-to-value ratios in excess of 80 percent. And about 9 percent of the IOs in these pools are going to subprime borrowers—that is, the riskiest customers. Yet those loans require interest-only payments, no amortization. Two weeks ago S&P required additional June 29-30, 2005 150 of 234 HELOCs are being used more for purchase money down payments. People no longer have to save to make a down payment. And when we look at HELOCs in general, for the last three years they’ve grown at a compound rate of over 30 percent a year. As would any supervisor, when I see a product growing 30 percent a year for three years, I tend to get a little nervous about the concentration risk. Where is the liquidity coming from for these? Again, a big chunk of it is going to the securitization markets. I think one of the challenges we have as bank supervisors is that, to the extent the banks are originating these loans with the intent to sell them to the market, they’re looking to the market for the credit definitions. We know from our QIS-4 [Quantitative Impact Study 4] results, looking at the Basel II exercise, that we had a huge disparity in the results on loss expectations on home equity loans and other mortgage products. A lot of these are new types of products. The confidence intervals around the expected defaults, I think, are a lot wider for them than for those that have traditional structures. We also know that there’s a lot of correlation risk that could happen here. If the housing price bubble does break in a market where employment is dropping, people could be leaving an area and we could have more defaults. In addition, we know that the dropping of home prices, in and of itself, tends to create more defaults, especially with negligible equity in these properties. Also, to the extent that people default and the banks have more properties to foreclose, there are neighborhood effects, with losses getting bigger when the defaults do occur. So, what I am concerned about from a liquidity perspective, since these are being securitized and moving into the markets—and there is plenty of appetite in the market to take these products— is the lack of discipline relative to previous periods. In the ancient days, when mortgage loans stayed on the books of financial institutions, liquidity limitations forced them to choose the higher June 29-30, 2005 151 of 234 understands the structure of these loans any better than some of us do in terms of pricing the risk, as evidenced by the S&P move two weeks ago. So, again, I’m not overly concerned. Especially with the record profits and capital in banks, I think there’s a huge cushion. But the implications of this for housing wealth and for investors who take the ultimate risk in these securities could create some problems in terms of the way economic growth proceeds going forward. And it’s something that I think was appropriate to spend the time talking about today." CHRG-110shrg50409--24 Mr. Bernanke," Well, first, of course, I would like to revise and extend my remarks from March of 2007. The issue was that the subprime crisis triggered a much broader retreat from credit and risk taking, which has affected not just subprime lending but a wide variety of credit instruments. And that is why it has become a much bigger element in the situation than, frankly, I anticipated at that time. The housing market is still under considerable stress and construction is still declining. I do believe that we will start to see stabilization in the construction of new homes sometime later this year or the beginning of next year, and that will be a benefit because the slowing construction pattern has been subtracting about 1 percentage point from the growth of the GDP going back now for some time. So that will be a benefit. House prices may continue to fall longer than that because of the large inventories of unsold homes that we still face. And then I would have to say that there is uncertainty about exactly what the equilibrium level that house prices will reach is. Unfortunately, it is that uncertainty, which is generating a lot of the stress and risk aversion we are seeing in financial markets. It is for that reason--the need to find a footing, to find stability in the housing market--that I do think that action by this Congress to support the housing market through strengthening the GSEs and FHA and so on is of vital importance. Senator Menendez. Let me talk about the other major driver, then, of what is happening to our economy, and that is the whole question of energy prices and oil. You know, I appreciate in your answer to the Chairman and in your testimony, because we have had testimony before the Congress by all executives who say that the difference between supply and demand over the last 2 years would largely lead us to a concern that, in fact, speculation may have driven the price of oil up an additional $50 a barrel. You have the view that that may not be the most significant thing in prices, but you do take the view that useful steps can be taken to improve the transparency and functioning of future markets. Are you ready to say to the Committee today what some of those useful steps are? Or are you still depending upon that Committee that you are meeting with to look at that? Because we do not have a lot of time here. " FOMC20080805meeting--79 77,MR. WILCOX.," I would just augment Bill's comment with two other observations. There's plenty of probability mass out in the tail. I think it actually is two-sided risk. We illustrated one side of that risk in our ""severe financial stress"" scenario. The other point I would make is that our projection for national house-price declines of 12 percent cumulative in 2008 and 2009 makes plenty of room for a very much more severe decline in Florida, California, and other highly stressed areas, and we have attempted to take that regional diversity into account. It's a rough exercise, to be sure, but we're not oblivious to the fact that some areas are doing much worse than the average. That is the nature of averages. " fcic_final_report_full--428 II. Housing bubble. Beginning in the late s and accelerating in the s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for home- owners and investors. III. Nontraditional mortgages. Tightening credit spreads, overly optimistic as- sumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to in- crease the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mort- gages and to make prudent financial decisions. These factors further ampli- fied the housing bubble. IV. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies er- roneously rated mortgage-backed securities and their derivatives as safe in- vestments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages. V. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enor- mous concentrations of highly correlated housing risk. Some did this know- ingly by betting on rising housing prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions. VI. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liq- uidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were in- sufficiently transparent about their housing risk, creating uncertainty in mar- kets that made it difficult for some to access additional capital and liquidity when needed. FOMC20060131meeting--99 97,MR. HOENIG.," Mr. Chairman, in thinking about the status of the U.S. economy and the appropriate funds rate target at this meeting, I would start by suggesting that, in my judgment at least, the current funds rate is probably within the neutral range. Therefore, we should be mindful of not going too far, especially when it would appear that growth is slowing to trend. The most compelling reason for considering the move now is the continued drift upward in core inflation, but even in this case, I think we need to be especially aware of the past increases in the funds rate. We have yet to see their full effects on inflation. The fourth-quarter growth was surprising; but at this point, as others have said, it does not yet alter our long-term outlook. Like the staff, however, I revised upward my 2006 forecast ¼ percentage point and now expect that growth will be about 3¾ percent in 2006, about ½ percentage point above trend, and will return to trend in 2007. Turning to the inflation outlook, I expect core CPI inflation to be about 2½ percent this year, as higher energy prices are passed through to higher overall and core inflation. However, it is reasonable to expect that the increase will be temporary, as others have said, with core inflation likely to fall back to 2¼ percent in 2007. The reasons for this pattern have a familiar ring. Greater-than-trend growth reflects the lagged effects of past monetary accommodation and generally supportive financial conditions, whereas the prospective slowing growth reflects the removal of monetary accommodation and, in this instance, higher energy prices. Evidence from our District is consistent with an outlook of strong but slowing growth as well. Manufacturing production and new orders rose solidly. Expectations for future production remained high, and expectations for future orders actually surged. Hiring plans also rose strongly in December and January. However, for the District as a whole, hiring announcements were only slightly greater than layoff announcements. Finally, housing showed signs of leveling off, and consumer spending was solid, though not spectacular, during the holiday season. In fact, a number of our contacts said their holiday sales were below plan. Just quickly in the farm sector, there are concerns being voiced for 2006 following a generally good year in 2005, and they were mostly that drought may be reemerging in the District. Wage pressures in the District remain mostly subdued, and increases in raw material costs actually slowed somewhat. However, manufacturers continued to raise output prices in response to past increases in input costs, and a substantial number said they were raising wages more than normal for certain types of workers in short supply. Reports of retail prices said that increases were down somewhat from the last meeting but still higher than they were just last summer. Let me turn just briefly to the risks. I would submit that inflation risks are on the upside and output risks have become more on the downside recently, not exactly the kinds of risk that are friendly from a policy perspective. The outlook for core inflation is 2¼ to 2½ percent. This is higher than I would prefer. Moreover, the potential for even higher energy prices makes core inflation more likely to be higher rather than lower over the next several months. But at the same time, the risks to output are on the downside. First, forward momentum has certainly diminished. For example, real GDP grew about 2.6 percent during the last half of 2005, decidedly below trend. In addition, while the fourth-quarter slowdown was probably temporary, it could also be signaling a more fundamental slowdown. Finally, a possible increase in the term premium poses downside risks to growth. You know the term premium is far below the historical average. If the decline reverses faster than expected, both would be significantly weaker as shown by the Greenbook alternative scenario. As I see things then falling out, the choices are obviously difficult, but I think that the inflation risk for the time-being is the greater risk, and therefore I would be inclined to move at this meeting. But we should have the odds no greater than 50-50 that more upward changes are likely in the fed funds rate at the next meeting. And finally, Mr. Chairman, although I have not served as long with you as some others around this table, I have served among the longest with you, and I would like you to know it has been a real privilege." FinancialCrisisReport--523 By using the phrase, “sourced from the Street,” Goldman may have misled investors into thinking that the referenced assets had been purchased from several broker-dealers and obtained at arms-length prices, rather than simply taken directly from Goldman’s inventory and priced by its own personnel. Moreover, this phrase also appears to hide the fact that Goldman had an adverse interest to investors and was seeking to transfer unwanted risk from its own inventory to the clients it was soliciting. By claiming it was “not a Balance Sheet CDO,” Goldman may have misled investors into believing that Goldman had little interest in the performance of the referenced assets in Hudson, rather than having selected the assets to offset risks on its own books. In addition to the Hudson marketing booklet, in December 2006, Goldman issued an Offering Circular which it distributed to potential investors. 2263 The Offering Circular contained the statement that no independent third party had reviewed the prices at which the CDS contracts were sold to Hudson 1. 2264 In addition to lacking third party verification, no external counterparty had participated in any aspect of the CDS contracts – all of the CDS contracts had been produced, signed, and priced internally by two Goldman trading desks which exercised complete control over the Hudson CDO. Internally, while Hudson 1 was being constructed, Goldman personnel acknowledged that they were using a novel pricing approach. 2265 At one point, Mr. Swenson sent an email to Mr. Birnbaum, raising questions about how they could explain some of the pricing decisions. Mr. Swenson wrote that he was: “concerned that the levels we put on the abx cdo for single-a and triple-bs do not compare favorably with the single-a off of a abx 1 + abx 2 trade,” telling Mr. Birnbaum “[w]e need a goo[d] story as to why we think the risk is different.” 2266 The prices that Goldman established for the CDS contracts that Hudson “bought” affected the value of the CDO and the Hudson 1 securities Goldman sold to investors, but the Offering Circular failed to disclose the extent to which Goldman had single-handedly controlled the pricing of 100% of the CDO’s assets. Perhaps the most serious omission from the marketing booklet and other offering materials was Goldman’s failure to disclose the fact that it would be the sole short party in the entire $2 billion CDO. The Goldman materials told investors that an affiliate, Goldman Sachs International (GSI), would be the “credit protection buyer” or initial short party for the Hudson 1 CDO. 2267 It was 2263 2264 2265 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196. Id. at 021821241. See, e.g., 9/19/2006 email from Michael Swenson to Thomas Cornacchia and Joshua Birnbaum, GS MBS-E- 012684557 ( “we are going to price an innovative full capital structure $1+bb CDO deal with 60% of the risk in ABX (no one has done this before).”); 9/21/2006 email from Darryl Herrick to Deeb Salem, Michael Swenson, Joshua Birnbaum, Peter Ostrem, and Edwin Chin, GS MBS-E-012685645. 2266 2267 9/27/2006 email from Michael Swenson to Joshua Birnbaum, GS MBS-E-012689798. 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196, at 021821229. This disclosure related to the master credit default swap, where Goldman Sachs International served as the credit protection buyer facing the Hudson Mezzanine 2006-1, Ltd., the legal entity that issued the Hudson 1 securities. See 12/1/2006 ISDA Master Agreement, GS MBS-E-021822056. In this role, Goldman was serving as an intermediary, and was protecting the CDO from credit risk by placing the Goldman Sachs name on the transaction and assuring investors that a single credit-worthy entity would be making all required payments to the Hudson 1 trust. Having one common practice for underwriters to act as the initial short party in a CDO, acting as an intermediary between the CDO vehicle and broker-dealers offering competitive bids in order to short the assets referenced in the CDO. 2268 The disclosure provided by Goldman contained boiler plate language suggesting that would be the role played by GSI in the Hudson transaction. Goldman never disclosed that it had provided all of Hudson’s assets internally, GSI was not acting as an intermediary, and GSI would not be passing on any portion of the short interest in Hudson to any other party, but would be keeping 100% of the short position. The Hudson disclosures failed to state that, rather than serving as an intermediary, Goldman was making a proprietary investment in the CDO which placed it in a direct, adverse position to the investors to whom it was selling the Hudson securities. CHRG-111shrg54589--87 Mr. Whalen," I think it is an effective practical question. The chief purpose of regulation should be to focus on things like suitability and the customer-focused issues. Obviously, systems and controls, risk management, all that are very important within a dealer, there is no question. But as I was saying before, there are certain classes of instruments that you really cannot risk manage. You were talking before about an airline that wants to put together a complex, customized swap for fuel. There is no problem with that. Everybody knows what the price of fuel is today. And you do the work, you calculate the optionality in the complex structure, and you can figure out what it is worth. The trouble comes if you look at the subprime complex structured asset market of a couple years ago, that we had everybody in agreement, much like playing Liar's Poker. The model became the definition of value for this class of instruments. But one day a number of people on the buy side started to question that assumption of ``mark-to-model.'' They started backing away from these securities. So did the dealers. So at some point--it is hard to say when--the consensus about value for that class of asset broke down. And that is where we are today. The buy-side customer still does not want to know about securities that have no visible cash market basis and effectively rely upon ``mark-to-model'' for price discovery. So I question really how effective risk management can be in those cases where we do not have a completely separate, independent reference point for value such as a liquid, cash market. " CHRG-111hhrg51698--108 Mr. Damgard," Well, I would say speculation has been demonized to the point where people think speculation is the same thing as manipulation. We speculate all the time by buying stocks, selling stocks. The people that are using futures markets historically, Mr. Congressman, have been institutional users that know precisely what the risks are, and they use those markets for price protection. We have seen those markets expand every year for the last 20 years with one exception, and it is really a credit to this Committee and the education that has gone on that has gotten more and more people involved in these markets that are used primarily by people that are managing risk. Now, without speculators, they wouldn't be able to do that, and the spreads would widen. So speculation is---- " FOMC20070321meeting--59 57,MR. STOCKTON.," That’s possible. We have not taken that view. Overall housing construction had some unexplained strength over the past year, not from a bottom-up demographic addition but just in terms of what we would have expected given the growth in employment, income, and wealth. Admittedly, the evidence is still very tentative, but we think we see some signs of demand stabilizing around current levels so that, in our starts forecast, we’ll be able to drive the months’ supply of homes back down relative to the low level that it had actually been running from the mid-1990s to the middle of the housing boom. So I don’t think we’re seeing an excess supply of homes that people just won’t want at current prices, or roughly current prices, but that is a considerable risk. Adding up household formations and demolitions—there’s a lot of uncertainty about that, and there’s a lot of cyclical sensitivity as well to the overall household formation rates. So whether the housing stock outran the long-run determinants is kind of hard to nail down. We see that as a risk, but it’s not incorporated in this forecast. If that were the case, there could be a bigger drag on housing activity than we’re anticipating." FOMC20070509meeting--82 80,MR. KOHN.," So here is my reasoning. I thought that the average includes lots of episodes of more or less steady growth in steady state and then other episodes of cyclical adjustments. In my mind, we were in the middle of a kind of mini-cycle, which was an adjustment from greater-than-sustainable growth to growth that we hope is sustainable. We’ve seen that the adjustment had already created some inventory overhangs and some changes in capital spending plans. So I thought that, because we’re not at a steady state, things might be a little more uncertain than usual. But I compensated for that by narrowing my confidence bands in ’08 and ’09 [laughter] when I think we’ll be close to a kind of a steady state. On the skews part, like President Geithner, I had downside skews on output. It wasn’t so much housing because I think that, with the adjustment to demand or activity that’s in the staff forecast and my own adjustment to prices, the risks around that are approximately balanced. Nor was it a spreading of problems in the subprime market to other credit markets; I think we’ve seen enough since the subprime problems started to be pretty sure that the risk is no more than the normal kind. Rather, the risk I saw was from concerns about the financial position and the psychology of the household sector and the interaction of those with housing. So it was a spillover in some sense from housing to consumption. The financial obligations ratio is very high. Households, as President Geithner noted, are highly leveraged. One of the surprises to me in the development of subprime markets was apparently how many borrowers and lenders were counting on the future appreciation in houses just to support the debt service, to say nothing of the consumption that must be going on at the same time. I suspect that this is more widespread than just the subprime market. How many households were expecting price appreciation to continue more as it did before rather than to slow down or even for prices to decline (as I think they will), it’s hard to say. But I suspect there are a lot of these households, and I think we could get some feedback there. The staff has the saving rate actually declining in the second and third quarters, and there might be some technical reasons for that. Even to get modest consumption growth, we see a very gradual uptrend in the saving rate over time. That might be the most likely outcome, but it did suggest to me that there is at least some fatter tail on the possibility that households, seeing what’s happening in the housing market and to their financial obligations, will draw back more quickly from spending. When President Geithner and I were in Basel, the most popular question to us was whether capital spending would really pick up again. A number of central bankers doubted that that could happen as long as consumption wasn’t growing more rapidly. But I’m comfortable with the capital spending pattern so long as the consumption pattern looks something like the pattern in the Greenbook and like the one that I have as my most likely outcome. More generally, as you pointed out at one point last fall, Mr. Chairman, I think we’re in a very unusual situation of below-potential growth for an extended period—a situation that is pretty much unprecedented without breaking out one way or another. Some nonlinearity is going to come up and bite us here, and, as I see it, the nonlinearity is most likely in the household sector. Now, if income proceeds along the expected path, it seems to me that there are upside risks to inflation moving down to 2 percent and staying there in our forecast. I think that overall we’re facing a more difficult inflation environment than we have for the past ten years or so: the high level of resource utilization; rising import prices from the decline in the dollar and the high level of demand relative to potential supply globally, including in the emerging-market economies—one thing we heard in Basel was that increasing numbers of these economies are having trouble sterilizing their reserve accumulation and are running into inflation pressures from that happening—higher prices for energy, food, and other commodities; higher headline inflation; and possibly even slower trend productivity growth. I didn’t see a downside skew to any of these things. But, as I thought about the whole picture with all these things seeming to tilt a bit on one side and their interaction, it seemed to me that there was some upside risk to the possibility that inflation expectations would rise rather than stay where they are as assumed in my most likely outcome. Now, for policy purposes, I would weight the upside risk to inflation more than the downside risk to growth, but we’ll get to that later in the day. Thank you, Mr. Chairman." CHRG-110shrg50417--28 PENNSYLVANIA Ms. Wachter. Thank you. Chairman Dodd and other distinguished Members of the Committee, it is my honor to be here today to provide my perspective on the ongoing mortgage crisis and how and why stabilizing the housing market is essential to stabilizing the broader U.S. economy. The ongoing crisis in our housing and financial markets derives from an expansion of credit through poorly underwritten and risky mortgage lending. Until the 1990s, such lending was insignificant. By 2006, almost half of mortgage originations took the form of risky lending. The unprecedented expansion of poorly underwritten credit induced a U.S. housing asset bubble of similarly unprecedented dimensions and a massive failure of these loans and to today's system breakdown. Today's economic downturn could become ever more severe due to the interaction of financial market stress with declines in housing prices and a worsening economy feeding back in an adverse loop. We have the potential for a true economic disaster. I do not believe we will solve our banking liquidity problems if the housing downturn continues, and the housing market decline shows no signs of abating. Moreover, despite bank recapitalization and rescue efforts, economically rational loan modifications that would help stabilize the market are not occurring. We must directly address the need for these loan modifications in order to halt the downward spiral in mortgage markets and the overall economy. It is critical to bring stability to the housing market. While today prices may not be far from fundamental levels, just as they overinflated going up, there is great danger for overcorrection on the downside. In our current situation, as prices fall, market dynamics give rise to further expectations of price decline, limiting demand, and supply actually increases due to increased foreclosures, causing prices to decline further. A deflationary environment with demand decreases due to expectations of further price decline was in part responsible for Japan's ``lost decade'' of the 1990s. We cannot rely on a price decrease floor at currently market-justified fundamental levels if we rely on market forces alone, even, it appears, if augmented by the interventions so far of the Federal Reserve and Treasury. In fact, home inventories are not declining, and up to half of the inventory of homes are being sold through foreclosures at fire-sale prices in many markets. The Case-Shiller Price Index reflects the massive deterioration of housing wealth so far. Since the peak in 2006, housing values have fallen over 20 percent. While another 5- to 10-percent fall could bring us to market-clearing levels, actual price declines may far exceed this. And as house prices decline, these declines undermine consumer confidence, decrease household wealth, and worsen the system-wide financial stress. While banks have been recapitalized through the Capital Purchase Program--and there is discussion of the use of this funding for acquisitions--as yet, there is little evidence that bank lending has expanded. In order for the overall economy to recover and for conditions not to worsen, prudent lending to creditworthy borrowers needs to occur. Without financing for everyday needs, for education, small business investment and health, American families are at risk. And today the U.S. economy and the global economy are depending on the stabilization of their financial well-being. Moreover, the plans that are already in place do not appear to be leading to the modification of loans at the scale necessary in order to assure a market turnaround at fundamental levels instead of a severe and ongoing overcorrection. Barriers to economically rational loan modifications include conflicting interests, poor incentives, and risks of litigation to modify loans, particularly to modify loans deriving from mortgage-servicing agreements. Given the freefall in housing markets and its implications for credit conditions and the overall economy, there is a need for policies to address these barriers today. It is both necessary and possible to take effective action now. While housing values may not be far from fundamental levels, as housing values continue to fall, resolving the problem will become increasingly difficult and costly. Thus, solutions that are now possible may not be available going forward. Without expeditiously and directly addressing the housing market mortgage crisis, the Nation is at risk. Thank you. " CHRG-110shrg50369--89 Mr. Bernanke," Senator, we have to keep balancing those things. As I said, our current view is that inflation will moderate this year as oil and food prices do not rise as much this year as they did last year. We are also watching very carefully to make sure that higher oil and food prices do not feed into other costs and into other prices or that inflation expectations do not become unanchored. If those developments began to happen, that would certainly force us to pay very serious attention. At the moment, I think the greater risks are to the downside--that is, to growth and to the financial markets; but, again, we are always vigilant on all of our objectives and are always trying to balance those risks against each other. Senator Bunning. You read the Wall Street Journal. I am very sure of that. Today, in the Wall Street Journal, ``Report on profits a bright spot in the gloom. The Dow Jones Industrial Average has gained 6 percentage points since the first day of the year.'' In the Standard & Poor's index, 462 corporations have reported their earnings for the fourth quarter; 62 percent of those that have reported topped their earnings estimates--62 percent. If you drop out financials, carve out financials, which were 12 percent lower, the gloom and doom that I have heard here today is not gloom and doom. Are you going to tell me that these same corporations that reported--and we had a really low growth rate in the fourth quarter--are going to be worse in the first quarter? Or are we also going to have the same kind of reporting in the first quarter of 2008 that this profit report on the Standard & Poor's and the Dow is not as accurate in the first quarter as it was in the fourth? " CHRG-111shrg61651--73 Chairman Dodd," Thank you, Jack. Senator Merkley. Senator Merkley. Thank you very much, Mr. Chair, and thank you all for testifying today on these issues that are so important to our future economic health. Mr. Reed, you noted the question as to why do we rescue Long-Term Capital Management, and you noted that it stood alone, and I think you said, but there is an instinct in the system to save a major player. I want to turn back to that example to pursue that a little bit further. This was at the end of the 1990s and there were a lot of investments by major financial houses in Russian derivatives. If I recall right, Long-Term Capital Management, had it gone under, it would have been selling at fire sale prices. Many of these investments, which I believe we also had a number of large financial houses deeply invested in, including, I believe, Goldman and JPMorgan both had positions that were at risk, and so these other entities came together to help bail out Long-Term Capital Management to avoid at that point interconnections that were driven by market considerations. That is, one piece of the interconnectedness, if one firm fails and has to sell at fire sale prices, it drives down everybody else's asset portfolios. That is another form of interconnectedness or risk in the system. So could those of you who were involved in this or who have studied it share just a little bit more about the lessons to be learned from that setting, that form of risk, how that can be addressed? And it also certainly came up in mortgage-backed securities, the potential for them to be sold, and so forth. " fcic_final_report_full--226 THE BUST CONTENTS Delinquencies: “The turn of the housing market” .............................................  Rating downgrades: “Never before” ...................................................................  CDOs: “Climbing the wall of subprime worry” .................................................  Legal remedies: “On the basis of the information” .............................................  Losses: “Who owns residential credit risk?” ......................................................  What happens when a bubble bursts? In early , it became obvious that home prices were falling in regions that had once boomed, that mortgage originators were floundering, and that more and more families, especially those with subprime and Alt-A loans, would be unable to make their mortgage payments. What was not immediately clear was how the housing crisis would affect the fi- nancial system that had helped inflate the bubble. Were all those mortgage-backed securities and collateralized debt obligations ticking time bombs on the balance sheets of the world’s largest financial institutions? “The concerns were just that if people . . . couldn’t value the assets, then that created . . . questions about the solvency of the firms,” William C. Dudley, now president of the Federal Reserve Bank of New York, told the FCIC.  In theory, securitization, over-the-counter derivatives and the many byways of the shadow banking system were supposed to distribute risk efficiently among investors. The theory would prove to be wrong. Much of the risk from mortgage-backed securi- ties had actually been taken by a small group of systemically important companies with outsized holdings of, or exposure to, the super-senior and triple-A tranches of CDOs. These companies would ultimately bear great losses, even though those in- vestments were supposed to be super-safe. As  went on, increasing mortgage delinquencies and defaults compelled the ratings agencies to downgrade first mortgage-backed securities, then CDOs. Alarmed investors sent prices plummeting. Hedge funds faced with margin calls from their repo lenders were forced to sell at distressed prices; many would shut down. Banks wrote down the value of their holdings by tens of billions of dollars.  CHRG-111hhrg52397--292 Mr. Duffy," Well, I think Mr. Sprecher said it correctly, you have to look at a lot of these dealers, there are 12 large ones in the United States, of which they have operations throughout the world, and they can pass their book from one place to another so the book truly just travels along through the time zones. And that is a concern because they cannot operate outside the United States. Our concern with that aspect is if you take that market off of the United States, that hurts the regulated U.S. futures exchanges because we are really the price discovery mechanism for a lot of the look-alike's that trade over-the-counter, so that is the price that they are looking to use for their risk management needs. So if we have less liquidity in the over-the-counter trading on our exchange, it is going to hurt the whole food chain. So it is a concern. So when we look at--I will go back to maybe your other question about why we cannot take some of these trades in our clearinghouse, they are so customized in nature where a dealer may be out looking for the other side of a trade for not 6 milliseconds, like we trade at the CME Group, he may be out and be looking for 6 hours for the other side of his one particular trade for his one particular client. That is why it is very difficult. So we cannot bring those into our clearinghouse and assume the risk associated with those transactions at CME Group because we just do not have all the information we have on a standardized futures contract. But I guess that is a long way of saying is we are concerned about the liquidity, which is the direct result that the futures exchanges get from the over-the-counter market. The last panel made a statement, they said that the OTC market is roughly several times larger than a regulated exchange model. It is 5 times larger. It is much larger than a regulated exchange model, so they work together. And the pricing comes from the exchange model. " FinancialCrisisInquiry--142 CHAIRMAN ANGELIDES: Yield a couple of minutes more? BASS: Sure. First of all, I’ll—in the interest of full disclosure, I was a senior managing director at Bear Stearns for five and-a-half years from 1996 to 2001. So a lot of the people at that firm are very good friends of mine. And a lot of the people that ran the firm are very good friends of mine. In—in September of 2006, I went to Bear Stearns to meet with a guy named Bobby Steinberg, who at the time was their chief risk manager at the firm. He congregated a meeting in a conference room at their headquarters for me with the head of mortgage trading, the head of fixed income trading, the head of mortgage risk, fixed income risk and himself. And I went through my entire presentation as to what I saw building in the housing market where I— where I thought mortgage credit was going to go. And—and—and, you know, a couple points that I’ll make. Someone—someone in this morning’s hearing said did you ever contemplate housing prices ever dropping. They didn’t even have to drop for losses to show up. OK? If housing prices just went flat, they would have lost 9 or 10 percent on these securitizations, which would have wiped out everything up to close to the AAs. So to put it into perspective, I—I went through my presentation with their risk committee and said do you realize that if I’m right—and— and by the way, I’m one data point from Dallas, so I realize that they can discount what I had to say. But the presentation’s fairly compelling. If I’m right, do you realize what’s going to happen to this firm, knowing how—the firm’s position? And he said-- he said, Kyle, you worry about your risk management, and we’ll worry about ours. And that was the last time I spoke with them. Again, it’s—it’s one data point. And with regard to the Federal Reserve, I met one of President Bush’s staffers and—and went through it with him. And he suggested I go talk with the Federal Reserve here in D.C. And I met with one of the Federal Reserve board members and went through my— my presentation again, just a data point from Dallas—meeting at the Federal FOMC20080625meeting--47 45,MR. WASCHER.," No, I agree with you. I think our models have been surprised by the low rates of compensation growth. One way to think about it is that in the past we might have seen higher headline inflation passed through more quickly to compensation growth--as in the '70s, when those wage�price spirals were really led by prices, but then wages contributed by following. So far we haven't seen any sign that higher headline inflation has been putting upward pressure on compensation costs. I think there's a risk. We obviously included the simulation because we think there's a risk that could happen in the future, but to date we have not seen evidence that that's been the case. There are a number of reasons to think that things now might be different than they used to be. For example, just a structural reason, unions are less powerful than they used to be; a much smaller share of the work force is unionized. In the 1970s there were all sorts of automatic cost-ofliving adjustment clauses. Even when there weren't, there were big catch-ups for past inflation. Another structural reason might be that the minimum wage was higher in the 1970s, and it is lower in real terms now. I think more generally this fits in with the general notion that inflation expectations are less responsive to immediate shocks in headline inflation than perhaps they used to be. " CHRG-111shrg51303--99 Mr. Kohn," Well, I think we have done some of that, Senator, not to the same---- Senator Menendez. Some of it? I mean, how can you keep coming back and asking for monies in which you cannot quantify for us the systemic risk and the assets here? You are asking for an open-ended check, and gentlemen, you are not going to get that, even from those of us who have supported this overall effort, forgetting about AIG for the moment. You are not going to get that. You have got to quantify this risk. You have to tell us what is the level of the systemic risk. You have to give us a stress test analysis, as best as can be created, for us to quantify and figure out where we are going from here. But that doesn't seem to be the case right now. I am also concerned--you can't give me what they are asking for. I am also concerned of what is happening in the property casualty insurance market here as a result of the government actions that we are taking with AIG. What steps--and I know that there is a GAO report underway, an inquiry underway to assess the impact of all of the aspects of the financial rescue package for AIG and the United States insurance marketplace, and it seems to me that because we are giving them all this money, they keep pricing their products in ways that would not be sustainable for any other insurance company in the marketplace and therefore becomes anti-competitive with the rest of the industry. What steps are being taken to ensure that AIG's property casualty business is not being weakened, because at the end of the day, we may be the owners of it, and shouldn't there be an independent actuarial evaluation of their reserving and pricing practices here? Does anybody want to step up to the plate and answer that question? " CHRG-110shrg50369--30 Mr. Bernanke," Senator, we are facing a situation where we have simultaneously a slowdown in the economy, stress in the financial markets, and inflation pressure coming from these commodity prices abroad. And each of those things represents a challenge. We have to make our policy in trying to balance those different risks in a way that will get the best possible outcome for the American economy. Senator Shelby. Would you be trying to avoid stagflation, as some people call it? " CHRG-111hhrg51698--543 The Chairman," Could you pull the microphone a little closer? " Mr. Rosen,"--including reform that will relate to OTC derivatives. Measures are needed to improve regulatory transparency particularly to ensure appropriate capital oversight of professional intermediaries and OTC derivatives whose activities, as we have seen, can have systemic consequences. We look forward to working with this Committee and Congress on broad regulatory reform to address these issues. However, we are deeply concerned that the draft bill could have profound, albeit unintended, adverse consequences not merely for American markets, but for many mainstream American companies. This would contribute to the forces that are driving the current credit crisis. SIFMA's testimony describes the extraordinary extent to which mainstream American companies depend on CDS and other OTC derivatives to manage their risks and obtain access to financing. Direct and indirect limitations on access to these products will increase the risks to which these companies are subject, and in turn increase the risks of loss to which they are subject, the volatility of their earnings, their cost of funds, and thereby reduce their share prices and impair their competitiveness. A number of provisions in the draft bill raise these concerns. The proposed prohibition on purchasing so-called naked CDS protection would essentially eliminate the corporate CDS market. We can think of no traded product that is subject to a restriction of this kind, yet every financial product can be equally used for hedging or to express a positive or negative market view. It is precisely the interaction of these market views that is the essence of price discovery and efficient markets. As a result of this, CDS would become extremely expensive and illiquid in the sense of financial guarantee insurance or a product whose limitations the credit default swap market was specifically developed to address. American companies, including companies in the agricultural sector, would have reduced access to financing, and available financing costs would increase. Bank revenues from lending activity would also be reduced, placing further pressure on the financial strength of the banking sector, which currently depends heavily on public funds. Mandating the clearing of all OTC derivatives with a narrow exception for contracts that are both highly illiquid and highly customized is understandable but impractical, and we think unnecessary. Not all OTC derivatives can be cleared. As this Committee has heard, clearinghouses must be able to obtain reliable current pricing and historical data in order to calculate the appropriate collateral requirements and to model the clearinghouse risk. Also, not all companies have the operational infrastructure to participate. But rather than mandating clearing, we believe it would be far more effective for a prudential supervisor to have authority over all systemically significant market participants, including the authority to require clearing where it is appropriate and/or impose capital charges for the incremental risks represented by uncleared positions. We think this would be an important element in any comprehensive regulatory reform. With regard to carbon offsets, we believe it is clear that off-exchange markets compliment exchange markets. They serve as incubators for developing products, and they enable derivatives to be tailored to companies' risk management needs. Prohibiting them in the case of environmental derivatives will, in our view, only impede the development of a market that is a national priority. Provisions of the bill would impose indirect and potentially direct position limits on OTC derivatives. In our view, off-exchange physical positions have a far greater ability to influence commodity pricing and disrupt markets than purely notional financially settled contracts. In the absence of a perceived need to impose limits on the size of OTC physical positions, we don't see the justification for limits on notional exposures. The restrictive definition of bona fide hedging in the proposed bill would effectively impose a de facto position limit on OTC derivatives that are hedged on futures exchanges. However, the proposed position limit exception for swap dealers does not reflect the way in which companies manage their risk, or the manner in which swap dealers intermediate client risk. The result could be to curtail corporate access to OTC derivatives even for highly desirable risk management purposes. The draft bill also does not recognize that many index and other strategies are not speculative in nature, and would curtail the use of important strategies that are effectively market-neutral and stabilizing, and preclude fiduciaries from protecting retirees and others investing for retirement from protecting their retirement income from erosion due to high rates of inflation. Commercial interests are inherently directionally biased market participants and have the greatest capacity to influence prices and markets. All or virtually all the CFTC energy manipulation cases brought over the last 5 years have involved commercial energy traders. By decreasing the prevalence of directionally neutral participants and increasing the relative dominance of commercial interests, SIFMA is concerned that the draft bill would make the U.S. futures markets far more susceptible than they are today to manipulation. At a minimum, it will increase spreads and the cost of hedging for commercial interests. [The prepared statement of Mr. Rosen follows:] Prepared Statement of Edward J. Rosen, J.D., Partner, Cleary Gottlieb Steen & Hamilton LLP, New York, NY; on Behalf of Securities Industry and Financial Markets AssociationIntroduction Chairman Peterson, Ranking Member Lucas, and Members of the Committee: My name is Edward Rosen \1\ and I am appearing today on behalf of the Securities Industry and Financial Markets Association (SIFMA).\2\ We thank you for the invitation to testify today on the Committee's draft legislation, entitled ``Derivatives Markets Transparency and Accountability Act of 2009''.\3\ My testimony today reflects the views of SIFMA member firms active in both the listed and over-the-counter (OTC) derivatives markets in the United States and abroad.--------------------------------------------------------------------------- \1\ Mr. Rosen is a partner in the law firm Cleary Gottlieb Steen & Hamilton LLP, testifying on behalf of and representing the views of SIFMA and not those of Cleary Gottlieb Steen & Hamilton LLP. \2\ SIFMA brings together the shared interests of more than 650 securities firms, banks and asset managers locally and globally through offices in New York, Washington, D.C. and London. Its associated firm, the Asia Securities Industry and Financial Markets Association, is based in Hong Kong. SIFMA's mission is to champion policies and practices that benefit investors and issuers, expand and perfect global capital markets and foster the development of new products and services. Fundamental to achieving this mission is earning, inspiring and upholding the public's trust in the industry and the markets. (More information about SIFMA is available at http://www.sifma.org). \3\ Draft dated January 28, 2009 (1:08 p.m.).---------------------------------------------------------------------------Overview Preservation of the integrity of U.S. markets must be a paramount concern for the public sector and the private sector alike. SIFMA thus appreciates the Committee's current attention to this objective and commends the Committee for the ongoing leadership role that it has played over many years in sponsoring measures necessary to ensure the integrity of U.S. derivatives markets. SIFMA wholeheartedly endorses a number of the central themes that underpin the draft bill. Specifically, we agree that: Regulatory Transparency. Effective regulatory oversight of commodity markets requires appropriate regulatory transparency that ensures timely CFTC access to relevant position information; OTC Clearing. The clearance of OTC derivatives can and, we think, will play an important role in mitigating operational and counterparty risks for large segments of the OTC derivatives markets and, where appropriate, should be given a high priority by supervisors and the private sector; Speculative Limits. Limits on the size of speculative positions can play an important role in preserving orderly markets; and Global, Linked Markets. Listed derivatives, OTC derivatives and physical commodity markets are global and inextricably linked. We commend the draft bill's focus on these themes. Nonetheless, SIFMA and its members are deeply concerned by a number of provisions in the draft bill. We believe these provisions do not represent the most effective solutions to current market issues. Instead, we believe these provisions would have profound adverse consequences not merely for OTC and listed derivatives markets, but also for mainstream American companies. Specifically, key provisions in the draft bill would: Prohibit the purchase of uncovered CDS protection; Require the clearing of all OTC derivatives, subject to limited exceptions; Authorize the imposition of position limits for OTC derivatives; Prohibit off-exchange trading in futures on carbon credits and emission allowances; and Eliminate position limit exemptions for risk management strategies. We believe these provisions would: Deepen the current crisis by fundamentally undermining both the efficacy and availability of listed and OTC derivatives as risk management tools for large and small American businesses, thereby increasing costs, risks and earnings volatility for such companies throughout the economy; the draft bill's CDS- related provisions in particular would significantly and adversely impact access to, and the cost of, financing for American companies, which could lead to continued job losses; Increase (and not decrease) the susceptibility of commodity markets to manipulation and disorderly trading and enhance the ability of commercial traders with a vested interest in commodity prices to influence such prices; Impede successful development of cap and trade programs by prohibiting non-exchange derivatives on carbon offsets and emission allowances; Preclude pensioners, retirees and those saving for retirement from protecting the real dollar value of their retirement income against erosion from the effects of commodity price inflation through the use of commodity derivatives; and Drive the development outside the United States of markets in energy and other core commodities and financial products that are key to the U.S. economy, with the result that, while these markets would have the ability to inform or drive U.S. prices for the affected commodities and products, the U.S. Congress would have no ability to influence these markets. We believe the potential consequences of these provisions run directly counter to the Committee's own well-intentioned objectives. They also run counter to the efforts of Congress and the supervisory community to address the credit crisis and, if enacted, would almost certainly exacerbate the crisis. SIFMA understands that there is a need for regulatory reform and that such reform will need to address issues such as regulatory transparency and prudential oversight with respect to OTC derivatives. However, SIFMA strongly believes that any statutory changes in the regulation of OTC derivatives, particularly changes that would have such far-reaching consequences as those proposed in the draft bill, should only be undertaken in the context of broader regulatory reform and should focus on decreasing risk and improving transparency and efficiency in the OTC derivatives markets, while maintaining the significant benefits these markets currently provide for mainstream American companies and institutional investors. It is estimated that more than 90% of the 500 largest companies in the world use OTC derivatives.\4\ An even greater percentage (94%) of the American companies in this group use OTC derivatives. More than half of medium-sized American companies are estimated by Greenwich Associates to use OTC derivatives.\5\ These companies rely on access to OTC derivatives for important risk management purposes (some of which may, but many of which will not, fall within the draft bill's proposed definition of bona fide hedging).--------------------------------------------------------------------------- \4\ International Swaps and Derivatives Association, Inc., 2003 Derivatives Usage Survey, http://www.isda.org/statistics/. \5\ Greenwich Associates, http://www.greenwich.com.--------------------------------------------------------------------------- Mainstream American companies in every sector of the U.S. economy, including within the agricultural sector, depend on access to efficiently priced financing in order to make capital investments, purchase inventory and equipment, hire employees and otherwise fund their businesses. The availability of a robust corporate CDS market is essential if lenders are to meet the demand for these borrowings and to be in a position to do so on an efficiently-priced basis. CDS and other OTC derivatives thus not only play an important market function, they also play a critical role in enabling ordinary companies, outside the financial sector, to manage the risks of their businesses and to obtain the financing necessary to expand, and in many cases to sustain, their businesses. And, as the statistics cited above indicate, significantly more than half of the U.S. economy would be directly and adversely affected by the inability of professional intermediaries to make these products available and to utilize them themselves. Against this background and, particularly in the context of the current crisis, it is all the more important that Congress adopt legislative initiatives that preserve the benefits of these products, and access to these products, while carefully targeting those measures that are appropriate to protect the public interest. Our comments with respect to specific provisions of the draft bill are summarized in the following section.Section-by-Section CommentsProhibition of ``Naked'' CDS (Section 16) Section 16 of the draft bill would prohibit the purchase of CDS protection by any person who does not have direct exposure to financial loss should the referenced credit events occur. Very simply, the proposed prohibition would effectively eliminate the corporate CDS market. Although CDS are a relatively recent financial innovation, they have quickly become the most important tool available to banks and institutional investors, such as pension funds, for managing the credit risks arising from commercial loans and corporate bond investments. CDS, which are typically fully collateralized, are the only liquid financial instruments that enable a company exposed to a third party's default risk to manage that credit risk in an efficiently priced market. As such, CDS enable lenders to hedge the credit risks inherent in corporate financing that are essential to economic growth, and, in turn, reduce the cost of funds for borrowers. CDS also free up additional credit capacity, which enables banks to expand credit facilities available to their corporate clients. In addition, CDS provide important benefits for other market participants as well. For example, asset managers and other institutional investors use CDS as a liquid instrument through which to obtain credit exposure to particular companies and to adjust their credit exposures quickly and at a lower cost than alternative investment instruments. In addition, many market participants use CDS pricing to provide a more accurate valuation of credit risk than would otherwise be possible by looking solely to less liquid cash markets. No traded product is subject to a restriction similar to the one proposed to be imposed on CDS by the draft bill. This is not surprising given that the proposal would strictly limit CDS to hedging transactions and would significantly restrict the involvement of professional intermediaries and investors in these products. As a policy matter, the purchase of uncovered CDS protection is no different than buying or selling futures, options, stocks or bonds because the relevant product is perceived to be undervalued or overvalued by the market. These investment activities are critical to liquidity, reduced execution costs and efficient price discovery in these markets and all involve legitimate and, indeed, desirable investment activities. Absent the participation of intermediaries and non-hedgers, CDS would cease to trade in a market, and they would become extremely illiquid and costly--both to enter into and to terminate.\6\ As a direct result, lenders and investors would be left with far more limited and more expensive alternatives for managing the credit risks arising from their lending and investment activities. In turn, American companies, including those in the agricultural sector, would have significantly reduced access to financing, and the financing that would be available would be more costly. Bank revenues from lending activity would also be reduced, placing further pressure on the financial strength of the banking sector.--------------------------------------------------------------------------- \6\ The proposed requirement could also subject CDS to regulation as a form of financial guarantee insurance, thereby subjecting providers of protection to the additional burdens and inefficiencies of regulation by insurance supervisors in each of the 50 states.--------------------------------------------------------------------------- The impact of these effects on the credit crisis, and efforts to reverse the credit crisis, are plain. The OTC derivatives markets in general, and the corporate CDS market in particular, have performed extremely well and have remained liquid throughout the current market turmoil, providing important benefits not only for financial market participants but also for large numbers of mainstream American companies. The corporate CDS market in particular has provided a critical price discovery function for the credit markets, which have otherwise become extraordinarily illiquid during the crisis and, as a result, provide extremely little credit market price discovery apart from corporate CDS. Measures that would interfere with this function would be highly undesirable and would further exacerbate the credit crisis. The segment of the CDS market in which extremely significant losses have been incurred involved the writing of CDS protection on mortgage-related asset-backed securities; in many ways, a very different product than corporate CDS. The market for CDS on asset-backed securities is also a relatively small segment of the overall CDS market; generally less than 2% of the aggregate CDS market.\7\ Losses in this segment led, in part, to the rescue of the AIG insurance conglomerate and the failure or near failure of many monoline financial guarantee insurers subject to oversight by state insurance supervisors. The losses incurred through these products did not result, however, from flaws in the products; in fact, the products transferred the risk of the referenced asset-backed securities as intended by the parties. These losses were directly related to the unexpectedly large losses in the subprime mortgage sector and the leveraging of these exposures through highly structured securities, such as mortgage-related collateralized debt obligations (CDOs--not to be confused with CDS). A number of capital market participants incurred significant losses in the subprime mortgage-related CDS and CDO market.--------------------------------------------------------------------------- \6\ DTCC Deriv/SERV Trade Information Warehouse Reports (data as of the week ending January 23, 2009), http://www.dtcc.com/products/derivserv/data/index.php.--------------------------------------------------------------------------- Although some CDS market participants have incurred large losses in connection with corporate CDS, for example, in the case of CDS referencing financial institutions such as Lehman Brothers, the corporate CDS market nonetheless functioned well as a result of effective bilateral mark-to-market collateral arrangements. The private sector's initiative to establish a clearinghouse for CDS will further reinforce the salutary and stabilizing effects of appropriate bilateral collateral arrangements. The measures proposed in the draft bill would do little to address the regulatory issues actually presented by the failures and near failures resulting from these events; and we see nothing in the events of the recent past that would justify a response in the form of the effective elimination of corporate CDS.Mandatory Clearing of OTC Derivatives (Section 13) Section 13 of the draft bill would require the clearing of all OTC derivatives, subject to a very limited exemptive process in the case of products that are infrequently transacted, highly customized, do not serve a price discovery function and are entered into by parties able to demonstrate their financial integrity. The clearing of OTC derivatives transactions has the potential to provide many important benefits, including the mitigation of operational and counterparty risks and facilitation of regulatory oversight, and should be encouraged where appropriate. However, section 13 of the draft bill would mandate that all OTC derivative contracts must be cleared, including not only CDS but also other OTC derivatives such as interest rate and currency swaps, the markets for which are also significant and have performed well throughout the current credit crisis, with an extremely narrow exception for certain infrequently traded and highly customized contracts. Such a clearing requirement is unworkable as a practical matter and would adversely affect mainstream American companies and reinforce conditions contributing to the current credit crisis. As a threshold matter, not all OTC derivatives contracts are suitable for clearing or can be cleared without presenting unacceptable risk management challenges for a clearinghouse, and not all market participants can participate in a clearing system. In order to mitigate its counterparty risk, a clearinghouse must determine the aggregate risk to which it is exposed as a result of its clearing activities and must collect mark-to-market margin, in cash or liquid securities such as U.S. Treasury securities, every day from each of its members with respect to such members' positions in the clearinghouse. In order to do this, the clearinghouse must be able to model the risks associated with the products it clears and must be able to determine the amount of the market-to-market margin it is to pay or collect each day, a process that requires access to price data. The administrative and financing demands of participating in a clearinghouse on members are significant, and as a practical matter, mainstream American companies that are end users would not participate because they do not have the personnel, operational infrastructure and expertise, nor the cash and securities on hand, to do so. As evidence of this, although exchange-traded interest rate and currency futures are widely available, mainstream American companies are negligible users of such products. Reliable risk modeling requires statistically robust historical price data sets for each cleared product. Reliable mark-to-market margining, in turn, requires (1) products that are both completely standardized and sufficiently liquid (one or the other of these characteristics is not sufficient) and (2) ready access to reliable price sources. Even where these conditions are present, existing clearinghouses must have developed an approved risk modeling approach in order for market participants to clear their positions without subjecting themselves or the clearinghouse to inappropriate market and counterparty risks. Against this background, it is clear that a regulatory model that requires market participants to obtain a prior exemption based on highly subjective criteria before they transact would be utterly unworkable, would inject unnecessary legal uncertainty (potentially subjecting transactions to after-the-fact legal challenges), would interfere with the execution of risk management transactions and would impede new product development. Further, as noted above, limitations on the availability of CDS would directly and adversely affect American companies. While measures to promote standardization can afford risk-reducing benefits, there are many circumstances in which customized solutions will be more appropriate. For example, standardization of products effectively precludes the application of hedge accounting by American companies, as standardization vitiates the ability to structure customized hedges that comply with the requirements of Financial Accounting Standard 133. Without hedge accounting, American companies who do choose to use derivatives would experience significant volatility in their reported earnings, for reasons altogether unrelated to their core businesses. The potential for such volatility in reported earnings would result in less hedging and more risks being borne by companies who are ill-equipped to manage them. Moreover, the proposed provision is unnecessary and exemplifies the pitfalls of addressing the regulation of OTC derivatives outside of an appropriate comprehensive regulatory framework. As a practical matter, the major OTC derivatives intermediaries (at least in financial derivatives) are subject to supervision by Federal regulators, including the Office of the Comptroller of the Currency and the Board of Governors of the Federal Reserve System, as national banks, Federal Reserve System member banks or members of bank (or financial) holding company groups. These supervisors have plenary authority to identify those circumstances in which clearing is appropriate and to require such clearing and/or impose capital charges that address any incremental risks that are associated with transactions not so cleared. Indeed, the industry has been working with the Federal Reserve since 2005 on various voluntary initiatives to reduce risk and improve the infrastructure of the CDS market, including the development of a CDS clearinghouse. We believe a model under which these issues are addressed by a direct prudential supervisor of all systemically significant participants in the OTC derivatives markets is a far more effective approach than, and one that would avoid the significant pitfalls of, a more rigid statutory mandate such as the one included in the draft bill.Imposition of Position Limits on OTC Derivatives (Section 11) Section 11 of the draft bill would authorize the CFTC to impose position limits on ``speculative'' OTC transactions that are fungible with exchange-traded futures. The potential limitation on the scope of permitted OTC derivatives exposures as contemplated by section 11 of the draft bill would have potentially profound ramifications. The potentially adverse implications of such limits for mainstream American companies are significantly exacerbated by the draft bill's proposed categorization of risk management transactions as ``speculative.'' (See the immediately following discussion of section 6 of the draft bill.) The CFTC and the futures exchanges have been able to ensure orderly futures markets through, among other measures, limitations on speculative futures positions without having to limit, for example, off-exchange positions in fungible (i.e., deliverable) physical commodities. It is plain that large physical positions on either side of the market have a far greater potential to disrupt futures markets than do purely notional, financially-settled OTC derivatives. In the absence of such limitations on physical positions, or any perceived need for such limitations, we question the need to impose such limits on purely notional, financially-settled OTC derivatives positions. As noted above, any such proposal for direct and restrictive regulation of OTC derivatives would, in any event, be more appropriately considered in the context of broader regulatory reform.Elimination of Risk Management Exemption (Section 6) Section 6 of the draft bill would limit the availability of position limit exemptions for risk management positions other than those held by commercial entities directly engaged in a physical merchandising chain under a highly restrictive definition of bona fide hedging. The policy rationale for position limit exemptions has historically been based on the inference that a trader who is directionally neutral with respect to the price of a commodity underlying its futures position lacks the motivation to engage in abusive price manipulation. Thus, hedging, arbitrage and spread trading were early examples of cases in which such exemptions were available. As portfolio theory evolved, and financial futures and OTC derivatives became prevalent, a variety of risk management strategies became the basis for similar exemptions. The draft bill would reject this policy rationale and would arbitrarily subject broad ranges of financial hedging and risk management activity to the limitations applicable to truly speculative positions. SIFMA believes that these limitations would have a profound adverse impact on futures and OTC derivatives markets, on retirees and investors, and on companies seeking to manage the commercial and financial risks to which they are subject. These adverse effects are all the more troubling in light of the absence of any rigorous analysis of empirical data indicating that the involvement of noncommercial entities in the futures markets has caused the recent volatility in energy and other commodity prices. Indeed, the only rigorous analysis to date of relevant empirical data by the CFTC has reached precisely the opposite conclusion.Swap dealers and mainstream American companies. Section 6 of the draft bill would severely restrict the ability of swap dealers to provide customized OTC derivatives hedges to commercial end users and corporations. In most cases, swap dealers use a portfolio approach under which they manage price risk using combinations of physical transactions, OTC financially-settled transactions and exchange-traded futures. Thus, when entering into an OTC swap transaction with a counterparty, the dealer does not necessarily hedge that specific transaction with a specific offsetting transaction in the U.S. futures markets or the OTC derivatives markets. Rather than hedge the price risk created by a specific OTC transaction, the dealer might use the U.S. futures markets or the OTC derivatives markets to hedge the net exposure created by multiple transactions conducted contemporaneously or even at another point in time. Known as ``warehousing risk'', a dealer may also enter into numerous or long-dated OTC transactions with a client that is seeking to hedge its price risk. At the time of entering into the transactions, it may not be prudent or possible for the dealer to enter into offsetting transactions in the futures markets or with other OTC dealers. Thus, in warehousing risk, the dealer assumes the price risk from its client and manages it in its trading book using the portfolio approach described above. By requiring that dealers, in order to qualify for the hedge exemption from speculative position limits, be able to demonstrate that any given position in the futures or OTC derivatives markets (hedged by futures) serves as a hedge against a specific OTC transaction with a counterparty that is itself hedging price risk, the draft bill would prohibit useful and risk-reducing hedging, which clearly runs counter to the public policy goals of the draft bill, and would significantly limit dealers' ability to effectively intermediate the risks of their end user and corporate clients which, in turn, would likely significantly reduce liquidity in the futures and OTC derivatives markets, increase hedging costs and leave the markets far more susceptible than they are today to undue influence by commercial interests that have a stake in directional price movements. It would also increase hedging costs for mainstream American companies, leaving them more susceptible to price risk and less competitive.Index strategies. The draft bill's proposed speculative position limit provisions would limit futures trading that is not, in fact, speculative and that does not have a market impact analogous to speculative trading, and, in turn, could potentially interfere with commodity price formation to the detriment of the markets. As an example, pension plans and other investment vehicles hold portfolios whose ``real dollar'' value is eroded by inflation. Investment of a targeted allocation of the portfolio in a broad-based commodity index can effectively ``hedge'' that risk financially. Such a strategy, like ``bona fide'' physical hedging, is undertaken for risk management and risk reduction purposes, is passive in nature (i.e., positions are bought in accordance with the index algorithm and asset allocations and are generally held, not actively traded) and is not speculative in purpose or effect. The strategy does not base trading decisions on expectations as to whether prices will go up or down--the strategy is generally indifferent as to whether prices go up or down. The strategy generally leads to trading in the opposite direction of speculators, offsetting their impact: when commodity index levels rise, portfolio allocations to index strategies are reduced (resulting in selling), when commodity index prices fall, allocations to index strategies are increased (resulting in buying). Over the long term, the strategy acts as a stabilizing influence for commodity prices. These trends were found by the CFTC in its recent study to be consistent with its analysis of relevant trading data. On the other hand, we are unaware of a rigorous analysis of empirical trading data that supports the correlations that have been alleged between index trading and increasing commodity prices. In addition, investing on a formulaic basis in a broad-based commodity index would be the least effective means of ``manipulating'' the market for an individual commodity.Increased susceptibility to manipulation. By restricting the hedge exemption to commercial entities, the draft bill would, in effect, significantly increase the relative market share of these entities and simultaneously reduce liquidity, by reducing the sizes of positions of traders employing risk management strategies that are truly market neutral. Any proposed legislation on this topic must take into account three basic facts. First, although a commercial user's futures position may be offset by a physical position, commercial entities are almost never price neutral. Second, the category of market participant that is best positioned to influence market prices are commercial users controlling large physical positions. Third, significantly increasing the relevant market share of commercial entities increases the ability of such traders to influence prices. As a result, SIFMA believes that the draft bill would make the U.S. futures markets far more susceptible than they currently are to price manipulation by commercial traders with directional biases. Indeed, nearly all of the CFTC energy manipulation cases that have been brought over the last 5 years have been brought against traders at firms that would be considered commercial entities under the draft bill.Carbon Offset Credits and Emission Allowances (Section 14) Section 14 would establish an exchange monopoly for the trading of futures on carbon offset credit and emission allowances and criminalize off-exchange trading in such products. The most successful, liquid and efficient markets are those in which trading is permitted both on-exchange and off-exchange. Indeed, exchange markets are generally enhanced by the success of related off-exchange markets. Off-exchange trading is also essential for a number of reasons. Off-exchange markets serve as the incubators through which trading terms are able to coalesce around agreed market conventions that promote liquidity and efficiency. This process facilitates the evolution of standardized and liquid products that can be effectively exchange traded. Off-exchange trading also enables derivatives to be tailored to the risk management needs and circumstances of individual companies. Off-exchange trading also facilitates the cost-effective execution of large wholesale transactions for which an exchange environment can be inefficient. Finally, the proposed prohibition would eliminate the fundamental salutary market benefits of inter-market competition--a cornerstone of efficient markets and American capitalism. As a result, we believe the proposed prohibition would impair market efficiency and impede innovation and the successful development of these products. As a direct consequence of these effects, the proposed provisions would, in our view, undermine rather than promote the important national policy objective of encouraging the development of successful and efficient trading markets in these important products.OTC Reporting Requirements (Section 5) Section 5 of the draft bill would require the CFTC to impose detailed reporting requirements with respect to OTC derivatives. We note that the CFTC currently has the authority to ascertain information regarding the OTC derivatives positions of large traders holding reportable positions in related futures contracts. SIFMA urges the Committee to avoid the creation of an ongoing detailed reporting regime applicable to OTC derivatives generally, as such a regime has the potential to result in large amounts of, but disproportionately little useful, information, imposing significant costs and burdens on the resources of the private sector and the CFTC alike. SIFMA would not, however, be opposed to a carefully tailored reporting regime (similar to that currently employed by the CFTC) under which the CFTC may require firms to provide upon request targeted information regarding large positions in OTC derivatives that are fungible with exchange-traded futures contracts (or significant price discovery contracts) that are under review by the CFTC as part of its market surveillance function or in connection with any investigation.Reporting Entity Classification (Section 4) Section 4 of the draft bill addresses the classification and disaggregation of large position data and would require disaggregation and reporting of positions of swap dealers and index traders. SIFMA supports the classification of position data into categories that promote the market surveillance function of the CFTC. The distinction between market participants who have directionally biased positions and those that are directionally neutral is a key one in this context. On the other hand, since swap dealers and index traders may fall into either of these categories, it is not clear that the proposed disaggregation would promote the CFTC's surveillance function.Foreign Boards of Trade (Section 3) Section 3 of the draft bill would require the CFTC to impose specific rule mandates on foreign boards of trade. Recognizing that our markets are global and inextricably linked, international coordination and harmonization are important objectives. However, these objectives can be better accomplished without the prescriptive imposition of U.S. rules on foreign markets. In addition to potentially curtailing U.S. access to foreign markets, any such approach would likely be regarded as imperious and may well invite retaliatory measures that could compromise the ability of U.S. exchanges to compete for international business--currently an important growth segment of U.S. exchange markets.Conclusion OTC derivatives markets play a key role in the functioning of the American economy by helping companies, lenders and investors to manage risk and arrange financing. With the limited exception noted above involving the writing of CDS protection on mortgage-related asset-backed securities by AIG and monoline financial guarantee insurers, the OTC markets have performed well and remained liquid throughout the current market turmoil, providing important benefits for a large number and wide range of companies. It must be recognized that the consequences of many of the proposed provisions in the draft bill would not fall solely or even most heavily on the professional intermediaries participating in these markets. Instead, the consequences of these provisions would, if enacted, harm very large numbers of mainstream American companies whose financial strength is critical to the welfare and recovery of our national economy. As noted above, many American companies use OTC derivatives to hedge their cost of borrowing or the operating risks of their businesses. Many of those who do business overseas use OTC derivatives to hedge their foreign exchange exposures. Many companies also hedge their commodity and other price exposures. For many companies, the availability of efficiently priced access to financing and other products depends on access by their counterparties to OTC derivatives such as CDS and interest rate and currency swaps. By limiting or eliminating access to basic risk management tools that American companies routinely use in the day-to-day management of their businesses, the draft bill could have a potentially profound negative impact on these companies and our nation's economic recovery. Recognizing the importance of OTC derivatives, we continue to support efforts to address the risks and further improve the transparency and efficiency of the OTC derivatives markets. Similarly, recognizing the importance of efficient and orderly exchange markets we continue to support tailored measures to improve the efficiency and integrity of listed futures markets. We look forward to working with this Committee, Congress and regulators on initiatives designed to improve oversight of OTC derivatives, while maintaining the significant benefits the OTC derivatives markets currently provide, and to promote orderly and efficient exchange markets. The Chairman [presiding.] Thank you very much, Mr. Rosen. " FinancialCrisisReport--60 On September 8, 2008, Washington Mutual signed a public Memorandum of Understanding that it had negotiated with OTS and the FDIC to address the problems affecting the bank. Longtime CEO Kerry Killinger was forced to leave the bank, accepting a $15 million severance payment. 137 Allen Fishman was appointed his replacement. On September 15, 2008, Lehman Brothers declared bankruptcy. Three days later, on September 18, OTS and the FDIC lowered Washington Mutual’s rating to a “4,” indicating that a bank failure was a possibility. The credit rating agencies also downgraded the credit ratings of the bank and its parent holding company. Over the span of eight days starting on September 15, nearly $17 billion in deposits left the bank. At that time, the Deposit Insurance Fund contained about $45 billion, an amount which could have been exhausted by the failure of a $300 billion institution like Washington Mutual. As the financial crisis worsened each day, regulatory concerns about the bank’s liquidity and viability intensified. Because of its liquidity problems and poor quality assets, OTS and the FDIC decided to close the bank. Unable to wait for a Friday, the day on which most banks are closed, the agencies acted on a Thursday, September 25, 2008, which was also the 119 th anniversary of WaMu’s founding. That day, OTS seized Washington Mutual Bank, placed it into receivership, and appointed the FDIC as the receiver. The FDIC facilitated its immediate sale to JPMorgan Chase for $1.9 billion. The sale eliminated the need to draw upon the Deposit Insurance Fund. WaMu’s parent, Washington Mutual, Inc., declared bankruptcy soon after. C. High Risk Lending Strategy In 2004, Washington Mutual ramped up high risk home loan originations to borrowers that had not traditionally qualified for them. The following year, Washington Mutual adopted a high risk strategy to issue high risk mortgages, and then mitigate some of that risk by selling or securitizing many of the loans. When housing prices stopped climbing in late 2006, a large number of those risky loans began incurring extraordinary rates of delinquency as did the securities that relied on those loans for cash flow. In 2007, the problems with WaMu’s High Risk Lending Strategy worsened, as delinquencies increased, the securitization market dried up, and the bank was unable to find buyers for its high risk loans or related securities. The formal initiation of WaMu’s High Risk Lending Strategy can be dated to January 2005, when a specific proposal was presented to the WaMu Board of Directors for approval. 138 WaMu adopted this strategy because its executives calculated that high risk home loans were more profitable than low risk loans, not only because the bank could charge borrowers higher interest rates and fees, but also because higher risk loans received higher prices when securitized and sold to investors. They garnered higher prices because, due to their higher risk, the securities paid a higher coupon rate than other comparably rated securities. 137 “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1h. 138 See 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” submitted to Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302975-93, Hearing Exhibit 4/13-2a. FinancialCrisisReport--116 Mr. Cathcart told the Subcommittee that this change created further separation between him and his risk managers, and compromised the independence of risk management. 409 He testified at the Subcommittee hearing: Mr. Cathcart: The chairman adopted a policy of what he called double reporting, and in the case of the Chief Risk Officers, although it was my preference to have them reporting directly to me, I shared that reporting relationship with the heads of the businesses so that clearly any of the Chief Risk Officers reporting to me had a direct line to management apart from me. Senator Coburn: And was that a negative or a positive in terms to the ultimate outcome in your view? Mr. Cathcart: It depended very much on the business unit and on the individual who was put in that double situation. I would say that in the case of home loans, it was not satisfactory because the Chief Risk Officer of that business favored the reporting relationship to the business rather than to risk. 410 The subordination of risk management to sales was apparent at WaMu in many other ways as well. Tony Meola, the head of home loans sales, reported directly to David Schneider. He had direct access to Mr. Schneider and often pushed for more lenient lending standards. According to Ms. Feltgen, the sales people always wanted more lenient standards and more mortgage products, and Mr. Meola advocated for them. 411 One example was the 80/20 loan, which consisted of a package of two loans issued together, an 80% LTV first lien and a 20% LTV second lien, for a total CLTV of 100%. Ms. Feltgen said she was nervous about the product, as a 100% CLTV was obviously very risky. WaMu’s automatic underwriting system was not set up to accept such loans, but Mr. Meola wanted permission to “side step” the systems issue. 412 Mr. Schneider approved the product, and Ms. Feltgen ultimately signed off on it. She told the Subcommittee that it was a high risk 409 Id. 410 April 13, 2010 Subcommittee Hearing at 34. 411 Subcommittee Interview of Cheryl Feltgen (2/6/2010). 412 See 2/2006 WaMu internal email chain, “FW: 80/20,” JPM_WM03960778. product, but was priced accordingly, and that it might have been successful if housing prices had not declined. 413 FOMC20060510meeting--53 51,MR. STOCKTON.," Thank you, Mr. Chairman. I am told that counselors are taught to begin by acknowledging the validity of the fears and anxieties of those whom they are counseling. The strategy then is to deconstruct and examine in greater detail the specific sources of heightened anxiety in order to gain better perspective on the problems at hand. Being a naturally anxious person, I have had moments in the past six weeks when I felt the need to engage in a little “self help” therapy by employing this strategy on myself. So this morning, I thought that I would report the results of my efforts to identify and analyze some of the developments over the intermeeting period that could have made one more uneasy about the outlook for activity and inflation. I’ll admit that there have been a few reasons to be concerned. The growth in real GDP in the first quarter was very strong—even stronger than we had expected in the March Greenbook. And most components of spending surprised us to the upside. Moreover, hard evidence of the anticipated second-quarter slowdown is still sparse. Meanwhile, inflation concerns have been mounting. Oil prices are up another $10 per barrel, and the prices of non-oil commodities are soaring amid signs that the global economy is strengthening. The dollar seems to be sinking on good news and bad. The incoming data on core consumer prices have exceeded our expectations a bit. And measures of expected inflation have moved higher. Clearly, there is plenty to keep one up at night. At other times, I have awoken with the fear that recent developments could provoke us into a familiar trap of overshooting on policy. If policy were to lean against strength in activity and inflation pressure that was largely seen in the rear-view mirror, the risk of tightening too much and for too long would be amplified. In that regard, the evidence has continued to accumulate that housing markets are softening, and last Friday’s employment report at least hinted at some slowing in labor demand. Tightening significantly further when the economy already may have begun to decelerate risks an unwelcome cyclical downturn in the economy. Given our poor track record in predicting recessions, one should not take lightly the risk of overshooting the mark. I’m not embarrassed to admit that I’ve harbored both fears—that of falling behind the curve and that of overshooting—often on the same day and sometimes even in the same conversation with my colleagues. [Laughter] But in the end, I have come to the view that, while you are almost certainly somewhat behind or somewhat ahead of the curve, there are some good reasons to think that you are not too far from the curve. So just how strong is the economy at present, and will it maintain that strength going forward? As you know, we had been expecting a big bump-up in the growth of output in the first quarter, in part as activity rebounded from hurricane-depressed levels. And we surely got it. We are now estimating that the growth of real GDP in the first quarter was 5¼ percent, about ½ percentage point faster than projected in the March Greenbook. That said, it is important not to exaggerate the extent to which that surprise signals greater underlying momentum in the economy. About half of our miss in the first quarter reflected higher-than-expected federal spending. While I’ll admit that “higher-than-expected federal spending” might seem to be an oxymoron, we view the first-quarter miss as largely one of timing, related in part to FEMA outlays. We are expecting the level of federal spending to drop back in the current quarter. Inventory investment outside the motor vehicle sector, after being very subdued in the second half of last year, also has surprised us to the upside of late. Although it is presently providing a lift to activity, we would not expect inventory investment to be a source of ongoing impetus to production. Of course, these were not our only surprises. Household and business spending, too, have come in above our expectations, and we read domestic demand as having somewhat greater momentum than we had earlier thought. As a consequence, we revised up our projection for second-quarter growth in real GDP to 3¾ percent—similar to the above-trend pace that we experienced over the past year. Had everything else remained as it was in March, this greater strength in near-term activity would have led us to mark up our forecast for the remainder of the year as well. But there have been some powerful countervailing forces with which we have had to contend. The steep rise in the price of crude oil has continued to siphon purchasing power from the household sector. The bill for imported oil is now expected to be about $50 billion per year higher than in our March projection. Moreover, gasoline prices have increased even more than oil prices, reflecting a tight inventory situation that has resulted from some refinery shutdowns and from the higher costs associated with the switch in blends of reformulated gasoline. Because the spending propensities of oil company shareholders are likely lower than those of gasoline consumers, the transfer of income between these two groups also is likely to subtract some from consumer spending. In the very near term, we have households dipping into saving to meet their higher energy bills, but we think that some adjustment to overall spending plans probably is under way and that more will be required in coming quarters. Besides the restraining effects of higher oil prices, the recent increase in long-term interest rates is expected to weigh on activity over the remainder of the projection period. To be sure, some of that increase reflects higher expected inflation. But real long-term rates have increased as well, in part as term premiums have widened a bit. Mortgage rates and corporate bond rates are expected to run about 20 to 30 basis points above the levels that in our previous projection we had assumed would prevail. Obviously, those increases have been too recent to have yet affected demand; but we expect that, by the second half of the year, higher rates will be leaving an imprint on housing activity and business investment. As you know from reading the Greenbook, the stronger underlying momentum in the economy is eventually more than offset by the greater drag from higher energy prices and interest rates, leaving the level of output a touch weaker by the end of 2007 than forecast in March. What about inflation concerns? There can be little doubt that price pressures have intensified somewhat over the intermeeting period. As I noted earlier, crude oil prices have risen about $10 per barrel, and participants in futures markets expect those higher prices to persist. Other commodity prices have been soaring as well, especially prices for industrial metals. These increases can be expected to add a bit to core inflation in coming months. Another troubling development in the inflation picture has been the increase in most measures of inflation compensation and inflation expectations. TIPS measures of inflation compensation have increased between 15 and 20 basis points over the intermeeting period. At the same time, the Michigan survey measure of median year-ahead inflation expectations increased to 3.3 percent, and the median measure of inflation expectations five to ten years ahead edged up to 3.1 percent; both are about ¼ percentage point higher than in March. Still, these developments should be placed in perspective. None of these measures has breached the range that has been maintained over the past few years. And there have been several episodes during that period when expectations moved up as much as or more than they have in the past six weeks, only to reverse course on softer news about the economy or inflation. So for now, it is difficult to gauge the extent to which there has been any meaningful deterioration in inflation expectations. Moreover, we have scant evidence that higher price inflation or higher inflation expectations have become embedded in labor costs. As you know, the employment cost index (ECI) rose at an annual rate of just 2½ percent in the first three months of the year, more than 1½ percentage points less than we had projected. In contrast, we currently estimate that compensation per hour in the nonfarm business sector increased at a 5¾ percent annual rate in the first quarter, about 1½ percentage points more than we had projected. Nonetheless, despite their divergent movements last quarter, both measures actually decelerated over the past year. To be sure, because labor compensation tends to lag prices in the overall inflation process, this observation should provide only limited solace. But I do think the incoming information on labor costs makes it more difficult to argue that you have fallen far behind the curve. We continue to expect the growth of hourly labor compensation to pick up going forward in response to tight labor markets, the increases in labor productivity that have occurred in recent years, and the lagged effects of higher price inflation. Nevertheless, with price markups at very high levels, the projected acceleration in hourly labor compensation is expected to result chiefly in some narrowing of profit margins rather than in an increase in price inflation. What about the price data themselves? Both the core consumer price index (CPI) and core personal consumption expenditure (PCE) prices rose 0.3 percent in March, exceeding our expectations. Some of the surprise in both measures was attributable to higher-than- expected increases in apparel prices that may have more to do with imperfectly anticipated seasonal patterns than underlying trends and to a step-up in medical prices related to increased Medicare reimbursements. As a consequence, we attach only a small signal to this upside surprise. All told, the developments over the past six weeksCanother jump in oil prices, some deterioration of inflation expectations, and a slightly higher reading on core inflationCled us to mark up our projection of core consumer price inflation, but just by 0.1 percent in both 2006 and 2007. The pattern of projected inflation remains the same. As higher prices for oil and other commodities are passed through into the prices of final goods and services, core PCE inflation is projected to move up to a 2¼ percent pace this year. With those prices expected to flatten out next year and with the pass-through of the earlier run-ups largely complete, we expect core PCE inflation to ease back down to a 2 percent pace in 2007. Finally, what about the concern that we could be in the process of overshooting the mark on policy tightening? Because policy operates with a lag and because we are so poor at predicting turning points, this risk seems especially relevant after a period of substantial tightening. But given the strength that appears evident in both domestic and foreign economies, my guess is that the expansion is not so fragile that some modest overshoot on policy would result in a cyclical downturn in activity. Moreover, if our baseline assessment of the economy is close to the mark, a higher path for the funds rate might not even be deemed an overshooting. As we noted in a simulation in the Bluebook, greater policy tightening than is built into the baseline might be desired if your objective is to achieve a more rapid and pronounced decline in core price inflation. So, in the end, while we could see a heap of worries in a variety of different directions, we interpreted recent developments as warranting only small changes in our forecast. That forecast remains one in which activity slows to a more sustainable pace and inflation fluctuates around recent levels. Still, I don’t want to be seen as offering false reassurances. Much could happen to change the outlook. My own concerns about potential outcomes that could take us far from the staff baseline projection are centered mainly on asset markets. Asset markets are impressive information-processing machines that, for the most part, deliver very efficient outcomes. But those markets are also subject, from time to time, to abrupt shifts in confidence and psychology that are difficult for forecasters to predict and difficult for policymakers to influence. I see risks on both sides of the ledger here. One of the risks associated with overshooting is that, at some point, higher interest rates could trigger a sharp contraction in house prices and real estate activity. Given the long lags with which we receive reliable information on house prices, such developments might take some time to recognize and thus might prove harder to counteract than implied by our alternative scenarios. Of course, undershooting on policy also presents risks for asset markets. If policy were to trigger a substantial fall in the dollar, inflation pressures and your efforts to deal with those pressures could create some significant challenges for monetary policy and for the economy. Karen will have more to say on the prospects for the dollar in her presentation." FOMC20080109confcall--26 24,MS. YELLEN.," Thank you, Mr. Chairman. I agree with both the concerns that you expressed and the analysis that you offered. Based on the data we now have in hand, I support a 50 basis point reduction in the federal funds rate in the near future. I think a very good case can be made for moving down 25 basis points today, and it would be my preference. According to what Bill Dudley said, markets apparently do attach some probability to a move of that magnitude before the January meeting. I could also support a 50 basis point move today, but I am concerned that it might be taken as a sign of panic by the Committee and somehow wrongly indicate that we have inside information showing that things are even worse than markets already think or, alternatively, be seen as an overreaction to the employment report. But if we don't move today, I do think we need to take decisive action in January, and I hope you will give a strong signal that we will do so in your speech. I agree with the staff's assessment that the outlook for economic growth has weakened since December, and I also see the downside risks to the forecast as having increased since then. We have revised down our 2008 forecast also because of the sharp increase in energy prices and the deterioration we have seen in financial conditions just since December. It is good that conditions in money markets have improved somewhat, but equity prices have fallen very substantially--I guess around 6 percent since our last meeting. Credit spreads are up, and borrowing rates for many borrowers are higher in spite of a decline in Treasury yields. I also find the labor market developments worrisome. I try not to put too much weight on any single monthly observation, but I find it entirely believable and consistent with everything else we are seeing that we have entered, at best, a period of slow employment growth. It is something that we have been expecting all along. It helps to resolve some of the puzzles we have been discussing about why labor markets have been so strong relative to goods markets. It is true that consumer spending has been amazingly robust so far, but I find it unimaginable that it can continue when slow growth in disposable income is added to everything else that is weighing on households, particularly rising energy prices, accelerating declines in house prices, and falling stock prices. It seems to me that, with the stagnant or contracting labor market, the odds of a recession--and, as you argued, a potentially very nasty one--have risen. I am also very worried about the possibility of a credit crunch if higher job losses begins to make lenders pull back credit. It is true that on the inflation front the recent news hasn't been particularly good. It certainly is true that there are upside risks. But I do take comfort from the fact that inflation compensation has remained well behaved and that we already have slack in the labor market and more seems likely to develop. I support a significant rate cut not only because of the downgrade to the economic forecast since December but also because I think the stance of policy even now with the actions we have taken--I agree with you--is still within the neutral range. Given current prospects and the asymmetric nature of the risks, particularly the high tail risk associated with the credit crunch, I believe that policy should be clearly accommodative. So having revised down my forecast, I would support a significant funds rate cut as a way to catch up with where policy should be. " CHRG-110hhrg44903--80 Mr. Geithner," I think you are raising exactly the right question. I think that it is very important that we are not given responsibilities for which we do not have authority, and it is very important we are not given responsibilities which would conflict fundamentally with the basic obligations that the Congress gave us in the Federal Reserve Act. It is important, though, to recognize that all central banks in any serious economy are given a set of mandates that require a balance between price stability and some mix of sustainable long-term growth objectives. That mix differs. But also financial stability. And in any central bank, the basic lender of last resort instruments that are given to prevent liquidity problems from becoming solvency problems along with some broader financial stability are inherent to the functions of modern central banks. It is very important, though, to recognize that those instruments' responsibilities come with and have implications for moral hazard; and, therefore, it is very important they be complemented by a set of constraints on risk-taking and a framework for dealing with problems that can help limit and offset that moral hazard risk. But that basic framework of responsibilities, from price stability to financial stability, are integral to what all central banks live with every day, and those objectives do not need to conflict. " CHRG-111shrg57319--597 Mr. Killinger," I don't think there is any question. You heard this morning about the layering--we can call it the layering of risk, where the loan-to-value ratios might have increased, where there was more of a prevalence of putting second mortgages on top of firsts at origination, less documentation of some new products in some cases, and very thin pricing because there was so much money kind of chasing, wanting to make those loans. Senator Levin. You say thin---- " CHRG-111hhrg74855--77 Mr. Markey," Chairman Wellinghoff, much of your testimony focuses on the potential for the bill approved by the House Ag Committee to harm RTO markets and mechanisms used in those markets to ensure just and reasonable prices such as Financial Transmission Rights or Forward Capacity Markets but isn't there also a risk that this bill could also limit your ability to approve these or other mechanisms in a non-RTO market as well? " FOMC20080130meeting--190 188,MR. ROSENGREN.," Thank you, Mr. Chairman. The contours of our forecast are broadly in line with the Greenbook: Growth well below potential for the first half of this year results in additional slack in labor markets with a consequent reduction in the core rate of inflation over time. Our forecast returns to full employment by 2010 only if we reduce interest rates more than they are in the Greenbook. Thus, our baseline forecast assumes that we reduce rates 50 basis points at this meeting followed by additional easing in 2008, which eventually results in core inflation below 2 percent and the unemployment rate settling at our estimate of the NAIRU, somewhat below 5 percent. But even with this easing, there are significant downside risks to this forecast. Historically, increases in unemployment in excess of 0.6 percent and forecasts of two or more quarters of real GDP growth below 2 percent have almost always been followed by a recession. In fact, a variety of probit models looking at the probability of recession in 2008 indicate an uncomfortably high probability of recession, in most cases above 50 percent. Several factors make me concerned that the outlook could be worse than our baseline forecast. First, we have consistently underestimated weakness in residential investment. While our forecast assumes a gradual decline in real estate prices, it does not have a substantial feedback between rising unemployment rates causing further downward pressure on real estate prices and the health of financial institutions. Were we to reach a tipping point of higher unemployment, higher home foreclosures, increased financial duress, and falling housing prices, we would likely have to ease far more than if we were to act preemptively to insure against this risk. Second, our weak consumption is driven by negative wealth effects induced by weakness in equity markets and modest declines in real estate prices. However, the heightened discussion of a potential recession could easily result in a larger pullback by consumers. This would be consistent with the behavior of rates on credit default swaps of major retailers, which have risen significantly since the middle of December. Third, banks are seeing increasing problems with credit card debt. Capital One, one of the few concentrated credit card lenders, has had their credit default swap rate rise from less than 100 basis points to more than 400 basis points as investors have become increasingly concerned about the retail sector. While liquidity concerns have abated, credit risk for financial institutions has grown. Rates on credit default swaps for our largest banks have been rising since December, despite the announcement of additional equity investments. In addition, the greatest concern I hear raised by the financial community in Boston is a risk posed by the monoline guarantors. The movement in equity prices last week as a result of highly speculative statements on resolving the monoline problem indicates a sensitivity of the markets to significant further deterioration in the financial position of the monolines. Fourth, our model does not capture potential credit crunch problems, although supplementary empirical analysis conducted by the Boston staff suggests that such problems pose additional downside risks to our outlook. Bank balance sheets continue to expand as banks act in their traditional role of providing liquidity during economic slowdowns. While the balance sheet constraints are likely to be most acute at our largest institutions, further deterioration in real estate markets is likely to crimp smaller and midsize banks that have significant real estate exposures. Given my concerns that we could soon be or may already be in a recession, I believe the risks around our forecast of core inflation settling below 2 percent are well balanced. Inflation rates have fallen in previous recessions, and I expect that historical regularity to be maintained if growth is as slow as I expect. Thank you, Mr. Chairman. " CHRG-110hhrg34673--12 Mr. Bernanke," Mr. Chairman, first of all, policy is going to respond to new information. We are going to be continually reassessing our outlook and responding appropriately as we see the economy evolving. Policy also has to respond to risks. There are risks in both directions. On the real side, I talked about housing as a downside risk, but there is also some upside risk. We have seen very strong consumer spending numbers. We have seen some strong income growth which suggests that the economy may be stronger than we think. It is possible. And in a sense, aggregate spending may exceed our capacity and put pressure on product markets, and that would be a concern. The other issue is on inflation. We have had a period where inflation has been above where we would like to see it as far as consistency with price stability is concerned. In order for this expansion to continue in a sustainable way, inflation needs to be well-controlled. If inflation becomes higher for some reason, then the Federal Reserve would have to respond to that by raising interest rates. That would not contribute to the continued-- " FOMC20071031meeting--77 75,MR. KOHN.," Thank you, Mr. Chairman. In broad outline, the situation is evolving as we anticipated in our last meeting. Spending outside of housing has been well maintained. The housing market is very weak. Financial markets have been returning more toward normal functioning, banks have tightened credit terms and standards, and core inflation has remained low. I think it is the nuances around each of these that complicate our decision at this meeting. As Dave Stockton and others pointed out, spending outside housing has been a bit stronger than expected. Paths of consumption and investment, along with employment, seem to be moderating going into the fourth quarter, but gradually. Importantly, the data for September haven’t been especially weak, and these could have potentially been affected by the financial tightening, increased uncertainty, and reduced consumer confidence that followed the events of August. With growth in the third quarter likely to be at or above 3 percent and no material change in the output gap for several quarters now, it does appear that the real funds rate of 3 percent plus that persisted since mid-2006, while quite high relative to historical averages, was not far from the equilibrium real rate at that time, given the low level of long-term rates, the ready availability of credit at historically low spreads, and the high level of wealth relative to income through this period. It seems somewhere between difficult and impossible to calibrate the effects on aggregate demand of the rise in long-term rates last spring, the tightening of credit conditions of the past few months, and the expected decline in housing prices. The staff has judged 50 basis points of easing—we did that at the last meeting—to be enough to keep the economy near its potential in the context of the relatively solid incoming data. That doesn’t seem unreasonable, though it does leave the fed funds rate at the higher end of its historical range. Nonetheless, I see a couple of reasons for important downside risks to such a growth forecast. First, though the housing market was roughly in line with staff forecasts, builders have made only a little progress in reducing inventory overhangs. Moreover, reports suggest that downward price pressures are increasing—for example, the constant quality new home index declined in the past two quarters. Market expectations for the Case-Shiller index revised down, suggesting that the drop in house prices could be steeper than the moderate drop assumed in the staff forecast. Substantial decreases in house prices would at some point revive the demand for housing. At the same time, that decline threatens greater spillovers from wealth effects on consumption and from tighter credit conditions as lenders react to threats to their capital from declining collateral values. Second, although financial markets are improving in many respects, the trajectory is gradual, uneven, and subject to reversal. We saw this just in the past couple of weeks, when adverse housing data, downgrades of highly rated mortgages and senior tranches, and earnings warnings caused some risk spreads to widen out. The secondary markets for nonconforming mortgages are still quite disrupted. Clearly, uncertainty about the pricing of many of the assets in question, about the amount of credit that will get put back to the bank balance sheets, and about the size and location of the losses that have to be taken continue to make lenders very skittish. In this environment, I wouldn’t be at all surprised to see a further tightening of credit availability at banks in the coming months. The developments in housing and financial markets are also likely to weigh on business spending plans, as we saw hinted at in the capital spending revisions that some of the Reserve Banks reported, and for households as evidenced by the low confidence surveys. These downside risks are strong enough that I think they will persist even if we ease slightly tomorrow. Besides the influences I already cited, my judgment in this regard takes account of market expectations. The markets’ implied r* has been below the staff’s and, I think, the Committee’s implied r* for some time now, but the gap seems to have widened considerably. In an environment of increased uncertainty about the outlook, such disparities perhaps aren’t surprising, and we can’t substitute market participants’ judgment for our own, but I did take a little signal from the extent of the pessimism about aggregate demand that I inferred from the interest rate path in the market relative to the staff’s path in the Greenbook. I don’t think r* is quite as low as President Yellen was suggesting—it is perhaps in the 2 to 2½ range since term premiums are still low; and even with house prices declining, the wealth-to-income ratios are still pretty high, and the dollar has been falling. But I did assume a slight easing of monetary policy sometime in the fourth quarter in my projection. I also projected low, stable core and ultimately total inflation, but I do see some upside risks around this outcome if the economy follows its most likely path. It is still producing at a high level of resource utilization, and some measures of compensation and labor costs have been rising. Core CPI inflation on three-month and six-month bases has accelerated even if the acceleration hasn’t shown through to the PCE measures. Increases in energy and commodity prices, along with recent declines of the dollar, are also a risk factor—less from their direct effects on prices, which are likely to be small, but more because they could suggest a potential for a more inflationary psychology that could feed through to expectations. Our decision tomorrow will involve weighing these risks, the extent of the relative risk to our dual objectives, and the potential costs of missing in either direction in the context of the market conditions and expectations built into markets. Thank you, Mr. Chairman." CHRG-111hhrg52397--149 Mr. Price," So a decrease in potential business viability? Mr. Don Thompson. It is generally being exposed to a risk that is not its core business. 3M is a great example. They make all these little things in the book and they do a great job, and we all use them. Their specialty is not forecasting interest rates or forecasting the exchange rate of the U.S. dollar versus the Thai bhat. They would prefer to hedge those risks away and focus on their core business, which is the attitude of many of our corporate clients. However, if they have to post liquid securities or cash to a clearinghouse or if they have to suffer income statement volatility because their hedges have to be on an exchange and thus do not qualify for FAS 133 hedge accounting, they face a difficult choice: Do I pay the increased cost? Do I suffer the increase income statement volatility and go ahead and hedge the risk anyway or do I not hedge the risk and hope it works out for the best? I am sure some companies will pay the increased cost. I am sure some companies will say, ``No, we will leave the risk open.'' I think in neither case is that good for American business. " FOMC20060629meeting--122 120,MR. LACKER.," As I said yesterday, although the outlook for real growth is noticeably softer than it was at the last meeting, it doesn’t seem to me clearly inconsistent with growth around trend going forward. I see the risk of slowing the economy overly much in the near term by increasing real rates as relatively low. The way I look at the evidence, real short-term interest rates are still somewhat low by historical standards. If you compare the periods of extended growth, such as the late 1990s, it looks as though they come in between 3 and 5 percent and center near 4 percent or so, although I know there are many ways to measure them. Right now it appears that, by the same sort of measurement, the real funds rate is between 2½ and 3 percent. So I still sense that the real rate is low by historical standards for a period of economic expansion like the one we seem to be in now. My sense is that we may need to raise rates beyond today because it seems clear to me that we’re not pleased with recent inflation or the inflation outlook. The rate of inflation has been substantially higher over the past few months than we would like, and I think the level of inflation expectations is too high as well, although I recognize some of the subtleties involved in gauging inflation expectations accurately. Moreover, inflation expectations appear to be unnecessarily fluctuating; we’ve been on something of a rollercoaster ride for the past few months. Inflation expectations rose when the public wasn’t sure how we would respond to the oil-price shocks, just as they did after Katrina, and inflation expectations came down as they did last October and November only after we communicated our intentions. These ups and downs really serve no useful purpose in my view. Last night at dinner, Rachel Lomax made a relevant remark about the extent to which their regime anchors inflation expectations and causes firms to adjust to oil-price increases, not by passing through but by cutting wages and costs elsewhere. I think that’s a relevant example here. To say that some inflation currently is a consequence of oil-price increases is incomplete, as we all know, because the extent to which oil-price increases pass through to overall inflation is entirely a consequence of the policy reaction function that is either in place or is viewed as being in place by the public. Now, I’m not going to claim that this is the end of the world. This isn’t the 1970s. I think the credibility of our commitment to not let inflation rise to 10 percent is very secure. But we ought to be able to improve upon a policy regime and an accompanying equilibrium in which expectations for ten-year-ahead inflation fluctuate as much as they have over the past several months. So I agree with Governor Kohn that we ought to raise rates at this meeting. We ought to leave open the option in our statements that we could raise rates again. I think it’s very important to use today’s statement to clarify our intentions regarding inflation; otherwise we’re likely to be in for more rollercoaster rides in the months and quarters ahead. I have two concrete recommendations about the statement. First, note that on June 1 the Chairman characterized recent inflation readings as “unwelcome”—a very important word that harkens back to the word the Committee used in 2003 to communicate a lower bound on the range of inflation rates the Committee considered consistent with price stability. We should use that word again today in our statement to communicate that we do not view current inflation readings as consistent with price stability. I’m afraid that failing to do so would be a glaring omission and would unnecessarily perpetuate ambiguity about our intentions. My second recommendation about the statement has to do with the assessment of risk, the first sentence in alternative B, row 4, that reads, “Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain.” Placing anticipation of an aggregate demand slowdown front and center in our assessment of inflation dynamics seems odd to me in light of all of the talk around this table over the recent years about how flat the relationship is between aggregate demand and inflation. Moreover, even with the sentence that follows it in that paragraph, it seems to imply that we’re willing to simply wait for a moderation of inflation rather than take sufficient action ourselves. Given the Greenbook’s forecast, it asks a relatively modest output gap to do a whole lot of work. It also—but this is a sort of broader doctrinal issue—risks leaving the impression that our methodology for controlling inflation is to manipulate aggregate demand, and I’m not sure that’s entirely accurate. The assessment-of-risk sentence in alternative C would be much more appropriate than the first sentence in alternative B. It states clearly what we would like to see happen with inflation: “In order to foster price stability and a sustainable economic growth, the Committee seeks a medium-term decline in core inflation from its recent elevated levels.” My sense is that this is something that everyone around the table wants—a medium-term decline in core inflation; if that’s the case, we ought to state it clearly to the public. These two changes would send a much clearer message about our focus on inflation risks. Thank you, Mr. Chairman." FOMC20080430meeting--71 69,MR. SHEETS.," It is, quite frankly, pretty tough to get a straight and compelling answer out of the OPEC folks about how they think about the oil markets. A number of us have sat in international meetings and listened to various explanations. In fact, at one recent meeting in Basel, the representative from Saudi Arabia indicated that OPEC was not prepared to supply any more oil to the market because the market was already well supplied at the equilibrium price. It is really quite frustrating. Now, what they say in these meetings is that their analysis of supply-and-demand fundamentals would suggest a price of $70 a barrel, $80 a barrel, or something like that. Then they blame the residual on speculators and so on, and we spend a fair amount of time looking for such speculative effects in these oil prices, and we wouldn't want to rule anything out. I mean, from what we've seen, there may be an explanation out there that eludes us, but there are a number of things that we would expect to see if it were speculation--for instance, run-ups in inventories--that we don't see. We have also looked at the behavior of noncommercial traders, and it does not seem as though the noncommercial traders are actually predicting prices. Quite the opposite--they seem to be chasing the price, which is quite different from what we would have expected. Most recently, in a statement just this week, OPEC's president linked the run-up in oil prices to the depreciation of the dollar and indicated that, for every 1 percent decline in the dollar, oil prices would rise $4.00 a barrel, which strikes us as being just absolutely extraordinary. We can see 1 percent on the dollar moving oil prices 1 percent, but to get a coefficient beyond that just seems--I don't want to say ""economically impossible,"" but I'd like to see the model that generates it. Now, about how they actually talk about oil prices behind closed doors, I don't have any additional insight to provide other than what I've heard them say in some of these international meetings. Certainly in our analysis we try to think through the outlook for demand from countries like China and India. In fact, quite regularly we do a full-blown supply-and-demand balance exercise in which we say, ""Here is the price. What kind of supply-and-demand fundamentals would be necessary to deliver that price?"" We use the IEA, the EIA, and others as input, but we actually do our own separate analyses. We try to think very granularly about the demand from these emerging market countries and the implications that that has on the price. As to the last part of your question, I think certainly it's true, at least until recently, that there was a sense on the part of OPEC that, if they allowed the price to stay too high for too long, there would be a significant supply response that would end up driving the price back down. Now, the fact that they seem quite comfortable to live with the price of $115 or $120 a barrel suggests to me that maybe they have come to the conclusion that there is just more demand out there and, in some sense, they are going to ride the wave of this increasing demand in some of these emerging market economies. That said, the prices have risen a lot. They're up 75 percent or 80 percent over the past year. A year ago I'm sure that that's not what my predecessor was forecasting, and it's hard for me to imagine that we're going to see oil at $200 a barrel. Nevertheless, given the income and price elasticities of this thing, our view is that 1 percent greater global demand that's not met by supply could very well push prices up at least 10 percent. It isn't going to take a whole lot of surprise on global demand to have a significant impact on prices. As I said, I think that OPEC is aware of that and is willing to run the risk that there may be at some point a large supply response that could put significant downward pressure on the price of oil. " CHRG-111shrg56262--95 PREPARED STATEMENT OF ANDREW DAVIDSON President, Andrew Davidson and Company October 7, 2009 Mr. Chairman and Members of the Subcommittee, I appreciate the opportunity to testify before you today about securitization. My expertise is primarily in the securitization of residential mortgages and my comments will be primarily directed toward those markets. Securitization has been a force for both good and bad in our economy. A well functioning securitization market expands the availability of credit for economic activity and home ownership. It allows banks and other financial institutions to access capital and reduces risk. On the other hand a poorly functioning securitization market may lead to misallocation of capital and exacerbate risk. \1\--------------------------------------------------------------------------- \1\ Portions of this statement are derived from ``Securitization: After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.--------------------------------------------------------------------------- Before delving into a discussion of the current crisis, I would like to distinguish three types of capital markets activities that are often discussed together: Securitization, Structuring, and Derivatives. \2\--------------------------------------------------------------------------- \2\ See, Andrew Davidson, Anthony Sanders, Lan-Ling Wolff, and Anne Ching, ``Securitization'', 2003, for a detailed discussion of securitization and valuation of securitized products.--------------------------------------------------------------------------- Securitization is the process of converting individual loans into securities that can be freely transferred. Securitization serves to separate origination and investment functions. Without securitization investors would need to go through a very complex process of transferring the ownership of individual loans. The agency mortgage-backed securities (MBS) from Ginnie Mae, Fannie Mae, and Freddie Mac are one of the most successful financial innovations. However, as the last years have taught us, the so-called, ``originate to sell'' model, especially as reflected in private-label (nonagency) MBS, has serious shortcomings. Structuring is the process of segmenting the cash flows of one set of financial instruments into several bonds which are often called tranches. The collateralized mortgage obligation or CMO is a classic example of structuring. The CMO transforms mortgage cash flows into a variety of bonds that appeal to investors from short-term stable bonds, to long-term investments. Private label MBS use a second form of structuring to allocate credit risk. A typical structure uses subordination, or over-collateralization, to create bonds with different degrees of credit risk. The collateralized debt obligation or CDO is a third form of structuring. In this case, bonds, rather than loans, are the underlying collateral for the CDO bonds which are segmented by credit risk. Structuring allows for the expansion of the investor base for mortgage cash flows, by tailoring the bonds characteristics to investor requirements. Unfortunately, structuring has also been used to design bonds that obfuscate risk and return. Derivatives, or indexed contracts, are used to transfer risk from one party to another. Derivatives are a zero sum game in that one investor's gain is another's loss. While typically people think of swaps markets and futures markets when they mention derivatives, the TBA (to be announced) market for agency pass-through mortgages is a large successful derivative market. The TBA market allows for trading in pass-through MBS without the need to specify which pool of mortgages will be delivered. More recently a large market in mortgage credit risk has developed. The instruments in this market are credit default swaps (CDS) and ABX, an over-the-counter index based on subprime mortgage CDS. Derivatives allow for risk transfer and can be powerful vehicles for risk management. On the other hand, derivatives may lead to the creation of more risk in the economy as derivate volume may exceed the underlying asset by substantial orders of magnitude. For any of these products to be economically useful they should address one or more of the underlying investment risks of mortgages: funding, interest rate risk, prepayment risk, credit risk, and liquidity. More than anything else mortgages represent the funding of home purchases. The twelve trillion of mortgages represents funding for the residential real estate of the country. Interest rate risk arises due to the fixed coupon on mortgages. For adjustable rate mortgages it arises from the caps, floors and other coupon limitations present in residential mortgage products. Interest rate risk is compounded by prepayment risk. Prepayment risk reflects both a systematic component that arises from the option to refinance (creating the option features of MBS) as well as the additional uncertainty created by the difficulty in accurately forecasting the behavior of borrowers. Credit risk represents the possibility that borrowers will be unable or unwilling to make their contractual payments. Credit risk reflects the borrower's financial situation, the terms of the loan and the value of the home. Credit risk has systematic components related to the performance of the economy, idiosyncratic risks related to individual borrowers and operational risks related to underwriting and monitoring. Finally, liquidity represents the ability to transfer the funding obligation and/or the risks of the mortgages. In addition to the financial characteristics of these financial tools, they all have tax, regulatory and accounting features that affect their viability. In some cases tax, regulatory and accounting outcomes rather than financial benefit are the primary purpose of a transaction. In developing policy alternatives each of these activities: securitization, structuring and derivatives, pose distinct but interrelated challenges.Role of Securitization in the Current Financial Crisis The current economic crisis represents a combination of many factors and blame can be laid far and wide. Additional analysis may be required to truly assess the causes of the crisis. Nevertheless I believe that securitization contributed to the crisis in two important ways. It contributed to the excessive rise in home prices and it created instability once the crisis began. First, the process of securitization as implemented during the period leading up to the crisis allowed a decline in underwriting standards and excessive leverage in home ownership. The excess lending likely contributed to the rapid rise in home prices leading up to the crisis. In addition to the well documented growth in subprime and Alt-A lending, we find that the quality of loans declined during the period from 2003 to 2005, even after adjusting for loan to value ratios, FICO scores, documentation type, home prices and other factors reflected in data available to investors. The results of our analysis are shown in Figure 1. It shows that the rate of delinquency for loans originated in 2006 is more than 50 percent higher than loans originated in 2003. The implication is that the quality of underwriting declined significantly during this period, and this decline was not reflected in the data provided to investors. As such it could reflect fraud, misrepresentations and lower standard for verifying borrower and collateral data. The net impact of this is that borrowers were granted credit at greater leverage and at lower cost than in prior years.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In concrete terms, the securitization market during 2005 and 2006 was pricing mortgage loans to an expected lifetime loss of about 5 percent. Our view is that even if home prices had remained stable, these losses would have been 10 percent or more. Given the structure of many of these loans, with a 2-year initial coupon and an expected payoff by the borrower at reset, the rate on the loans should have been 200 or 300 basis points higher. That is, initial coupons should have been over 10 percent rather than near 8 percent. Our analysis further indicates that this lower cost of credit inflated home prices. The combination of relaxed underwriting standards and affordability products, such as option-arms, effectively lowered the required payment on mortgages. The lower payment served to increase the price of homes that borrowers could afford. Figure 2 shows the rapid rise in the perceived price that borrowers could afford in the Los Angeles area due to these reduced payment requirements. Actual home prices then followed this pattern. Generally we find that securitization of subprime loans and other affordability products such as option arms were more prevalent in the areas with high amounts of home price appreciation during 2003 to 2006. To be clear, not all of the affordability loans were driven by securitization, as many of the option arms remained on the balance sheet of lending institutions.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Figure 3 provides an indication of the magnitude of home price increases that may have resulted from these products on a national basis. Based on our home price model, we estimate that home prices may have risen by 15 percent at the national level due to lower effective interest rates. In the chart, the gap between the solid blue line and the dashed blue line reflects the impact of easy credit on home prices.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] On the flip side, we believe that the shutting down of these markets and the reduced availability of mortgage credit contributed to the sharp decline in home prices we have seen since 2006 as shown in Figure 4. Without an increase in effective mortgage rates, home prices might have sustained their inflated values as shown by the dashed blue line. \3\--------------------------------------------------------------------------- \3\ See, http://www.ad-co.com/newsletters/2009/Jun2009/Valuation_Jun09.pdf for more details.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Thus the reduced focus on underwriting quality lead to an unsustainable level of excess leverage and reduced borrowing costs which helped to inflate home prices. When these ``affordability'' products were no longer sustainable in the market, they contributed to the deflation of the housing bubble. The way securitization was implemented during this period fostered high home prices through poor underwriting, and the end of that era may have led to the sharp decline in home prices and the sharp decline in home prices helped to spread the financial crisis beyond the subprime market. The second way that securitization contributed to the current economic crisis is through the obfuscation of risk. For many structures in the securitization market: especially collateralized debt obligations, structured investment vehicles and other resecuritizations, there is and was insufficient information for investors to formulate an independent judgment of the risks and value of the investment. As markets began to decline in late 2007, investors in all of these instruments and investors in the institutions that held or issued these instruments were unable to assess the level of risk they bore. This lack of information quickly became a lack of confidence and led to a massive deleveraging of our financial system. This deleveraging further depressed the value of these complex securities and led to real declines in economic value as the economy entered a severe recession. In addition, regulators lacked the ability to assess the level of risk in regulated entities, perhaps delaying corrective action or other steps that could have reduced risk levels earlier.Limitations of Securitization Revealed To understand how the current market structure could lead to undisciplined lending and obfuscation of risk it is useful to look at a simplified schematic of the market. \4\--------------------------------------------------------------------------- \4\ Adapted from ``Six Degrees of Separation'', August 2007, by Andrew Davidson http://www.securitization.net/pdf/content/ADC_SixDegrees_1Aug07.pdf.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In the simplest terms, what went wrong in the subprime mortgage in particular and the securitization market in general is that the people responsible for making loans had too little financial interest in the performance of those loans and the people with financial interest in the loans had too little involvement in the how the loans were made. The secondary market for nonagency mortgages, including subprime mortgages, has many participants and a great separation of the origination process from the investment process. Each participant has a specialized role. Specialization serves the market well, as it allows each function to be performed efficiently. Specialization, however also means that risk creation and risk taking are separated. In simplified form the process can be described as involving: A borrower--who wants a loan for home purchase or refinance A broker--who works with the borrower and lenders to arrange a loan A mortgage banker--who funds the loan and then sells the loan An aggregator--(often a broker-dealer) who buys loans and then packages the loans into a securitization, whose bonds are sold to investors. A CDO manager--who buys a portfolio of mortgage-backed securities and issues debt An investor--who buys the CDO debt Two additional participants are also involved: A servicer--who keeps the loan documents and collects the payments from the borrower A rating agency--that places a rating on the mortgage securities and on the CDO debt This chart is obviously a simplification of a more complex process. For example, CDOs were not the only purchasers of risk in the subprime market. They were however a dominant player, with some estimating that they bought about 70 percent of the lower rated classes of subprime mortgage securitizations. What is clear even from this simplified process is that contact between the provider of risk capital and the borrower was very attenuated. A central problem with the securitization market, especially for subprime loans was that no one was the gate keeper, shutting the door on uneconomic loans. The ultimate CDO bond investor placed his trust in the first loss investor, the rating agencies, and the CDO manager, and in each case that trust was misplaced. Ideally mortgage transactions are generally structured so that someone close to the origination process would take the first slice of credit risk and thus insure that loans were originated properly. In the subprime market, however it was possible to originate loans and sell them at such a high price, that even if the mortgage banker or aggregator retained a first loss piece (or residual) the transaction could be profitable even if the loans did not perform well. Furthermore, the terms of the residuals were set so that the owner of the residual might receive a substantial portion of their cash flows before the full extent of losses were known. Rating agencies set criteria to establish credit enhancement levels that ultimately led to ratings on bonds. The rating agencies generally rely on historical statistical analysis to set ratings. The rating agencies also depend on numeric descriptions of loans like loan-to-value ratios and debt-to-income ratios to make their determinations. Rating agencies usually do not review loans files or ``re-underwrite'' loans. Rating agencies also do not share in the economic costs of loan defaults. The rating agencies methodology allowed for the inclusion of loans of dubious quality into subprime and Alt-A mortgage pools, including low documentation loans for borrowers with poor payment histories, without the offsetting requirement of high down payments. To help assure investors of the reliability of information about the risks of purchased loans, the mortgage market has developed the practice of requiring ``representations and warranties'' on purchased loans. These reps and warrants as they are called, are designed to insure that the loans sold meet the guidelines of the purchasers. This is because mortgage market participants have long recognized that there is substantial risk in acquiring loans originated by someone else. An essential component in having valuable reps and warrants is that the provider of those promises has sufficient capital to back up their obligations to repurchase loans subsequently determined to be inconsistent with the reps and warrants. A financial guarantee from an insolvent provider has no value. Representations and warranties are the glue that holds the process together; if the glue is weak the system can collapse. The rating agencies also established criteria for Collateralized Debt Obligations that allowed CDO managers to produce very highly leveraged portfolios of subprime mortgage securities. The basic mechanism for this was a model that predicted the performance of subprime mortgage pools were not likely to be highly correlated. That is defaults in one pool were not likely to occur at the same time as defaults in another pool. This assumption was at best optimistic and most likely just wrong. In the CDO market the rating agencies have a unique position. In most of their other ratings business, a company or a transaction exists or is likely to occur and the rating agency reviews that company or transaction and establishes ratings. In the CDO market, the criteria of the rating agency determine whether or not the transaction will occur. A CDO is like a financial institution. It buys assets and issues debt. If the rating agency establishes criteria that allow the institution to borrow money at a low enough rate or at high enough leverage, then the CDO can purchase assets more competitively than other financial institutions. If the CDO has a higher cost of debt or lower leverage, then it will be at a disadvantage to other buyers and will not be brought into existence. If the CDO is created, the rating agency is compensated for its ratings. If the CDO is not created, there is no compensation. My view is that there are very few institutions that can remain objective given such a compensation scheme. CDO bond investors also relied upon the CDO manager to guide them in the dangerous waters of mortgage investing. Here again investors were not well served by the compensation scheme. In many cases CDO managers receive fees that are independent of the performance of the deals they manage. While CDO managers sometimes keep an equity interest in the transactions they manage, the deals are often structured in such a way that that the deal can return the initial equity investment even if some of the bonds have losses. Moreover, many of the CDOs were managed by start-up firms with little or no capital. Nevertheless, much of the responsibility should rest with the investors. CDO bond investors were not blind to the additional risks posed by CDO investing. CDOs generally provided higher yields than similarly rated bonds, and it is an extremely naive, and to my mind, rare, investor who thinks they get higher returns without incremental risk. It is not unusual, however, for investors not to realize the magnitude of additional risk they bear for a modest incremental return. Ultimately it is investors who will bear the losses, and investors must bear the bulk of the burden in evaluating their investments. There were clear warning signs for several years as to the problems and risk of investing in subprime mortgages. Nevertheless, investors continued to participate in this sector as the risks grew and reward decreased. As expressed herein, the primary problem facing securitization is a failure of industrial organization. The key risk allocators in the market, the CDO managers, were too far from the origination process and, at best, they believed the originators and the rating agencies were responsible for limiting risk. At the origination end, without the discipline of a skeptical buyer, abuses grew. The buyer was not sufficiently concerned with the process of loan origination and the broker was not subject to sufficient constraints.Current Conditions of the Mortgage-backed Securities Market More than 2 years after the announcement of the collapse of the Bear Stearns High Grade Structured Credit Enhanced Leverage Fund the mortgage market remains in a distressed state. Little of the mortgage market is functioning without the direct involvement of the U.S. Government, and access to financing for mortgage originators and investors is still limited. Fortunately there are the beginning signs of stabilization of home prices, but rising unemployment threatens the recovery. In the secondary market for mortgage-backed securities there has been considerable recovery in price in some sectors, but overall demand is being propped up by large purchases of MBS by the Federal Reserve Bank. In addition, we find that many of our clients are primarily focused on accounting and regulatory concerns related to legacy positions, and less effort is focused on the economic analysis of current and future opportunities. That situation may be changing as over the past few months we have seen some firms begin to focus on longer term goals.The Effectiveness of Government Action I have not performed an independent analysis of the effectiveness of Government actions, so by comments are limited to my impressions. Government involvement has been beneficial in a number of significant respects. Without Government involvement in Fannie Mae, Freddie Mac, and FHA lending programs, virtually all mortgage lending could have stalled. What lending would have existed would have been for only the absolute highest quality borrowers and at restrictive rates. In addition Government programs to provide liquidity have also been beneficial to the market as private lending was reduced to extremely low levels. Government and Federal Reserve purchases of MBS have kept mortgage rates low. This has probably helped to bolster home prices. On the other hand the start/stop nature of the buying programs under TARP and PPIP has probably been a net negative for the market. Market participants have held back on investments in anticipation of Government programs that either did not materialize or were substantially smaller in scope than expected. Furthermore Government efforts to influence loan modifications, while beneficial for some home owners, and possibly even investors, have created confusion and distrust. Investors are more reluctant to commit capital when the rules are uncertain. In my opinion there has been excessive focus on loan modifications as a solution to the current crisis. Loan modifications make sense for a certain portion of borrowers whose income has been temporarily disrupted or have sufficient income to support a modestly reduce loan amount and the willingness to make those payments. However for many borrowers, loan modifications cannot produce sustainable outcomes. In addition, loan modifications must deal with the complexities of multiple liens and complex ownership structures of mortgage loans. Short sales, short payoffs, and relocation assistance for borrowers are other alternatives that should be given greater weight in policy development. The extensive Government involvement in the mortgage market has likely produced significant positive benefits to the economy. However unwinding the Government role will be quite complex and could be disruptive to the recovery. Government programs need to be reduced and legislative and regulatory uncertainties need to be addressed to attract private capital back into these markets.Legislative and Regulatory Recommendations I believe that the problems in the securitization market were essentially due to a failure of industrial organization. Solutions should address these industrial organization failures. While some may seek to limit the risks in the economy, I believe a better solution is to make sure the risks are borne by parties who have the capacity to manage the risks or the capital to bear those risks. In practical terms, this means that ultimately bond investors, as the creators of leverage, must be responsible for limiting leverage to economically sustainable levels that do not create excessive risk to their stakeholders. Moreover, lenders should not allow equity investors to have tremendous upside with little exposure to downside risk. Equity investors who have sufficient capital at risk are more likely to act prudently. Consequently, all the information needed to assess and manage risks must be adequately disclosed and investors should have assurances that the information they rely upon is accurate and timely. Likewise when the Government acts as a guarantor, whether explicitly or implicitly, it must insure that it is not encouraging excessive risk taking and must have access to critical information on the risks borne by regulated entities. In this light, I would like to comment on the Administration proposals on Securitization in the white paper: ``Financial Regulatory Reform: A New Foundation.'' \5\ Recommendations 1 and 2 cover similar ground:--------------------------------------------------------------------------- \5\ http://www.financialstability.gov/docs/regs/FinalReport_web.pdf pp. 44-46. 1. Federal banking agencies should promulgate regulations that require originators or sponsors to retain an economic interest in a material portion of the credit risk of securitized credit --------------------------------------------------------------------------- exposures. The Federal banking agencies should promulgate regulations that require loan originators or sponsors to retain 5 percent of the credit risk of securitized exposures. 2. Regulators should promulgate additional regulations to align compensation of market participants with longer term performance of the underlying loans. Sponsors of securitizations should be required to provide assurances to investors, in the form of strong, standardized representations and warranties, regarding the risk associated with the origination and underwriting practices for the securitized loans underlying ABS. Clearly excessive leverage and lack of economic discipline was at the heart of the problems with securitization. As described above the market failed to adequately protect investors from weakened underwriting standards. Additional capital requirements certainly should be part of the solution. However, such requirements need to be constructed carefully. Too little capital and it will not have any effect; too much and it will inhibit lending and lead to higher mortgage costs. The current recommendation for retention of 5 percent of the credit risk does not seem to strike that balance appropriately. When a loan is originated there are several kinds of credit related risks that are created. In addition to systematic risks related to future events such as changes in home prices and idiosyncratic risks such as changes in the income of the borrower, there are also operational risks related to the quality of the underwriting and servicing. An example of an underwriting risk is whether or not the borrower's income and current value of their home were verified appropriately. Originators are well positioned to reduce the operational risks associated with underwriting and fight fraud, but they may be less well positioned to bear the long term systematic and idiosyncratic risks associated with mortgage lending. Investors are well positioned to bear systemic risks and diversify idiosyncratic risks, but are not able to assess the risks of poor underwriting and servicing. The securitization process should ensure that there is sufficient motivation and capital for originators to manage and bear the risks of underwriting and sufficient information made available to investors to assess the risks they take on. The current form of representations and warranties is flawed in that it does not provide a direct obligation from the originator to the investor. Instead representations and warranties pass through a chain of ownership and are often limited by ``knowledge'' and capital. In addition current remedies are tied to damages and in a rising home price market calculated damages may be limited. Thus a period of rising home prices can mask declining credit quality and rising violations of representations and warranties. Therefore, incentives and penalties should be established to limit unacceptable behavior such as fraud, misrepresentations, predatory lending. If the goal is to prevent fraud, abuse and misrepresentations rather than to limit risk transfer then there needs to be a better system to enforce the rights of borrowers and investors than simply requiring a originators to retain a set percentage of credit risk. I have proposed \6\ a ``securitization certificate'' which would travel with the loan and would be accompanied by appropriate assurances of financial responsibility. The certificate would replace representations and warranties, which travel through the chain of buyers and sellers and are often unenforced or weakened by the successive loan transfers. The certificate could also serve to protect borrowers from fraudulent origination practices in the place of assignee liability. Furthermore the certificate should be structured so that there are penalties for violations regardless of whether or not the investor or the borrower has experienced financial loss. The record of violations of these origination responsibilities should publically available.--------------------------------------------------------------------------- \6\ http://www.ad-co.com/newsletters/2008/Feb2008/Credit_Feb08.pdf and ``Securitization: After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.--------------------------------------------------------------------------- I have constructed a simple model of monitoring fraudulent loans. \7\ Some preliminary results are shown in Table 1. These simulations show the impact of increasing the required capital for a seller and of instituting a fine for fraudulent loans beyond the losses incurred. These results show that under the model assumptions, without a fine for fraud, sellers benefit from originating fraudulent loans. The best results are obtained when the seller faces fines for fraud and has sufficient capital to pay those fines. The table below shows the profitability of the seller and buyer for various levels of fraudulent loans. In the example below, the profits of the seller increase from .75 with no fraudulent loans to .77 with 10 percent fraudulent loans, even when the originator retains 5 percent capital against 5 percent of the credit risk. On the other hand, the sellers profit falls from .75 to .44 with 10 percent fraudulent loans even though the retained capital is only 1 percent, but there is a penalty for fraudulent loans. Thus the use of appropriate incentives can reduce capital costs, while increasing loan quality.--------------------------------------------------------------------------- \7\ The IMF has produced a similar analysis and reached similar conclusions. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/chap2.pdf.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Under this analysis the Treasury proposals would not have a direct effect on fraud. In fact, there is substantial risk the recommended approach of requiring minimum capital requirements for originators to bear credit risk would lead to either higher mortgage rates or increased risk taking. A better solution is to create new mechanisms to monitor and enforce the representations and warranties of originators. With adequate disclosure of risks and a workable mechanism for enforcing quality controls the securitization market can more effectively price and manage risk. Recommendation 3 addresses the information available to investors: 3. The SEC should continue its efforts to increase the transparency and standardization of securitization markets and be given clear authority to require robust reporting by issuers of asset backed securities (ABS). Increased transparency and standardization of securitization markets would likely to better functioning markets. In this area, Treasury charges the SEC and ``industry'' with these goals. I believe there needs to be consideration of a variety of institutional structures to achieve these goals. Standardization of the market can come from many sources. Possible candidates include the SEC, the American Securitization Forum, the Rating Agencies and the GSEs, Fannie Mae and Freddie Mac. I believe the best institutions to standardize a market are those which have an economic interest in standardization and disclosure. Of all of these entities the GSEs have the best record of standardizing the market; this was especially true before their retained portfolios grew to dominate their income. (As I will discuss below, reform of the GSEs is essential for restoring securitization.) I believe a revived Fannie Mae and Freddie Mac, limited primarily to securitization, structured as member-owned cooperatives, could be an important force for standardization and disclosure. While the other candidates could achieve this goal they each face significant obstacles. The SEC operates primarily through regulation and therefore may not be able to adapt to changing markets. While the ASF has made substantial strides in this direction, the ASF lacks enforcement power for its recommendations and has conflicting constituencies. The rating agencies have not shown the will or the power to force standardization, and such a role may be incompatible with their stated independence. Recommendations 4 and 5 address the role of rating agencies in securitization. 4. The SEC should continue its efforts to strengthen the regulation of credit rating agencies, including measures to require that firms have robust policies and procedures that manage and disclose conflicts of interest, differentiate between structured and other products, and otherwise promote the integrity of the ratings process. 5. Regulators should reduce their use of credit ratings in regulations and supervisory practices, wherever possible. In general I believe that the conflicts of interest facing rating agencies and their rating criteria were well known and easily discovered prior to the financial crisis. Thus I do not believe that greater regulatory authority over rating agencies will offer substantial benefits. In fact, increasing competition in ratings or altering the compensation structure of rating agencies may not serve to increase the accuracy of ratings, since most users of ratings issuers as well as investors are generally motivated to seek higher ratings. (Only if the regulatory reliance on rating agencies is reduced will these structural changes be effective.) To the extent there is reliance on rating agencies in the determination of the capital requirement for financial institutions, a safety and soundness regulators for financial institutions, such the FFIEC or its successor, should have regulatory authority over the rating agencies. Rather than focus on better regulation, I support the second aspect of Treasury's recommendations on rating agencies (recommendation 5) and believe it would be better for safety and soundness regulators to reduce their reliance on ratings and allow the rating agencies to continue their role of providing credit opinions that can be used to supplement credit analysis performed by investors. To reduce reliance on ratings, regulators, and others will need alternative measures of credit and other risks. I believe that the appropriate alternative to ratings is analytical measures of risk. Analytical measures can be adopted, refined, and reviewed by regulators. In addition regulators should insist that regulated entities have sufficient internal capacity to assess the credit and other risks of their investments. In this way regulators would have greater focus on model assumptions and model validation and reduced dependence on the judgment of rating agencies. The use of quantitative risk measures also requires that investors and regulators have access to sufficient information about investments to perform the necessary computations. Opaque investments that depend entirely upon rating agency opinions would be clearly identified. Quantitative measures can also be used to address the concerns raised in the report about concentrations of risk and differentiate structured products and direct corporate obligations. I recently filed a letter with the National Association of Insurance Commissioners on the American Council of Life Insurers' proposal to use an expected loss measure as an alternative to ratings for nonagency MBS in determining risk based capital. Here I would like to present some of the key points in that letter: An analytical measure may be defined as a number, or a value, that is computed based on characteristics of a specific bond, its collateral and a variety of economic factors both historical and prospective. One such analytical measure is the probability of default and another measure is the expected loss of that bond. While an analytical measure is a numeric value that is the result of computations, it should be noted that there may still be some judgmental factors that go into its production. In contrast, a rating is a letter grade, or other scale, assigned to a bond by a rating agency. While ratings have various attributes, generally having both objective and subjective inputs, there is not a particular mathematical definition of a rating. Analytical measures may be useful for use by regulators because they have several characteristics not present in ratings. 1. An analytical measure can be designed for a specific purpose. Specific analytical measures can be designed with particular policy or risk management goals in mind. Ratings may reflect a variety of considerations. For example, there is some uncertainty as to whether ratings represent the first dollar of loss or the expected loss, or how expected loss is reflected in ratings. 2. Analytical measures can be updated at any frequency. Ratings are updated only when the rating agencies believe there has been sufficient change to justify an upgrade, downgrade or watch. Analytical measures can be computed any time new information is available and will show the drift in credit quality even if a bond remains within the same rating range. 3. Analytical measures can take into account price or other investor specific information. Ratings are computed for a bond and generally reflect the risk of nonpayment of contractual cash flows. However, the risk to a particular investor of owning a bond will at least partially depend on the price that the bond is carried in the portfolio or the composition of the portfolio. 4. Regulators may contract directly with vendors to produce analytical results and may choose the timing of the calculations. On the other hand, ratings are generally purchased by the issuer at the time of issuance. Not only may this introduce conflicts of interest, but it also creates a greater focus on initial ratings than on surveillance and updating of ratings. In addition, once a regulator allows the use of a particular rating agency it has no further involvement in the ratings process. 5. Analytical measures based on fundamental data may also be advantageous over purely market-based measures. As market conditions evolve values of bonds may change. These changes reflect economic fundamentals, but may also reflect supply/ demand dynamics, liquidity and risk preferences. Measures fully dependent on market prices may create excessive volatility in regulatory measures, especially for companies with the ability to hold bonds to maturity. Even if regulators use analytical measures of risk, ratings from rating agencies as independent opinions would still be valuable to investors and regulators due to the multifaceted nature of ratings and rating agency analysis can be used to validate the approaches and assumptions used to compute particular analytical measures. Additional measures beyond the credit risk of individual securities such as stress tests, market value sensitivity and measures of illiquidity may also be appropriate in the regulatory structure. The use of analytical measures rather than ratings does not eliminate the potential for mistakes. In general, any rigid system can be gamed as financial innovation can often stay ahead of regulation. To reduce this problem regulation should be based on principles and evolve with the market. Regulators should always seek to build an a margin of safety as there is always a risk that the theory underlying the regulatory regime falls short and that some participants will find mechanisms to take advantage of the regulatory structure. Finally, as discussed by the Administration in the white paper, the future of securitization for mortgages requires the resolution of the status of Fannie/Freddie and role of FHA/GNMA. As stated above, I believe that continuation of Fannie Mae and Freddie Mac as member owned cooperatives would serve to establish standards, and provide a vehicle for the delivery of Government guarantees if so desired. The TBA, or to be announced, market has been an important component in the success of the fixed rate mortgage market in the United States. Careful consideration should be given to the desirability of fixed rate mortgages and the mechanisms for maintaining that market in discussions of the future of the GSEs. ______ CHRG-111hhrg48867--173 Mr. Price," Thank you, Mr. Chairman. I want to thank the panelists, as well, for their testimony today and their forbearance with the questions and the time. I think it is important to remember that our Nation has provided the greatest amount of freedom and opportunity and success for more people than any nation in the history of mankind. And I think it is incumbent upon us to appreciate that we haven't done that by virtue of excessive regulation. It would seem that it would be important for us, as Members of Congress, to attempt to define what has allowed that success--if you define that as success--what has allowed that success to occur and attempt to embrace those fundamental principles. Everybody has talked about systemic risk, but I don't know that we have a definition of it. Anybody care to give me a definition of systemic risk? " CHRG-111shrg61651--75 Mr. Reed," There was a tremendous amount of leverage. Senator Merkley. ----101 or something like that. Senator Reed. Yes, it was tremendous leverage, and what we should have learned was that there wasn't enough capital to absorb the risks that were in the system, and therefore, when the risks manifest themselves, the human reaction is, let us gang together and we will see if we can take this together. Well, we had a situation there that was a one-institution version of what later happened to all of us and where basically the taxpayer had to step in because there wasn't enough capital in the private sector to cover the risks that were manifesting themselves in this crisis we have gone through. And so my question about Long-Term Capital was there was the anatomy of the problem that we are today wrestling with. It was alone that sat there. It was tremendously interconnected. As you say, it had counterparty lines. It had all sorts of assets which conceivably would have been liquidated at very distressed prices and so forth, which would have impacted the market. And yet as a system, we sort of ganged together, papered it over, and went on having learned nothing. " fcic_final_report_full--274 Prince and Rubin appeared to believe up until the fall of  that any downside risk in the CDO business was minuscule. “I don’t think anybody focused on the CDOs. This was one business in a vast enterprise, and until the trouble developed, it wasn’t one that had any particular profile,” Rubin—in Prince’s words, a “very important member of [the] board”  —told the FCIC. “You know, Tom Maheras was in charge of trading. Tom was an extremely well regarded trading figure on the street. . . . And this is what traders do, they handle these kinds of problems.”  Maheras, the co-head of Citigroup’s investment bank, told the FCIC that he spent “a small fraction of ” of his time thinking about or dealing with the CDO business.  Citigroup’s risk management function was simply not very concerned about hous- ing market risks. According to Prince, Bushnell and others told him, in effect, “‘Gosh, housing prices would have to go down  nationwide for us to have, not a problem with [mortgage-backed securities] CDOs, but for us to have problems,’ and that has never happened since the Depression.”  Housing prices would be down much less than  when Citigroup began having problems because of write-downs and the liquidity puts it had written. By June , national house prices had fallen ., and about  of subprime adjustable-rate mortgages were delinquent. Yet Citigroup still did not expect that the liquidity puts could be triggered, and it remained unconcerned about the value of its retained super-senior tranches of CDOs. On June , , Citigroup made a presenta- tion to the SEC about subprime exposure in its CDO business. The presentation noted that Citigroup did not factor two positions into this exposure: . billion in super- senior tranches and . billion in liquidity puts. The presentation explained that the liquidity puts were not a concern: “The risk of default is extremely unlikely . . . [and] certain market events must also occur for us to be required to fund. Therefore, we view these positions to be even less risky than the Super Senior Book.”  Just a few weeks later, the July  failure of the two Bear Stearns hedge funds spelled trouble. Commercial paper written against three Citigroup-underwritten CDOs for which Bear Stearns Asset Management was the asset manager and on which Citigroup had issued liquidity puts began losing value, and their interest rates began rising. The liquidity puts would be triggered if interest rates on the asset- backed commercial paper rose above a certain level. FOMC20080430meeting--320 318,MR. LACKER.," Presumably, the rate we pay would be viewed as a risk-free rate. Presumably, any market rate would be priced relative to that to include a credit premium in the usual way. If any other dynamics are anticipated by the staff, it would be useful to know that. But the usual presumption we have is that observed market rates would have our rate plus a credit premium booked into it, or transaction costs, or whatever. I'd just make that comment. " FOMC20080430meeting--204 202,VICE CHAIRMAN GEITHNER.," I don't think the canary is wheezing. Look, I think there are lots of good arguments on both sides of this. I think all the good ones have been made. The markets have been giving us a pretty good test against the concern, which I think we all share, that if we move today we risk some significant erosion of our inflation credibility or inflation expectations feeding through the dollar into a commodity price spiral. We have had a pretty good test of it. Over the past several weeks, there has been a very substantial shift in expectations for the path of the fed funds rate, which embody substantial expectations around a near-term cut and very little beyond that and some modest retracing as we go forward. Expectations have come down despite what has happened to oil prices. Inflation has come down. The dollar is stronger on net over that period. This is pretty good validation that the path that is represented in alternative B does not come with excessive risk that we will be eroding our credibility. We can't know for sure. It's good to be worried about that risk, but the protection against that risk is fairly good. What strikes me about this discussion is the extent of the gap in this Committee in how we think about the way to measure the stance of monetary policy. What we could do is use a seminar and a bit of history on this. It would be nice to run monetary policy back over the past four decades to see, if it had been set with a basic policy regime in which we looked only at the real fed funds rate deflated by headline inflation today, what the outcomes would have been for the economy at that time. That's essentially what you guys are saying. It seems to me that you are basically saying that equilibrium doesn't vary and that deflating the nominal fed funds rate with some mix of headline and core today is the best way to judge the stance of policy. But I think it's worth having a little exercise in it. It is hard to look back. " FOMC20070509meeting--75 73,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Our outlook has changed very little. As in March, we see the expansion continuing, with growth moving back up to potential—we see potential around 3 percent—later this year. This view rests on the familiar expectations: Housing stabilizes relatively soon without a major drop in prices; investment spending strengthens somewhat as the temporary factors holding it down recede and positive fundamentals reassert themselves; consumption moderates a bit but continues to be supported by strong income growth; the saving rate moves up but only modestly and slowly; and external demand remains strong. We still expect inflation to moderate gradually to a rate just below 2 percent for the core PCE by the end of ’08. We view the recent numbers as somewhat reassuring. Recent data in general have provided a bit more comfort for this scenario. On balance, the downside risks to growth have diminished a bit. The risk that inflation will fail to moderate sufficiently, however, remains significant and material. But in general, the overall outlook, in our view, hasn’t changed that much. Now, our forecast assumes that we hold the fed funds rate where it is for a while. Our expected path is above the market’s but below the Greenbook’s. We’re below the Greenbook because, although our expected forecast is really similar, we attach somewhat greater weight to alternative scenarios that suggest slower growth. The recent growth numbers have been, on balance, encouraging, and the markets are a bit more confident about the outlook than they were. But I still think the downside risks to growth are significant. Housing could still surprise on the downside, and we could see a deeper, more protracted contraction in activity and, of course, broadly based more-substantial declines in prices. Consumption could be weaker for this reason or because the saving rate rises for other reasons, such as pessimism about long-run income growth. The household sector is substantially more leveraged than it was, and it has less of a cushion to absorb shocks and, therefore, presents some risk of amplifying rather than mitigating broader weakness in the economy. Although a bit better than it was in March, the investment outlook is still a bit tenuous, and it seems unlikely to be a substantial source of strength if broader weakness in demand in the rest of the economy materializes. The most rapidly growing parts of the world are growing well above potential and face rising inflation and substantial asset-price inflation, and I think the authorities there are generally starting tentatively to tighten policy more significantly. On the inflation front, we still face substantial uncertainty about what is happening to underlying trends and how they will evolve. The broader inflation environment is, if anything, less benign than it has been over the past three quarters, with inflation accelerating a little outside the United States, energy and commodity prices continuing to show signs of rapid demand growth, the dollar potentially weakening further, compensation here firming a bit, and productivity growth probably staying a bit below what we thought was trend. In this context, with inflation still running about 2 percent, inflation expectations could drift up. Continuing on the risks for a bit, I still think we live with a significant risk of a sharp deterioration in financial markets. Credit spreads, other risk premiums, low levels of implied volatility, and the strength of asset prices in many parts of the world—all imply a level of confidence in ongoing, stable growth and low inflation that seems a bit implausible. In addition, the low level of long forward rates seems hard to reconcile with the strength of demand growth outside the United States, suggesting that much of the world is likely to need to move further toward tighter monetary policy. As financial conditions exert more restraint on demand growth globally, we could see a rapid unwinding of this long period of very benign assessment of fundamental risks. We, of course, face some risk of policy actions here in the form of trade or investment protection. This risk, against the backdrop of some uncertainty about the strength of productivity growth going forward, might make the rest of the world less comfortable financing our still-large external balance on the favorable terms that have prevailed thus far. On the longer-term outlook for potential in the United States, we are sticking with our forecast of 3 percent, but we have altered the mix a bit, just as the Greenbook has in some sense; however, we feel a little less comfortable with our basic view about potential. We lowered our productivity growth assumption a bit, to 2.25 for the nonfarm business sector, and raised our estimate of trend hours a bit. If potential is lower than we’re assuming, then we are less likely to see the moderation of inflation that we currently expect, but we would expect a lower path for output growth as well. At this stage, however, in view of the strength in income growth that we’ve seen, earning expectations, and other measures, we’re reluctant to embrace a more negative view about growth in potential. On balance, in view of these risks, I favor staying where we are for a while. I don’t think there is a very strong case for tightening policy or for inducing a significant rise in market expectations about the path of the fed funds rate going forward, nor do I think now that we’re at risk of being too tight. So, in general, I think the best choice for us is to continue to lean against the expectation that we will move to reduce rates soon. Thank you." FOMC20060328meeting--268 266,MS. DANKER.," I will read the directive wording from page 25 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 4¾ percent.” And now the risk assessment from the statement that was just handed out: “The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.” Chairman Bernanke Yes Vice Chairman Geithner Yes Governor Bies Yes President Guynn Yes Governor Kohn Yes Governor Kroszner Yes President Lacker Yes Governor Olson Yes President Pianalto Yes Governor Warsh Yes President Yellen Yes" CHRG-111shrg52619--113 Mr. Dugan," People were watching. I think what drove that initially--my own personal view on this--is that most of those loans were sold into the secondary market. They were not loans held on the books of the institutions that originated them. And so for someone to sell it and get rid of the risk, it did not look like it was something that was presenting the same kind of risk to the institution. And if you go back and look at the time when house prices were rising and there were not high default rates on it, people were making the argument that these things are a good thing and provide more loans to more people. It made our examiners uncomfortable. We eventually, I think too late, came around to the view that it was a practice that should not occur, and that is exactly why I was talking earlier, if we could do one thing--two things that we should have done as an underwriting standard earlier is, one, the low-documentation loans and the other is the decline in downpayments. " FOMC20050202meeting--154 152,MR. KOHN.," Thank you, Mr. Chairman. My forecast for economic activity in 2005 and 2006, like the rest of yours, was for growth a little faster than the trend rate of growth in potential. That reflects my judgment that the forces that had been holding back the economy in recent years have largely dissipated, allowing the effect of relatively stimulative financial conditions to continue to show through and raising the level of production relative to potential. My projection for growth in 2005 and 2006 is in line with the rate of growth in 2004. Yet energy prices, whose rise must have damped growth to some degree in 2004, are expected to be flat or somewhat lower. In addition, financial conditions have eased since the middle of the year, with bond rates and the exchange rate lower and stock prices a little higher. So, as I thought about my projection, the logical question seemed to be whether we were on the verge of a much stronger pace of economic growth. Although that’s a possibility, I see several factors that should keep growth to a moderate pace. Monetary policy and fiscal policy are at the top of the list. On the fiscal side, the partial-expensing provisions probably brought forward some capital expenditures from 2005 to 2004. For monetary policy, I assumed a continued gradual withdrawal of monetary stimulus along the lines built into the staff’s forecast or the market’s. That should lead to rising real intermediate- February 1-2, 2005 106 of 177 investment spending directly, take something off the increase in house and equity prices—holding down gains in wealth—and support the dollar. Of course, that hasn’t been the experience over the last six months or so, as President Lacker just pointed out. But longer-term real rates have fallen to such a low level that I find it difficult to believe they won’t rise from here, provided moderate growth is sustained. Indeed, I see an important downside risk to the forecast from the possibility of a sizable jump in longer-term real interest rates, which could have a pretty serious effect on house prices and consumption if it results from an unwinding of special factors or from a revision of unreasonably low expectations rather than from an unexpectedly faster pace of economic activity. Until those rates ratchet higher, however, their low level, along with the basically sideways movement of equity prices since late last year, would seem to suggest that caution among savers and spenders has not dissipated entirely. At the very least, the behavior of bond yields and stock prices seems inconsistent to me with a new more ebullient attitude that would presage boom-like conditions. In addition, the behavior of the trade deficit is likely to be damping the growth of demand on U.S. resources for a while. The staff forecast, which has net exports making a modest net negative contribution on average over the next two years, is itself premised on a pickup in foreign demand—a pickup we don’t yet see in the data. This suggests to me another source of downside risk. Over the long haul, as people become more reluctant to send us growing proportions of their savings, the deficit will have to fall. That will put considerable pressure on productive capacity in the United States, but it’s not at all clear when that will begin to happen. Finally, in making my forecast of real growth, I took account of my serial forecast errors. I’ve been overpredicting growth since I got on the Committee, so I used a sophisticated algorithm to compensate for this propensity: I decided what I really wanted to forecast and I took a little off! February 1-2, 2005 107 of 177 My projection for core PCE inflation for 2005 and 2006 that goes with this path of output is slightly higher than the staff forecast. I gave some weight to the market-based core PCE numbers, which have been running higher than the total core PCE, but that forecast remains below 2 percent, and it is stable at that level. For inflation, the question I wrestled with was: Why not further increases this year after the acceleration of 2004? In that regard, the recent data from the last part of 2004 have been supportive, I think, of a stable inflation forecast. With these data, every broad index of core inflation—from GDP prices to the CPI to PCE—grew less rapidly in the second half of last year than in the first— and significantly less rapidly, by at least ½ percentage point. This pattern is not consistent with accelerating prices. It reinforces the hypothesis that a good portion of the pickup in core inflation in the first half of 2004 was attributable to special factors: a reversal of the unexplainable undershoot in inflation in 2003 and the pass-through of higher energy, commodity, and other import prices from late 2003 and early 2004. At least in terms of energy prices—not imports, which are a big question mark—I think these upward pressures should not be a factor in 2005. In labor markets, increases in measures of compensation also slowed from the first half of the year to the second. Now, this is particularly noteworthy in that one might have expected the previous run-up in energy prices and the strength in productivity increases in recent years to put upward pressure on compensation gains. As a consequence, I think I’m a little less concerned than some others of you that slack has already been absorbed. I can only explain the recent pace of compensation data if appreciable slack is persisting in labor markets to balance these other upside pressures. In this environment, continued intense competitive conditions are likely to limit labor cost increases and the ability or willingness of firms to pass through shorter-term increases in unit labor costs into prices and thus risk market share. Finally, inflation came in lower in the second half of 2004 than I had expected. My projection was at the low end of our collective central tendency, so most of you were a little higher February 1-2, 2005 108 of 177 decline in the unemployment rate. But energy and import prices rose more than I had anticipated. Consequently, I also wondered whether at midyear I had given enough weight to the factors restraining inflation—slack, elevated markups, and stable inflation expectations. To be sure, slack should be diminishing, businesses will try to resist any squeeze on markups, and the economy may be closer to potential than it appears right now. If the dollar declines substantially, import prices will increase, reducing foreign competitive pressure. Or if trend productivity slows more than projected, firms could be more insistent and more successful in passing through costs than is consistent with keeping inflation in check. Still, for now, I think low, stable inflation is the most likely outcome for the next few years, provided policy continues gradually to firm, as slack slowly diminishes and output grows at a moderate pace. As for the balance of risks, I’ve always thought that that phrase applies primarily, or first and foremost, to the most likely path for inflation and output relative to our objectives at the assumed path for policy. And, in that context, the risks still seem to me to be balanced. The fact that I found myself asking these particular questions about the outlook suggests, perhaps, a slight skew to the distribution around these modal outcomes. But I think we should await further developments to assess whether those skews will become large enough to influence the central tendencies, the balance of risks, and the path on which we remove policy accommodation, or whether, as the market and the staff expect, we actually will need to slow the pace of tightening in the future. Thank you, Mr. Chairman." FOMC20061025meeting--98 96,CHAIRMAN BERNANKE.," Thank you. Let me summarize what I heard, and then I would like to make a few comments of my own. There were several themes around the table. Many people noted the bimodal economy. Housing is still quite weak, although a number of people noted that they thought the lower tail had been trimmed somewhat. Autos are undergoing inventory adjustment, and some people noted slowing in a few other sectors. However, the general view was that spillovers from housing to the rest of the economy had not yet occurred. Most people noted that the labor market is quite healthy, with widespread shortages of labor, particularly of skilled workers. It was further noted that consumption spending would be supported by the job market, by income growth, and by the fall in energy prices. Overall, the assessments of growth, as I heard them, were that it would be moderate going forward, either around potential or perhaps slightly below potential, and some saw a bit of upside risk to that projection. With respect to inflation, costs of raw materials and energy are rising more slowly or are declining, and headline inflation has fallen with energy costs. Some felt that core inflation would moderate gradually, but others were less confident about that. The behavior of rents and the behavior of productivity are two important unknowns going forward, and wage growth probably presents the biggest upside risk to inflation. Most members expressed concerns that the high level of inflation could raise inflation expectations and undermine Fed credibility. So the general view, which I think essentially everyone shares, was that the upside risks to inflation exceed the downside risks to growth at this juncture. I hope that summary was okay; let me just make a few comments of my own. As a number of people noted, the intermeeting data were actually fairly limited. The employment report did indicate a fairly strong labor market. There is still, to my mind, some disconnect between the anecdotes and the data; in particular, the wage data do not yet reflect what I’m hearing around the table about wage premiums. For example, average hourly earnings actually grew more slowly in the third quarter than in the second quarter. I think the ECI next week will be a very important check for our anecdotes. On the positive side, as Kevin and others noted, the tone was generally stronger in financial markets. The stock market is up. I note the ten-year real rate was up about 15 basis points since the last meeting, which I take to be a positive indication of growth. Oil prices continue to decline, which obviously is good for both growth and inflation. I thought you might be interested in thinking about the quantity effects of the decline in oil prices. We’ve had a decline in oil prices of about $15, which back-of-the-envelope calculations or FRB/US analysis can tell us should add about 0.45 percent to the level of real consumption or about 0.35 percent to the level of real GDP. Dave Reifschneider was very helpful in finding those numbers. That’s a change to the level, so the oil price declines could add 0.3 to 0.4 percentage point to growth, say, over the next six quarters. Another way to look at that is to think about the relationship between oil prices and house prices. A rule of thumb that might be useful is that a $3 decline in oil prices offsets approximately a 1 percentage point decline in house prices in terms of overall consumption effects. So oil price declines are essentially the negative equivalent of a 5 percent decline in house prices. An interesting question that we may have to address at some point is, what is the policy implication of oil price declines? I think it’s clear that oil price declines will lower both total and core inflation, but will also increase growth. Therefore, our policy response to the lower oil prices could depend on our preferences about growth versus inflation and also our assessments of the risks to both of those variables. On the housing correction, I agree that there is perhaps some reduction in the lower tail. But it’s important to point out that, even if we see some stabilization in starts and permits, a lot of inventory is still out there, and there’s going to be an inventory correction process that could be quite significant. The current months’ supply of homes for sale is greater than 6 now, excluding cancellations; the number over the past eight years has been very stable around 4, although before 1997 it was higher and more variable, which is a source of uncertainty. To get a sense of the magnitudes of the potential housing correction, I asked Josh Gallin to do the following simple simulation. Single-family housing sales were about 1.0 million at an annual rate in July, about 1.05 million in August. So I asked Josh to consider a case in which sales flatten out at the level of 1.1 million and continue at that level indefinitely; in addition, homebuilders respond to three-fourths of the increase in sales by extra building and allow the other fourth to go into reducing inventory. When you do that calculation, you find that you actually work off the inventory. By the end of 2008, the months’ supply is down to 4.1. Part of that decrease occurs because the sales level is higher, and so the denominator is bigger as well. Thus that particular scenario is a sensible one in terms of getting the inventories down. However, the effects on GDP, because the correction is still significant, are not trivial, but they are also not that large. The effect of this scenario on GDP growth from the fourth quarter of this year to the second quarter of next year is about 0.2 on growth and about 0.1 in the third and fourth quarters. So a very substantial part of the housing correction is still in place because of the need to work off inventories over the next few quarters. Those are a few comments on the real side. I think that some of the tail risk has been reduced. I agree with the Greenbook that growth should be slow, at least through the first quarter of next year, because of housing corrections, but consumption will probably pick up and lead to a stronger growth path after that. Let me say a few words about inflation. I think I need to push back a little on the view that there has been no improvement in core inflation or total inflation. In fact, inflation is very slow to respond to its determinants, and the fact that we actually have seen some improvement in some sense is a positive surprise, not a negative surprise. The attention that’s paid to the twelve-month lagging inflation measure is a problem in this context, because we had four months of 0.3 percent readings from March to June, and they’re going to stay in that twelve- month lagging measure until next March. I can predict with great confidence that next March through next June the twelve-month lagging inflation measure will decline. So I think it’s more useful, President Lacker, to look, a bit at least, at the higher-frequency measures to see what the trend of movement is. Although, like President Lacker and others, I’m not happy with the level, I think the direction is actually very good. For example, the core CPI three-month went from 3.79 in May to 2.75 in September, so it’s a decline of 104 basis points. The core PCE three- month inflation measure went from 2.95 in May to 2.20 in September, using the staff estimate for the core PCE deflator for September. So it’s certainly moving in the right direction. The other comment I would make about this subject is that we must keep in mind how much is tied to the owners’ equivalent rent component. I would say, in fact, that once you exclude that, if you do, just for comparison, that 2006 is roughly equivalent to 2005 in terms of core PCE inflation. To look at the high frequency numbers, excluding OER, which I’m doing now for illustrative purposes, core CPI fell from 3.01 in May to 2.23 in September, and core PCE inflation fell from 2.52 in May to 1.93 in September at an annual rate. This is saying that a significant part of the speedup and now the decline in the rate is related to this owners’ equivalent rent phenomenon—not all of it, but a significant part. It’s important to know that because, as we’ve discussed around the table, the OER may have its own dynamic. It may respond in different ways to monetary policy than some other components do. It is an imputed price, which people do not actually observe, and so it may have a different effect on expectations than, say, gasoline prices or other easily observed prices. The other important aspect of the OER is that, to the extent that it is a major source of the inflation problem, it makes clear that inflation probably has not been a wage-push problem so far because owners’ equivalent rent is obviously the cost of buildings, not the cost of labor. So if you look at inflation over the past few months, there has been slow improvement, and so far I don’t think that we have seen a great deal of feedthrough of wage pressures into inflation. I’ve looked through all the various categories of goods and services whose prices have increased, and I can find no particular relationship to labor market factors. Another comment along this line: It’s also true that inflation of even 2.20 percent, which was the core PCE three-month inflation rate in September, is too high in the long run. I agree it should be lower than that. We do have to ask ourselves, given that inflation has been high and that, as people pointed out, it has been high for a number of years now, how quickly we should bring it down. Most optimal monetary policy models will suggest that a slow reduction is what you would try to achieve if you start off far away from the target and if the real economy is relatively weak. Now, the question arises whether we are going in the right direction. I think so far we are, but I would certainly agree that we have to ensure that we continue to go in the right direction. The Greenbook forecast is predicated on a constant federal funds rate from the current level; actually the rate declines in 2008. But what it leaves out is the notion that we are gathering information and trying to resolve uncertainty, depending on how things develop. Obviously, policy can respond in one direction or another and could, if inflation does not continue to decline, be more aggressive to achieve that. I felt I needed to talk a bit about the fact that we do have some improvement in inflation, and so the situation cannot really be said to be deteriorating. Having said all of that, now let me come back and agree with what I’ve heard, which is that, although we have not yet seen much wage-push inflation, clearly the risk is there. Anecdotally, and to some extent statistically, we have very tight labor markets. It is surprising how little wage push there has been so far, and if labor markets continue to stay at this level of tightness, then one would expect that you would get an inflation effect that would be uncomfortably persistent. That is a real concern, which I share with everyone around the table. If the Phillips curve language doesn’t appeal to you, another way of thinking about it is that, if the labor market stays this tight, which means that growth is at potential or better, then the real interest rate that is consistent with that growth rate needs to be higher than it is now. I agree with that point as well. So my bottom line is that I do agree that inflation is the greater risk, certainly. I think that the downside risk from output has been slightly reduced. I also think the upside risk to inflation has been slightly reduced. Thus we’re not in all that different a position than we were at our last meeting. We can discuss the implications of that tomorrow. I think I’ll stop there. Yes, President Poole." FOMC20080625meeting--160 158,MR. KROSZNER.," Thank you very much. Obviously, as we have all discussed, we are facing enormous challenges from the continuing strength in prices and price changes in energy and raw materials. Now, some of those are relative price changes that we don't have the tools to address directly. Recently, we have seen wheat come down as Australia has been able to replant, and it seems that things are going to come back. Corn has gone up, as we heard from a number of people around the table, because of the challenges there. We don't have the tools to address that directly, but obviously, when so many of these commodity prices and energy prices are going up, that leads to concerns about where both headline inflation and core inflation are going. So we definitely do have to be very mindful of that. I think the type of approach that we are taking in alternative B is a reasonable one. Given the challenges that we are facing right now with the fragility in the financial markets--the continuing smoldering of those embers, with still chances that they could reignite and cause us a great deal of difficulty--it seems sensible to me to be roughly where we are now in terms of policy but to be signaling that we understand that challenges are coming from various sources that could lead to inflation pressures and that we need to be ready to offset those. In terms of how accommodative monetary policy is, I think actually it would be worthwhile--and maybe at the end of this I might pose a question to Brian--to look at LIBOR� OIS spreads and how much they typically go up during recessionary periods. I know that other risk spreads typically go up, but my understanding is that those typically don't go up as much. Since so many contracts are based off the one-month and three-month LIBOR, that 75 basis points suggests that at least now we might want to take that into account in thinking about where monetary policy stands relative to other times when we would have had a funds rate at roughly this level. In terms of the language, I share Governor Warsh's view on the use or lack of use of the word ""considerable."" I think President Stern's suggestion--this is always a very dangerous and difficult game--would actually push the markets further than they are because I agree that broadly the path that they are seeing in the future is a reasonable one for them to see. This language would roughly keep it there. Taking out the acknowledgement of downside risks to growth remaining would make me concerned because (1) I certainly see those as still being there and (2) I think that would push the markets further to think that this is a signal that next time we are going to do it, and I don't think we are quite there yet. Thank you, Mr. Chairman. " FOMC20080430meeting--104 102,MR. HOENIG.," Thank you, Mr. Chairman. Economic activity continues to be slow in the Tenth District with a soft tone in our residential and nonresidential construction and certainly in our retail sales. Mitigating this weakness, however, to some extent is continued strength in energy and agriculture exports and, to a lesser degree, manufacturing. With regard to exports, one interesting development is a shortage of shipping containers domestically and internationally that is limiting the volume of exports of both our agricultural and some of our manufacturing products. On balance though, the District activity continues to be stronger than the national economy, and this is reflected in better employment growth and firm labor markets in many parts of our region. In my recent discussions with directors at our Bank and in our Branches and the Economic Advisory Council members, several themes have been prominent. Concern about inflation has escalated to the highest level I've been involved with in the last decade. Businesses across the board are experiencing the largest input cost pressures in recent memory for them. Many businesses have not been able to absorb these cost pressures and have raised prices to both retail and business customers, and generally speaking, businesses are finding much less resistance to price increases than in the past. Businesses also report that suppliers are increasingly reluctant to make contractual price quotes very far in the future. We have also been monitoring the effects of credit availability on business capital spending in our area. Although businesses report some tightening of credit conditions, credit costs and availability are not the primary factors behind reduced capital spending plans. Bank loans have actually continued to grow. Instead, businesses cite uncertainty about the economic outlook as the main impediment to investment. They are in a wait-and-see mode. So spending is being held back not for financial reasons but just caution. Indeed, they suggest that uncertainty about whether monetary policy will be eased further is a factor currently inhibiting their capital spending plans. They want to see when we're done. Turning to the broader economic output and the national economy, I have revised down my growth estimate for the first half of 2008 but have had few changes to my longer-term outlook. Compared with the Greenbook, I see somewhat stronger growth this year and somewhat weaker growth next year. Weaker growth in the first half of this year is coming largely from the effects of higher energy prices on consumer and business spending coupled with the continued weakness in residential construction. I would say that the effect of high energy prices is now about as large as or even larger than the contraction in residential construction, and I think that the energy outlook constitutes a main downside risk to growth in the period ahead. In contrast--and contrary to the Greenbook and the views of some--I think that energy and housing perhaps now more than credit problems are holding back economic growth. Certainly credit conditions have continued to tighten as reflected in the April Senior Loan Officer Opinion Survey, and markets for many asset-backed securities, of course, have shut down. But the availability of credit for good business and household borrowers does not appear to have really been restricted that much. They are pricing more wisely for risk, and that is probably a positive. Consequently, the downside economic risks from a pronounced credit contraction appear to have diminished considerably over the past few months. I want to turn to inflation. In my view, the inflation outlook has worsened considerably. For the first time in many years, we are seeing significant inflation pressure from goods prices, especially imported goods prices. Moreover, the recent moderation in monthly inflation numbers is coming mainly from some softness in service prices, which in my opinion, is unlikely to continue. More optimistic views of inflation, including those in the Greenbook, rely heavily on economic slack and a turnaround in food and energy prices to improve the outlook. I am skeptical on both counts. I do not think that there will be as much slack generated in the current slowdown as does the Greenbook, and there is evidence that the effects of output and employment gaps on inflation have fallen, well, actually more than a little over the past two decades. Furthermore, I have not seen any indication that elevated energy and food price inflation is likely to dissipate soon, as many of these pressures are reflective of international economic developments that we have talked about here, including the weakness in the dollar. I believe that we are entering a dangerous period, if I can use that word, in which inflation expectations are beginning to move higher and inflation psychology is becoming more prominent in business decisions. In this regard, I also do not take much comfort from favorable readings of labor costs as wages tend to follow prices in my experience. In these circumstances, I am concerned that maintaining a highly accommodative policy stance for an extended period would greatly increase the likelihood that inflation exceeds our long-run objectives. Thank you. " FinancialCrisisReport--51 At the same time that WaMu was implementing its High Risk Lending Strategy, WaMu and Long Beach engaged in a host of shoddy lending practices that contributed to a mortgage time bomb. Those practices included qualifying high risk borrowers for larger loans than they could afford; steering borrowers to higher risk loans; accepting loan applications without verifying the borrower’s income; using loans with teaser rates that could lead to payment shock when higher interest rates took effect later on; promoting negatively amortizing loans in which many borrowers increased rather than paid down their debt; and authorizing loans with multiple layers of risk. In addition, WaMu and Long Beach failed to enforce compliance with their lending standards; allowed excessive loan error and exception rates; exercised weak oversight over the third party mortgage brokers who supplied half or more of their loans; and tolerated the issuance of loans with fraudulent or erroneous borrower information. They also designed compensation incentives that rewarded loan personnel for issuing a large volume of higher risk loans, valuing speed and volume over loan quality. WaMu’s combination of high risk loans, shoddy lending practices, and weak oversight produced hundreds of billions of dollars of poor quality loans that incurred early payment defaults, high rates of delinquency, and fraud. Long Beach mortgages experienced some of the highest rates of foreclosure in the industry and their securitizations were among the worst performing. Senior WaMu executives described Long Beach as “terrible” and “a mess,” with default rates that were “ugly.” WaMu’s high risk lending operation was also problem-plagued. WaMu management knew of evidence of deficient lending practices, as seen in internal emails, audit reports, and reviews. Internal reviews of WaMu’s loan centers, for example, described “extensive fraud” from employees “willfully” circumventing bank policy. An internal review found controls to stop fraudulent loans from being sold to investors were “ineffective.” On at least one occasion, senior managers knowingly sold delinquency-prone loans to investors. Aside from Long Beach, WaMu’s President Steve Rotella described WaMu’s prime home loan business as the “worst managed business” he had seen in his career. Documents obtained by the Subcommittee reveal that WaMu launched its High Risk Lending Strategy primarily because higher risk loans and mortgage backed securities could be sold for higher prices on Wall Street. They garnered higher prices, because higher risk meant they paid a higher coupon rate than other comparably rated securities, and investors paid a higher price to buy them. Selling or securitizing the loans also removed them from WaMu’s books and appeared to insulate the bank from risk. From 2004 to 2008, WaMu originated a huge number of poor quality mortgages, most of which were then resold to investment banks and other investors hungry for mortgage backed securities. For a period of time, demand for these securities was so great that WaMu formed its own securitization arm on Wall Street. Over a period of five years, WaMu and Long Beach churned out a steady stream of high risk, poor quality loans and mortgage backed securities that later defaulted at record rates. Once a prudent regional mortgage lender, Washington Mutual tried – and ultimately failed – to use the profits from poor quality loans as a stepping stone to becoming a major Wall Street player. FinancialCrisisReport--6 Documents obtained by the Subcommittee reveal that WaMu launched its high risk lending strategy primarily because higher risk loans and mortgage backed securities could be sold for higher prices on Wall Street. They garnered higher prices because higher risk meant the securities paid a higher coupon rate than other comparably rated securities, and investors paid a higher price to buy them. Selling or securitizing the loans also removed them from WaMu’s books and appeared to insulate the bank from risk. The Subcommittee investigation indicates that unacceptable lending and securitization practices were not restricted to Washington Mutual, but were present at a host of financial institutions that originated, sold, and securitized billions of dollars in high risk, poor quality home loans that inundated U.S. financial markets. Many of the resulting securities ultimately plummeted in value, leaving banks and investors with huge losses that helped send the economy into a downward spiral. These lenders were not the victims of the financial crisis; the high risk loans they issued were the fuel that ignited the financial crisis. (2) Regulatory Failure: Case Study of the Office of Thrift Supervision The next chapter focuses on the failure of the Office of Thrift Supervision (OTS) to stop the unsafe and unsound practices that led to the demise of Washington Mutual, one of the nation’s largest banks. Over a five year period from 2004 to 2008, OTS identified over 500 serious deficiencies at WaMu, yet failed to take action to force the bank to improve its lending operations and even impeded oversight by the bank’s backup regulator, the FDIC. Washington Mutual Bank was the largest thrift under the supervision of OTS and was among the eight largest financial institutions insured by the FDIC. Until 2006, WaMu was a profitable bank, but in 2007, many of its high risk home loans began experiencing increased rates of delinquency, default, and loss. After the market for subprime mortgage backed securities collapsed in July 2007, Washington Mutual was unable to sell or securitize its subprime loans and its loan portfolio fell in value. In September 2007, WaMu’s stock price plummeted against the backdrop of its losses and a worsening financial crisis. From 2007 to 2008, WaMu’s depositors withdrew a total of over $26 billion in deposits from the bank, triggering a liquidity crisis, followed by the bank’s closure. OTS records show that, during the five years prior to WaMu’s collapse, OTS examiners repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, asset quality, and appraisal practices, and requested corrective action. Year after year, WaMu promised to correct the identified problems, but never did. OTS failed to respond with meaningful enforcement action, such as by downgrading WaMu’s rating for safety and soundness, requiring a public plan with deadlines for corrective actions, or imposing civil fines for inaction. To the contrary, until shortly before the thrift’s failure in 2008, OTS continually rated WaMu as financially sound. The agency’s failure to restrain WaMu’s unsafe lending practices stemmed in part from an OTS regulatory culture that viewed its thrifts as “constituents,” relied on bank management to correct identified problems with minimal regulatory intervention, and expressed reluctance to interfere with even unsound lending and securitization practices. OTS displayed an unusual amount of deference to WaMu’s management, choosing to rely on the bank to police itself in its use of safe and sound practices. The reasoning appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then rely on WaMu’s assurances that problems would be corrected, with little need for tough enforcement actions. It was a regulatory approach with disastrous results. FOMC20070807meeting--63 61,MS. PIANALTO.," Thank you, Mr. Chairman. The reports that I am hearing from business leaders in the Fourth District lead me to conclude that the pace of economic activity hasn’t changed a great deal since our last meeting. However, the uncertainties surrounding the business climate seem to have risen measurably. The troubled housing sector is still weighing on the region, as it is nationally. I now have little doubt that this theme is going to recur throughout the balance of the year and perhaps well beyond. My view of the housing sector conforms closely to the way housing is depicted in the Greenbook baseline, but I have had many conversations in the past few weeks with anxious industry insiders, who believe that housing markets are likely to worsen substantially over the balance of the year with the possibility of significant spillovers to other sectors of the economy. The stories they tell me sound a lot like the greater housing correction scenarios that are depicted in the Greenbook. Indeed, casualties in the mortgage markets are rising, and I am hearing more and more that the fallout from housing is affecting deals in other sectors of the economy. For example, I talked with a CEO who runs a large national real estate development company. He told me that some of his projects are being held up by his investment banker’s inability to price deals and to bring them to market. Where the deals can be priced, risk spreads have widened across a range of issuers and financial instruments. This CEO’s comments are very much in line with the points that Bill Dudley made in his report earlier this morning. Because of these uncertainties in financial markets, some of my contacts confirm that they have been reevaluating their capital formation plans. They are trimming their projections of some of the projects that they are going to put on the books, and that led me to trim my projection for business fixed investment accordingly. Even with this adjustment, however, I am concerned that the pattern of business investment that I have incorporated into my GDP projections for this meeting may still be somewhat optimistic. This is a risk to the outlook that was not on my radar screen at our last meeting. The June retail price measures gave us more evidence that the inflation trend may be coming down. Inflation moderated in the second quarter, as measured by the median CPI and the 16-percent trimmed mean that we produce at the Cleveland Fed. I am not yet persuaded that this progress will be sustained, but the patterns in the June data were promising. My projection for inflation in the outyears of the forecast are actually a little more favorable than what is in the Greenbook baseline, primarily because I still expect a bit more potential GDP growth than the Greenbook envisions. So I am feeling more comfortable about the inflation risks than I have felt for a while but less comfortable about the real-side risks. My overall risk assessment is moving closer into balance. Nevertheless, I still think that inflation is the predominant risk we face today. Thank you, Mr. Chairman." CHRG-111shrg51303--91 Mr. Kohn," So if, in fact, there are no credit losses on them and they pay off at par in the end, the taxpayer will realize the gain on that, because we paid market price for them when we bought them from the counterparties, who already had margins. So if they go up in value, five-sixths of that increase will belong to the taxpayers. Senator Corker. I have a hard time understanding the systemic risk issue then. The company was bankrupt. It could not meet its obligations. So, in our wisdom, we decided to fund all of this--this insurance product was drawn up so they had to put up collateral every time the value went down. If we had not funded that, there still was no systemic risk that I understand. If we would have had long on insurance, like most of Buffett's companies and others are, if we were long on insurance instead of this crazy mechanism that AIG had come up with, there still were no losses. So if we had just said we are not going to fund these, we will stand behind these as the Federal Government, but we are not going to fund the collateral in the interim, what would have been the systemic risk? " CHRG-111hhrg55811--7 Mr. Lucas," Thank you, Mr. Chairman. Thank you for holding this hearing. I think the discussion draft the committee has before it today is an interesting next step in our review of the overall counterderivatives market. Since the Administration's proposal on this issue was published on August 11th, the end-user community has been constantly knocking on my door. As ranking member of the House Agriculture Committee, I listened to the testimony of the end-user community, the exchanges and the traders, when they appeared in front of that committee on September 17th. The common theme to the testimony was that the Administration's proposal overreached and would treat many bona fide hedgers as systematically risky financial institutions. Are there problems in the derivatives markets? Yes. What we cannot do is overreach or overregulate. If we do, the impact will be felt far beyond Wall Street and reach Main Street. It will cost jobs, economic development, and ultimately increase the prices consumers pay for energy, food, and manufactured goods. I am anxious to hear from our second panel today if this draft allows effective legitimate domestic risk management better than the Administration's proposal. And I am equally anxious to hear if our regulators still want to regulate everybody to avoid regulatory arbitrage or if they recognize the concerns that we shared when they appeared in front of the House Agriculture Committee that their approach will make risk management too expensive and increase prices and volatility. Mr. Chairman, we need to improve the safety and soundness of our financial regulation, but we cannot do it at the expense of economic development, increased prices, and job losses. Thank you, Mr. Chairman. " CHRG-111hhrg53246--143 Mr. Gensler," I think that bringing derivatives onto centralized clearing and exchanges will actually be an enormous benefit to the market. I think it will promote transparency and efficiency, and end users will get the benefit of seeing those prices, where right now they can't. And I think it will lower risk. So, though I might not have understood the question, but I don't see it as a disruption, I see it as an enormous benefit to markets. " CHRG-111hhrg51698--349 Mr. Neugebauer," Mr. Taylor, I know that I heard from a number of my producers when we had the anomalies in the cotton market, and everybody was scrambling as they wanted to certainly find a way to sell at the prices the commodity contracts moved to. Since then, things have seemed to have stabilized some. Can you kind of give me a quick snapshot? Currently, are the markets behaving in a more normal way and are producers able to cover or put in place the risk management that they need to do? " FOMC20070131meeting--46 44,MR. LACKER., Ex post subprime mortgage-backed securities seem to have been overvalued in the sense that they underestimated default risk for some market segments. So the presumption would be that such information gets taken on board and reflected in the prices of new mortgage-backed securities and that it would translate into higher credit spreads at the retail level. In your remarks you seemed to suggest that there is a chance that this process of adjustment might cause markets not to work. I’m wondering what you meant by that. FOMC20080318meeting--51 49,MR. ROSENGREN.," Thank you, Mr. Chairman. Since our last meeting, the economic data have continued to indicate a very weak economy and that, in all likelihood, we have entered a recession. Like the Greenbook, my outlook is particularly influenced by indications of significantly weaker labor markets and a housing market that is as yet showing no signs of reaching bottom. Private payroll employment fell 101,000 in February, and the sum of the downward revisions in December and January was about the same magnitude. Not only have we had three months of declining private payroll employment, but also the decline has been widespread across most industries. The Blue Chip economic forecast, the Greenbook forecast, and our own forecast have the unemployment rate peaking somewhere between 5� and 6 percent. While most analysts are in the process of downgrading their forecasts from skirting to actually having a mild recession, the risk of a more severe downturn is uncomfortably high. A major determinant of the severity of a downturn will be the housing market. Because recent developments in the housing market are so different from most postwar history, I remain very concerned that the effects of substantial declines in housing prices will be difficult to capture in statistical models based on historical data. The Case-Shiller index indicates that housing prices fell approximately 10 percent in 2007, and a decline of similar magnitude this year would mean that many homes purchased in the past several years are in a negative equity position. Elevated foreclosures and large inventories of unsold properties are providing abundant opportunities to purchase homes at heavily discounted prices financed at low interest rates by historical standards. But widespread concerns that prices will continue to fall have resulted in many prospective buyers deferring purchase decisions. To date, the housing market has been quite weak, despite relatively low unemployment rates. But if our forecasts are right, job losses this year are likely to exert a significant further drag on housing prices as rising unemployment rates force additional home sales or foreclosures. Falling housing prices are likely to have a collateral impact on consumption. Perhaps reflecting this risk, the credit default swap rates on retailers have been rising, and we are increasingly hearing of retailers that are closing stores or postponing expansions. Retailers, like consumers, are aware that high oil prices, increasing job losses, and losses of wealth in the stock and housing markets are not likely to be conducive to robust consumption. Exacerbating the negative economic news is the continued deterioration in financial markets. Credit spreads have widened significantly over the past six weeks, with many spreads more than 50 basis points higher than at the last meeting. Hedge fund and money managers that I talk to are acutely aware of the counterparty risk and are very carefully managing their collateral. Most firms with excess collateral are in the process of managing that position down. The deleveraging that is going on has reduced the willingness of banks and other financial intermediaries to finance their positions. In addition, as concerns with liquidity rise, we are once again seeing renewed pressure on the asset-backed commercial paper market. The rise in credit default swaps for companies like Washington Mutual and Lehman Brothers indicates increased concerns for the solvency of other large financial institutions with large exposures to mortgages. The potential for a further episode of financial market dysfunction and for runs on additional financial firms is significant. My primary concern at this time is that we could suffer a severe recession. Falling collateral values and impaired financial institutions can significantly exacerbate economic downturns. Some indicators of inflation are higher than we want, but during previous recessions, commodity prices and inflation rates fell. Given my forecast for the economic outlook, I expect substantial excess capacity to significantly reduce inflationary pressures going forward, and I see little evidence that higher commodity prices are causing upward pressures on wages and salaries. " FOMC20080805meeting--138 136,MR. MISHKIN.," Well, I get one more chance in the policy round. That is the one I am going to really go for. I am sure that people are waiting for it. [Laughter] My modal forecast has not changed appreciably. Clearly, I am very concerned about the headwinds as a result of the difficulty in recapitalizing financial institutions, which Governor Warsh talked a lot about. As a result, I think that we are going to have subpotential growth for quite a period of time. However, the bigger concern is that I see downside risks as having risen substantially. So let me first talk about the things that are the less worrisome downside risks. I think there are increased downside risks just on the real side of the economy. In particular, the consumer has been very resilient, but I am not as sure that that will be true in the future. We just saw terrible auto sales. It could be just one month, and it could bounce back up. But it could be a precursor to much bigger problems, which would not be completely surprising given some of the other things going on with housing prices and credit restrictions. That is one downside risk. The second is that European growth may have shifted down, and so the kind of problems that we are experiencing here perhaps are being experienced there, particularly in terms of lower housing prices in some parts of the euro zone. That could mean less demand for our exports, and it would be another negative for economic activity. The third is that we have actually seen a backup in mortgage rates, and that can have a direct effect on housing demand. It is pretty grim when you look at what is going on in terms of housing starts, but it could get worse. It can't go below zero, but it could get worse. So if that were all there was, I would say that there may be a little increase in downside risk, but it wouldn't frighten me. But I really am very worried about the potential downside risks in the financial sector. I have to disagree very strenuously with the view that, because you have been in a ""financial stress"" situation for a period of time, there is no potential for systemic risk. In fact, I would argue that the opposite can be the case. Just as a reminder, remember that in the Great Depression, when--I can't use the expression because it would be in the transcripts, but you know what I'm thinking--something hit the fan, [laughter] it actually occurred close to a year after the initial negative shock. In this particular environment, we have to think about where we started. We were very lucky that this financial disruption occurred when bank balance sheets actually were in very good shape initially. You know, thank our lucky stars that it happened at that point. We are now a year into this. Bank balance sheets do not look very good, for all the reasons that we have been discussing. In fact, they look pretty grim. We have had some failures, and we are concerned about other failures. So we have a very different environment. In that situation, if a shoe drops--and we have had big shoes dropping; we had Bear Stearns, we had the GSEs, and we had smaller cases like IndyMac--and if financial systems are in a very weakened state, really bad things could happen. I think that there really is a serious danger here. In particular, we could have a dynamic through a decline in demand for housing because of the backup in mortgage rates or other reasons lowering housing prices and that spilling over into the financial system in terms of raising credit spreads, which then lowers demand, and we could get a nasty, vicious spiral. It is exactly one of these adverse feedback loops that we are all concerned about. So this is not off the table, and it very much worries me. I will talk about the implications of that for policy later. On the inflation front, although I definitely see upside risks, I think they may have diminished just a smidgen. There is a question about how large those upside risks are. In terms of my thinking about what drives the inflation process, it is expectations about future output gaps and expectations about inflation over a long period, not a short-term period. I see absolutely no evidence that, in the last couple of months, we have had deterioration in long-term inflation expectations. If anything, they have gotten a little better since March. If you look at the numbers--and Bill had it in his picture--basically there was some ratcheting up when the crisis first hit. I would argue a lot of that had to do with inflation risk, because there really was increasing inflation risk. There has been a slight movement up--maybe a tenth, maybe you could say two-tenths--in expectations when you look at forecasters. I am very skeptical of consumer surveys because, exactly what behavioral economics tells us, there is framing. If headline inflation is high, short-term inflation expectations go up, which should happen, but long-term inflation expectations also go up. When headline goes down, then they will come down. There was a nice little article from the San Francisco Fed in one of those little letter deals on exactly this issue, which came up with exactly this conclusion. I recommend that you read it; and the good news is that it takes only four minutes to read because the articles are meant to be very short. So I really do not see that there has been deterioration, and--I think that this is very important--it is why I stressed the issue of the analytic framework for thinking about the inflation process and what monetary policy can do. We can't control relative prices, but we can do something about long-run inflation expectations and expectations about future output gaps. So I haven't seen a problem lately that there has been deterioration in long-run expectations. What about output gaps? Well, if anything, they look as though they are expected to widen maybe a smidgen, not that much. We don't have any indication to expect that we will be overshooting in terms of having output greater than potential. Again, that should not be raising inflation. It should, if anything, maybe lower it a bit. Finally, of course, oil prices are lower. I don't think that means that they will stay low because the volatility is huge; but at least the fear that they are going to keep on going up and up and up--so it would not be a one-shot change but would be put into long-run inflation--has, I think, diminished somewhat. So where do I stand in terms of the upside risk? There still is upside risk because having high headline inflation does have the potential to spill over into inflation expectations. All of us have that concern. But I want to emphasize very strongly that it has not happened yet; I think that is very important. I also think it is very important to monitor this. One concern that members of the Committee have is that we wouldn't react fast enough because we have sometimes been inertial in the past. That is a serious concern. But I think there is a strong argument that, when you have very big downside risks to economic activity, you want to deal with inflation expectations when they actually indicate that there is some problem. And I just do not see that at this juncture. Thank you very much. " FOMC20070918meeting--122 120,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. In my view, the balance of risks has changed significantly over the past several weeks. Although outside of housing we don’t see much evidence nationally of a significant softening of growth, growth is likely to be somewhat softer than we had expected, and the downside risks to that lower path have increased substantially. I think inflation risks have diminished somewhat, but we have to remain attentive to the familiar sources of continued upward pressure. Financial conditions have tightened since the August meeting, even with the increase in the amount of easing priced into markets, and despite the moderation in the LIBOR term spread to fed funds over the past few days, conditions in credit and funding markets remain very fragile. Even under relatively optimistic assumptions about how these developments in markets will unfold, the process of adjustment will take some time to work through the financial system, and very protracted impairment to market functioning would raise, of course, the possibility of even more-adverse outcomes on the real side of the economy. These changes, in my view, justify a reduction in the fed funds rate at this meeting. Monetary policy has an important role to play in reducing the width of the adverse tail of the range of potential outcomes for real activity. By reducing the probability of an extremely bad outcome on the real side, monetary policy can help mitigate some of the coordination problems that are hampering financial market functioning and delaying the necessary repricing of risk that needs to take place, particularly in markets for term funding, the interbank market, and for mortgage-related products. The difficult and consequential judgment we face is about the appropriate size of the monetary policy response to these changes in risks to the outlook. I believe the arguments work in favor of doing more now rather than less. Policy needs to provide a convincing degree of insurance against a more adverse outcome. Of course, there are risks of erring on the side of doing too much now, and let me just address three of those risks. First, a large move could add to concerns about the downside risks to growth and about financial fragility rather than mitigating those concerns. My view, however, is that doing too little now would risk exacerbating uncertainty about the macroeconomic outlook, and a gradualist, tentative response would be more disconcerting than encouraging. The risk of underdoing it now is that we will ultimately be forced to do more. A second risk is that a large move now could add to uncertainty about future inflation outcomes. This is true. However, I think various measures of changes to the inflation outlook suggest that risks to inflation have moderated a bit, and the markets are displaying a fair amount of confidence in both our will and our ability to keep future inflation stable at reasonably low levels. Acting in a way that suggests that we believe our credibility is more fragile would be more disconcerting than encouraging to the markets. The third risk is that a large move could reinforce concerns that we are adding to the moral hazard in the financial system. This is, I think, an inevitable, necessary consequence of acting to provide insurance against an extremely negative outcome, but it’s not a good argument against doing what we think is justified by the balance of risks to the outlook. In this context, it is important to be careful in the way we talk publicly about moral hazard regarding this balance. In our financial system there is a substantial amount of leverage in institutions and vehicles that are subject to very acute liquidity risk, and part of what you are now seeing in Europe, in the United Kingdom in particular, are the effects on confidence of finding the wrong balance, frankly, between concerns about moral hazard and the appropriate role of the central bank in situations like this. I think the framework that the Chairman laid out in Jackson Hole explains exactly the right balance between what we cannot or should not try to do and what is important to do with monetary policy. The process of adjustment and deleveraging that is under way in markets, in asset prices and risk premiums, is necessary, and we should not direct policy at interrupting or arresting that process or at insulating investors or institutions from the consequences of the decisions that got us to this point. Our objective should be to help facilitate that process but to do so in a way that reduces the chance that it will cause too much damage to the functioning of the core of the financial system and to confidence, because of the consequence of such a scenario for the real economy. To get through this process, bank balance sheets need to expand substantially, and we’re fortunate that they can expand and are now expanding very substantially. A range of nonbank financial institutions and financing vehicles will have to be unwound and restructured. Asset prices and risk premiums may have to move further as more deleveraging takes place and assets are liquidated. Some of the inevitable increase in macroeconomic uncertainty is priced into expectations. Investors will have to get more comfortable that they can make judgments about how to value mortgage-related and other asset-backed securities, despite the loss of faith in ratings. The process of differentiation among strong and weak institutions, conduits, financing vehicles, et cetera, also has to continue. But as many of you said, this process could take quite some time, and it will leave us with the risk of a fair amount of fragility in markets in the interim. Let me end just by reminding you of what I’ll call the “Bernanke Doctrine of Credibility” that the Chairman laid out at one of our previous meetings. Credibility for a central banker is not just about the confidence that we instill in markets that we will act to keep inflation stable and low. It is also a function of our capacity to demonstrate that we have a sufficient feel for the evolution of the economy and about confidence and that we will meet those inflation objectives without excessive cost to real activity and confidence. Part of that credibility is a feel for what is happening in markets and a capacity to look forward and anticipate the potential implications that those developments may have for the outlook. Thank you." FOMC20070918meeting--320 318,MR. PLOSSER.," Thank you, Mr. Chairman. Actually, I do have some sympathy for this proposal. I think it is very creative. But there are a lot more people around this table who know a lot more details about this market, how it works, and how treasurers work than I do, and I will certainly defer to their judgment. But I have a couple of points that I’d like to make. President Hoenig made the point that really gives me a little pause as I absorb this. What I’m really worried about is the law of unintended consequences, and I don’t know what they are right now. Many of you around the table have raised some possibilities that this could exacerbate. I think President Poole’s suggestion about creating a tension between large and small banks about who has access to this could prove to be a problem. I also agree that it might be unusual, but it would be troubling if, in fact, we ended up lending money in this facility going below the targeted funds rate, which would be maybe unlikely but would complicate our lives in other dimensions as well. I also worry a bit as I look at the market—and this probably has more generally to do with provisions of liquidity—that part of the problem here is price discovery. Who has the risk? Where are the risks, how much are they, and how do we price them? I worry a bit, too, about the degree to which providing liquidity shuts down or slows down the price-discovery process, which is something that we really want to get done. I don’t know how to answer that question, but it’s one that I just sort of struggle with in trying to think about whether we are hampering the process of price discovery, by slowing it down and making it easier for people, or are we moving it along at a faster rate. I don’t know the answer to that. The last point, I think, is more of a policy question. Again, President Hoenig, I think, made it. If we view this as a temporary tool, which I think is fine, it is important that we lay out in our own minds under what circumstances in the future we would decide whether or not to implement this tool and how we decide. What criteria do we have? We need something a little more objective than just whenever we want to. I worry a bit that by failing to do so we will abandon some expectations about how the market will react to this and when they might expect us to use it or not. Do I know what the consequences of that will be? I don’t know. I’m struggling with those kinds of questions, so having a little more time to think through some of these things would be very helpful. Those are my comments. Thank you." FOMC20080805meeting--13 11,MR. DUDLEY.," I think it is a fair point that we shouldn't assume that ""normal"" is returning to the LIBOR�OIS spreads that applied before August 2007, so we have to look at a broader set of indicators. For example, I think that it would be worthwhile looking at the spread between jumbo mortgage rates and conforming mortgage rates as evidence of the degree of the shadow price of balance sheet capacity. I think that, once financial institutions either raise sufficient capital or stop taking loan-loss provisions or writing down assets so that they have enough capacity to expand their balance sheets, we will be getting to the end of this process. Another thing I would say to add to the answer I gave earlier to President Evans is that the trajectory of housing in all of this is going to be hugely important. One thing that may signal the next phase, maybe the beginning of the end, is when people really do get a sign that the housing sector is starting to bottom, probably first in activity and then in price. Once that happens, the huge risk premium embedded in some of these mortgage-related assets will then collapse. That means that the mark-to-market losses in a lot of institutions will start to fall. So I think that is going to be a very, very important metric once housing starts to really bottom and people get some visibility about how much home prices will go down. You know, when the argument is about whether home prices are going to go down 15 percent or 20 percent, that will be a very different argument from the argument now, which is whether home prices are going to go down 15 percent or 30 percent. " FOMC20050202meeting--76 74,MR. GRAMLICH.," I’m going to get to meatier things! [Laughter] Is it desirable to have an anchor? I think it is, and I think Bill Poole gave the reason—that we actually have more flexibility to move against unemployment if we have a well-understood anchor. On the other side, I’m gratified that nobody is really in favor of a full, formal inflation targeting routine, such as was described in the document by the International Finance Division. The system is not broken. We have somehow or other managed to convey that the Committee cares a lot about low inflation, and many of us in our talks have even used the word “anchor.” There may be some incremental steps we could take, but I agree with what Mike just said—that since it is not broken, we should be very, very careful. Mr. Chairman, you raised the question of asset prices, and I notice that nobody has commented on that, so let me. It strikes me that asset prices are a fundamentally different breed of cat here. Asset prices—stock prices, exchange rates, even housing prices—I see as part of the monetary transmission mechanism. We should, as we say, take them into account in making our forecasts and doing our analysis of the economy, but I think we have to leave them out of the index. If we go to targeting some index or another, I don’t want that index to include anything about asset prices. I think that’s a fundamentally different notion. The staff, I think, gave us good information. As for me, I favor a core index on the grounds of the numbers shown here. If we have an index and want to keep it in a zone, I’d like to have that February 1-2, 2005 46 of 177 out of the zone. And to me, it’s almost self-evident that we would want to use consumer prices and the rate of inflation. On the question of what is our target, everybody seems to be for 1 percent on the bottom, and that’s fine. I am, too; there’s little disagreement about that. But I think some of you are being a little too hawkish on the top side. There’s an old experiment that I learned about in graduate school from Richard Ruggles, who used to be a professor at Yale: Offer somebody $10,000 and the choice of ordering from a catalog of all goods and services made this year or five years ago, and take a poll on which option they vote for. Try it. You all give talks to Chambers of Commerce and so forth. I’ve been doing it for years, and people will consistently vote for the current menu. Obviously, this experiment has to be done at a much higher level of scientific rigor. But I think in the utility sense, even core PCE rates as high as 3 percent may be more or less consistent with price stability, given the great difficulty we have in dealing with technological change in price indexes. On the range or point issue, I think Janet raises a good point about the point, and this is the way I take her point. [Laughter] Let’s say the point is 2 percent, and the inflation rate goes from 2.4 to 2.5 to 2.6 to 2.7 percent. That won’t be a huge issue and we might not have to explain that. But I have to come back to the fact that when I think about inflation, I actually do think in terms of ranges. I’m prepared to believe that inflation will fluctuate within a zone, and I’m not going to worry in that range. So I’m a little more comfortable with setting a range or zone than I am a point. It will require occasional explanation when inflation gets out of the zone, but I think that we ought to be prepared to do that. If it does get out of the zone, we ought to be able—thinking among ourselves—to say why that is. So, I guess I don’t find that too costly. In terms of how we do this, I would definitely take a low-key approach. I think we’d want to be clear that this is part of a broader agenda. We have our dual mandate, and we feel that if we make it clear what our inflationary anchor is, we can actually fight unemployment better. This wouldn’t February 1-2, 2005 47 of 177 step as we could possibly imagine. I actually liked the paragraph that Ben wrote, so something like that might be a good start. Should we consult with Congress? Yes, we would have to consult with Congress. And there is a risk in consulting with Congress because their first question is going to be, “Well, are you going to set a range for unemployment?” The staff dealt with that issue in their document and found that doing so actually risks making fundamental macroeconomic mistakes. So, I would not want to be forced to set a range for unemployment—and we would face that risk. At the same time, if we’re going to do something like this, I think we do have to tell Congress about it. But open up the Federal Reserve Act? No way. Thank you." FOMC20071031meeting--83 81,MR. MISHKIN.," Thank you, Mr. Chairman. My forecast is actually quite similar to the Greenbook forecast. In terms of inflation, I see a little faster movement back to 2 percent, where I think inflation expectations are grounded, but the difference is very minor. I do think the risks are quite balanced around that. In terms of economic growth, I am fairly comfortable with the Greenbook forecast, maybe a smidgen less sanguine in the next two quarters but really not very different. However, in terms of the issue of potential downside risk, I do think that, given the policy path that the Greenbook assessed, there are substantial downside risks and they come from several sources. One source is that the financial market disruptions have led to some tightening of lending standards. I think that could have some potential effect on business investment. The housing market is pretty grim. We still have a big inventory overhang, and there is a question about whether that large inventory overhang is going to lead to even fewer housing starts than the Greenbook has forecasted. Furthermore, it has raised the issue about house prices, which have spillovers into household spending. The spreads for commercial real estate are still very high, and so there is a question about whether commercial real estate will be as strong as it has been. That is a bit worrisome as well. Consumer confidence has not deteriorated too much, but it has been on a path of deterioration. So, again, I worry a little about what the consumer might do. In general, I worry more about these downside risks, given the policy path of keeping the federal funds rate constant. What about the financial markets and their disruptions? Well, I think that there are two elements to the disruption in these big, widening credit spreads. One is the valuation risk: All of a sudden people realized that they didn’t know as much about what kind of assets were in portfolios and how complicated the structures were in terms of those assets. Clearly, the solution to that problem is price discovery. We see that happening, but it is going to be very slow. So that problem, in terms of the credit markets, will take a fair amount of time to resolve. The second element is what I call macro risk, which is the concern about a downward spiral: The problems in the credit markets will lead to a weakening of the economy, which then makes price discovery harder to do, which means that you have wider credit spreads, which then make things worse. Of course, that’s the issue with the tail risk that all of us have been talking about. I think the policy change that we did in September clearly had a big impact. It did exactly what we wanted it to do. It is almost a textbook case in doing what we wanted it to do—it took out a lot of the macro risk. It didn’t take out the valuation risk, which is getting better but very slowly over time. So looking at this issue and thinking about going forward in terms of the credit markets, I am a little worried that credit markets are still quite skittish. That has several elements. One is the danger that macro risk could come back. So there is a question about shoes dropping. There is an issue about what we might do at this meeting, and then there are issues about what might actually happen that people don’t know about. One thing that is sort of surprising is that, when you look at what is happening in credit spreads, they seem pretty reasonable in their steady but very slow improvement. But then, you sense some discomfort—in particular, the reaction to the Treasury superconduit has not been very positive. If it worked, it would actually reveal information because it would look like the way that the old clearinghouses used to work, when they would combine assets. Randy knows all about this because he studied this stuff. You pool your assets, then you monitor each other, and then you actually create information that makes the markets work better. I think that is what the Treasury was trying to get at. But the skepticism in the markets is such that they think this could be used to hide information about assets and that other shoes may be dropping in this regard. This does not give me a lot of confidence, and so I worry very much at this juncture, which I think is a critical one, that a policy move could have an effect of sending the credit markets in a bad direction. That is something we have to take into account tomorrow. Thank you." FOMC20050322meeting--126 124,MR. FERGUSON.," Thank you, Mr. Chairman. At the last meeting, I described the economy as being in what I called a mid-cycle sweet spot, so the obvious question is: What has happened since then? I would say that, in general, my headline is bifurcated. One is, “so far so good;” and two is, “there are a number of caveats”. Let’s first look at the “so far so good” part of the headline. As all of you have already pointed out, the economy seems to be gaining momentum. Households continue to be in good shape. The saving rate is, unfortunately, low, but that is supporting consumption. Households are also being supported by an increase in compensation per hour that continues to look quite robust. As the Greenbook has pointed out, there seems to be no pothole on the investment side, so the business fixed investment component is also kicking in. Nevertheless, as a number of you have already indicated, some concerns have arisen recently on the inflation front. But I think we should also recognize that long-term inflation expectations continue to be well anchored. And importantly, while a number of costs have gone up, unit labor costs themselves continue to be, if anything, quite moderate. All of this suggests to me—though I will point out some caveats—that the incoming data are not flashing a signal that we are clearly behind the curve. So what are the caveats that seem to be important? Both of them deal with some uncertainties regarding the supply side of the economy. First, we have a question about what is going on in the labor markets. As all of you know, several meetings ago, and then at the AEA [American Economic Association], I put forth some relatively rudimentary analysis that suggested that some of the decline we’ve seen in labor force participation rates may not turn around very quickly. The staff has done some much more sophisticated analysis and has come to a not too March 22, 2005 62 of 116 increase in labor hours that can go into overall potential GDP. The staff has done that, and I support that conclusion. The second uncertainty with respect to the supply side has to do with productivity growth. This, I think, will be an ongoing question for us for some time to come. I recognize—as do others, including President Yellen—and applaud the fact that there appear to be many positive signs with respect to productivity growth. We had a discussion in this room, for example, in a meeting with the SIA, suggesting that Moore’s Law continues to be in shape, which is obviously a very positive thing. And we have seen some upside surprises in income and productivity growth, which, again, is a very positive development. Having said all of that, the staff takes into consideration the net debt financing of financial firms and the financing gap information, both of which show that firms have a great deal of room left to invest; the staff views those as positive signs that there is some potential upside to productivity. I would say that we should at least be a little cautious in that assessment because those developments may involve some negative signs. So I think there’s a little question mark on the capital deepening component of productivity increases. At this stage, I’m generally willing to support the consensus that has emerged around the table, and in the Greenbook forecast, that productivity probably is in good shape. But we need to monitor that. Another caveat has to do with this issue of energy prices. I, along with Governor Bernanke, realize that energy prices play a relatively small part in inflation in the U.S. economy, particularly against the backdrop of well-contained unit labor costs. However, like others, I recognize that the increases in oil prices seem to have had a dramatic impact on market psychology and may be the thing that could undermine the relatively well-contained inflation expectations that have been March 22, 2005 63 of 116 dynamics are such that not only are oil prices likely to be in a higher range, as indicated by the far- dated futures, but also that the surprises are more likely to be skewed to the upside. In my view, the recent increases in oil prices reflect some real concerns that world supply will not be able to keep pace with demand growth, as a few of you have already said. In particular, I think the cushion of spare production capacity has narrowed significantly. In preparation for this meeting, I asked the staff to do an options-derived probability density function of WTI prices. I don’t have the results to hand out, but when one looks at the December 2005 function, there is a particularly large skew to the right-hand side. I think this is telling us that there are significant market concerns that prices could surge in the event of supply disruptions. These concerns have pushed up both futures prices—which to me can be interpreted as a mean expectation for future spot prices—and also spot prices today, reflecting, I think, some heightened precautionary motives for holding inventories. So there is a real risk that with very low short-run price elasticity of demand, a supply shock could lead to very big moves in price and potentially unhinge the inflation expectations that we have benefited from. So I think that is another caveat to worry about. Finally, President Geithner has raised a few times the question of whether or not the predictability of our language has been the source of a reduction in either implied volatilities or spreads over Treasuries. I had the staff do some basic historical charts to look at this issue. We first introduced in the Chairman’s congressional testimony in 2003 the notion that we’d keep rates low for a considerable period, and that showed up in our press statement for the first time in August 2003. Since then, obviously, we’ve gone through other terms such as “patience,” “measured pace,” et cetera. All of that I think has played to some degree in the reduction of implied volatilities and March 22, 2005 64 of 116 implied volatilities and in the spreads over Treasuries, both started to decline many, many months before our original focus on using the kind of language we’ve been using. So while I don’t necessarily disagree that there are carry trades and that some real risks have emerged, in my view we should not take too much of the blame for that upon ourselves. I think a number of market dynamics have driven that, along with predictability and transparency at the Fed. That leads me to the final point: What does all this mean for monetary policy? First, I would say, at bottom, that I find the baseline outlook to be credible and reasonable. But it is surrounded by a range of risks that I believe, as do others, are primarily on the upside. Against that background, it seems prudent to continue to execute our pre-announced strategy. The economy is growing well and needs less and less stimulus; therefore, continuing to remove our accommodative policy at a measured pace seems to me reasonable. Second, given the stage of the cycle, the skew in the general risk assessment that I outlined, and the need to manage market expectations, I think we should use our statement to signal our awareness that inflation pressures may have picked up. The incoming data are indicative of that. If we are wrong on the upside risks, both we and the market will adjust. On the other hand, if we fail to reflect the existence of these upside risks, we could easily be perceived as being behind the curve, with negative consequences in terms of inflation dynamics and, potentially, our own credibility. Finally, I think the statement, as drafted in the last meeting, clearly links the concept of a measured removal of accommodation with a general sense of the incoming data. And I believe that gives us the kind of flexibility that we need. Therefore, I’m not terribly supportive of removing the “measured pace” concept at this stage. I think we have sufficient flexibility using that phrase, when March 22, 2005 65 of 116 how things were evolving. So I would caution against making that kind of change in the statement today. Thank you, Mr. Chairman." CHRG-111hhrg53245--78 Mr. Kanjorski," I agree with you, but I wanted to perhaps attack part of your premise there. I recall very clearly in 2005, the Chairman of the Federal Reserve was testifying before this committee. I specifically asked him a question, whether or not there was a real estate bubble in his opinion, and he said he thought there was, and that the price of real estate was ever increasing, but it was perfectly manageable and it did not constitute a risk to the system. If he in fact were the gatherer of that information and the analyzer of that information, we would have missed the opportunity to have found systemic risk. What is your answer to Mr. Greenspan's lack of perceiving that difficulty? Ms. Rivlin. I think he was just wrong. He said that himself. He did not see this one. I think we have learned a lot about bubbles. One thing we have learned is that interest rates is not a perfect tool for controlling them, which is why I would give them more leverage control as well. " FOMC20060328meeting--84 82,MR. MOSKOW.," Okay. Well, most of my contacts this time were upbeat about current conditions. Though the Midwest continues to underperform the rest of the nation, the U.S. economy seems to remain on solid footing. So we tried to assess whether the strength in January and February was just a transitory bounceback from the fourth quarter or whether it represents some persistent forward momentum. And while a few contacts expressed concerns about higher energy prices and softening housing markets—as we were just discussing—most pointed to an economy with substantial staying power. A bit of good news is that the Chicago purchasing managers’ index, which will be released on Friday, will show a significant increase—from 54.9 to 60.4. The persistent momentum in the economy appears to be creating some pressure on resources. One example is the airline industry. Business and leisure travel are at very high levels, with strong bookings for the past few months. Load factors are at near-record highs, in part reflecting a reduced capacity in the industry. There continue to be more reports of fare increases, and surprisingly the increases are now being led by the low-cost carriers. We’re hearing about tightening labor markets. Manufacturers continue to have difficulty finding skilled workers. In the temporary-help area, Manpower—headquartered in our District— said that wage growth is accelerating nationally. Three months ago wages were basically flat on a year-over-year basis. Now they’re expecting increases of 4 to 5 percent in the second quarter of this year. Kelly Services, also headquartered in our District, reported steady nationwide increases in the 3 percent to 4 percent range. But both companies noted that labor markets were still nowhere near as tight as they were in the late ’90s. Speaking of labor markets, to update the GM–Delphi–UAW saga, Rick Wagoner, General Motors’ CEO, thinks that the GM buyout plan will take the heat off the poor Delphi–UAW relations, lessening the chance of a strike there. He expects a significant number of GM and Delphi workers to sign up for the plan. This will allow them to reduce the size of their workforce more quickly. One aspect of this agreement that parties are not publicizing widely, for obvious reasons, is that GM and Delphi should have more flexibility in hiring temporary workers and outsourcing in the future. The temporary workers will have lower wages, and they won’t have the full GM benefit package. Turning to the outlook, I feel that the near-term risks to the forecast have changed somewhat since our last meeting. On the growth front, I had previously thought that high energy prices and sticker shock from heating bills might damp spending substantially. And on the price front, I was concerned that pass-through of higher energy prices and other costs could boost core inflation and feed through to inflation expectations. Neither risk has materialized so far. Private domestic demand appears to be growing at a solid pace. The recent price news has been favorable, and inflation expectations have moved little. So what are the risks now? I do not see many immediate downside risks to growth; to the contrary, I personally think that the risk may have tilted to the upside. It’s true that housing appears to be moderating, but the softening seems to be happening much as we expected it to. In contrast, consumption growth continues to be quite strong. This may be a signal that households are more confident about their permanent income prospects, perhaps because of healthy labor markets and the strong underlying productivity growth. If so, then we could be in for some continued robust consumer spending. In addition, growth abroad has improved. Notably, Japan and Europe are showing some life. Thus, we could see more demand emanating from abroad. So in the short term, growth will likely exceed potential. But given a funds rate path like that in the Greenbook, which I would characterize as a touch restrictive, my outlook and the Greenbook’s get growth back to potential by 2007. Despite the recent good readings on inflation, the current strength of the economy is showing through in our simple indicator-based forecasts of inflation. We run about two dozen forecasting models that encompass common statistical indicators of future inflation. These are not structural models. They are simple regression forecasting models that use only current data, and they have no explicit conditioning assumptions regarding future policy, oil prices, or other such factors. And this contrasts with a more structural methodology like the FRB/US model. Nearly all of these indicator models predict some uptick in core inflation over the next two years—not a big one but to something a bit above 2 percent in 2007. Looking ahead, these projections would probably move down with a further string of good news about prices and more-balanced prospects for resource utilization. Nonetheless, given the models’ forecasts and the fact that we currently are operating with very little resource slack in the economy, I see a risk that inflationary pressures will be somewhat greater than what is currently built into the Greenbook." FOMC20050630meeting--352 350,MR. MOSKOW.," Thank you, Mr. Chairman. In recent weeks we’ve heard a wide variety of views about business conditions in the Seventh District. Most sectors have good news as well as some bad news but, overall, conditions are positive and seem consistent with an economy growing near trend. Evidently, accommodative policy is offsetting the drags from energy and the international sector. Within manufacturing, heavy equipment producers continue to report strong sales growth. For example, all 21 of Caterpillar’s business units are above plan. This year some of their product lines have sold out for 2006, and they have begun taking orders for 2007. In contrast, one of our directors who is the CEO of a large diversified manufacturing company reports a surprisingly sharp slowdown in orders, although he concedes that business had been growing at an unsustainably high rate. The Chicago Purchasing Managers’ Index, which will be released today, edged down from 54.1 in May to 53.6 in June. In retail, apparel sales are generally strong and mall traffic seems good, but a retailer in home furnishings reported a marked slowdown in sales during the past six to eight weeks. In motor vehicles, GM noted strong sales in response to its new marketing program. GM and Ford both continue to forecast light vehicle sales of about 16.8 million units in 2005—the consensus forecast from our recent auto outlook symposium had similar numbers for 2005—and they expect sales to remain near this pace in 2006. Labor markets continue to improve. Temporary-help firms report that growth is moderate, not spectacular. They say demand is soft for low-skilled workers, but it is stronger for professional, technical, and clerical workers. And average temp wage and benefit increases have held steady in June 29-30, 2005 110 of 234 The news on the price front is similar to what we’ve seen in the last few meetings, with increases for plastics, rubber, and heavy machinery—and, of course, energy. Integrated steel producers are burdened by high coke and iron ore prices. In contrast, steel scrap prices have fallen 35 percent from their peak in November of last year, which reduced the costs for the mini mills. Turning to the national outlook, since our last meeting we’ve learned that the soft patch was temporary, as many of us expected. Furthermore, the core inflation numbers improved but energy prices moved up even further, as we’ve just been discussing. Looking forward, our outlook is very similar to the forecast in the Greenbook, with growth slowing in the current quarter but picking up somewhat in the second half of the year. On balance, we project that GDP will increase at a rate near 3½ percent both this year and next. The story underlying this forecast is a familiar one. Accommodative monetary policy and the trend in underlying productivity appear sufficient to offset the current drag from higher energy prices. On the inflation front, we don’t see broad-based resource constraints pushing up prices. The pass-through of cost pressures to consumer prices has been modest. In fact, Mr. Chairman, after you left our board meeting two weeks ago, my directors gave me a hard time regarding the suggestion that businesses had any pricing power at all. In addition, inflation expectations remain contained, even with the most recent increase in energy prices. So we see core PCE price inflation peaking at 2 percent this year and edging off a touch next year. Of course, we should not be too sanguine. It would be unfortunate if underlying core inflation drifted above 2 percent, and there is some risk of that happening. Resource slack has narrowed, as Dave Wilcox pointed out earlier. And given our uncertainty as to the true level of potential output, we may already have closed most meaningful resource gaps. With oil prices June 29-30, 2005 111 of 234 could happen if we are perceived to be improperly monetizing the higher oil prices. Therefore, it will be important for us to continue to remove policy accommodation in order to contain inflationary pressures and inflationary expectations. So at this meeting, we should increase rates by 25 basis points. For the remainder of 2005, we may need to increase rates more than currently expected by the futures markets. I agree with the view expressed by some people during the chart show: Risk management suggests that a path with higher interest rates would be a better course for our policy than the one outlined in the futures market. And given the risks to the inflation outlook, a flat federal funds rate of 3¾ percent throughout 2006, as the markets expect, is simply too low." FOMC20060629meeting--109 107,MR. KOHN.," Thank you, Mr. Chairman. Incoming data have tended to confirm to a degree both the downside risks to growth and the upside risks to core inflation that we’ve been talking about at recent meetings. Higher inflation interacting with policymaker comments on the inflation situation triggered higher expected real interest rates and more uncertainty about the longer-term future. That in turn further tightened financial conditions, leading to more markdown of growth prospects. Notably, the worry about added inflation pressures has not been confined to the United States, given strong growth abroad, high energy and commodity prices, and a sense that output is close to potential. Widespread policy tightening and greater uncertainty have led to increased caution on the part of investors and tighter global financial conditions. The incoming data certainly have influenced my projections—I expect less growth and more inflation than I did a few months ago. I’m also even less confident, if that’s possible, than I was given these surprises. The key question in my mind is whether the conditions are in place or soon will be in place—that is, after tomorrow—to keep core inflation at considerably lower levels than it has been so far this year. I think they are, and in this regard I’m a touch more optimistic than the staff. I have slightly lower inflation for 2007 with the same policy assumption. Most important, I don’t believe that the extra inflation we’ve had results from the economy producing beyond its long-run potential. We obviously can’t be very confident about this. The decline in the unemployment rate to noticeably below 5 percent occurred only at the beginning of this year, but the behavior of compensation last year and this year suggests to me that the NAIRU is more likely to be under than to be over 5 percent. Perhaps better job- matching through Internet search, declining real minimum wages, and lingering worker insecurity, after the only-moderate increase in employment early in this expansion, have lowered the NAIRU a touch. We should expect compensation growth to pick up as in the staff forecast, but the implications of this pickup for inflation are unclear, given elevated profit margins and what is likely to be a competitive business environment. I do think relative price adjustments are playing an important role in what we’ve been seeing. I suspect I have been implicitly underestimating the effect of higher energy prices on both output and inflation. Before this year, the effect of rising energy prices on inflation was offset by slack in the economy, and the effect on activity was offset by easing monetary policy that was put in place to counter that slack. With both slack and easing policy disappearing, the effects of higher energy prices are showing through in both output and inflation. Another adverse price shock seems to be coming from the housing market, where the previous run-up in prices and the higher interest rates are weakening prospects for home price appreciation. This weakening, in turn, is both reducing activity and raising actual and imputed owners’ equivalent rents. The longer-term inflation effects of both these relative price changes will depend on their persistence and their propagation into other prices. In this regard, President Poole, I see us as perhaps accommodating the first-round effects of the increase in prices but making sure they don’t propagate beyond that, rather than having a price-level target that would bring us back down to the old price level. With regard to persistence, petroleum prices have leveled out since April, and futures markets don’t suggest further increases. It’s difficult to get much of a fix on future rent increases, as prices and rents realign to higher interest rates and lower expected capital gains. In the past, most of that realignment has come through prices; but we don’t have many observations, and the required adjustment appears much larger this time. There are two keys to preventing the relative price changes from becoming embedded in broader and more persistent inflation: low inflation expectations and a competitive business environment. If energy prices do flatten out, headline inflation will come down, and I think that will help to contain the inflation expectations of households and businesses and bring down core inflation. The propagation of higher rates of increase in rents, should they persist, to other prices I found much harder to analyze. After all, homeowners are, in effect, paying themselves higher imputed prices, and it’s not clear that they would change their behavior in labor markets to expect higher wages as a result. Moreover, with respect to owners’ equivalent rent, I think our usual financial market measures of inflation expectations may not be reliable indicators of behavioral shifts. Expected persistent increases in owners’ equivalent rent will boost expected CPI showing up in TIPS spreads but not necessarily affecting other pricing decisions. A persistence of elevated rent increases will put a premium on viewing their implications for future inflation rather than on simply reacting to the incoming data. The competitive environment will depend largely on the degree of resource utilization. In this regard, the negative effects of the oil and housing market developments on activity, along with the tightening in financial conditions, suggest that activity could well run at least a little below the rate of growth of potential for the next several quarters. That will help to limit longer-run inflation pressures. In a sense, the forces that seem to be pushing up inflation are also contributing to the conditions that should hold it in check. In sum, recent inflation data have been an unpleasant surprise, but the source of the price increases—that is, price shocks, not overshooting—and the economic conditions coming into place should imply a softening of core inflation over the next 1½ years. This outcome is based on the assumption that the relative price increases don’t become more broadly embedded in other prices and second-round effects. We’ll talk tomorrow about how policy might contribute to reducing the odds of that possibility. Thank you, Mr. Chairman." FOMC20071031meeting--175 173,MR. ROSENGREN.," Thank you, Mr. Chairman. I, too, find myself torn between alternative A and alternative B and have been anguishing over them much of the last week figuring out where I come out. The economic outcome detailed in both Boston’s and the Board’s forecasts with no change in interest rates seems reasonable. The evidence since the last meeting indicates that there may have been more strength in the real economy than we expected in the third quarter; and financial markets have been recovering, but they are certainly not back to normal. The risks are clearly on the downside, and our forecast expects a weak fourth quarter. So certainly an argument for alternative B is to cut when it is clearer that the fourth quarter will be weak or we have data of more-significant collateral damage from the housing sector. The argument for alternative A would seem to be that we should take out more insurance against the downside risks. The costs for such action are not great; and given the downside risk, some additional insurance is not unreasonable. However, we have discussed the modal forecast at some length, but our rigor around the tail is quite limited, making it difficult to determine how often and how much insurance should be taken out against downside risk. Thus, I prefer to wait until there are more data that the economy is weakening, which I think is likely to happen. Just to comment on the assessment of risks—when I look at the uncertainty in terms of GDP growth, I think of the histograms. That’s quite stark. If the major concern we have is downside pressure on prices of housing, which is my concern—that housing prices continue to decline and housing gets much worse—I think 25 basis points is probably a small premium to pay. But I doubt that I would change where I would put the weighting even with a 25 basis point cut. I think the housing scenario that is detailed in the Greenbook will still be there whether or not we cut the 25 basis points, and my guess is that between now and December we’ll have more confirmation that it is a concern. Whatever we do in terms of the language, we need it to be consistent and accurate, and I am a little worried about the language in alternative A being consistent and accurate with what we are going to portray in our uncertainty of risks if we show those histograms. So if we’re showing the histograms, regardless of whether or not we have a 25 basis point cut, I think the alternative B language is more consistent with at least what we put down. Unless people think that, with the 25 basis point cut, there is a big shift in the uncertainty and the risks to GDP growth, I do worry about how that will play out in the market and what kind of a tension there will be." FOMC20060328meeting--75 73,MS. JOHNSON.," Well, again, over a longer period, I think we face a real energy issue as a global economy. And I find it very hard to believe that energy prices are, in fact, going to be five or six or seven or eight years from now where that far-dated futures price is putting them right now. But I’m sure they’ll go both up and down in between. And for the period over which monetary policy is made, I can’t do better than what the markets are seeing. I am expecting that, over time, the standard of living of many, many, many people on the planet is going to rise. And I’m assuming that the rise will imply some overall higher consumption of energy per capita and that the higher prices are indeed precisely what we need to stimulate new technologies, to stimulate substitutions in all the right places. It will be because the economy is growing that prices of energy will go up, not because the economy is somehow going to get in trouble. Other things can also arise. The political situation in China is by no means guaranteed. I may be a bit more concerned than others about this subject, but I see no reason not to think that we’ll have another bad hurricane season. I just don’t know why people don’t see serial correlation in what’s going on with the hurricanes. Not only in the Caribbean but around the world, we’re seeing more and more weather-driven phenomena owing to the higher temperature in the oceans and various other things. But I don’t see endogenous weaknesses. I think the global economy in a very fundamental sense actually has balanced risks—many of the worst shortcomings in many of the economies with whom we trade, both financially and in real goods and services, have been fixed. I think the conduct of policy is better, broadly speaking. I think we could have a very good five years. I can’t put my finger on anything that in the next five years is inevitably bound to cause us a problem. But I think that over some long period, as more and more people have higher standards of living, we are going to have a big change in relative prices. And some economies are going to do a better job of absorbing those relative prices than others. But the U.S. economy might do one of the best jobs in absorbing those relative price changes." FOMC20080130meeting--199 197,MR. KOHN.," I thought we needed some insurance, and I also assumed some fiscal stimulus as in the Greenbook. I still see, despite these policy responses, risks around my outlook for activity as skewed to the downside, and it's because of the potential further increases in required compensation for risk and tightening standards for extending credit and the feedback on demand. Although inflation has been running higher than expected of late, and that is troubling, I expect it to ease back even with my more accommodative policy. The combination we've seen of slower income growth and higher inflation suggests elements of a supply shock, and that's obviously coming from the energy sector and its spillover into food. It is true, as President Fisher pointed out, that some of those increases in food and energy prices are coming from demand from emerging-market economies, but to the extent that such demand is putting upward pressure on our prices and it's not really sucking exports from the United States at any great rate, I think that it acts more like a supply shock on the U.S. economy than a demand shock. Energy and other commodity prices should level off in an environment of slower global growth, and they've started to do that. They have at least showed signs of leveling off recently. Greater slack in resource utilization and product markets should discipline increases in costs and prices. At least some of the reports about airlines suggest that they have tried to pass through fuel surcharges and have been unable to do so, and I think that's an encouraging sign from the inflation perspective. Any easing of inflation pressure does require that inflation expectations not begin to ratchet higher. I agree with everyone else. I'm persuaded that the balance of evidence is that they have not, despite the rise in five-yearforward inflation compensation and despite the persistently higher rate of increases of total headline than of core inflation. But this is something we will need to monitor very carefully. I interviewed Paul Volcker yesterday afternoon for our oral history project. The discussion with him reminded me again of the high cost of reversing a rise in inflation once higher inflation expectations become entrenched. Thank you, Mr. Chairman. " FinancialCrisisInquiry--109 BLANKFEIN: I think nobody—looking what happened and the most horrible thing of this crisis, what has happened to consumers, to individuals, in the mortgage market, in other things have taken on debt as a consequence of behavior. And the confluence of behavior and the recession I would say no one would argue that there shouldn’t be more protection and safeguards and regulation of that interaction between finance and the consumer. CHAIRMAN ANGELIDES: All right. There’s one minute left. And the only final question I have is for you, Mr. Dimon. How do you control—correct the asymmetry in compensation? Let me just say it simply. I was in the private sector half my life. I was in a business where you put real equity at risk and if you lost you lost. You bet big, you could also lose big. There’s an asymmetry here where in the financial services industry it seems that it’s almost like you’re at a Black Jack table in which you never really get wiped out. At the end of the day the worst you can do is walk out with what you had. On the other hand, if you hit big you can hit big. It seems to always tilt towards making the biggest bet possible because there’s no consequence for the biggest bets. How do you correct that? DIMON: Well, there’s a consequence that you could lose your job. You could lose your reputation. But I do think that you raise an issue. The first way to correct it is that you actually risk adjust it, actually look at the capital being deployed and you make an evaluation. Did they do the right things for the right reason, for the client, et cetera? So you are constantly trying to evaluate are you doing the right things on trading debts. But it is a little one- sided that way. And the more senior the people become, the more stock they own in the company. So they are responsible for the well being of the whole company and they will pay a price if our company pays a price. I think that’s generally—you’ve seen that a lot of the companies that went belly-up their people did pay a price. CHRG-111hhrg74855--177 Mr. Gensler," I think, Congressman, commercial hedgers have raised two concerns. One is could they enter into commercially needed but particular tailored transactions that aren't standard and the answer is an unambiguous yes but that is a legitimate question they have raised. Some members of the Senate or the House might feel differently but the administration says yes. Two is on the standard contracts they have raised the question is how is credit priced in there? Will they have to post collateral if it is lowering risk to a clearinghouse? " FinancialCrisisInquiry--56 That’s the change. CHAIRMAN ANGELIDES: All right. Thank you very much. All right. Let’s go—thank you. Mr. Holtz-Eakin? HOLTZ-EAKIN: I want to pick up on that and ask a question a little more broadly of the whole panel. Each of you, in your testimony, talked about problems of managing risk and excessive risk. Mr. Blankfein talked about under pricing of risk that led to massive leverage across wide swaths of the economy. A discussion from Mr. Dimon about compensation practices and misjudgments about aggressive underwriting standards. Mr. Mack talks about not having sufficient resources to manage those risks. And so each of the institutions you represent are publicly traded. They have audit committees. They have boards. They have internal auditors. And so my question is what is it about this traditional structure that failed us? Why is it that the risks that you have identified weren’t uncovered in the moment? And what specifically has each of you done, in addition to what you’ve discussed, to change your risk management practices since the crisis? We’ll just start with Mr. Blankfein. BLANKFEIN: I think if I had to say one thing in specific—and a lot of—we focus a lot, a lot of efforts and always have on risk management and our senior risk managers rise to the highest levels, including our named executive -- one of our named executive officers is our risk manager. So it’s the highest level of the firm. I’d say the one thing that we constantly learn from every crisis—‘98, tech, this one, of course, which is a different level—is the need for more stress tests. Very often in our business, we go through the analytical process of what could go wrong versus what is the probability of that going wrong. And, therefore, tend to discount the consequences too much. FOMC20051101meeting--113 111,MR. MOSKOW.," In our contact calls for this round, energy prices were a pervasive concern. So far they’ve had a limited effect on consumer spending, but our contacts worry that high heating bills will take a bigger bite out of sales in the coming months. In contrast, we’re seeing the impact on costs right now. Nearly every contact reported pressures from higher energy prices. There are many examples, but here’s one that seemed a bit more surprising than others. A large specialty November 1, 2005 29 of 114 which is a petroleum derivative. He said that in 30 years in the furniture business, this is the first time that the stuffing cost more than the fabric or the frame. [Laughter] Labor markets are also starting to generate cost pressures. For example, both Manpower and Kelly report signs of tighter labor markets. These contacts say that many firms, after having been very cautious about hiring, now feel they have pushed productivity growth as far as it can go and, accordingly, finally feel they need to hire more permanent employees, particularly in office jobs. Our contacts see this as a further sign that firms are more confident about demand. One of the staffing services firms said that they are paying higher wages and also spending more on recruiting and retention bonuses. And several of our directors report that they’re budgeting larger salary increases for 2006, in the range of one-half to a full percentage point higher than this year. The consensus among our contacts was that only a portion of these higher costs has been passed through to prices, at least so far. Several reported that labor costs are mostly eating into margins, which is what we’ve been expecting. But more price increases may be coming. A home goods retailer noted that they had set their current list prices last spring. When they decide how to price their products for next year, they’ll take into account the fuel cost outlook at that time. There has been no let-up in the auto industry’s woes. Our contacts say that higher oil prices seem to have frozen consumers, and showroom traffic is down. There have been some interesting developments with regard to labor costs in the auto industry. GM’s recent renegotiation of its health care liabilities, if ratified, would be the UAW’s [United Auto Workers] first major mid-contract give-back in history. Ford and DaimlerChrysler will be demanding similar concessions. Indeed, it might be that the Delphi bankruptcy has helped the industry at least get the ball rolling on some November 1, 2005 30 of 114 a clear possibility of a strike at Delphi that could seriously disrupt the auto industry, particularly General Motors. For the national outlook, the last six weeks of data have confirmed that the dislocations from Katrina and Rita have had a limited impact on aggregate economic activity. Outside the areas affected by the hurricanes, labor markets are improving at a pace similar to earlier in the year. And I’m getting favorable impressions of business sentiment from my contacts, which is a good sign for hiring and capital spending. However, there is a risk that the recent sluggishness in consumer expenditures and low levels of confidence may be foreshadowing a period of somewhat softer growth in consumption. Households have further run down savings to maintain spending in the face of higher energy prices, and it’s very difficult to gauge how this might influence consumption going forward. With regard to inflation, the readings on core prices in the last quarter were good. Given all that I’ve heard in recent weeks, though, it seems likely that past increases in energy and material costs will soon begin to show through more clearly in prices downstream, as is forecast in the Greenbook. Furthermore, labor markets have tightened. As I noted, many of my business contacts are planning for larger increases in wages and benefits next year. They can only absorb these higher costs in margins for so long. Finally, there’s a chance that increases in costs and prices will result in a meaningful rise in longer-run inflation expectations, which would be a risk to the longer-run Greenbook forecast. All of these risks add up to increasing the funds rate by 25 basis points again today. Looking ahead, I think we should continue tightening. At least we are comfortably in the middle of a neutral range, and there’s a possibility we’re going to have to go further. There’s a good deal of uncertainty November 1, 2005 31 of 114 Bluebook suggests that a 4 percent nominal funds rate might be the midpoint of the range, but I’m personally skeptical that the rate is that low. This is going to be an important issue for us to consider going forward. I’m glad that we at least started the discussion earlier today, and I hope we’ll continue it later in the meeting." FOMC20051213meeting--71 69,MS. YELLEN.," Thank you, Mr. Chairman. Incoming data since our last meeting have been quite encouraging. Economic growth over the next few quarters should be boosted by rebuilding and the full return of energy production in the Gulf. As rebuilding winds down and the lagged effects of monetary policy tightening take hold, it seems plausible that growth will slow toward potential, keeping unemployment around the current level of 5 percent, the scenario envisioned in the Greenbook. The economy’s remarkable resilience in the face of devastating hurricanes and three years of rising energy prices suggest that the expansion has gained footing and no longer needs support from December 13, 2005 35 of 100 whether policy might actually need to move to a restrictive stance in order to forestall inflationary pressures. I will therefore focus my attention on the factors affecting the inflation outlook. To do that, we need to look first at the here and now and remind ourselves that recent readings on core prices have consistently come in at or below expectations. There are no signs of acceleration. In fact, core PCE [personal consumption expenditures] price inflation has slowed over the past year; the most recent reading of 1.8 percent over the past twelve months is down 0.3 from the preceding year. And the downward inflation trend has continued through this year, with core PCE inflation running at only 1.6 percent over the past six months, which is about the middle of my preferred range. Of course, even though recent core inflation data look pretty darn good, there may be forces at work that could undermine price stability. In my remaining remarks, I’d like to comment on some factors that could push inflation higher and consider their likely effects in the current situation. The first risk to price stability is that, contrary to the Greenbook forecast, growth may not actually subside toward potential. So labor and product markets could tighten further, pushing unemployment below NAIRU, which current estimates place around 5 percent. This possibility is illustrated in the stronger aggregate demand scenario in the Greenbook. That simulation shows that monetary policy would, of course, need to tighten. But the inflation consequences would be modest, given a reactive Taylor rule monetary policy response. So to deal with this risk, it seems to me that policy need not be preemptive. A sustained slowdown in productivity growth would pose a more challenging dilemma for policy and the inflation outlook. Fortunately, however, productivity growth over the past year has not slowed. Quite the contrary, it has been surprisingly robust. Output per hour in the nonfarm business December 13, 2005 36 of 100 productivity growth of around 2¾ percent. As I discussed at our meeting a year ago, I think there are compelling reasons why productivity growth may well remain elevated for some time, having to do with the gradual diffusion of new technologies and workplace practices throughout the economy. Therefore, I concur with the staff’s conclusion that the accumulated evidence indicates that structural productivity growth is around 3 percent and with the corresponding upward revision in the outlook for actual productivity. Given the sluggish adjustment of wages to changes in productivity, the stronger path of productivity reduces the rate of growth of unit labor costs, putting downward pressure on inflation. So productivity trends suggest a tempering of inflationary pressures, not an intensification. Energy prices also pose a potential threat to inflation. But as I argued a few meetings back, the empirical evidence does not support significant pass-through of energy prices into core inflation. I won’t repeat those arguments today but simply note, once again, that core PCE inflation has actually moderated, despite a nearly 30 percent increase in energy prices over the past year, on top of a 15 percent rise in the previous year. Moreover, energy prices on the whole have come down sharply of late, and, therefore, the risk of significant pass-through to core inflation has moderated as well. In addition, it appears that the Fed’s credibility has held up well this year, despite the supply shocks associated with higher energy prices and hurricanes. Survey measures of longer-run inflation expectations are about where they stood before the storms. Longer-run inflation expectations based on Treasury securities have come down about ¼ percentage point since the last FOMC meeting and are now below levels of a year ago. Finally, it’s possible that wage growth could accelerate, putting upward pressure on the growth of unit labor costs and inflation. And, indeed, the Greenbook forecast projects exactly such an acceleration, reflecting lagged pass-through of earlier increases in both energy prices and productivity December 13, 2005 37 of 100 employment cost index, will increase 4.2 percent in 2006, following a 3 percent gain this year. It projects an even larger—1.7 percentage point—acceleration in compensation per hour in the nonfarm business sector. To gauge the likelihood of such an acceleration in compensation, my staff examined the pass- through of energy prices and productivity into wages. They used forecasting models in which wage inflation is determined by lagged wage inflation, price inflation, productivity growth, and the unemployment rate. Now, it turns out that when the sample period used in the analysis includes the 1970s, our empirical work finds clear evidence of pass-through from energy prices into compensation. But when the sample begins in the 1980s, pass-through effects from energy prices to compensation are dramatically weaker or insignificant. This result is consistent with the finding I reported previously. There is no real evidence that energy prices pass through to core consumer inflation since the early 1980s. With respect to the pass-through of productivity growth into compensation, our staff finds evidence of only very gradual pass-through regardless of the sample period. Going forward, our models predict significantly less increase in compensation growth than the Greenbook over the 2006­ 2007 forecast horizon. We conclude from this empirical work that an increase in inflation due to a sharp acceleration in compensation growth is, at most, an upside risk to inflation and not the most probable outcome. I opened my remarks by noting that a key issue facing us over the next few meetings is whether policy needs to move to a restrictive stance in order to forestall inflationary pressures. While we must obviously remain vigilant and respond to developments that threaten price stability, the evidence that we have at this time, in my opinion, points to relatively low and stable inflation going December 13, 2005 38 of 100 tightening takes hold and the economy reaches a turning point. Therefore, it’s important that we keep the lags of monetary policy actions in mind in our deliberations and not go too far." CHRG-111hhrg51698--63 Mr. Gooch," They are the members, but, that you definitely require their cooperation. But you also require global cooperation, because these instruments are also traded throughout Europe. So you can't have a clearing mechanism that considers that all of the transactions are only in the U.S. Additionally, of course, there are highly illiquid instruments that just dump themselves for clearing, and that the financial system benefits from the willingness of investors to put capital at risk that provides liquid markets. I am a free marketeer myself, so I believe that it is important to have free liquid markets. If you create price controls, you create shortages. This price control, which is what it would amount to be, would be creating a shortage of credit. You know, blaming the CDS is like shooting the messenger, because the CDS were the instruments that were certainly used in the financial markets, but there was no ultimate failure in the CDS market. The CDS markets performed perfectly. What is failing is the mortgages and the lending that was done to persons that shouldn't have been borrowing. And to that extent we have a sort of global responsibility for having just enjoyed living beyond our means and having a massive global credit bubble, and that credit bubble also drove oil prices to $140. I mean, until it burst, investors overseas that would be concerning themselves with the future needs of the growing economy in countries like China, buying up oil reserves, was what partly was driving the price of oil. So it is not the credit derivatives that are at fault, it is the entire free, cheap credit in the system that was the problem. " FinancialCrisisInquiry--7 One contributing factor to the attractiveness of the housing market was public policy’s active support of the expansion of homeownership, recognizing the societal benefits. For our industry, it is important to reflect on some of the lessons learned and mistakes made over the course of the crisis. At the top of my list are the rationalizations that we made to justify that the downward pricing of risk was different. While we recognize that credit standards were loosening, we rationalized the reasons with arguments such as: the emerging markets were growing more rapidly, the risk mitigants were better, there was more than enough liquidity in the system. A systemic lack of skepticism was equally true with respect to credit ratings. Rather than undertake their own analysis, too many financial institutions relied on the rating agencies to do the central work of risk analysis. Another failure of risk management concerned the fact that risk models, particularly those predicated on historical data, were too often allowed to substitute for judgment. Next, size mattered. Whether you owned $5 billion or $50 billion of supposedly no-risk super-senior debt in a CDO, the likelihood of loss rate would appear to be the same. But the consequences of a miscalculation were obviously much bigger if you had a $50 billion exposure. Third, risk monitoring failed to capture the risk inherent in off-balance sheet activities such as structured investment vehicles, or SIVs. It seems clear now that financial institutions with large off-balance sheet exposure didn’t appreciate the full magnitude of the economic risks they were exposed to. Equally worrying, their counter parties were unaware of the full extent of those vehicles and therefore, could not accurately assess the risk of doing business. CHRG-109hhrg28024--11 Mr. Bernanke," Mr. Chairman and members of the committee, I am pleased to be here today to present the Federal Reserve's monetary policy report to the Congress. I look forward to working closely with the members of this committee on issues of monetary policy, as well as on matters regarding the other responsibilities with which the Congress has charged the Federal Reserve system. The U.S. economy performed impressively in 2005. Real gross domestic product increased a bit more than three percent, building on a sustained expansion that gained traction in the middle of 2003. Payroll employment rose two million in 2005, and the unemployment rate fell below five percent. Productivity continued to advance briskly. The economy achieved these gains despite some significant obstacles. Energy prices rose substantially yet again, in response to increasing global demand, hurricane-related disruptions to production, and concerns about the adequacy and reliability of supply. The gulf coast region suffered through severe hurricanes that inflicted a terrible loss of life, destroyed homes, personal property, businesses and infrastructure on a massive scale, and displaced more than a million people. The storms also damaged facilities and disrupted production in many industries, with substantial effects on the energy and petrochemical sectors and on the region's ports. Full recovery in the affected areas is likely to be slow. The hurricanes left an imprint on aggregate economic activity as well, seen in part in the marked deceleration of real GDP in the fourth quarter. However, the most recent evidence, including indicators of production, the flow of new orders to businesses, weekly data on initial claims for unemployment insurance, and the payroll employment and retail sales figures for January suggests that the economic expansion remains on track. Inflation pressures increased in 2005. Steeply-rising energy prices pushed up overall inflation, raised business costs, and squeezed household budgets. Nevertheless, the increase in prices for personal consumption expenditures, excluding food and energy, at just below two percent, remained moderate, and longer-term inflation expectations appeared to have been contained. With the economy expanding at a solid pace, resource utilization rising, cost pressures increasing, and short-term interest rates still relatively low, the Federal Open Market Committee over the course of 2005 continued the process of removing monetary policy accommodation, raising the Federal funds rate two percentage points in eight increments of 25 basis points each. At its meeting on January 31st of this year, the FOMC raised the Federal funds rate another one quarter percentage point, bringing its level to four and a half percent. At that meeting, monetary policymakers also discussed the economic outlook for the next 2 years. The central tendency of the forecasts of members of the Board of Governors and the presidents of Federal Reserve Banks is for real GDP to increase about three and a half percent in 2006 and three percent to three and a half percent in 2007. The civilian unemployment rate is expected to finish both 2006 and 2007 at a level of between four and three quarters percent and five percent. Inflation, as measured by the price index for personal consumption expenditures excluding food and energy, is predicted to be about two percent this year and one and three quarters percent to two percent next year. While considerable uncertainty surrounds any economic forecast extending nearly 2 years, I am comfortable with these projections. In the announcement following the January 31st meeting, the Federal Reserve pointed to risks that could add to inflation pressures. Among those risks is the possibility that to an extent greater than we now anticipate, higher energy prices may pass through into the prices of non-energy goods and services or have a persistent effect on inflation expectations. Another factor bearing on the inflation outlook is that the economy now appears to be operating at a relatively high level of resource utilization. Gauging the economy's sustainable potential is difficult, and the Federal Reserve will keep a close eye on all of the relevant evidence and be flexible in making those judgments. Nevertheless, the risk exists that with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately, in the absence of countervailing monetary policy action, to further upward pressure on inflation. In these circumstances, the FOMC judged that some further firming of monetary policy may be necessary, an assessment with which I concur. Not only the risks to the economy concern inflation. For example, a number of indicators point to a slowing in the housing market. Some cooling of the housing market is to be expected and would not be inconsistent with continued solid growth of overall economic activity. However, given the substantial gains in house prices and the high levels of home construction activity over the past several years, prices and construction could decelerate more rapidly than currently seems likely. Slower growth in home equity in turn might lead households to boost their saving and trim their spending relative to current income by more than is now anticipated. The possibility of significant further increases in energy prices represents an additional risk to the economy. Besides affecting inflation, such increases might also hurt consumer confidence and thereby reduce spending on non-energy goods and services. Although the outlook contains significant uncertainties, it is clear that substantial progress has been made in removing monetary policy accommodation. As a consequence, in coming quarters, the FOMC will have to make ongoing provisional judgments about the risks to both inflation and growth, and monetary policy actions will be increasingly dependent on incoming data. As I noted, core inflation has been moderate, despite sharp increases in energy prices. A key factor in this regard has been confidence on the part of 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. Thus far, the news has been good. 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 prospects are important, not just because price stability is in itself desirable and part of the Federal Reserve's mandate from the Congress, but also because price stability is essential for strong and stable growth of output and employment. Stable prices promote long-term economic growth by allowing households and firms to make economic decisions and undertake productive activities with fewer concerns about large or unanticipated changes in the price level and their attendant financial consequences. Experience shows that low and stable inflation and inflation expectations are also associated with greater short-term stability of output and employment, perhaps in part because they give the central bank greater latitude to counter transitory disturbances to the economy. Similarly, the attainment of the statutory goal of moderate long-term interest rates requires price stability because only then are the inflation premiums that investors demand for holding long-term instruments kept to a minimum. In sum, achieving price stability is not only important in itself; it is also central to attaining the Federal Reserve's other mandated objectives of maximum sustainable employment and moderate long-term interest rates. As always, however, translating the Federal Reserve's general economic objectives into operational decisions about the stance of monetary policy poses many challenges. Over the past few decades, policymakers have learned that no single economic or financial indicator, or even a small set of such indicators, can provide reliable guidance for the setting of monetary policy. Rather, the Federal Reserve, together with all modern central banks, has found that the successful conduct of monetary policy requires painstaking examination of a broad range of economic and financial data, careful consideration of the implications of those data for the likely path of the economy and inflation, and prudent judgment regarding the effects of alternative courses of policy action on prospects for achieving our macroeconomic objectives. In that process, economic models can provide valuable guidance to policymakers, and over the years, substantial progress has been made in developing formal models and forecasting techniques. But any model is by necessity a simplification of the real world, and sufficient data are seldom available to measure even the basic relationships with precision. Monetary policymakers must therefore strike a difficult balance, conducting rigorous analysis informed by sound, economic theory and empirical methods, while keeping an open mind about the many factors, including myriad global influences at play in a dynamic, modern economy like that of the United States. Amid significant uncertainty, we must formulate a view of the most likely course of the economy under a given policy approach, while giving due weight to the potential risks and associated costs to the economy should those judgments turn out to be wrong. During the nearly 3 years that I previously spent as a member of the Board of Governors and of the Federal Open Market Committee, the approach to policy that I just outlined was standard operating procedure under the highly successful leadership of Chairman Greenspan. As I indicated to the Congress during my confirmation hearing, my intention is to maintain continuity with this and the other practices of the Federal Reserve in the Greenspan era. I believe that with this approach, the Federal Reserve will continue to contribute to the sound performance of the U.S. economy in the years to come. Thank you, and I'd be happy to take your questions. [The prepared statement of Hon. Ben. S. Bernanke can be found on page 65 in the appendix.:] " FinancialCrisisReport--241 Risk Factors in Insurance Fees. Under a new FDIC deposit insurance pricing system that takes effect in 2011, large depository institutions with higher risk activities will be required to pay higher fees into the Deposit Insurance Fund. 948 This new assessment system is designed to “better capture risk at the time large institutions assume the risk, to better differentiate among institutions for risk and take a more forward-looking view of risk, [and] to better take into account the losses that the FDIC may incur if such an insured depository institution fails.” 949 It is the product of both past FDIC revisions and changes to the insurance fund assessment system made by the Dodd-Frank Act. 950 It is intended to impose higher assessments on large banks “with high-risk asset concentrations, less stable balance sheet liquidity, or potentially higher loss severity in the event of failure,” and impose those higher assessments when the banks “assume these risks rather than when conditions deteriorate.” 951 Under this new system, banks with higher risk activities will be assessed higher fees, not only to safeguard the insurance fund and allocate insurance costs more fairly, but also to help discourage high risk activities. Financial Stability Oversight Council. The Dodd-Frank Act has also established a new intra-governmental council, the Financial Stability Oversight Council (FSOC), to identify systemic risks and respond to emerging threats to the stability of the U.S. financial system. 952 The council is comprised of ten existing regulators in the financial services sector, including the Chairman of the Federal Reserve Board of Governors, the Chairman of the FDIC, and the Comptroller of the Currency, and is chaired by the Secretary of the Treasury. This Council is intended to ensure that U.S. financial regulators consider the safety and soundness of not only individual financial institutions, but also of U.S. financial markets and systems as a whole. (2) Recommendations To further strengthen oversight of financial institutions to reduce risk, protect U.S. financial markets and the economy, and safeguard the Deposit Insurance Fund, this Report makes the following recommendations. 1. Complete OTS Dismantling. The Office of the Comptroller of the Currency (OCC) should complete the dismantling of the Office of Thrift Supervision (OTS), despite attempts by some OTS officials to preserve the agency’s identity and influence within the OCC. 2. Strengthen Enforcement. Federal banking regulators should conduct a review of their major financial institutions to identify those with ongoing, serious deficiencies, and review their enforcement approach to those institutions to eliminate any policy of deference to bank management, inflated CAMELS ratings, or use of short term profits to excuse high risk activities. 948 See 2/7/2011 FDIC Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing, RIN 3064. 949 Id. 950 See Sections 331, 332 and 334 of the Dodd-Frank Act. 951 2/7/2011 FDIC press release, “FDIC Approves Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing,” http://www.fdic.gov/news/news/press/2011/pr11028.html. 952 See Title I, Subtitle A, of the Dodd-Frank Act establishing the Financial Stability Oversight Council, including Section 112(a) which provides its purposes and duties. 3. Strengthen CAMELS Ratings. Federal banking regulators should undertake a comprehensive review of the CAMELS ratings system to produce ratings that signal whether an institution is expected to operate in a safe and sound manner over a specified period of time, asset quality ratings that reflect embedded risks rather than short term profits, management ratings that reflect any ongoing failure to correct identified deficiencies, and composite ratings that discourage systemic risks. 4. Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council should undertake a study to identify high risk lending practices at financial institutions, and evaluate the nature and significance of the impacts that these practices may have on U.S. financial systems as a whole. FOMC20080916meeting--130 128,MS. PIANALTO.," Thank you, Mr. Chairman. The recent financial market news is shaking people's confidence dramatically. But even before recent events, the evidence was already pointing to more effects of the financial crisis on the real economy than I had built into my projection at our last meeting. The reports from my District contacts and the incoming data caused me to revise down my near-term output projection even before the latest round of financial market troubles. The improvement in net exports that was reflected in the second-quarter GDP growth has not encouraged manufacturers in my District to revise up their export projections. They are still holding firmly to the opinion that the global economy is slowing and that export growth will slow with it for several quarters. Of course, manufacturers are concerned about weakness spreading further within their domestic customer base. The ongoing turmoil in financial markets continues to affect businesses in my District. Some of the banks in my District are finding it very, very difficult to attract new capital and to manage their way out of trouble. I am hearing that credit is harder to come by for many borrowers who in the recent past would not have thought twice about their creditworthiness. Last week I met with a business contact with a very long and successful track record of buying and operating private companies. He reported that he had reached a deal with a bank to finance a project at a 7 percent interest rate with the loan amortized over a fifteen-year term. On the morning of the close just three days later, the bank faxed him the paperwork, which reflected a 12 percent interest rate on a nonamortizing loan with a 10-year term. So the deal obviously is not going forward. One of my directors, who heads a very large regional banking organization, reported at our board meeting last week that many banks are shedding assets and that in some cases they are walking away from longstanding customer relationships in order to do so. He said that investors are very skeptical about putting new equity into banking deals and that those who have done so in the past vow not to be burned twice, let alone a third time. Of course, inflation remains an important issue as well. My contacts, as Dave mentioned in his report, are not so confident that a broad array of intermediate and retail prices are actually going to move back down as a result of the recent decline in energy and other commodity prices. Several of my contacts report that major suppliers are trying to maintain their prices despite the decline in raw material costs just to make up for a long period of absorbing price increases. Nevertheless, most of my contacts agree that the commodity price environment has stabilized considerably, making me more confident that core inflation will gradually slow over the next couple of years. At our last meeting, my forecast was broadly consistent with the Greenbook baseline. Today my forecasts for output and prices are broadly similar to the Greenbook's for 2009 and 2010, although I am expecting more weakness in economic activity in the second half of this year than the Greenbook is forecasting. My contacts in the manufacturing sector have persuaded me that exports are going to be weaker in the short term than I had previously thought, and I have also revised down my consumption path on the basis of the credit constraints on households. Although I am more encouraged about the recent decline in energy and commodity prices, I would like to see further evidence of price stability in these markets and also continued stability in inflation expectations for a while longer before I reduce the upside risk that I place on my inflation outlook. However, a growing risk to my outlook is that the short-term weakness that I have now built into my outlook extends further out into the forecast period. I worry that my outlook doesn't fully capture all of the many ways in which financial forces at work in the economy are actually going to restrain spending. On Friday, I was convinced that the best course of action was to keep an even keel in these rough seas--to be flexible, of course, but to look beyond the latest wave crashing over the bow. Only six weeks ago, inflation risks were on the verge of being unacceptable, and today the troubles of Wall Street are the focus. I was sure that we were going to be in for many more surprises; I just didn't know when and from where they would be coming. So I supported not only keeping our policy unchanged but also keeping our language changes to a minimum even if that language missed some nuances of the outlook. Given the events of the weekend, I still think it is appropriate for us to keep our policy rate unchanged. I would like more time to assess how the recent events are going to affect the real economy. I have a small preference for the assessment-of-risk language under alternative A. I think it captures my concern that the downside risks have intensified. However, I can support some of the comments and changes to highlight the financial market strains that were made by President Lockhart and President Stern. So I can support the language under alternative B with some additional comments about the financial strains that we are facing. Thank you, Mr. Chairman. " CHRG-109shrg26643--30 Chairman Bernanke," Thank you. Mr. Chairman and Members of the Committee, I am pleased to be here today to present the Federal Reserve's Monetary Policy Report to the Congress. I look forward to working closely with the Members of this Committee on issues of monetary policy as well as on matters regarding the other responsibilities with which the Congress has charged the Federal Reserve System. The U.S. economy performed impressively in 2005. Real gross domestic product increased a bit more than 3 percent, building on the sustained expansion that gained traction in the middle of 2003. Payroll employment rose two million in 2005 and the unemployment rate fell below 5 percent. Productivity continued to advance briskly. The economy achieved these gains despite some significant obstacles. Energy prices rose substantially yet again in response to the increasing global demand, hurricane-related disruptions to production, and concerns about the adequacy and reliability of supply. The Gulf Coast region suffered through severe hurricanes that inflicted a terrible loss of life, destroyed homes, personal property, businesses and infrastructure on a massive scale, and displaced more than a million people. The storms also damaged facilities and disrupted production in many industries with substantial effects on the energy and petrochemical sectors and on the region's ports. Full recovery in the affected areas is likely to be slow. The hurricanes left an imprint on aggregate economic activity as well, seen in part in the marked deceleration of real GDP in the fourth quarter. However, the most recent evidence, including indicators of production, the flow of new orders to businesses, weekly data on initial claims for unemployment insurance, and the payroll employment and retail sales figures for January, suggest that the economic expansion remains on track. Inflation pressures increased in 2005. Steeply rising energy prices pushed up overall inflation, raised business costs, and squeezed household budgets. Nevertheless, the increase in prices for personal consumption expenditures excluding food and energy, at just below 2 percent, remained moderate, and longer-term inflation expectations appear to have been contained. With the economy expanding at a solid pace, resource utilization rising, cost pressures increasing, and short-term interest rates still relatively low, the Federal Open Market Committee over the course of 2005 continued the process of removing monetary policy accommodation, raising the Federal funds rate 2 percentage points in eight increments of 25 basis points each. At its meeting on January 31 of this year, the FOMC raised the Federal funds rate another one-quarter percentage point, bringing its level to 4\1/2\ percent. At that meeting, monetary policymakers also discussed the economic outlook for the next 2 years. The central tendency of the forecast of Members of the Board of Governors and the Presidents of the Federal Reserve Banks is for real GDP to increase about 3\1/2\ percent in 2006 and 3 percent to 3\1/2\ percent in 2007. The civilian unemployment rate is expected to finish both 2006 and 2007 at a level between 4\3/4\ percent and 5 percent. Inflation, as measured by the price index for personal consumption expenditures excluding food and energy, is predicted to be about 2 percent this year and 1\3/4\ percent to 2 percent next year. While considerable uncertainty surrounds any economic forecast extending nearly 2 years, I am comfortable with these projections. In the announcement following the January 31 meeting, the Federal Reserve pointed to risks that could add to inflation pressures. Among those risks is the possibility that to a greater extent than we now anticipate, higher energy prices may pass through into the prices of nonenergy goods and services or have a persistent effect on inflation expectations. Another factor bearing on the inflation outlook is that the economy appears now to be operating at a relatively high level of resource utilization. Gauging the economy's sustainable potential is difficult and the Federal Reserve will keep a close eye on all the relevant evidence and be flexible in making those judgments. Nevertheless, the risk exists that with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately--in the absence of countervailing monetary policy action--to further upward pressure on inflation. In these circumstances, the FOMC judged that some further firming of monetary policy may be necessary, an assessment with which I concur. Not all of the risks to the economy concern inflation. For example, a number of indicators point to a slowing in the housing market. Some cooling of the housing market is to be expected and would not be inconsistent with continued solid growth of overall economic activity. However, given the substantial gains in house prices, and the high levels of home construction activity over the past several years, prices and construction could decelerate more rapidly than currently seems likely. Slower growth in home equity, in turn, might lead households to boost their saving and trim their spending relative to current income by more than is now anticipated. The possibility of significant further increases in energy prices represents an additional risk to the economy. Besides affecting inflation, such increases might also hurt consumer confidence and thereby reduce spending on nonenergy goods and services. Although the outlook contains significant uncertainties, it is clear substantial progress has been made in removing monetary policy accommodation. As a consequence, in coming quarters, the FOMC will have to make ongoing, provisional judgments about the risks to both inflation and growth, and monetary actions will be increasingly dependent on incoming data. As I noted, core inflation has been moderate despite sharp increases in energy prices. A key factor in this regard has been confidence on the part of public and investors in the prospects for price stability. Maintaining expectations of low and stable inflation is an essential element in the Federal Reserve's effort to promote price stability, and thus far the news has been good. Measures of longer-term inflation expectations have responded only a little to larger fluctuations in energy prices that we have experienced, and for the most part they were low and stable last year. Inflation prospects are important, not just because price stability is in itself desirable and part of the Federal Reserve's mandate from the Congress, but also because price stability is essential for strong and stable growth of output and employment. Stable prices promote long-term economic growth by allowing households and firms to make economic decisions and undertake productive activities with fewer concerns about large or unanticipated changes in the price level and their attendant financial consequences. Experience shows that low and stable inflation and inflation expectations are also associated with greater short-term stability and output and employment, perhaps in part because they give the central bank greater latitude to counter transitory disturbances to the economy. Similarly, the attainment of the statutory goal of moderate long-term interest rates requires price stability, because only then are the inflation premiums that investors demand for holding long-term instruments kept to a minimum. In sum, achieving price stability is not only important in itself; but it is also central to attaining the Federal Reserve's other mandated objectives of maximum sustainable employment and moderate long-term interest rates. As always, however, translating the Federal Reserve's general economic objectives into operational decisions about the stance of monetary policy poses many challenges. Over the past few decades, policymakers have learned that no single economic or financial indicator or even a small set of such indicators can provide reliable guidance for the setting of monetary policy. Rather, the Federal Reserve, together with all modern central banks, has found that the successful conduct of monetary policy requires painstaking examination of a broad range of economic and financial data, careful consideration of the implications of those data for the likely path of the economy and inflation, and prudent judgment regarding the effects of alternative courses of policy action on the prospects for achieving our macroeconomic objectives. In that process, economic models can provide valuable guidance to policymakers and over the years substantial progress has been made in developing formal models and forecasting techniques. But any model is by necessity a simplification of the real world and sufficient data are seldom available to measure even the basic relationships with precision. Monetary policymakers must therefore strike a difficult balance, conducting rigorous analysis informed by sound economic theory and empirical methods while keeping an open mind about the many factors including myriad global influences at play in a dynamic modern economy like that of the United States. Amid significant uncertainty, we must formulate a view of the most likely course of the economy under a given policy approach while giving due weight the potential risks and associated costs to the economy should those judgments turn out to be wrong. During the 3 years that I previously spent as a Member of the Board of Governors of the Federal Open Market Committee, the approach to policy that I have just outlined was standard operating procedure under the highly successful leadership of Chairman Greenspan. As I indicated to the Congress during my confirmation hearing, my intention is to maintain continuity with this and the other practices of the Federal Reserve in the Greenspan era. I believe that with this approach, the Federal Reserve will continue to contribute to the sound performance of the U.S. economy in the years to come. Thank you, Mr. Chairman. " CHRG-111hhrg52397--230 Mr. Duffy," Thank you, Chairman Kanjorski, for this opportunity to present our views on effective regulation of the OTC derivatives market. Treasury Secretary Geithner's May 9, 2009, letter to Senator Harry Reid outlined the Administration's plan for regulatory reform of the financial services sector. His plan proposed increased regulation of credit default swaps and other OTC derivatives. This committee posed seven questions for our consideration this morning. We agree with many of Secretary Geithner's proposals. For example, we support position reporting for OTC derivatives and agree that enhanced price transparency across the entire market is essential to quantify and control risk. We believe, however, that the measure chosen to achieve these ends should be fine-tuned to avoid adverse consequences for U.S. markets. We are concerned that legislation mandating the clearing of all OTC transactions could well induce certain market participants to transfer this business offshore, resulting in significant loss of U.S. futures business. By reducing liquidity on U.S. exchanges, this would undermine the Congress' attempt to establish greater transparency, price discovery, and risk management of U.S. markets. We applaud the Administration's efforts to enhance transparency, stability, integrity, efficiency, and fairness in all markets, but we believe that with slight modifications to the proposal outlined by Secretary Geithner, and the inclusion of a few additional measures would complement the Administration's efforts. We have responded to your specific questions at length in our written testimony. Let me offer a brief summary of our responses: First, we agree with the informed consensus that the financial crisis was attributable in part to the lack of regulation in the over-the-counter market, which was not subject to appropriate disclosure and risk management techniques. Second, clearing should be offered to the OTC market in a form that makes a compelling alternative to the current model. Central counterparty clearing offers a well-tested method to monitor and collateralize risk on a current basis, reducing systemic risk and enhancing fairness for all participants. Third, we are not in favor of government-mandated clearing even though we are strong proponents of the benefits of central counterparty clearing. Central counterparty clearing serves as an effective means to collect and provide timely information to regulators. It also reduces systemic risk imposed on the financial system by unregulated, bilateral OTC transactions. Nevertheless, rather than compel clearing of all OTC transactions, we believe appropriate incentives should be put in place. The incentives could be in the form of reporting and capital charges for uncleared OTC positions and reduce capital charges for cleared OTC positions. We believe they would contribute both to the transparency and the reduction of systemic risks. Fourth, obviously, we are strong proponents of the benefits of exchange trading of derivatives, but we are also realists on the issue of whether exchanges can generate sufficient liquidity to make exchange trading efficient and economical for our customers. We are concerned that government-mandated exchange trading will be a massive waste of resources and capital. Fifth, in our view, electronic trading offers many benefits. It levels the playing field. It enhances price transparency and liquidity. It speeds execution and strengthens processing and eliminates any classes of errors of unmatched trades. Overall, it is an enormous benefit to the market and to our customers. Electronic trading when coupled with our intelligent audit and compliance programs allows us to better monitor our markets for fraud and manipulation. It also gives us the tools to effectively prosecute anyone foolish enough to engage in misconduct in a forum with a perfect audit trail and a highly skilled enforcement staff. Sixth, we believe that there is an appropriate balance between price discovery and liquidity that is effectively controlled by the current procedures to police excessive speculation. Regulated future markets and the CFTC have the means and the will to limit speculation that distorts prices or the movement of commodities in interstate commerce. Seventh, we operate trading systems in a clearinghouse in which every bid and offer, as well as every completed transaction, is instantaneously documented. In addition, those records are preserved for an extended period of time. We hope that our views on regulating the OTC market will be given significant weight based on our record and experience, and I look forward to answering your questions. Thank you, sir. [The prepared statement of Mr. Duffy can be found on page 132 of the appendix.] " FOMC20080625meeting--67 65,MR. HOENIG.," Mr. Chairman, I will begin my remarks this afternoon with a brief update on the conditions in our District. Overall, District economic activity continues to expand moderately, with strengthened energy, agriculture, and export manufacturing more than offsetting the softness in our housing, retail sales, and other types of manufacturing activity. District labor markets continue to perform reasonably well. While job growth has slowed over the past few months, unemployment remains very low, and many sectors continue to have difficulty finding workers, especially skilled ones. Evidence on wage pressures is mixed. Although wage pressures have moderated somewhat in our Beige Book survey, some recent labor union contracts have built in rising profiles for hourly wage increases over the term of the contract. Rising energy and commodity input prices are continuing to negatively affect our District economic activity. Reports from businesses suggest that higher energy and food prices are being quickly passed on to the customer now. However, businesses are having mixed success in passing on other cost increases, resulting in some severe erosion in margins and profitability in some of the firms. To illustrate some of the cost�price dynamics, I would like to take just a minute and relate the recent experience of one of our Branch directors, who operates a multi-line manufacturing firm. I mention this because I am hearing it more and more. In addition to rising fuel prices, his business has seen a doubling in steel costs since January, with July quotes on steel tubing up an additional 25 percent. In response, his company recently announced a price increase of 16 to 18 percent across a range of products. Competitors immediately matched or exceeded his price increases. Notably, he made these price increases despite a decline in new orders in May. He also noted that import prices from China that he has seen have risen 28 percent this year and that ocean freight prices have risen about 20 percent. As a result, customers who previously bought Chinese products are now purchasing U.S.-manufactured goods. It is interesting--I talked with some of the folks at Union Pacific, and their shipments into the Midwest have dropped slightly, but their shipments out have increased about 3 to 4 percent. So that is what is going on in the region. More broadly, turning to the national economy, I have revised up my growth estimate for the first half of 2008, but it has made little change in my longer-run outlook. Compared with the Greenbook, I see somewhat stronger growth in the second half of this year and somewhat weaker growth next year and in 2010. Most of the difference from the Greenbook in 2009 and 2010 comes from the policy path assumptions. I assume that policy accommodation is removed at a more rapid pace than does the Greenbook. Recent economic data suggest that, although downside risks to growth remain, they have diminished. I continue to judge that the potential spillover effects from the financial distress have understandably been overestimated in this Committee's recent decisions and in Greenbook forecasts in recent months. In my view, the greater risks to the outlook come from rising energy and commodity prices and less from the financial distress as we go forward. In my view, current policy accommodation is greater than needed to address these risks. As I indicated at the last meeting, I believe that the upside risks to inflation have increased considerably over the past several months. Like the Greenbook, I expect both overall and core PCE inflation to move higher in the second half of this year. If this happens and we maintain the current level of the funds rate, I believe we are likely to see further erosion in inflation expectations, which will undermine our credibility with financial markets and the public. In this event, I judge we will greatly increase the likelihood that we will need to raise rates more aggressively, taking rates above neutral, in order to achieve our longer-run inflation objectives; and that is of significant concern to me, Mr. Chairman. Turning to the issue of long-term projections, let me comment that I have felt somewhat constrained by the current three-year horizon for our quarterly projections. Of the options presented by the subcommittee, I am most comfortable with providing estimates of the values for total inflation, output growth, and unemployment at which the economy is likely to converge. I am not sure, however, how we want to label these estimates, if they are included in the table. I understand that putting these estimates out might be interpreted as a move closer to inflation targeting, but I think that this is a bridge we are ready to cross since we adopted the enhanced projections process. The other options seem less desirable. Given the resources required, by my staff at least, I doubt that we could provide a meaningful forecast at a four-year or five-year horizon, and I am not sure how projections for average values over a period of five to ten years ahead would be interpreted by the public. In my view, appropriate policy should be expected to return the economy to its long-run equilibrium over a three-to-five-year period, with the length of the period depending on the nature of the shock. Setting out a five-to-ten-year horizon could be construed as a weakening in our commitment to achieve our mandate in a timely manner. Thank you. " CHRG-111hhrg53234--15 Mr. Kohn," I think there are minimal possibilities. I think some people have asked whether, if we see a systemic risk from the individual institution, that would affect our monetary policy deliberations. But in my view, I think there really is a congruence between the stability of the financial system and monetary policy. We can achieve our objectives of maximum employment and stable prices much more readily in a stable financial system. So I just don't see important instances in which there would be conflicts. " FOMC20070918meeting--167 165,MS. DANKER.," I’ll be reading the directive from page 35 of the Bluebook, and the assessment of risks from the table distributed today. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with reducing the federal funds rate to an average of around 4¾ percent.” Then: “Developments in financial markets since the Committee’s last regular meeting 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.”" FOMC20070807meeting--98 96,MR. KOHN.," Thank you, Mr. Chairman. Building on what the Vice Chairman just said, I have been listening in on that Morning Call. I’ve found it very useful, and it’s certainly an opportunity to ask questions if you have them. My forecast for the most likely outcome for output over the next few years is close to that of the staff—growth a little below potential for a few quarters, held down by the housing correction, and the unemployment rate rising a little further. Although some recent data for housing, consumption, and capital spending have been a bit to the soft side, we need to view those data against the background of a lower path for potential GDP and recall the tendency we’ve seen over the past several quarters for short runs of data that are a little hotter or a little cooler than we expected. I think this is sort of what it feels like when the economy is running at about 2 percent. I see a number of reasons to think that moderate growth remains the most likely outcome going forward. First, as President Stern has stressed from time to time, is the natural resilience of the economy, its tendency to grow near potential unless something is pushing it one way or another. If anything, this resilience has probably increased over the past couple of decades, reflecting more- flexible labor and product markets. Second, global growth remains strong, supporting the growth of exports. I don’t think this growth should be undermined by the fact that some unknown quantity of losses in the U.S. mortgage market is being absorbed by investors overseas, and the recent declines in the dollar will reinforce the effects of good foreign demand for U.S. goods and services. Third, the most likely factor to throw the economy off its potential is the financial markets. My most likely forecast assumed that the credit markets would begin to settle down over coming weeks with some, but limited, net tightening of conditions. I’ll return to the subject in a bit, but my outlook in this regard does rest fundamentally on the very strong financial condition of the nonfinancial business sector and commercial banks and my expectation that most households accounting for the vast bulk of consumer spending will not find credit availability newly constrained. Finally, a resumption of growth in consumption should be supported by moderate growth in jobs and household income as the rebound in productivity is limited by the slower path for trend productivity and as income shares shift a little toward labor. I also assumed that households would not face a repeat of the rise in gasoline prices that has taken something out of recent consumption demand. Then moderate growth in consumption along with good export markets should, in turn, support business investment spending. I expect this path for output to be associated with core inflation remaining in the neighborhood of 2 percent. If energy prices follow the path in futures markets, total inflation would come down to 2 percent as well. Basically I don’t see anything in my central tendency forecast for the economy that would push inflation very much one way or another. The economy produces around its long-run potential. My NAIRU was 4¾ percent. Inflation expectations as best we can judge are anchored at something like 2 percent PCE inflation. I’m encouraged that the most recent data on prices have tended to confirm that core inflation remains fairly low. Most measures of compensation also do not show a marked acceleration that might be associated with producing appreciably beyond the economy’s sustainable level of production. Risks around my inflation forecast remain to the upside, provided that output follows my most likely path. Utilization is tight. The recent run-up in energy prices could still feed through to expectations. The damped increase in productivity growth implies greater pressure on business costs and margins. Historically, nominal wages have tended to respond more sluggishly to changes in trend productivity than do prices, and this could be especially the circumstance when workers have seen real incomes held down by higher energy prices and business profit margins have been high. At the same time, like many around this table, I think that the downside risks around the forecast of moderate growth and production going forward have increased. For some time I thought that the risk of a shortfall from our central tendency outweighed the risk of an overshoot, mainly centered on housing and consumption. But the financial developments of the last intermeeting period have appreciably increased those risks. As many have remarked, and Bill said so nicely, problems have spread from the subprime sector to a good part of the mortgage market more generally, including a severe restriction on securitization of nonconforming mortgages. Some business credit has been affected. Spread are widening across a broad array of instruments and ratings. This has occurred in an atmosphere of greatly increased volatility and uncertainty, partly related to the questions about the pricing of complex structured credits that weren’t well understood and compounded by a loss of confidence in the rating agencies. The uncertainty is also a reflection of the perception that activity and prices in the housing market have not yet shown any signs of beginning to stabilize. I agree that we need to keep our focus on the effects of these developments and the financial markets on the economy, not on the distribution of wealth in the financial sector. The relationship of financial markets to real activity is multifaceted, not easily modeled with interest rates and stock prices, especially when markets are reconsidering risk. Tightening nonprice terms of lending, the reduced availability of credit, and simply the pervasive sense of uncertainty about the price of assets and cash flows can also affect spending. In such an environment, it wouldn’t be surprising if businesses and households postponed capital investments. I agree that this reassessment is a fundamentally healthy but somewhat messy correction to more-sustainable term and risk premiums. The most likely outcome is that it will be limited in duration and effect, and that’s what I assume for my forecast. Well-capitalized banks and opportunistic investors will come in and fill the gap, restoring credit flows to nonfinancial businesses and to the vast majority of households that can service their debts. In the end, credit conditions will be tighter than they were a little while ago, for the most part justifiably so, and the effect on output will probably not be very large. To be sure, the latest episode comes on top of a rise in term premiums over the May to June intermeeting period. As a consequence, financial conditions have tightened noticeably in the past few months, even abstracting from market disruptions of the last week. The federal funds rate has been as high as it has been in part to offset the accommodative effects of low volatility and tight term and credit premiums. I think that, even in the relatively benign adjustment scenario, we’ll need to look at whether that rate is still sufficiently supportive of economic activity. But in the circumstances—that is, the benign adjustment—that reassessment can await further information about aggregate demand and further assurance that inflation will remain low. I assumed an easing of policy in 2008 and 2009 in my projections to take account of this. But we can’t know how the market situation will evolve. I also believe that there’s a non-negligible chance of a prolonged and very messy adjustment period that would feed back substantially on confidence, wealth, and spending. With the rating agencies discredited and markets vulnerable to adverse news on the economy, the period of unusual uncertainty could be prolonged. The greatest risk is in the household sector, where uncertainty about valuations of mortgages could continue to feed back on credit availability, housing demand, and prices in a self-reinforcing cycle. Moreover, as lenders and borrowers revise assumptions about house prices even further, credit from home equity lines of credit and mortgage refinancings will become even less available and more expensive, putting to the test the hypothesis that I have been working under—that the feedback from housing on consumption can be approximated by a wealth effect, not something more serious working through housing equity withdrawal. As I noted, I don’t think this is the most likely outcome, but this tail of distribution is a lot fatter than it was only a month or so ago. Thank you, Mr. Chairman." FOMC20050920meeting--98 96,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. The balance of evidence since our last meeting still supports, in our view, a reasonably positive outlook for output and inflation. If we look through, as we should, the transitory effects of Katrina and the reconstruction, and if we factor in what the futures market tells us about the expected magnitude and duration of the rise in energy prices, we still see an economy growing slightly above trend with core inflation following a path somewhat, but not substantially, above our preferred range. The fundamentals still seem favorable to continued expansion with solid productivity growth, strong corporate balance sheets, reasonable growth in household income, and favorable financial conditions. And on the strength of this view, with real interest rates still quite low, we believe that we need to continue to tighten monetary policy at this meeting and beyond. At the September 20, 2005 73 of 117 Now, of course, the degree and balance of uncertainty has changed. We face a higher degree of overall uncertainty. It will be harder to assess over the next few quarters the underlying pace of demand growth. The rise of energy prices pre-Katrina—some of which remains even as the initial effects of the hurricane on expectations have washed out of energy markets, except for natural gas—creates some risk of a larger shock to confidence and behavior than seems to have been evident over the last two years. Damage from future hurricanes to energy and product output may prove harder to bridge through the release of international product reserves. Our capacity to discern the underlying rate of inflation is also somewhat diminished, perhaps less because of the effect of energy prices than the difficulty of sorting out what is actually happening to productivity growth and unit labor costs. Apart from reducing overall confidence around the forecasts, the balance of risks has probably shifted, too—shifted toward a somewhat higher probability of slower growth relative to the path of potential output and toward a greater risk of a larger and more persistent rise in core inflation. If the former risk materialized, the latter might be mitigated. These are risks across the spectrum of scenarios, rather than the most probable combination. But to acknowledge the change in uncertainty is not to suggest that it would be appropriate for us to stop or to push down the expected path of the nominal fed funds rate until we can better assess what we do not know now. The net effect of the changes to the outlook, on balance, probably does not alter the desirable path of the nominal fed funds rate relative to what we thought in mid-August. With the real rate still rather low, my inclination would be to continue to weight the upside risk to inflation as greater than the prospective risk of a significant September 20, 2005 74 of 117 growth is still only prospective. This implies that the slope of the expected fed funds rate should remain materially positive, even if we move today. And I think we would be better off after this meeting if the markets raised the expected path a bit than if the path were to fall from its pre- meeting trajectory. I think we probably know a little less today than we did in August about how far we are going to have to move, even if the economy appears to be following the path of our forecast. If we move today, all we know is that we’re 25 basis points higher than we were. The fact that we are that much closer to some point we can’t measure is a less valuable observation. We may even know less today about where equilibrium lies and whether that range has moved. And, of course, we still face some probability that we’ll have to move past it, or past what in retrospect we thought was equilibrium. Most of the hard questions we face look pretty much like they did at the last meeting. How strong and durable can we expect the expansion to be in the face of less optimism about future housing price gains or other factors that could cause household saving to rise and consumption to grow more slowly? Will this dramatic rise in energy prices over the past two years cause more substantial damage to business and consumer confidence? Will the world’s private savers continue to be willing to acquire claims on the United States at the higher rate implied by our current account forecast, and to do so on such favorable terms? Will business margins start to erode in a way that will portend slower investment and employment growth? Will the U.S. political system be able to make a credible effort in the near term to improve our medium-term fiscal position and sustain our relatively open trade policy? And, if not, do we risk September 20, 2005 75 of 117 These are all factors that could hurt future growth, but that doesn’t mean that monetary policy should be more accommodative than would otherwise make sense in anticipation of those negative effects or should try to preempt them. Rather, these familiar imbalances and concerns make the cost of any erosion in our credibility greater. Thank you." FinancialCrisisInquiry--21 We have seen, in our view, four crises unfold: a mortgage crisis, a capital markets crisis, a global credit crisis, and a severe global recession. The mortgage crisis originated with the dramatic expansion in the availability of mortgage credit through subprime lending and aggressive mortgage terms even in prime products. This led to a greater debt burden for consumers. Lenders, prompted by lower interest rates, rapidly rising home prices, and large amounts of capital available, made credit available to borrowers who could not previously qualify for a mortgage or extended more credit to a borrower who could or perhaps should—would not be able to handle. The national policy to expand American homeownership was also popular and created tailwinds. No one involved in the housing system—lenders, rating agencies, investors, insurers, consumers, regulators, and policy makers, foresaw a dramatic and rapid depreciation of home prices. When the nation did experience this rapid depreciation in home prices, the first that had been experienced since the Great Depression, many of these loans became very unfavorable and the option of refinancing disappeared leading to defaults. The second crisis came in investment banks in the capital markets area. Investment banks not only had underwritten mortgages, but they had retained significant amounts of the risk by holding interest and providing backup liquidity for mortgage-related securities they had sold. Investment banks created products based on these mortgage assets. The risk of these assets spread. This happened when a monoline insurer guaranteed the mortgages or a structured investment vehicle brought the mortgage securities and having the money- market funds to purchase that commercial paper from those vehicles. Third, the stress of the financial crisis began to spread beyond the investment banks and mortgages to other fixed income products and to more market participants. This destabilized the financial institutions and non-financial institutions that had little to do with the U.S. or the mortgage market. This contagion was, in fact, global. Without government intervention to restore liquidity to capital markets, the risk of global economic collapse was very real. CHRG-111hhrg51698--490 Mr. Concannon," Absolutely. Today the OTC derivatives market is a phone-based market. The only difference of NASDAQ when it was formed and the equities market at the time was that it had centralized clearing. It allowed us to form a market around this centralized clearing and bring pricing transparency to an otherwise inefficient market. OTC derivatives today, given the bilateral nature of the product, the product is actually priced based on your creditworthiness. That doesn't exist in things that are centrally cleared. We standardize creditworthiness through a clearinghouse and a system of margin, standardized margin, and collateral collection. So, just like any equity owner can buy a share of Microsoft and they are not judged on their status and their financial well-being, they don't pay a different price. And that can be delivered in the over-the-counter derivatives market. I think it is important, though, that we take steps. Clearing first is an important concept here because of the nature of the market today. It is a highly complex market. And it can continue to be a phone-based market, but we can eliminate a lot of the counterparty risk by just introducing mandated clearing. " FOMC20050322meeting--95 93,MR. MOSKOW.," Thank you, Mr. Chairman. Activity continues to firm in the Seventh District. In general, my contacts are more upbeat than they were a couple of months ago, and there is much more confidence that the expansion is on a solid, self-sustaining footing. And we’re hearing more news about price increases and price pressures. Nevertheless, activity has not yet heated up to the point that there is broad-based pressure on capacity. The positive news is fairly widespread. Demand continues to be robust for heavy trucks and for equipment used in construction, agriculture, and oil and gas industries. Our contacts in retail trade, including shopping mall operators, and in consumer advertising also tell us that business is good The news on hiring, however, is more subdued. Notably, the two major temporary-help firms headquartered in our District reported that their growth has slowed since our last meeting. Also, there is an important downside risk for our District’s economy: The well-publicized woes of General Motors and Ford could develop into an even larger drag than we have seen to date. It’s not clear how the auto market will evolve in 2005. Year-to-date sales have been weak, as automakers appear to be testing the market with lower incentives. Still, the Big Three have not yet backed off their earlier projections that light vehicle sales will run about 16¾ million units this year. They are hoping that sales will increase as the year proceeds, similar to the pattern in 2004 after they raised incentives. But based on our conversations, it is unclear whether the automakers will be willing to March 22, 2005 26 of 116 Given the increasing momentum in the District economy, we took a hard look at resource constraints and price pressures. Heavy vehicle production continues to be constrained by shortages of engines, axles, and especially tires. And Caterpillar expects production to be straining capacity at least through 2005. On the price front, the environment has clearly changed. For example, the head of a large bank told me that, for the first time in many years, suppliers are telling customers to buy now or pay higher prices in 30 days. Manufacturers’ long-term contracts for materials are running out, and several report paying premiums in order to ensure supply and keep production running at full tilt. As more of these long-term contracts expire, cost pressures and pass-through could intensify. Even auto suppliers are digging in their heels and resisting further price reductions. In contrast, the steel price picture looks better, as you mentioned earlier. As one contact noted, this is perhaps due in part to increased production in China. Also, on the international scene, a major retailer told us that his European suppliers recently boosted prices between 8 and 12 percent after holding the line last year. In response, the retailer shifted some business to suppliers in the Far East. Turning to the national economy, it’s clear that growth is on firm, self-sustaining ground. So our focus should shift more to assessing inflationary pressures, and there are indications that inflation risks may have increased. Recent price data and, as I just mentioned, comments from our business contacts, do have a firmer tone. Oil prices continue to surprise us on the upside, the declining dollar is showing through to higher import prices, TIPS measures of inflation compensation have moved up, and resource slack could be smaller than we thought. In particular, work done by our Bank’s economists—and by the Board staff, as Dave discussed—suggests that March 22, 2005 27 of 116 These developments have increased our inflation forecast, but quantifying the extent of the inflation risk is difficult. When we run our models using data back to the 1960s, the models forecast higher PCE inflation—nearly 2 percent this year and next year. But the economy has changed a lot, particularly starting in the early 1980s. When we limit the data to the last 20 years, the uptick is diminished. Furthermore, I do not get the impression that a 1970s-type inflationary mentality is creeping into my contacts’ decisionmaking processes. So, on balance, taking everything into consideration, I think we can continue our pattern of measured rate increases, and I don’t think we need major changes in the wording of our statement at this meeting. Futures markets expect us to move the funds rate to 3¾ percent by year-end. But if a more aggressive tightening is warranted, we could easily get to 4¼ percent just by increasing the funds rate 25 basis points at each meeting. This would be perfectly consistent with our “measured pace” language. But we may need to move more aggressively after this meeting; some warning clouds have clearly developed. We often say we need to be data-dependent. I think it’s particularly important now. We’ll get two months of price data before our May meeting and, of course, a lot of other data. And we’ll want to look carefully at those data in assessing our next steps." FOMC20050322meeting--164 162,VICE CHAIRMAN GEITHNER.," I think there’s a disadvantage in validating the market’s current expectations so explicitly. There are two ways to think about framing our policy assumption or giving a signal. One is to say, “with policy unchanged, et cetera.” The other is to say, “taking the expected path now priced in the markets, we think X.” That’s an approach a number of central banks have taken. To me it doesn’t make sense to make that significant a change in our basic signal at this time; I think there’s a lot of risk in a validation that explicit. In my view, there’s actually a lot of virtue in the combination of these changes to the statement, because they condition and qualify “measured” without taking that word out. So it’s a move in the direction of giving us more flexibility without claiming we think there’s been any abrupt change in the balance of risks. As Vincent said, we can fall back on making explicit what has been implicit—which is that the risks have been balanced only if we commit to do the right thing. If you don’t believe we’re going to do the right thing, …" FOMC20080916meeting--151 149,MR. KOHN.," Thank you, Mr. Chairman. I think that, even before the recent intensification of financial market turmoil, there were trends becoming increasingly evident over the summer, since late June, that suggested that the economy was on a substantially slower path than it had been before. Resource utilization was falling appreciably, and the expected downward path of inflation in the future had much better odds of occurring. Indeed, I think that the expected weakness in the economy and the financial markets are interacting. We have one of these feedback loops in play. There has been a lot of concern not only in the United States but in other countries as well, as I heard in Basel last weekend, about a spillover--that the problems were not confined to the mortgage markets but were spilling into the loan books of the banks. That was related to the weakening in economic activity and was tightening up credit conditions, which would, in turn, further weaken economic activity. So this feedback loop was at work certainly in the United States and was beginning to be felt a little more in other countries as well. Since late June we have come to know a couple of things a little better. One is that consumption is not immune to soft labor markets, increases in energy prices, declining housing wealth, and tighter borrowing conditions. Even if we can't parse out the effects of each of these factors, consumption has weakened substantially. We have had three months in a row of declines in the retail control component and very weak auto sales. Although recent declines in oil prices will support disposable incomes and consumption, I think the other sources of restraint on households-- declining house prices and tighter credit conditions--are more likely to intensify than to abate in coming quarters. Another thing we know is that businesses have not gotten ahead of their need to shed labor, and they continue to trim staff in response to actual and expected weakness in demand. The decline in employment shows no signs of abating. Initial claims are running more than 50,000 higher than they were at the end of June, and they have remained elevated past the time that the introduction of the temporary extended benefits should have been felt. The unemployment rate is already � percentage point higher than anyone around this table predicted for the end of the year. The household survey, along with national income statistics, could be signaling greater softness in activity and higher output gaps than is evident in the GDP and spending data. Another thing we have learned, as Nathan emphasized, is that foreign economies have not decoupled from the United States, and their prospects have been revised down substantially. They're absorbing the effects of weaker U.S. domestic demand on their exports, and growing risk aversion in financial markets is spreading abroad. The latter, the growing risk aversion, is beginning to have, as Chris Cumming was noting, effects on a number of emerging-market economies, where capital inflows show signs of abating or even reversing; and indicators of financial stress have risen as a consequence of all this. Because of the stronger dollar, we will be able to rely less on exports going forward than we did before. We never expected a rapid return to more normal financial market functioning, but the adjustment in the financial sector now looks to be more severe and to take longer than we thought before. Financial firms need to bolster profits to offset losses and track capital. They need to delever by reducing debt relative to equity. They need to consolidate, and above all, they need to protect themselves against the possibility of a run. All of this implies a prolonged period of very cautious lending and a high cost of capital for borrowers relative to benchmark interest rates. If the current severe financial situation persists, I think the flight to safety and liquidity could dry up credit to a broad array of all but the very safest borrowers and reduce asset prices with feedbacks on spending, and that feedback loop could intensify if these market conditions pertain. I think that's a substantial downside risk to the growth outlook. Not all news affecting spending has been negative. Capital goods orders have held up. The decline in interest rates and commodity prices that respond to the markdown in global growth will help support domestic demand, and actions to stabilize the GSEs are helping the mortgage market. Activity is more likely to stagnate than to decline. But I think that we can be more certain than we were, say, at the end of June that the economy will move substantially away from our high employment objective over the next several quarters and that the downside risks to that are larger. On the inflation side, incoming data have been disappointing, a little worse than anticipated, perhaps suggesting greater pass-through. The rise in import prices at the beginning of the third quarter was higher than anticipated. But we've also learned over the last couple of months that oil and other commodity prices can go down as well as up. The drop in retail energy prices helped to reverse much of the run-up in inflation expectations at the household level and reduced inflation compensation in financial markets at least over the next five years. Weaker economies, along with lower commodity prices, are expected to reduce inflation in our trading partners, and that along with the dollar should lower import price inflation. The broadest measures of labor compensation available through the second quarter continue to suggest no upward pressure on the pace of increases in nominal labor costs. Despite elevated headline inflation, surprisingly good growth of productivity is holding down unit labor costs. Taking all of this together, I think that, despite the incoming inflation data, we can have greater confidence in our forecast that inflation will decline late this year and run much lower in the next few years than in the past year or so, though the risks to that still lie on the upside until we actually see the decline in headline inflation persist. On policy, Mr. Chairman, I support alternative B, keeping the funds rate at 2 percent. I think that, at least for now, is consistent with lower inflation and a slow return to full employment in the future over time. We need to assess the effects of the financial turmoil. If asset price declines accelerate and the tightening of financial conditions is large and likely to be sustained, I would be open at some point in the future to a lowering of interest rates. Thank you, Mr. Chairman. " FOMC20060808meeting--70 68,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Growth has moderated, but the economy still seems, to us at least, likely to grow at a reasonably good pace over the forecast period, somewhere in the vicinity of 3 percent. We expect core inflation to moderate gradually from current levels, declining to around 2 percent in ’07. This forecast assumes that monetary policy follows a path fairly close to what’s in the market and in the Greenbook. The key difference between our view of the outlook and that of the Greenbook forecast is in the strength of demand growth relative to potential next year. We have reduced a bit our estimate of potential and also of actual growth, but we still expect the economy to expand at a rate close to potential. This is a very favorable forecast, and we have to recognize, of course, that the economy is going through a set of extremely complicated transitions, including a large, adverse, sustained relative price shock of uncertain duration and a substantial adjustment in asset prices that is now concentrated in housing. Our capacity to anticipate the evolution of these forces and to assess their effect on growth and inflation is, of course, very limited. The forces that now appear to be working on the economy still present the unpleasant combination of upside risk to inflation and downside risk to growth; but for the moment we believe that the former, the possibility that our forecast is too optimistic on inflation, remains the predominant risk. I have a few points on the growth outlook. The economy has clearly slowed, and the composition of growth within the United States and here relative to the rest of the world has changed. These changes were inevitable, and if they continue to occur smoothly, they seem desirable and necessary. As a share of aggregate demand within the United States, residential investment had to contract and consumption had to slow. And U.S. domestic demand had to slow relative to domestic demand growth in the rest of the world. The key issue we face is judging whether we have significantly more weakness ahead of us than we are now expecting. In our view, most signs at present point to fundamentally healthy economic conditions. The survey-based measures of confidence are holding up okay. Real household income growth seems likely to be good going forward. Businesses have the resources and the motivation to sustain fairly strong rates of investment growth. Structural productivity growth, even post- revision, still seems strong. Inventory levels remain relatively thin, and the tentativeness that characterized much of the expansion in terms of investment and hiring should be a source of some comfort. Global demand is still quite strong, of course, and together these forces will offset part, but not all, of the weakness coming from the adjustment in housing and consumption growth. The principal risk to this outlook for growth lies in the possibility that households will slow consumption more sharply because of rising energy costs, higher interest rates, greater pessimism about future income gains, or the effect of the housing adjustment on perceived wealth. Financial markets are showing a little more concern about future growth, but not a lot. This concern is most evident in the greater inversion in the yield curve that has emerged at the one-year to two-year horizon. I think you can see in the market some moderation of exuberance in credit markets, but just a little. Overall, the markets seem to reflect a reasonably favorable view of future growth prospects. On the inflation side, as I said, we expect core inflation to moderate, not quickly and not dramatically but by enough and soon enough to bring core PCE inflation down to just below 2 percent over the next 18 months. The issue we face is not so much about the acceleration in core inflation that occurred in late 2003 and 2004. After that acceleration, core inflation was sort of trendless, in the vicinity of 2 percent for much of the two-year period, until the past six months, when we saw this uptick. The real problem we face is assessing the extent to which the very recent acceleration in core inflation reflects transitory factors, such as the indirect effects of energy prices, and the extent to which it may reflect pressures from higher resource utilization and other things less benign and less transitory. Energy pass-through, of course, seems part of it, but probably not all of it. Shelter doesn’t account for all of it either. This judgment is critical for us, and we need to be careful that we’re not assuming away the more uncomfortable explanation, such as a broader inflationary impulse or a rise in pricing power that could reflect increasing acceptance of higher inflation. How confident can we be that the pressures that have induced this rise in core inflation will moderate sufficiently to bring down the rate of increase in core PCE prices to the vicinity of 2 percent or below? Reasonably confident, I think. With the economy growing at or slightly below trend, with growth of unit labor costs peaking and decelerating a bit as the Greenbook forecast anticipates, with inflation expectations moderating at short horizons and pretty stable at longer-run horizons, with energy prices flattening out, and with the dollar falling only a little, this forecast seems reasonable. But note the number of assumptions and conditions this forecast depends on. Also, the expected path for inflation implies only a very gradual moderation and a period of sustained inflation above what is presumed to be consistent with this central bank’s long-term preferences. The risks of this forecast, as I said, still seem to lie on the upside. It may be some time before we can be confident that the forces are in place to produce the necessary moderation. More generally, however, we face the very difficult consequential challenge of trying to figure out the longer-term consequences of having been in an exceptionally long period of exceptionally low real interest rates—both real short rates and forward rates—that were induced by monetary authorities here and around the world. Real short rates now look as though they were perhaps lower relative to the estimates of equilibrium even than we thought. Perhaps more remarkable was the low level of forward real rates during much of our tightening phase. These financial conditions may have produced more inflation momentum than we thought, and this may be the case even though there is some reassurance in the stability of long-term expectations. Those expectations are substantially below the peak in ’04 at the long horizon. However, the rise in asset prices and residential investment and the leverage caused by this long period of very expansionary monetary policy may lead to a process of adjustment in asset prices that could be more sustained and more damaging in terms of confidence and of demand than we expect. This risk is greater if we end up allowing more inflation than our forecast anticipates, for the required monetary policy response could induce an even sharper adjustment in risk premiums and asset prices. This possibility argues for a lot of humility in judging the appropriateness of the present stance of monetary policy and what will be appropriate over time, and it argues mostly for having as much flexibility as we can going forward, emphasizing that the inflation risks remain the predominant concern of the Committee. Thank you." FOMC20060629meeting--113 111,MR. WARSH.," Thank you, Mr. Chairman. In terms of my overall comments, I consider my views really in the center of gravity, as the Vice Chairman described it, of the speakers around the table and probably, again, quite a bit more optimistic in terms of GDP growth and perhaps also more concerned about inflation risks than the Greenbook. When I look at the strength of the fundamentals of the economy, including strong and accelerating profits, low unemployment, highly accessible capital markets, and remarkably strong balance sheets both for consumers and businesses, I find it hard to reconcile those with some of the pessimism coming not just from the Greenbook but also from some economists that the markets follow. The two trends and the two sets of data seem to be going in very different directions. Regarding the data that have come in since our last FOMC meeting, some time has been spent here on a few of the negative surprises, so I want to highlight a few of the positive bits of news. Federal tax receipts in May were up 26 percent from May a year ago. For the past twelve months, as we’ve talked about before, total tax receipts into the government went up 12.9 percent. Core retail sales rose 0.4 percent in May, up about 6.9 percent year over year if we exclude some of the more volatile items. According to surveys and anecdotes, the manufacturing base continues to be remarkably robust, both in terms of growth and in terms of jobs. I’d also note that durable goods orders, though not incredibly robust over the past month, represent growth of about 10 percent over the past three months if we exclude aircraft and look only at nondefense capital goods. So all in all, I think that the data suggest a more positive trend. What I’d like to do is spend a little time talking about how the markets have reacted to this news and build on a couple of the points that Dino made at the outset. First, a lot of pundits have described the “new volatility” in the marketplace, and I think that Dino made a very compelling case that the volatility has really not been nearly as severe as the commentators suggest. Volatility has in some ways been a euphemism for the fact that the markets have been down, and those are obviously quite different things. [Laughter] I think another bit of conventional wisdom is influencing decisionmakers, both in Washington and in business, and it is probably important to correct. That idea is that somehow the Fed has been the cause of this market volatility. I think that is largely incorrect. When I look at what has happened, I think that the markets are focused more and more on core economic fundamentals. We have changed in the perspective of the markets, which used to think some months and quarters ago that bad news meant good news and now they think that bad news is actually bad news. The bad news previously meant that we weren’t going to be moving rates higher. Again, I think the markets, not the commentators, have a better understanding that they really need to be focusing on economic fundamentals. When I look at the economic fundamentals, one of the data points that I look to is the state of corporate profit growth at this point in the cycle. Over the past twelve months, it was 13.6 percent, and if we look at bottom-up analyst forward estimates for the S&P 500 or for the Russell, it appears that those analyst estimates are actually accelerating. As a former banker, I will admit to some bias in these numbers, but they’ve been tracking reasonably well. The forward estimates are that corporate profits should be up something like 16 percent. So one of the things that we can do over the next several meetings is see how actual results track against those expectations, and my bet is that there will not be as much disappointment in those numbers as the top-down macroeconomic views would suggest. Diving down into some of the individual markets, I suggest that they’re telling us different things about the state of the economy and the state of inflation prospects. First, the equity markets have been off on the order of 7 or 8 percent, and many people, myself included, would have thought that that would have significantly affected CEO confidence, that it would have changed some perspectives about where they are in the capital expenditure cycle. I think that probably has happened in the IPO market. The IPO market has gotten slower and more selective, and issues that can come to market now have been at the top end of what’s in the pipeline. If we look more broadly, however, beyond what’s going on in the equity markets, if we look at the cap-ex market, capital expenditures appear to be above plan generally from the discussions I’ve had with folks who are on boards of different companies. One CEO called before coming out with a survey of CEO expectations for growth in capital expenditures, and he exclaimed, “What are you guys seeing that we’re not?” In some way he was checking to try to understand what the reason was for concern when his company surveys continue to be quite positive. The only caution I have is that, if you look across a breadth of CEO surveys on growth, the survey numbers have, in fact, come down from, let’s say, April to June. But, again, my sense of the matter is that CEOs are scratching their own heads at this very moment that we’re having a discussion about the economy in transition. The messages that come from the Fed and from other policymakers over the next month, including in the Chairman’s monetary policy testimony, will be very important to set the tone, because CEOs are not sure whether to continue to hit the accelerator or whether this might be a time in their own businesses for a pause in capital expenditures. I have a few comments on a couple of other markets. Normally in a time like this, when the equity markets are off 7, 8, or 9 percent, the merger and acquisition markets, which I view as a pretty good proxy for CEO confidence, would stop. In fact, that hasn’t happened: M&A pipelines are more robust than ever. The unthinkable deals are being printed and being published. Pipelines are terrifically strong, and CEOs are ready in some ways to “bet the company” on the strength of their convictions—another reason that I have confidence that business growth could well be in excess of the Greenbook estimates. Let me make two or three other comments. First, in terms of inflation, as I look at the commodity markets and at the TIPS markets, I’m most comforted not so much by relative moves, because those TIPS markets are certainly not perfect in describing inflation expectations, but by the responsiveness of those markets to remarks that have come from folks around this table. That is, if we think about what our authority is in influencing inflation expectations, the very real-time changes in the TIPS markets give me comfort that at this point in the cycle we will be able, with proper and appropriate policies that we’ll discuss tomorrow, to change those inflation expectations rather dramatically. So I think that’s a reasonably comforting idea. Finally, the fixed-income markets and high-yield markets certainly have moved higher in terms of spreads but, again, not a lot by historical perspectives. Under normal market conditions or more-pessimistic market conditions than we have now, that move, even a small relative move, would have slowed down those pipelines. Instead, liquidity is plentiful. A couple of anecdotes that we heard before describe the situation: 25 or 30 basis points in the high-yield markets are not changing activity. They’re not changing the interest of investment banks and issuers in coming to market as quickly as they can. So in terms of market functioning, apart from price, those markets are working exceptionally well. What would be a reason for pessimism, and what would be a reason to think that the volatility that has been discussed over the past several weeks might turn into real volatility? One thing that I look to with some degree of concern is the prices that are being paid and the leverage that’s being put on companies that could change the liquidity in those markets very quickly. I wouldn’t be surprised to find—over the forecast period for sure and maybe even over 2006—a “club” deal in which many private equity partners group together in a highly leveraged situation to buy a very large public company and take it private and, after the course of due diligence and of that acquisition, the deal closes and they find that they missed the first coupon. That is, the leverage that is being put on these companies, for all the reasons we have discussed around this table, is relatively remarkable. Those leverage ratios used to sound like purchase prices, and they’re expecting meaningful cost savings that can come out of these businesses six and nine months out. I suppose I’m concerned that, as these deals come together, there might be a negative surprise that affects the company so that the first coupon would be impossible or difficult to meet. In that circumstance, all the optimism that I’ve described in terms of these debt markets could dissipate rather markedly. So I don’t want to suggest a degree of optimism that isn’t borne out by the facts. That’s something we need to continue to stay attuned to. Thank you, Mr. Chairman." FinancialCrisisReport--92 WaMu did, at times, exercise oversight of its third party brokers. A 2006 credit review of its subprime loans, for example, showed that Long Beach – which by then reported to the WaMu Home Loans Division – had terminated relationships with ten brokers in 2006, primarily because their loans had experienced high rates of first payment defaults requiring Long Beach to repurchase them at significant expense. 292 But terminating those ten brokers was not enough to cure the many problems with the third party loans WaMu acquired. The report also noted that, in 2006, apparently for the first time, Long Beach had introduced “collateral and broker risk” into its underwriting process. 293 WaMu closed down its wholesale and subprime channels in 2007, and its Alt A and subprime securitization conduits in 2008. (b) Risk Layering During the five-year period reviewed by the Subcommittee, from 2004 to 2008, WaMu issued many loans with multiple higher risk features, a practice known as “risk layering.” At the April 13 Subcommittee hearing, Mr. Vanasek, its Chief Risk Officer from 2004 to 2005, testified about the dangers of this practice: “It was the layering of risk brought about by these incremental changes that so altered the underlying credit quality of mortgage lending which became painfully evident once housing prices peaked and began to decline. Some may characterize the events that took place as a ‘perfect storm,’ but I would describe it as an inevitable consequence of consistently adding risk to the portfolio in a period of inflated housing price appreciation.” 294 Stated Income Loans. One common risk layering practice at WaMu was to allow borrowers to “state” the amount of their annual income in their loan applications without any direct documentation or verification by the bank. Data compiled by the Treasury and the FDIC IG report showed that, by the end of 2007, 50% of WaMu’s subprime loans, 73% of its Option ARMs, and 90% of its home equity loans were stated income loans. 295 The bank’s acceptance of unverified income information came on top of its use of loans with other high risk features, such 291 Id. at 58615. 292 12/2006 “Home Loans – SubPrime Quarterly Credit Risk Review,” JPM_WM04107374, Hearing Exhibit 4/13- 14. 293 Id. at JPM_WM04107375. 294 April 13, 2010 Subcommittee Hearing at 16. 295 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82. as borrowers with low credit scores or the use of low initial teaser interest rates followed by much higher rates. FOMC20080625meeting--71 69,MR. FISHER.," Mr. Chairman, you are going to get a contrapuntal tune here. That is the beauty of this table and the different perspectives around it. I am going to take a different approach today than I have in the past. I am going to talk a bit about the Eleventh District first, which I don't often do. The reason for that is, because of its nature and size, because of its being the leading exporting state in the country now, and because of its job creation, it is in a slightly different position--or significantly different position, depending on which District it is compared with--from the rest of the country. Our job growth through March is running about 3.8 percent. Unemployment in April was 4.1 percent, despite a sizable influx of immigrants, which we see from new license plate registrations from California and particularly from Florida as well as from people still coming across the border. Sales of existing homes rose in May, while inventories and prices held steady. Apartment demand is robust, and rents in the major cities, such as Dallas and Houston, are rising. The real export growth of Texas was 7.2 percent in April after 3.9 percent in the first quarter. That is telling you that our chemicals are now being priced aggressively but also that everything else is being priced aggressively worldwide. That's a significant export sector for us. Importantly, on the price front, the Dallas Fed's own Texas manufacturing outlook survey and the regional CPI data indicate continuing price increases and substantial evidence of passthrough to higher final goods prices. Thirty-nine percent of the respondents report the ability to realize higher prices of finished goods currently; another 45 percent expect to be able to realize higher prices in the next six months. Despite these strong numbers, our soundings and our instinct project a slowdown in the future. We have been projecting a slowdown--we haven't seen it. Discretionary income has been bolstered by employment, but squeezed by rising food and energy prices and credit constriction. So we are looking for the District to slow and yet to continue to outperform relatively speaking. I would like to devote the rest of my comments to the U.S. economy and to the global economy, particularly to the contrapuntal insights I have gained from my soundings. First, on the global economy, Nathan, our own research at our little globalization institute in Dallas indicates that the projections of real economic growth of most of the advanced countries are being revised downward whereas expected inflation is being revised upward. For the major emerging market economies, growth realization, at least as it appears in their forecasts, for the most part holds up, but inflation expectations are being steadily revised upward. In other words, the two types of economies share on the inflation front, whereas there is disparity and a little cacophony as far as growth is concerned. We are working on it, but we have yet to develop a reliable measure of global slack. JPMorgan, with whom we have been working, has a slack index that purports to be global. But as you pointed out, Nathan, it excludes China. Minor oversight. It also excludes India. One would think that the growing slack in the advanced countries would be mitigating price pressures. Yet those countries with numerical price objectives or inflation targets--from Mexico to Turkey to New Zealand to the European Central Bank to the Brits--are now contending with inflation in excess of their target or comfort range. I was thinking the other day of Mervyn King's comment that, once they had to write to the Chancellor of the Exchequer, it would lead to a lot of letter-writing. It took 15 years for the first letter to be written after inflation targeting was embraced. Of course, two years ago this was resurrected, and now they seem to be doing so with a great deal more frequency. Now there is a risk of acquiring writer's cramp. I would say that, if we were under the same strictures as the Bank of England, we might be subject to the same concerns. In our last meeting, I posited that something persistent and pernicious was occurring on the inflation front. Mr. Chairman, the one thing that is even clearer now--particularly after my soundings, which I'll report in just a second--than it was in May is that inflationary pressures, inflation expectations, and anticipatory behavioral responses among consumers and businesses have intensified, whereas our confidence about economic growth has improved. I don't believe that we are out of the woods yet on the risk of a credit-induced slowdown, though I believe our liquidity initiatives are a proper and good palliative, as you know. But if Robert Frost will forgive me, the woods are not lovely, and they are indeed deep and dark on the price front. Although the tail risk of economic recession has diminished, I think it still exists; certainly the anemia--just to use another word that you referred to--does. But the risk of inflation, in my view, has assumed greater depth and breadth since we last met. Stated differently, I don't believe that inflation expectations are presently well anchored, here or elsewhere. I believe they are being--just to kill the sea analogy, Don--torn from their moorings and are at risk of going adrift. Now, I took a different approach this time with the 30-odd interlocutors with whom I discussed the outlook. I simply asked them one question: What is different in this cycle from what you have seen before? Most of these people have been in business for 30 years plus. Here are some sample testimonials as to what they are seeing. The CEO of Fluor, which has a $38 billion backlog currently, said, ""When I started here in 1974, we put inflation contingencies into every contract. In the 1990s, that had not only gone away, but we were confident we could negotiate cost down to below what we were bidding. Now it is just the opposite."" The CFO of Frito-Lay, which just pushed through a 9 percent price increase (which, parenthetically, WalMart accommodated at 7 percent), said, ""Most of our executives are in their late 30s or early-tomid 40s. They have never seen these kinds of numbers. This is reminiscent of the aftershock to Nixon's wage and price controls, and we are currently having to hold seminars to teach management how to manage inflation."" From the CEO of Wal-Mart USA: ""We see increased""--and this is his word--""pervasive price pressures. I am telling you that we have an economy where the real people are being trampled by inflation, and for the first time in memory, we are getting noise from employees about the cost of living."" Wal-Mart raised the pay of 60 percent of their associates between single and double digits in the last quarter, and my contact said, ""We are now contemplating a series of measures such as providing discounts to employees to counter considerable employee angst about the cost of living."" From the CEO of KimberlyClarke, who just notified the retailers of a 7 percent price increase to come in August after the 7 percent they pushed through in February, in addition to which they are going to add a shipping surcharge: ""Customers are no longer asking if, but when, we will increase prices, so they can move in anticipation."" I can give you other testimonials, Mr. Chairman. One of my favorites, by the way, has to do with a very small operation, a three-store dry cleaning operation, Faulkner's Fine Dry Cleaning in Dallas. They approached me the other day to say that they would have to increase the price of cleaning our shirts because the price of 18-inch white hangers, which are steel-based, has increased 65 percent. They showed me the circular that had been sent around by the fabric cleaning supply company that is the last remaining manufacturer of hangers in the United States. All of that manufacturing has gone to China. The circular that they are sending their customers, the cleaners, says ""What should cleaners do? Raise your prices. You're worth it."" Then--and this strikes at the heart of every son of every Australian--Budweiser, which raised its prices 3� percent in February, according to our local distributor, plans to raise 3� percent again in September. And the Bud distributor in North Texas, who has had that distributorship for 43 years, said that never before in his lifetime had he seen two price increases in one year. Finally, the CEO of JCPenney's just returned from an around-the-world buying trip. After 11 years of apparel price deflation, Chinese manufacturers are seeking 8 to 9 percent price increases in '09, 11 to 12 percent for footwear, and for small kitchen appliances in the mid-20s. The CFO of the company told me that they are running at minimum staffing levels. If anybody begins to break the wage barrier, then, ""Katie, bar the door!"" So, Mr. Chairman, I would say that currently our patient--the economy--is indeed a sick puppy. Some of its vital organs--geographic regions such as the one I am fortunate to live in, or a strong export sector of the United States, or entrepreneurs and business leaders who have learned to wring unanticipated efficiency and profits out of globalization or from within cyberspace--are very strong. Yet others--states like California and Florida, the housing sector, and overall consumer confidence--are bleeding, if not hemorrhaging. This is not to mention the still precarious state, despite the very good report that Bill gave, of our financial system as it recovers, I hope with our help, from years of its recklessness and excess. I think we have, like loyal practitioners and with the equivalent of the Hippocratic oath, done the job that we are expected to do in terms of resuscitating the victim. That is the good news. The real bad news is that our patient appears to be acquiring a staph infection in this hospital that we have created, and that staph infection is inflation. I believe inflation is upon us. I believe expectations are discounting more inflation. Very importantly--and this is tough to get from the models--I believe that behavioral changes are beginning to manifest themselves. Now, some would argue that this infection is temporary and may well go away. Others will argue that it will be stayed by strong rhetoric. Still others say that it will require--I don't know if it's an antibiotic or an antidote--further tightening, lest the infection spread and counteract the good that we have done with our liquidity facilities and by previous policy decisions. That seems to me to be the problem that we will have to deal with at this meeting, and I look forward to hearing my other colleagues' opinions. Thank you, Mr. Chairman. " FOMC20080430meeting--273 271,MR. EVANS.," My primary comment in all of this is related to what President Stern, I think, said. The way the objectives are worded here is ""enhanced monetary policy implementation,"" and the memo is worded more like, ""How do we get our federal funds rate target effectively?"" or something like that. But there is really no discussion that I could find about the transmission of our policy actions to the economy and to inflation. Under our current regime, we think, quite confidently, that the short-term federal funds rate prices short-term risk-free assets along the yield curve all the way up to the Treasuries and then corporates are priced off all of that. I associate that with Marvin Goodfriend, who taught me that quite some time ago. It's not money; it's not liquidity; it's not the reserves per se. It would be nice if, for each alternative, there were some discussion that we are preserving our understanding of the policy transmission mechanism or that we are enhancing it or whatever. President Lacker mentioned the Bank of England--maybe we could set the policy rate as they do. The question is, What will the markets do in terms of actively arbitraging something that helps price these securities? This may not be an issue for many of these systems, but until there's some kind of analysis, I'm not so sure. It's not just averaging over the maintenance period, and I think that analysis would be useful. " FOMC20080318meeting--98 96,MR. FISHER.," Just very quickly, I said that the liquidity situation we're in diminishes the efficacy of fed funds policy; I'm not saying it's not a worthwhile tool. Second, I was fully supportive until we got to 3.5. Then we went from 3.5 to 3 percent. Everything we wanted to go one way then went the opposite way. So I just made the observation that it didn't seem to be effective. Third, I think I spent even more time in Japan than President Geithner, who is an expert on Japan, and you cannot compare the two economies. They are geared totally differently, with totally different efficiency. I'd be happy to debate that at a later point. I think it's a very poor analogy. Now, having said that, I respect the enormous macroeconomic downside risk that we have--and I have one of the most pessimistic forecasts--but there's a price to be paid for what we're doing unless it is efficient, and that price is reflected in inflation expectations. That's my point, Mr. Chairman. " FinancialCrisisReport--22 These practices were used to qualify borrowers for larger loans than they could have otherwise obtained. When borrowers took out larger loans, the mortgage broker typically profited from higher fees and commissions; the lender profited from higher fees and a better price for the loan on the secondary market; and Wall Street firms profited from a larger revenue stream to support bigger pools of mortgage backed securities. The securitization of higher risk loans led to increased profits, but also injected greater risks into U.S. mortgage markets. Some U.S. lenders, like Washington Mutual and Countrywide, made wholesale shifts in their loan programs, reducing their sale of low risk, 30-year, fixed rate mortgages and increasing their sale of higher risk loans. 21 Because higher risk loans required borrowers to pay higher fees and a higher rate of interest, they produced greater initial profits for lenders than lower risk loans. In addition, Wall Street firms were willing to pay more for the higher risk loans, because once securitized, the AAA securities relying on those loans typically paid investors a higher rate of return than other AAA investments, due to the higher risk involved. As a result, investors were willing to pay more, and mortgaged backed securities relying on higher risk loans typically fetched a better price than those relying on lower risk loans. Lenders also incurred little risk from issuing the higher risk loans, since they quickly sold the loans and kept the risk off their books. After 2000, the number of high risk loans increased rapidly, from about $125 billion in dollar value or 12% of all U.S. loan originations in 2000, to about $1 trillion in dollar value or 34% of all loan originations in 2006. 22 Altogether from 2000 to 2007, U.S. lenders originated about 14.5 million high risk loans. 23 The majority of those loans, 59%, were used to refinance 21 See, e.g., “Shift to Higher Margin Products,” chart from Washington Mutual Board of Directors meeting, at JPM_WM00690894, Hearing Exhibit 4/13-3 (featuring discussion of the larger “gain on sale” produced by higher risk home loans); “WaMu Product Originations and Purchases By Percentage - 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i (showing how higher risk loans grew from about 19% to about 55% of WaMu’s loan originations); SEC v. Mozilo , Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 17-19 (alleging that higher risk loans doubled at Countrywide, increasing from about 31% to about 64% of its loan originations). 22 8/2010 “Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data Sources,” Government Accountability Office (GAO), Report No. GAO-10-805 at 1. These figures include subprime loans, Alt A, and option payment loans, but not home equity loans, which means the totals for high risk loans are understated. 23 Id. at 5. an existing loan, rather than buy a new home. 24 In addition, according to research performed by FOMC20080805meeting--149 147,MS. YELLEN.," Thank you, Mr. Chairman. I favor alternative A--no change in the funds rate and a balanced assessment of risks designed to leave market expectations concerning the path of the funds rate roughly unchanged. Oops, I made a mistake, there is no A. [Laughter] So I propose to create it by changing the wording of the first sentence of alternative B, paragraph 4, to read, ""Both downside risks to growth and upside risks to inflation are of significant concern to the Committee."" As it is currently worded, B(4) downplays the downside risks to growth, which have intensified since our last meeting as the credit crunch has worsened and emphasizes inflation risks, which have moderated slightly as oil prices have fallen. The assessment of risks in alternative B, as it stands, is unbalanced and--as Brian just pointed out and the Bluebook does also--is more hawkish than the primary dealers and most market participants generally expect. So it is likely to shift the fed funds futures path and other interest rates upward. I see no case, at this juncture, for signaling that we are likely to adjust policy upward before the end of the year. Indeed, there is a non-negligible probability, to my mind, that the next move will be down and not up. There is already significant slack in the labor market, and with the economy expected to grow at a near-recessionary pace in the latter half of this year, the unemployment rate is poised to rise further. This growing slack is working to contain inflationary pressures as evidenced by the stability and low level of wage growth. I expect that growing slack will continue holding down wage inflation going forward. Long-term inflation expectations seem relatively well contained, and core inflation has been stable for the past several years. Finally, a major component of the surge in headline inflation--oil price increases--has finally started to show some sign of reversing direction. Although the real funds rate remains quite accommodative by the usual metrics, we are clearly not in a business-as-usual situation. We are in the midst of a serious credit crunch that has, again, worsened during the intermeeting period, as exemplified by the developments at Freddie and Fannie and the other things that many of you have pointed to in our last round. We are likely seeing only the start of what will be a series of bank failures that could make matters much worse. Given these financial headwinds, it is not clear to me that we are accommodative at all; I agree, Mr. Chairman, with the comments you just made on this matter. Given my preference for an inflation target of around 1� percent and equal welfare weights on the inflation and unemployment gaps, I view the Greenbook policy path and forecast as a roughly optimal trajectory to the attainment of our goals. Although core inflation exceeds the level I consider consistent with price stability, unemployment also exceeds the level consistent with full employment. Given our dual mandate and a forecast that envisions a growing unemployment gap, coupled with declining inflation under the Greenbook funds rate path, I see no case for jolting expectations in such a way as to, in effect, tighten policy now. I feel especially strongly about this in view of the major downside risks to the economy from an intensifying credit crunch. " FOMC20060131meeting--167 165,MS. DANKER.," Thank you, Mr. Chairman. In that the decision has been to go ahead with the status quo in the same way as in the past, I will read the wording out of page 31 of the Bluebook—the directive wording first and the risk assessment second, dropping the word “well.” “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 4½ percent.” And “The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.” Chairman Greenspan Yes Vice Chairman Geithner Yes Governor Bies Yes Governor Ferguson Yes President Guynn Yes Governor Kohn Yes President Lacker Yes Governor Olson Yes President Pianalto Yes President Yellen Yes" FOMC20060131meeting--104 102,MR. POOLE.," Thank you, Mr. Chairman. What strikes me from my conversations with my contacts is the growing confidence that they do not see major risks on either side, that there are reduced standard errors around their projections. Very few had comments or concerns about inflation outside of energy, which, of course, is on everybody’s mind. I’d like to make an analytical point that actually comes from my UPS contact. I think I mentioned at an earlier meeting that UPS is moving its business off the mixed rail—the piggyback. That move is a consequence of the fact that the railroads are unable to speed up delivery times, which in turn is a consequence of the railroads’ decision that it is not worth the capital investment that would be necessary for what for railroads is a relatively low-yielding business. UPS is also working to maximize the return on its own capital. The company is very disciplined about adding capital and is planning to price low-yielding business out of its network. That is, for the low-yield products, they’re going to raise prices expecting that the business will go away. My contact at UPS said that he thought that the strategy would not really be successful and that they will probably be looking at substantial increases in capital spending in ’07, once they find that they have optimized their existing plant, that the volume doesn’t go away when they try to raise the prices on it, or that not enough of it goes away. And I think that this phenomenon might be more general in our economy. Companies are very disciplined about their capital investment. But as the economy continues to expand, they’re going to run out of ways to optimize the existing capital plant, and we will see investment coming in stronger over the next couple of years. That’s an observation that may have more general application. I support the Greenbook’s forecast, plus or minus a quarter of a standard deviation. [Laughter] Not worth worrying about. Instead, what I’ve been trying to do is to make lists—and these could be much longer—of risks on the high side and the low side. On the high side, I would point to commodity prices, which are high and have gone up a lot, and growing strength—as I just commented—in business fixed investment. I mention high money growth, because I don’t think that the rapid money growth is fully explained, and it certainly has frequently been a precursor of higher inflation. Some indicators on the other side—we talked about housing, the possible reversal of the unusually low saving rate, the behavior of the yield curve, the risk of oil supply disturbances. Most of oil has been demand-driven, but supply disturbances because of the problems in the Middle East primarily—Africa as well—could certainly produce a significant downward shock on economic activity and upward shock on prices. No doubt these lists could be amplified, and I think it’s probably worth spending more time thinking through the risks and how to respond to various events than it is trying to optimize the forecast and get that last quarter of standard deviation exactly right. Mr. Chairman, many around the table have commented about their experience serving here. I will, of course, echo those. I would like to put a little different angle on it. Of the people who have had a major impact in my life, you are certainly one. I mark on the fingers of one hand the people who have had extraordinary influence on me. You have influenced me mostly in my professional life but also in many aspects of leadership that go beyond economics and policy in a narrower sense. So I thank you for that. I am also looking forward to continuing to learn from you. I understand that you have some books, at least in your head. And given my interest in making sure we have clear communication, I have a suggestion for a title for your first book. And it is in line with some books by your predecessors. So I suggest “The Joy of Central Banking.” [Laughter] And I suggest that your second book be “More Joy of Central Banking.” [Laughter]" CHRG-111shrg57322--187 Mr. Sparks," Dr. Coburn, yes, and--well, I do not know exactly what they knew. It would have been determined under the diligence they did. But I will tell you, Goldman Sachs also many times invested in the equity of those deals. Senator Coburn. I understand. Everything can be invested in if the price is right compared to the risk. I am not disputing that. But I am going back to the question that you have AAA rating on stated income loans, on packages you put together to underwrite. Correct? " FinancialCrisisReport--69 Mr. Vanasek shared his concerns with Mr. Killinger. At the Subcommittee’s hearing, Mr. Killinger testified: “Now, beginning in 2005, 2 years before the financial crisis hit, I was publicly and repeatedly warning of the risks of a potential housing downturn.” 177 In March 2005, he engaged in an email exchange with Mr. Vanasek, in which both agreed the United States was in the midst of a housing bubble. On March, 10, 2005, Mr. Vanasek emailed Mr. Killinger about many of the issues facing his risk management team, concluding: “My group is working as hard as I can reasonably ask any group to work and in several cases they are stretched to the absolute limit. Any words of support and appreciation would be very helpful to the morale of the group. These folks have stepped up to fixing any number of issues this year, many not at all of their own making.” 178 Mr. Killinger replied: “Thanks Jim. Overall, it appears we are making some good progress. Hopefully, the Regulators will agree that we are making some progress. I suspect the toughest thing for us will be to navigate through a period of high home prices, increased competitive conditions for reduced underwriting standards, and our need to grow the balance sheet. I 177 April 13, 2010 Subcommittee Hearing at 85. 178 3/2005 WaMu internal email chain, Hearing Exhibit 4/13-78. have never seen such a high risk housing market as market after market thinks they are unique and for whatever reason are not likely to experience price declines. This typically signifies a bubble.” fcic_final_report_full--279 Gary Gorton, then a finance professor at the University of Pennsylvania’s Wharton School, who began working as a consultant to AIG Financial Products in  and was close to its CEO, Joe Cassano. The Gorton model had determined with . confidence that the owners of the super-senior tranches of the CDOs insured by AIG Financial Products would never suffer real economic losses, even in an economy as troubled as the worst post–World War II recession. The company’s auditors, Pricewa- terhouseCoopers (PwC), who were apparently also not aware of the collateral re- quirements, concluded that “the risk of default on [AIG’s] portfolio has been effectively removed and as a result from a risk management perspective, there are no substantive economic risks in the portfolio and as a result the fair value of the liability stream on these positions from a risk management perspective could reasonably be considered to be zero.”  In speaking with the FCIC, Cassano was adamant that the “CDS book” was effec- tively hedged. He said that AIG could never suffer losses on the swaps, because the CDS contracts were written only on the super-senior tranches of top-rated securities with high “attachment points”—that is, many securities in the CDOs would have to default in order for losses to reach the super-senior tranches—and because the bulk of the exposure came from loans made before , when he thought underwriting standards had begun to deteriorate.  Indeed, according to Gene Park, Cassano put a halt to a  million hedge, in which AIG had taken a short position in the ABX in- dex. As Park explained, “Joe stopped that because after we put on the first  . . . the market moved against us . . . we were losing money on the  million. . . . Joe said, ‘You know, I don’t think the world is going to blow up . . . I don’t want to spend that money. Stop it.’”  Despite the limited market transparency in the summer of , Goldman used what information there was, including information from ABX and other indices, to estimate what it considered to be realistic prices. Goldman also spoke with other companies to see what values they assigned to the securities. Finally, Goldman looked to its own experience: in most cases, when the bank bought credit protection on an investment, it turned around and sold credit protection on the same invest- ment to other counterparties. These deals yielded more price information.  Until the dispute with Goldman, AIG relied on the Gorton model, which did not estimate the market value of underlying securities. So Goldman’s marks caught AIG by surprise. When AIG pushed back, Goldman almost immediately reduced its July  collateral demand from . billion to . billion, a move that underscored the difficulty of finding reliable market prices. The new demand was still too high, in AIG’s view, which was corroborated by third-party marks. Goldman valued the CDOs between  and  cents on the dollar, while Merrill Lynch, for example, val- ued the same securities between  and  cents.  On August , Cassano told PwC that there was “little or no price transparency” and that it was “difficult to determine whether [collateral calls] were indicative of true market levels moving.”  AIG managers did call other dealers holding similar bonds to check their marks in order to help its case with Goldman, but those marks were not “actionable”—that is, the dealers would not actually execute transactions at the quoted prices. “The above estimated values . . . do not represent actual bids or offers by Merrill Lynch” was the disclaimer in a listing of estimated market values provided by Merrill to AIG.  Goldman Sachs disputed the reliability of such estimates. “Without being flippant” FOMC20080430meeting--112 110,MR. KOHN.," Thank you, Mr. Chairman. My forecasts of output and inflation for this and the next two years are in the central tendencies of the Committee forecasts. My Okun's law machine went haywire under the pressure of Debbie's deadline, [laughter] so my unemployment forecasts need to be revised. But I hit the 5:00 deadline, I think. I have stronger growth in 2008 than the Greenbook because I was hesitant to adopt the staff's assumption about persistent, serially correlated downside misses relative to fundamentals in consumption and investment implied by entering a recessionary period when we haven't seen those misses yet. But I didn't discount this possibility entirely, reasoning that the extraordinarily depressed business and household sentiment was significant. I came out between the Greenbook baseline and the ""nearterm upside risk"" alternative scenario. Despite slightly stronger growth than in the Greenbook, I have roughly the same headline and core inflation paths that are declining gradually through the next few years. I took some slight encouragement from recent better readings on core. I reasoned that flat commodity prices would reverse any recent tendency for inflation expectations to rise, and I anticipate that vacant housing units will continue to put downward pressure on rent increases. I have a couple of observations on the outlook. First, I think the expectation of improving financial conditions is critical to the favorable medium-term outcome for the economy that President Geithner was just talking about. We don't really know what the current state of overall financial conditions is and how spending is likely to respond to them. Directionally, I think we can say that the severe deterioration that was much in evidence around the time of the last meeting has stopped, as concerns about an even more generalized set of failures--the seizing up of markets and lending--have abated with our actions and with successful capital-raising by intermediaries. We have seen improvements in many segments of the markets, but continued deterioration in term funding suggests to me that there are continued worries about and pressures on credit availability, and credit availability and the cost of credit will be under some pressure as credit is re-intermediated through the banks. Even with some of the recent gains, markets are still fragile and impaired. Spreads have retraced only a small portion of the run-up since last summer. I noticed in Bill's charts that most of those spreads are back down to, say, those in January; and in January, we thought the markets were pretty impaired. So they are still very, very high by historical standards. Mortgage securitization markets away from GSEs remain broken. There are problems in some other securitization markets, including CMBS. A number of intermediate- and longer-term interest rates are still higher than they were before the crisis hit in August. Baa corporate bonds, which is about the median borrower rating for a corporation, long-term muni bonds, and prime jumbo mortgages are all higher than before we did any easing. Nonprice terms and standards are being tightened considerably, judging in part from the Senior Loan Officer Opinion Survey, and I think that process is likely to continue for a while. To be sure, short-term interest rates are a lot lower than they were in August. But I suspect that a continuation of current conditions would not be consistent with much of a pickup in growth and an eventual return toward full employment. This is a circumstance in which relationships between the federal funds rate and other measures of financial conditions have changed very, very substantially, and characterizing the stance of policy and financial conditions by looking at some measure of the real federal funds rate can be quite misleading in these circumstances. I think we need to be careful about how we characterize and think about the stance of policy. The sense that it is neutral right now, much less accommodative, depends very much on our expectations of substantial increases in risk-taking in financial markets. Now, I do think that the most likely path is improving financial market conditions, lower spreads, reopened securitization markets, and stabilization and maybe partial reversal of some of the tighter terms that have evolved. But this process is going to be slow. Until the housing market shows more signs of stabilizing, it is more likely to be subject to backsliding than to sudden unexpected improvements. A corollary to this line of thinking is that there isn't a lot of ease in the pipeline in the conventional sense. Our reductions in the fed funds rate have not eased financial conditions. They have kept them from tightening even more than they would have done otherwise. The lagged effects of policy easing come from improvements in financial markets. That is, as we look forward, the lagged effects of policy easing come from the improvements in financial markets that allow the reductions in the actual and expected paths of short-term rates to show through to the cost of capital more broadly defined. This is a longer and more nuanced process than the usual rules of thumb about seeing the effects of ease on output after X quarters and inflation after Y quarters. My second point about the outlook is that the risks around my forecast for growth are still to the downside. Uncertainty is huge. We are sailing in a fog in uncharted waters, and the depth finder is on the fritz. So much for sailing analogies. [Laughter] Too bad Bill Poole is not here, though I am glad Jim is here. Let me note that for the record. [Laughter] Downside risks from financial market meltdown have been reduced, though not eliminated. But I think an important source of downside risk now is the economy itself--the threat of recessionary tendencies taking hold. I am told we have never had three months of substantial employment declines and business and household sentiment as depressed as they are right now without sliding into a recession. Businesses and households have been unusually cautious in how they invest their savings, moving into government-only money funds and bank deposits, boosting M2, and demanding much larger compensation for taking risks. They are facing much tighter terms for their credit and uncertainty about its availability. It seems to me there is a reasonable possibility that this extraordinary caution in managing their financial portfolios and uncertainty about credit availability will carry over into their spending decisions. That is not my projection or apparently the central tendency of the Committee, but it must be a significant downside risk. In contrast, the risk to total inflation seems skewed to the upside by the potential behavior of commodity prices. I don't understand why these prices have risen so much over the last six months or so. To be sure, over the last several years the rise in prices must have reflected increasing demand in emerging-market economies, but over the past half-year the prospects for global growth have weakened. In those circumstances, I would expect the effects of lower interest rates--say, in the United States--to be offset by weaker demand. Still, prices have risen. The possibility that those types of surprises will continue poses an upside risk to headline inflation and, along with that, a risk to inflation expectations. Nonetheless, I saw the risk around a gradual downtrend in core inflation as about balanced, with the possibility of greater slack offsetting the possibility of higher commodity prices. I take some comfort in my projection for core inflation and implicitly for the more persistent aspects of overall inflation from the continued moderate increases in labor compensation. Those increases have been moderate for some time despite very high headline inflation for several years along with still-elevated markups for nonfinancial businesses. Outside of commodities, cost pressures appear to be muted, and businesses are able to absorb increases. Still, I agree that commodity price increases, like any supply shock, have complicated our choices. We are facing a sluggish economy with downside risks as well as uncomfortably high total inflation that is feeding through to some limited extent into core inflation and, by some measures, into inflation expectations, especially near-term expectations. I do think, however, that we need to keep in mind that the higher inflation is largely a function of these commodity prices rather than a broad acceleration in overall prices. Core inflation has come in less than we anticipated it would. I also take some comfort, relative to some of the tone I have heard around the table, in what has happened in markets over the intermeeting period. Markets have built in another � point decline in the fed funds rate but then an increase further out. So somehow they are taking this promise of an increase seriously. At the same time they did that, the dollar rose--it didn't fall--and the long-term inflation compensation built into markets came down. So I don't see the evidence in financial markets that we are on the cusp of the broad decline in our credibility that I have sensed that some others see around the table. Thank you, Mr. Chairman. " FOMC20070321meeting--73 71,MS. YELLEN.," Thank you, Mr. Chairman. Recent data on economic activity have been downbeat in many sectors, and I agree with the general tenor of the Greenbook that the near-term outlook is weaker than before. Indeed, we have cut expected growth this year almost ½ percentage point, to 2¼ percent. This pace of growth is substantially below potential, and we expect the unemployment rate to start to edge up fairly quickly. Even relative to this lower baseline, I think the downside risks to the prospects for output growth have sharpened in the intermeeting period. I’m especially concerned about two risks—broader retrenchment in financial markets along the lines that we’re seeing in the subprime mortgage market and a further hesitation and faltering of capital spending. As we discussed in detail two years ago, an asset price bubble inevitably leads to unsustainable imbalances in the economy and a misallocation of resources. The extraordinary run-up in house prices in recent years led to construction and sales booms that couldn’t last. So far the adjustments to more-sustainable levels of housing starts and sales have been relatively orderly. However, there is still an overhang of precarious financing from the past relaxed mortgage-lending standards that has to be eliminated. For example, in 2005 and 2006 something like 40 percent of first-time homebuyers put no money down with their purchase. The market is beginning to recognize the size of this overhang and, with the recent deterioration in the performance of subprime mortgages, is dramatically reassessing mortgage risk. Going forward, we will have to closely monitor increases in mortgage-risk compensation and tightening of credit standards. Such changes, especially if they go too fast or too far, could amplify the housing- sector decline as has been recognized, pushing housing prices and activity down, and with spillovers to consumer spending, they could prove to be a substantial drag on the overall economy. Despite the recent turmoil in equity and mortgage markets, a reassessment of overall risk has yet to occur. We are still in an environment of low long-term yields, ample liquidity, and what appears to be a generally low level of compensation for risk. For example, I recently talked with the principals of several major private-equity funds, who were not just amazed but also appalled about the amount of money their industry has attracted. [Laughter] One partner said that he would have no difficulty immediately raising $1 billion. Indeed, one of his biggest problems is would-be investors who get angry at him because he is unwilling to take their money. This unwillingness reflects his difficulty in identifying deals that are likely to yield adequate returns even though, for the buyout firms, debt also is available in what they depict as very attractive so-called covenant-lite terms—perhaps too attractive given the vulnerability of some of the highly leveraged yields. My contacts suggest that some private-equity firms with similar assessments of the shortage of profit opportunities are less restrained and do take additional money, partly because of the large upfront fees that are generated by these deals. So just as we have seen in mortgage markets, the bubble in private equity, as my sources characterize it, and the overabundance of liquidity more generally raise the risk of a sharp retrenchment in credit and higher risk spreads with associated risks to economic growth and, conceivably, even financial stability. A second, related risk concerns investment spending. It’s surprising that, despite the ample financing available, firms have still been reluctant to ramp up their capital spending. Certainly, any precipitous tightening of financing could curtail investment. However, as noted in one of the Greenbook alternative simulations, greater business pessimism about future returns to new capital is also a significant risk. The recent pullback in orders and shipments for capital goods has persisted and deepened more than any of us had anticipated. Even for high-tech spending, which continues to expand, my contacts on the manufacturing side are not very optimistic. Sales of PCs and related equipment were mildly disappointing in 2006, and our contacts don’t see the introduction of the Microsoft Vista operating system in January as having generated much enthusiasm among businesses. Turning to inflation, our outlook for core inflation, like that of the Greenbook, has changed little since January. I continue to anticipate gradually moderating inflation with core PCE price inflation edging down from 2¼ percent in 2006 to 2 percent this year. There are certainly clear upside risks to this forecast, especially given the resumption of increases in energy prices. These risks remain despite some weakening in the outlook for real activity. In principle, the anticipated subpar growth should help relieve inflationary pressures. However, we remain very uncertain about what par is. The continued low unemployment rate, coupled with recent sluggish output growth, suggests via Okun’s law that potential output could be growing in the vicinity of 2¼ percent. If, contrary to our assumption, that were the case, any labor market tightness now boosting inflation might not diminish this year. More-favorable news is found in recent survey evidence on inflation expectations. As many of you have commented in past meetings, inflation expectations are perhaps more influential to the inflation outlook than is the unemployment rate. Their relative stability over the past several years has probably been a key factor restraining the rise in inflation over the past two years. However, what has not generally been noted is the importance of near-term inflation expectations, those with a forecast horizon of a year or two. Both economic theory and empirical evidence suggest that these near-term inflation expectations are as important as long-run expectations for determining inflation dynamics. The latest Blue Chip and Professional Forecasters surveys both show expectations of core inflation edging down next year. For example, the SPF shows core PCE inflation dropping to 2 percent next year, exactly in line with our own forecast. I also see the general downward tilt in inflation expectations over the next couple of years as contributing to a favorable inflation prognosis." CHRG-111hhrg58044--70 Mr. Snyder," Mr. Price, the FTC estimated that 59 percent of the people pay less as a result of credit-based insurance scores. Frankly, in public testimony given by companies in the States, the numbers are really much higher for many companies. We would envision first of all a very negative effect on the vast majority of policyholders directly. Secondly, it would deprive the market of a critical tool that has allowed the market to evolve much more toward objective underwriting individually tailored to each risk, which in turn is giving the companies the confidence to write virtually everybody. Under the old system that was sort of pass/fail, you were either very good, normal or you were relegated to the high cost assigned risk plans. Now, because of the tool that is capable of individual accurate and objective risk assessment, insurance companies are pretty much able to write anyone who comes to them, which has resulted in the shrinkage to historic lows of these high risk pools, so there are a number of harms that would come, some directly, to the majority of policyholders, and then indirectly to a market as a whole resulting in less competition and potentially less availability of insurance. " FOMC20080430meeting--91 89,MS. YELLEN.," Thank you, Mr. Chairman. In looking at the latest Blue Chip forecasts for GDP growth, I noted that the range between the highest and lowest is among the largest on record. The 10 most optimistic forecasters are predicting over 2� percentage points faster Q4-over-Q4 growth than the 10 most pessimistic ones. Such forecast dispersion is indicative of the unusually high degree of uncertainty that we are facing. The Greenbook presents one of the most pessimistic economic forecasts; yet I find its recessionary projection quite plausible and see downside risks that could take the economy well below that forecast. Although I found it especially difficult this time to decide on the most likely outcome for the economy, I ended up submitting a forecast that shows somewhat more growth in 2008 than the Greenbook, even though we shared the same assumption concerning monetary policy this year. My forecast projects 2008 growth of � percent. This averages no growth in the first half and 1� percent growth in the second. The unemployment rate increases to just over 5� percent by the end of this year, a bit lower than the Greenbook. In one critical area--namely, the adverse effects of financial sector developments on the real economy--I remain just as pessimistic as the Greenbook. Although the likelihood of a severe financial panic has diminished, the risks are by no means behind us. Moreover, credit conditions have turned quite restrictive. This credit crunch reflects the drying up of financing both for markets that were important sources of business and consumer credit and from banks that are contending with capital-depleting losses and illiquid assets. Among banks, the latest Senior Loan Officer Opinion Survey noted a clear tightening of lending standards, and my own discussions with bankers confirmed this point. They say they are carefully reassessing and significantly curtailing existing home equity lines of credit as well as unsecured consumer loans of all sorts. Banks are also clamping down on the provision of revolving business credit, even to very creditworthy customers. For example, the treasurer of Chevron, a highly rated oil company that, as you can guess given energy prices, has a very strong profit outlook, recently complained to me that banks were reluctant to extend even its credit line. Such reluctance is also evident for lending to students, consumers, and other businesses. The risk of a deepening credit crunch remains as a weak economy--especially with further sharp declines in housing prices--escalates credit losses, harms financial institution balance sheets, and causes them to scale back lending even further. My sense from our business contacts is that their perception of reduced access to credit is causing them to manage their firm's liquidity more carefully and is leading to some deferrals in capital spending projects as a precautionary measure. Certainly the mood is decidedly more pessimistic and cautious. Amid the gloom of the credit crunch, I do see a possible silver lining in that it may amplify the effects of the fiscal stimulus package, and this is part of the reason that my forecasted downturn is a little milder than the Greenbook's. In particular, because of the credit and liquidity considerations, the latest fiscal package could well provide a bigger bang for the buck than the tax rebates in 2001. First, the current tax rebates are more directly targeted at lower-income households, which are more likely to be credit constrained and to spend the cash once it's in hand. Second, given the current tightening of credit availability, households will likely spend an even greater fraction of the tax rebates than they did in 2001. Of course, there is considerable uncertainty about assessing the potential size of these effects. But over the next few months as the checks go out and the retail sales reports come in, we should get a pretty quick preliminary read on how things are shaping up. Regarding inflation, the most worrying developments since we met in March have been the price surges for a wide variety of raw materials and commodities, especially the jump in the price of crude oil. From the U.S. perspective, this run-up in prices represents mainly a classic supply shock, which could threaten both parts of our dual mandate, although the decline in the dollar has slightly exacerbated the severity of the impact. Like the Greenbook, my forecast for inflation does take commodity price futures at face value and foresees a leveling-out of prices going forward. Although I must say, after four years of being wrong, I am beginning to feel like Charlie Brown trying to kick that football. The most recent core consumer price data have shown some improvement, and like the Greenbook, I'm optimistic that core inflation will subside to around 1� percent over the forecast period, assuming that the commodity prices do finally level off and compensation remains well behaved. An interesting analysis by Bart Hobijn of the New York Fed as well as my own staff implies that, in an accounting sense, pass-through from the run-up in oil and crop prices may have boosted core inflation as much as 0.3 percentage point over the past two years. So a leveling-off of these prices could lower not only headline but also core inflation. My core PCE inflation forecast is a tenth or two lower than the Greenbook this year and next also because we assume lower passthrough of the dollar depreciation to non-oil import prices. We have been reexamining the data on this issue and find the evidence quite convincing that pass-through has been quite low recently-- lower, for example, than embodied in the FRB/US model. With respect to inflation expectations, market-based measures have now edged down. We took little comfort from this fact, however, because we had viewed the uptick in inflation compensation in recent months mainly as a reflection of a higher inflation risk premium and not a reflection of higher inflation expectations. I am also somewhat concerned that the median expectation for inflation over the next five to ten years in the Michigan survey has ticked up. " FOMC20050503meeting--79 77,MR. GUYNN.," Thank you, Mr. Chairman. I interpret what is characterized as softness in some of the recent data releases as an indication that at least the risks to the path of real output growth, which has averaged 3½ percent since the end of the recession and 4.3 percent over the last eight quarters, may have increased. It’s my sense that both consumer and business confidence may still be a bit more fragile than we thought, and it seems most likely that the skittishness is more due to the uncertainty about high energy prices and their likely persistence rather than a reaction to higher interest rates. Recent data and the anecdotal reports I hear from our Southeast business leaders, from both large and small companies, seem to suggest some new caution when it comes to spending and hiring decisions. A director who is a senior level executive of Georgia Pacific Corporation says that recent box sales, which track consumer nondurables fairly well, have tapered off slightly, whereas another director, who is Chief Financial Officer of UPS, reports that business is steady but not spectacular. At a meeting of our Small Business Advisory Council two weeks ago, there was a near consensus among those in the non-services sector that persistently high energy prices were taking a toll on profits and were causing some capital spending plans to be put on hold. Obviously, the earnings May 3, 2005 35 of 116 Furthermore, the large gains in temporary employment may be indicative of reluctance to add full- time employees unless absolutely necessary. Despite the increased uncertainties, however, I view the most likely path for output, as does the Greenbook, to be near or even above potential and, as such, unlikely to require attention from monetary policy. I’m a bit more concerned about the recent price developments which, while not alarming, have now given us several months of upward tilt to measures of inflation—regardless of the index one prefers. The price pressures we see in our region, while mirroring the general upward drift reflected in the national data, are still uneven, with some intended and actual price increases becoming more widespread and sticking and others being greeted with resistance. For example, our Georgia Pacific executive reported that for the last two months attempts to get price increases on many consumer products were meeting with less success than was the case in late 2004. He indicated that his customers now were more aggressively playing suppliers off against one another. At the same time, he reported that the prices of building materials were now clearly reflecting the higher energy costs involved in their production. Residential construction in Florida remains white hot, with continuing concern about speculation in those markets as I’ve been reporting for a while now. And just two days ago, one of our former directors from central Florida reported that one of the area’s largest contractors was told that concrete was about to go on allocation and to discontinue Saturday deliveries. That same source also indicated that drywall was about to be in short supply again. At the same time, our staff’s work on disaggregating the CPI inflation data indicates that the largest contributors to increased inflation have come mostly from factors other than the pass-through May 3, 2005 36 of 116 the rental equivalence measure for housing. Over the past six months, the negative contribution to inflation from goods has been reversed, more clearly exposing the underlying trend in services inflation, which has been rising at nearly 3 percent for the past year. In short, the various price and real-side data, tempered with anecdotal reports, lead me to the assessment that, while the risks to the real-side economy have clearly increased, the risks to inflation are now clearly to the upside and policy remains accommodative. Markets are expecting another 25 basis points of tightening today, and this seems to me the right path for us to be on. Having said that, I conclude that, with the increased uncertainty about the real economy, we need to think hard, very hard, about just how much we really know and what to say about the path of policy going forward. Like President Minehan, I suggest that it might be time to let some of the policy uncertainty show through. Thank you, Mr. Chairman." fcic_final_report_full--240 Mark-to-market write-downs were required on many securities even if there were no actual realized losses and in some cases even if the firms did not intend to sell the securities. The charges reflecting unrealized losses were based, in part, on credit rat- ing agencies’ and investors’ expectations that the mortgages would default. But only when those defaults came to pass would holders of the securities actually have real- ized losses. Determining the market value of securities that did not trade was diffi- cult, was subjective, and became a contentious issue during the crisis. Why? Because the write-downs reduced earnings and capital, and triggered collateral calls. These mark-to-market accounting rules received a good deal of criticism in re- cent years, as firms argued that the lower market prices did not reflect market values but rather fire-sale prices driven by forced sales. Joseph Grundfest, when he was a member of the SEC’s Committee on Improvements to Financial Reporting, noted that at times, marking securities at market prices “creates situations where you have to go out and raise physical capital in order to cover losses that as a practical matter were never really there.”  But not valuing assets based on market prices could mean that firms were not recording losses required by the accounting rules and therefore were overstating earnings and capital. As the mortgage market was crashing, some economists and analysts estimated that actual losses, also known as realized losses, on subprime and Alt-A mortgages would total  to  billion;  so far, by , the figure has turned out not to be much more than that. As of year-end , the dollar value of all impaired Alt-A and subprime mortgage–backed securities total about  billion.  Securities are im- paired when they have suffered realized losses or are expected to suffer realized losses imminently. While those numbers are small in relation to the  trillion U.S. economy, the losses had a disproportionate impact. “Subprime mortgages themselves are a pretty small asset class,” Fed Chairman Ben Bernanke told the FCIC, explaining how in  he and Treasury Secretary Henry Paulson had underestimated the repercussions of the emerging housing crisis. “You know, the stock market goes up and down every day more than the entire value of the subprime mortgages in the country. But what created the contagion, or one of the things that created the conta- gion, was that the subprime mortgages were entangled in these huge securitized pools.”  The large drop in market prices of the mortgage securities had large spillover ef- fects to the financial sector, for a number of reasons. For example, as just discussed, when the prices of mortgage-backed securities and CDOs fell, many of the holders of those securities marked down the value of their holdings—before they had experi- enced any actual losses. In addition, rather than spreading the risks of losses among many investors, the securitization market had concentrated them. “Who owns residential credit risk?” two Lehman analysts asked in a September  report. The answer: three-quarters of subprime and Alt-A mortgages had been securitized—and “much of the risk in these securitizations is in the investment-grade securities and has been almost en- tirely transferred to AAA collateralized debt obligation (CDO) holders.”  A set of large, systemically important firms with significant holdings or exposure to these se- curities would be found to be holding very little capital to protect against potential losses. And most of those companies would turn out to be considered by the authori- ties too big to fail in the midst of a financial crisis. FOMC20080430meeting--121 119,CHAIRMAN BERNANKE.," Thank you, and thank you all for very helpful comments. As usual, let me briefly summarize what I heard today and then make a few comments of my own. Again, in summary, data since the March meeting have been soft, and economic activity is weak. But the recent news has not generally been worse than expected. There was disagreement over whether we are technically in a recession. Most saw improved economic growth in the second half of 2008 with further improvement in 2009, although some saw more-protracted weakness. The housing sector remains weak, though there were reports of improvement. Starts and the demand for new houses continue to decline. Prices are falling. Inventories of unsold homes remain very high. Housing demand is affected by restrictive conditions in mortgage markets, fears that house prices have much further to fall, and weakening economic conditions. Retail sales, sentiment, and consumer spending have generally been soft, reflecting a long list of headwinds, including tightening credit, weaker house prices, and higher energy prices. Payrolls are falling, although there are some pockets of strength. Unemployment is likely to keep rising. It may remain somewhat high into 2010. We will soon see whether the fiscal stimulus package affects either the consumer or business investment plans. Possibly, liquidity-constrained consumers may respond more strongly than normally. Business sentiment is also relatively weak, reflecting in part credit conditions but also the uncertain prospects for the economy and continued cost pressures. Investment has softened somewhat, including declines in commercial real estate investment. Strength in foreign markets is helping support U.S. production and profits, especially manufacturing, although foreign economies may slow in the coming quarters. The energy and agricultural sectors are strong. Financial conditions have improved in the past month, with financing conditions better, credit risk spreads coming in a bit, and both equities and real interest rates up since the last meeting. Decent earnings, a sense on the part of some that the bulk of the write-downs in the banking sector have been taken, the ability of financial institutions to raise capital, and possibly Fed actions, including liquidity provision and the actions regarding Bear Stearns, have contributed to the improvement. On the other hand, many markets remain fragile, including the key interbank market and other short-term funding markets. Some expressed the view that moresignificant write-downs and financial stress lie ahead, as house prices continue to fall and the slowing economy weakens credit quality, and that the full impact of tighter credit has not yet been felt in the nonfinancial economy. Others, however, were less concerned about the real effects of the financial conditions. Financial conditions and the housing market probably remained the most important downside risks to growth, although energy prices were also cited. Readings on core inflation were moderate in the intermeeting period, although some of the reasons for improvement may be transitory. Oil prices have continued to move up, contributing to higher headline inflation. Other commodity prices have also begun to rise again. Many firms noted these strong cost pressures and indicated some ability to pass those costs along to consumers. Inflation breakevens showed improvement at some horizons since the March meeting, possibly reflecting lower risk premiums, though survey inflation expectations were higher. The dollar appreciated during the intermeeting period, but longer-term depreciation and rising import prices remain another source of pressure on inflation. Nominal wage gains remain moderate, however, and markups are high. Uncertainty about the course of oil and other commodity prices adds to overall inflation uncertainty and perhaps to inflation risks that are now somewhat more to the upside. Many participants expressed concerns about these upside risks, about inflation expectations, and about the maintenance of the Fed's inflation-fighting credibility. Any comments? Let me just add a few thoughts to what has already been said. On the real side, I think that I am probably somewhat more pessimistic than the median view that I heard around the table. First of all, I am reasonably confident that we are in a recession. We don't see these dynamic patterns of employment, sentiment, and so on without a recession being eventually called by the NBER. That fact, I believe, raises the risks of more-rapid declines in employment and consumer spending in the months ahead because there seem to be somewhat more-adverse dynamics in a recession scenario. Second, I remain concerned about housing, which is not showing really any significant signs of stabilization. Mortgage markets are still dysfunctional, and the only source of mortgage credit essentially is the GSEs, which are doing their best to raise fees and profit from the situation. Sales of new homes remain weak. Inventories of unsold homes are down in absolute terms, but they still are very high relative to sales. We heard this morning of yet even faster price declines for housing. As I've said several times at this table, until there is some sense of a bottoming in the housing market and in housing prices, I think that we are not going to see really broad stabilization, either in the economy or in financial markets. Now, there are some positives--exports, for example--which have kept manufacturing and other industries from declining as much as usual during a recession. Interestingly, this could be a mirror image of the 2001 recession. In 2001, the business sector was weak, and consumption and housing were strong. We could have the mirror image this time. In financial markets, there certainly have been improvements, and that is certainly encouraging. I agree with people about that. But we have heard a few people in the market say that credit losses and write-downs are in the ninth inning. As a baseball fan, I think we are probably closer to the third inning. Let me explain why I think that. The IMF recently projected aggregate credit losses on U.S.-based assets of about $945 billion worldwide, with about a quarter of those coming in the U.S. banks and thrifts. The Board staff has a somewhat lower number, around $700 billion to $800 billion, but they have a higher fraction in U.S. banks and thrifts. So the basic numbers are pretty similar in that respect. The staff projection for credit losses for U.S. commercial banks and thrifts, excluding investment banks, is about $215 billion for this year and next year and $300 billion if the recession is more severe. In addition, the staff projects about $60 billion in write-downs of CDOs and other types of traded assets. Now, most of those $60 billion write-downs have been taken. They are mostly held by the top banks, and they have mostly been already written off. However, of the $215 billion to $300 billion in projected credit losses, so far U.S. banks and thrifts have acknowledged only about $60 billion. So if you put together those numbers, you find that we are about one-third of the way through total losses. Now, there are, in fact, obviously some countervailing factors. Banks and thrifts have already raised about $115 billion in capital since the middle of last year, which essentially covers the losses announced so far. But that said, there is still a lot of deleveraging to go. There is going to be a long process of selling assets, reducing extensions of credit, and building capital ratios. This may not yet be fully felt in the real economy, but it will eventually be there. So I do think that we are going to see continued pressure from financial markets and credit markets, even if we don't have any serious relapses into financial stress. So, again, I am somewhat more skeptical about a near-term improvement in economic growth, although I do acknowledge that the fiscal package and other factors that the Greenbook mentions will be helpful. The question has been raised about whether monetary policy is helpful and what the stance of monetary policy is. I agree with the comment that the real federal funds rate is not necessarily the best measure of the stance of monetary policy right now. Let me take an example that was given in the New York Fed's daily financial report a couple of days ago, which was about the all-in cost of asset-backed securities backed by auto loans. According to this report, in February of '07, the three-year swap rate was about 5 percent, and the spread on AAA tranches of auto-backed ABS was about 10 basis points. The all-in cost was 5.07 percent for this particular asset. In February of '08, the three-year swap rate was 3.15 percent, almost 2 percentage points lower, but the spread on AAA tranches was 195 basis points. Therefore, the overall all-in cost of auto loan ABS was 5.36 percent. So the net effect is--well, is monetary policy doing anything? Absolutely. We have reduced the safe rate. We have brought down the cost of funds. But the spreads have obviously offset that. So what we have really done is essentially offset the effects of the credit crisis. Obviously, if we had not responded to the situation, those costs would be much higher, and the extent of restriction would be a lot greater. For these reasons, I really do believe that we need to take a much more sophisticated look at what the appropriate interest rate is. The Taylor rules, in particular, are just not appropriate for the current situation because the equilibrium real interest rate of 2 percent that is built into them is not necessarily appropriate. Let me turn to inflation, which a lot of people talked about today. First, let me just say that I certainly have significant concerns on the nominal side. In particular, I have a lot of anxiety about the dollar. Foreign exchange rates in general are not well tied down, and they are very subject to sentiment and swings in views. Therefore, although I think that the depreciation of the dollar so far is a mixed bag--obviously, it has effects on different parts of the economy--I do think that there is a risk of a sharper fall with possibly adverse implications, in the short run, for U.S. assets and, in the long run, perhaps implications for our position as a reserve currency and so on. So I think that is an issue to be concerned about. For that reason and for other reasons as well, I am very sympathetic to the view I hear around the table that we are now very, very close to where we ought to be, that it is time to take a rest, to see the effects of our work, and to pay equal attention to the nominal side of our mandate. I agree with all of that. So I am hopeful that in our policy discussion tomorrow we will be fairly close around the table. That being said, I do want to take a little exception to some of the discussion about inflation. There is an obvious and very elementary distinction between relative price changes and overall inflation. Let me ask you to do the following thought experiment. Imagine you are speaking to your board. Last year, as a first approximation, headline inflation was 4 percent, labor compensation grew at 4 percent, and oil prices rose 60 percent. Let's imagine that we had been so farsighted and so effective that we managed to keep headline inflation last year at 2 percent. The implications would have been, assuming that relative price changes were the same, that wages would have grown at 2 percent and that oil prices would have risen at 57 percent. In the conversation with your board, your board would say, ""This inflation is killing us. These costs are killing us. We have to pass them through."" They would, and they would be right. When there are big changes in relative prices, that is a real phenomenon, and it has to be accommodated somehow by nominal price shifts. So to the extent that the changes in food and oil prices reflect real supply-and-demand conditions, obviously they are very distressing and bad for the economy and create a lot of pain, but they are not in themselves necessarily under the control of monetary policy. If we give the impression that gasoline prices are the Fed's responsibility, we are looking for trouble because we cannot control gasoline prices. That said, of course we need to address the overall inflation rate. We need to address inflation expectations. All of that is very important. But, again, we need to make a distinction between relative price changes and overall inflation. Now, a more sophisticated response to that is, ""Well, maybe monetary policy is contributing to these relative price changes as well""; and I think that is a very serious issue. Certainly the dollar has some effects on oil prices. But keep in mind that a lot of the depreciation of the dollar is a decline in real exchange rates, which is essential in any case for balancing our external accounts. So, yes, the depreciation of the dollar, through our policies, has contributed somewhat to commodity prices. But compared with the overall shifts in relative prices that we have seen, I think it is not that large. There are other hypotheses suggesting that we have been stimulating speculation in a bubble, suggesting that low real interest rates contribute to commodity price booms. I don't want to take more time, but the evidence for those things is very limited. In particular, the fact that we have not seen any buildups in hoarding or inventories is a very strong argument against the idea that inflation expectations, hoarding, or speculation is a major factor in energy price increases. So, yes, the nominal side is very important. We need to address that. I agree with that. But we should try to help our audiences understand the very important distinction between real and nominal changes. I think I will stop there. If I can ask for your patience, we could do the briefing on the alternatives today and give ourselves more time tomorrow. Around the table, does that seem okay? I'll call on Bill English. " FOMC20080430meeting--318 316,MR. MISHKIN.," I am very comfortable with the analysis and the approach, so I don't have any major comments there. Although in the white paper you might mention them, I would like to take options 1 and 3 off the table. Option 1 has just too much administrative burden. We have enough tsuris already. Although option 3 may work well in countries with very different structures of the banking system, I don't think it is a feasible alternative for us. So I think that we should look at options 2 and 5, and I am certainly comfortable with another look at option 4. One issue that I worry about a bit is that these markets do sort out some interbank credit risk issues. We don't want to lose that, so we have to be very aware of it. I also worry a bit about setting a price when there is a credit risk element to it. When there is no credit risk element--if you want to set the Treasury bill rate--it is no big deal. But there may be an issue there, I am not sure, and it should be one of the considerations in this context. Thank you. " FOMC20060920meeting--140 138,VICE CHAIRMAN GEITHNER.," Thank you. Let me just start with the broad contours of our outlook. Growth has obviously slowed. The second half is likely to be relatively weak, but the only place we see pronounced weakness is in housing, and we expect a return to moderate growth going forward. Core inflation seems to be easing a bit, and it may have peaked in the second quarter, if you look just at the three-month annualized numbers. But inflation remains uncomfortably high, and our forecast assumes only a very gradual moderation over the next two years. In terms of numbers, we expect the real economy to grow at around its 3 percent potential rate in ’07 and ’08. We expect core PCE inflation on a Q4/Q4 basis to come in just below 2½ percent in ’06 and to moderate to about 2 percent in ’07 and 1.8 percent in ’08. Our outlook is largely unchanged from August. It’s conditioned on a path for policy that is flat at current levels for two to three quarters. This puts us slightly above the level that is currently priced into the risk-adjusted Eurodollar futures curve. In terms of uncertainty and risk, we see somewhat greater downside risks to demand growth than we saw in August, but the inflation risks still seem likely to be to the upside. Weighing the balance among these competing risks, we believe, as we did in August, that inflation risks should remain the predominant concern of the Committee, not so much, to borrow the Chairman’s formulation, because the probability of a higher inflation outcome is substantially greater than that of a much weaker growth outcome but because the costs of an erosion in inflation performance would be more damaging. On the growth outlook, we’re seeing a somewhat greater adjustment in residential investment than we anticipated, but this has not yet induced or been accompanied by a significant weakness outside housing. Of course, the outlook for the economy as a whole should not be particularly sensitive to plausible estimates of the direct effects of the remaining adjustment, whatever it is, left in residential investment. What seems more important, of course, is the potential effect of what’s happening in housing on consumer and business spending. We just don’t see troubling signs yet of collateral damage, and we are not expecting much. The fundamentals supporting relatively strong productivity growth seem to be intact. The acceleration of the nominal compensation growth that appears to be under way, combined with the moderation of headline inflation that we expect as energy prices moderate, should produce fairly strong growth of household income, even with the moderation in employment growth to trend. Corporate balance sheet profitability remains strong. Domestic demand growth outside the United States is expected to remain quite robust even though there has been some moderation in current measures of activity in some markets. Of course, the level of interest rates is not particularly high in nominal or real terms. Equity prices and credit spreads suggest a reasonable degree of confidence in the prospects for future expansion. Financial market participants report very strong continued demand for credit and for risk generally and very ample liquidity. This strength may reflect other factors that are operating on demand for financial assets, but still survey-based measures of confidence have not deteriorated dramatically. This, of course, may prove too optimistic on the growth outlook, and the risks seem weighted to the downside. On the inflation front, recent data have not altered our forecast or, really, our assessment of the risks to that forecast. Although there are signs of moderation in underlying inflation, the core PCE and a range of alternative measures continue to grow at levels that are uncomfortably high. We expect further moderation to occur only gradually over the forecast period. The latest data have been somewhat reassuring, and inflation expectations at various horizons have behaved relatively well since our last meeting. The acceleration in compensation growth and unit labor costs does not justify a higher inflation forecast in our view, provided that expectations remain well anchored, business markups fall, the ongoing moderation in growth reduces pressure on resource utilization, the futures curve proves a reasonably accurate prediction for the path of energy prices, the dollar declines only modestly, and so forth. These are reasonably good arguments, but we still think the risks are to the upside. Over the past two years, we have consistently revised up our forecasts for inflation. I’m not sure we really yet understand the forces behind the unanticipated acceleration in underlying inflation. Medium-term inflation expectations, while not rising at stated levels, may be higher than is consistent with an inflation objective in the range the Committee has talked about in the past. Containing these upside risks should be the dominant focus of policy until we see a more-pronounced moderation in current and expected underlying inflation. As my comments imply, we don’t have a lot of differences with the Greenbook on the contours of the outlook. The Greenbook shows slower growth relative to lower potential but also more inflation than we do. It also shows more slack with more inflation and a little less confidence in the strength of demand growth than we do for the reasons I hope I explained. I see certain questions as key. On the growth front the question is, Will weakness cumulate? If we see a more-pronounced actual decline in housing prices, will that have greater damage on confidence and spending? But the more interesting questions are really on the inflation forecast, and let me just talk very briefly about two. First, does the Greenbook forecast produce enough moderation in inflation soon enough to keep inflation expectations anchored? The baseline forecast has inflation falling to 1.5 percent, at least based on the last time we saw a long-term forecast, only over a very protracted period—a period that is significantly longer than the one many central bankers would consider an acceptable deviation from an inflation target. We have already seen a bit of troubling speculation from people who write about us. This Committee may have more inflation tolerance or a higher implicit target than its predecessor. Should we try to achieve a more rapid moderation of inflation? How should we evaluate the costs and benefits of trying to achieve a quicker and more substantial moderation of inflation, particularly given the tenuous state of the evidence on inertia and persistence? Is this gentle and gradual expected moderation in inflation optimal, given the softness of the outlook for demand? These are questions that are worthy of a more explicit discussion by the Committee, particularly if we’re going to talk about moving toward a quantitative definition of price stability with more disclosure around the forecast. The second and related question is about inflation in our forecast: With the stance of monetary policy that is now priced into the markets—this is a softer path than the one in August—how confident can we be that we are likely to achieve the forecast of sustained growth and gradually moderating core inflation? I think we can be less confident than the confidence you might read into current market expectations and the uncertainty that surrounds them. Of course, the behavior of long-term inflation expectations in financial markets suggests that this risk is not particularly high at present and that we can take some more time to get a better handle on the evolution of the economy before deciding what is next in terms of monetary policy actions. But I think that we may have more to do, and we should try to avoid fostering too much confidence in the markets that we’re done. We need to preserve the flexibility to do more if that proves necessary to keep inflation expectations anchored. Thank you." CHRG-110shrg50369--53 Mr. Bernanke," Well, we do have some data on investor-owned properties, and that has been increasing quite a bit. And my recollection is that among the mortgages that are having problems, something on the order of 20 percent of them are investor-owned; therefore, it is not a family that is being in risk of losing their home. So that is a significant consideration, and I think that in those cases investors who make a bad investment should bear the consequences. Senator Bennett. That is my own attitude as well. But we are having conversations about stimulus packages around here, and it had not occurred to me, until I had this information from people in the housing market, that if we could stimulate people to buy the lower-priced houses, and those are the people who need the shelter, anyway, and there is not a surplus of inventory there, that that would have a very salutary effect both in terms of taking care of people's needs and on the economy, because home builders would start to build again, they just would not be building in that portion of the housing market where there is an oversupply. But you do not have any specific data as to where the price points are in the inventory overhang? " FOMC20050202meeting--158 156,VICE CHAIRMAN GEITHNER.," We haven’t changed our view of the national outlook significantly since the last meeting. Our forecast is quite close to the Greenbook in all components, and quite close, I think, to the central tendency of the rest of your forecasts. I don’t have anything material to report about the economy of the Second District that I think has relevance to the national outlook. On the assumption that monetary policy follows a path close to that now priced into markets, we expect growth to be above potential over the forecast period, at slightly above 3½ percent, with core PCE inflation staying around 1½ percent. We think the distribution of probabilities around that forecast is roughly balanced, and we have somewhat more confidence in our forecast this time than we did at the last FOMC meeting. At the margin, we see less downside risk to the growth forecast than we have over the past few meetings. The resilience of the expansion in the face of recent shocks, the breadth of underlying strength in the main components of GDP except net exports, the fundamental sources that seem likely to underpin a continuation of recently strong consumer spending and investment, the survey- based measures of consumer and business confidence, the anecdotal reports of somewhat diminished business caution, and the moderate pace of the expansion so far all seem to add to the arguments in February 1-2, 2005 111 of 177 There is some talk among people who run major global corporations in New York about fragility remaining in the outlook, about a world of lower growth and higher volatility, about more lurches in the outlook for economic activity and asset prices. But I think the overall tone is a bit more positive; it has become progressively more positive over the last few months. On the inflation outlook, we face diminished risk of a significant decline in inflation from current levels and somewhat higher risk of some acceleration of inflation from these moderate levels, although the recent news, of course, has been reassuring. As productivity growth slows, resource utilization increases, and unit labor costs accelerate, we lose some of the cushion that has supported what has been a very benign performance of inflation recently. Profit margins are substantial enough to absorb significant acceleration in labor costs and other costs, but firms seem to be reporting increasing pricing power still. With the markets apparently confident that we will continue to move the fed funds rate closer to equilibrium—whatever that is—we’ve been successful in keeping inflation expectations stable at relatively low levels. This forecast, of course, looks implausibly benign. It’s hard to imagine that the path of the economy between now and the end of 2006 will materialize as the consensus not just around this table but among private forecasts seems to envision. The confidence around this view, which is evident in low credit spreads—low risk premia generally—and low expected volatility, leaves one, I think, somewhat uneasy. The general reduction in fear and uncertainty that now prevails has the effect of making everything look better. But, of, course it also may increase our vulnerability to some adverse shock and could magnify the effects of some types of shocks. The greatest risk to the forecast, I believe, involves this combination of very low risk premia with our large growing external imbalance, uncertainty about the prospects for a meaningful improvement in the fiscal baseline, and uncertainty about the sustainability of high structural productivity growth. Together, these factors increase the probability of some unwelcome surprise— some unwelcome shock to asset prices which, of course, could feed into a substantial slowdown in February 1-2, 2005 112 of 177 Obviously, it would not make sense for us to use our monetary policy signal to reintroduce more cautious risk premia and greater uncertainty. But we probably need to be careful over time, to the extent that it is possible, to avoid doing things that reinforce an unhealthy degree of confidence in the future path of the fed funds rate or leave that path less responsive to changes in the data and the outlook. Monetary policy should, in my view, continue to be directed at moving the fed funds rate higher toward a level more comfortably in the range of equilibrium and at convincing markets that we will continue to move the funds rate higher at a pace determined by our evolving view of the outlook—that is, sufficiently fast to keep inflation expectations stable at low levels. I don’t know whether that path will end up being steeper or softer than what is now priced into markets. As we move today, I think the signal in our statement should try to be neutral to the expectations now prevailing about the near-term path of monetary policy. Thank you." CHRG-111hhrg51592--160 Mr. Neugebauer," I think in your testimony, Mr. Joynt, that you didn't--you criticized proposals to replace ratings with bond spreads or CDS spreads, because you think the market prices, by definition, are inherently volatile than a fundamentally driven credit rating. When you were looking at your ratings and kind of, you had your story and you were sticking to it, were you monitoring the spreads on some of the credit default swaps to say, ``Hmm, there's some risk premiums there that other people think are there, that we're not recognizing.'' I mean, did the bell go off for somebody? " FOMC20070321meeting--37 35,MR. REINHART.," No, no, no. Because primary dealers’ economists, quite often, probably are reporting their modal forecast because they’re telling a story about where the Committee was going forward and painting an overall picture of the economy, whereas the Eurodollar contracts reflect averaging across all the states of nature. What we see when we look at options is a growing downside tail. So it could be the emergence of that significant downside tail, which economists will talk about as a risk to their outlook but traders actually have to price, as another reason that those two things are diverging." CHRG-110shrg50369--14 Mr. Bernanke," I will conclude with a quick update on the Federal Reserve's recent actions to help protect consumers in their financial dealings. The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted; and pressures on bank capital and the continued poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domestic product held up well through the third quarter despite the financial turmoil, but it has since slowed sharply. Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate--at 4.9 percent in January--has moved up somewhat. Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market. In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course. Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in many areas. Changes in the availability of mortgage credit amplified the swings in the housing market. During the housing sector's expansion phase, increasingly lax lending standards, particularly in the subprime market, raised the effective demand for housing, pushing up prices and stimulating construction activity. As the housing market began to turn down, however, the slump in subprime mortgage originations, together with a more general tightening of credit conditions, has served to increase the severity of the downturn. Weaker house prices in turn have contributed to the deterioration in the performance of mortgage-related securities and reduced the availability of mortgage credit. The housing market is expected to continue to weigh on economic activity in coming quarters. Home builders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and closely related industries. Consumer spending continued to increase at a solid pace through much of the second half of 2007, despite the problems in the housing market, but it appears to have slowed significantly toward the end of the year. The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in spending, as did the declines in household wealth associated with the weakness in house prices and equity prices. Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the 3 months ending in January, compared with an average increase of almost 100,000 per month over the previous 3 months. However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year. The business sector has also displayed signs of being affected by the difficulties in the housing and credit markets. Reflecting a downshift in the growth of final demand and tighter credit conditions for some firms, available indicators suggest that investment in equipment and software will be subdued during the first half of 2008. Likewise, after 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 a more encouraging note, we see few signs of any serious imbalances in business inventories aside from the overhang of unsold homes. And, as a whole, the nonfinancial business sector remains in good financial condition, with strong profits, liquid balance sheets, and corporate leverage near historical lows. In addition, the vigor of the global economy has offset some of the weakening of domestic demand. U.S. real exports of goods and services increased at an annual rate of about 11 percent in the second half of last year, boosted by continuing economic growth abroad and the lower foreign exchange value of the dollar. Strengthening exports, together with moderating imports, have in turn led to some improvement in the U.S. current account deficit, which likely narrowed in 2007--on an annual basis--for the first time since 2001. Although recent indicators point to some slowing of foreign economic growth, U.S. exports should continue to expand at a healthy pace in coming quarters, providing some impetus to domestic economic activity and employment. As I have mentioned, financial markets continue to be under considerable stress. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the financial markets in recent months. To help relieve the pressures in the market for interbank lending, the Federal Reserve--among other actions--recently introduced a term auction facility, through which prespecified amounts of discount window credit are auctioned to eligible borrowers, and we have been working with other central banks to address market strains that could hamper the achievement of our broader economic objectives. These efforts appear to have contributed to some improvement in short-term funding markets. We will continue to monitor financial developments closely. As part of its ongoing commitment to improving the accountability and public understanding of monetary policymaking, the Federal Open Market Committee--or FOMC--recently increased the frequency and expanded the content of the economic projections made by Federal Reserve Board members and Reserve Bank presidents and released to the public. The latest economic projections, which were submitted in conjunction with the FOMC meeting at the end of January and which are based on each participant's assessment of appropriate monetary policy, show that real GDP was expected to grow only sluggishly in the next few quarters and that the unemployment rate was likely to increase somewhat. In particular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2\1/2\ percent to 2\3/4\ percent projected in our report last July. FOMC participants' projections for the unemployment rate in the fourth quarter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4\3/4\ percent projected last July for the same period. The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial turmoil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend and the unemployment rate edging lower; the improvement reflects the effects of policy stimulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets. The incoming information since our January meeting continues to suggest sluggish economic activity in the near term. The risks to this outlook remain to the downside. The risks include the possibilities that the housing market or the labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further. Consumer price inflation has increased since our previous report, in substantial part because of the steep run-up in the price of oil. Last year, food prices also increased significantly, and the dollar depreciated. Reflecting these influences, the price index for personal consumption expenditures--or PCE--increased 3.4 percent over the four quarters of 2007, up from 1.9 percent in 2006. Core price inflation--that is, inflation excluding food and energy prices--also firmed toward the end of the year. The higher recent readings likely reflected some pass-through of energy costs to the prices of core consumer goods and services as well as the effect of the depreciation of the dollar on import prices. Moreover, core inflation in the first half of 2007 was damped by a number of transitory factors--notably, unusually soft prices for apparel and for financial services--which subsequently reversed. For the year as a whole, however, core PCE prices increased 2.1 percent, down slightly from 2006. The projections recently submitted by FOMC participants indicate that overall PCE inflation was expected to moderate significantly in 2008, to between 2.1 percent and 2.4 percent--the central tendency of the projections. A key assumption underlying those projections was that energy and food prices would begin to flatten out, as implied by quotes on futures markets. In addition, diminishing pressure on resources is also consistent with the projected slowing in inflation. The central tendency of the projections for core PCE inflation in 2008, at 2.0 percent to 2.2 percent, was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices. Beyond 2008, both overall and core inflation were projected to edge lower, as participants expected inflation expectations to remain reasonably well anchored and pressures on resource utilization to be muted. The inflation projections submitted by FOMC participants for 2010--which ranged from 1.5 percent to 2.0 percent for overall PCE inflation--were importantly influenced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate and about the timeframe over which policy should aim to achieve those rates. The rate of inflation that is actually realized will, of course, depend on a variety of factors. Inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect. Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate. Indeed, the further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month. Should high rates of overall inflation persist, the possibility also exists that inflation expectations could become less well anchored. 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 could reduce the flexibility of the FOMC to counter shortfalls in growth in the future. Accordingly, in the months ahead, the Federal Reserve will continue to monitor closely inflation and inflation expectations. Let me turn now to the implications of these developments for monetary policy. The FOMC has responded aggressively to the weaker outlook for economic activity, having reduced its target for the Federal funds rate by 225 basis points since last summer. As the Committee noted in its most recent post-meeting statement, the intent of those actions has been to help promote moderate growth over time and to mitigate the risks to economic activity. 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. In particular, the FOMC will need to judge 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 by the risks to that forecast. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. 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. Finally, I would like to say a few words about the Federal Reserve's recent actions to protect consumers in their financial transactions. In December, following up on a commitment I made at the time of our report last July, the Board issued for public comment a comprehensive set of new regulations to prohibit unfair or deceptive practices in the mortgage market, under the authority granted us by the Home Ownership and Equity Protection Act of 1994. The proposed rules would apply to all mortgage lenders and would establish lending standards to help ensure that consumers who seek mortgage credit receive loans whose terms are clearly disclosed and that can reasonably be expected to be repaid. Accordingly, the rules would prohibit lenders from engaging in a pattern or practice of making higher-priced mortgage loans without due regard to consumers' ability to make the scheduled payments. In each case, a lender making a higher-priced loan would have to use third-party documents to verify the income relied on to make the credit decision. For higher-priced loans, the proposed rules would require the lender to establish an escrow account for the payment of property taxes and homeowners' insurance and would prevent the use of prepayment penalties in circumstances where they might trap borrowers in unaffordable loans. In addition, for all mortgage loans, our proposal addresses misleading and deceptive advertising practices, requires borrowers and brokers to agree in advance on the maximum fee that the broker may receive, bans certain practices by servicers that harm borrowers, and prohibits coercion of appraisers by lenders. We expect substantial public comment on our proposal, and we will carefully consider all information and viewpoints while moving expeditiously to adopt final rules. The effectiveness of the new regulations, however, will depend critically on strong enforcement. To that end, in conjunction with other Federal and State agencies, we are conducting compliance reviews of a range of mortgage lenders, including nondepository lenders. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of, and improved enforcement for, all categories of mortgage lenders. The Federal Reserve continues to work with financial institutions, public officials, and community groups around the country to help homeowners avoid foreclosures. We have called on mortgage lenders and servicers to pursue prudent loan workouts and have supported the development of a streamlined, systematic approach to expedite the loan modification process. We also have been providing community groups, counseling agencies, regulators, and others with detailed analyses to help identify neighborhoods at high risk from foreclosures so that local outreach efforts to help troubled borrowers can be as focused and effective as possible. We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue. In addition to our consumer protection efforts in the mortgage area, we are working toward finalizing rules under the Truth in Lending Act that will require new, more informative, and consumer-tested disclosures by credit card issuers. Separately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards. Using the Board's authority under the Federal Trade Commission Act, we expect to issue proposed rules regarding these practices this spring. Thank you. I would be pleased to take your questions. " CHRG-110shrg50409--8 Mr. Bernanke," Chairman Dodd, Senator Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. The U.S. economy and financial system has confronted some significant challenges thus far in 2008. The contraction in housing activity that began in 2006 and the associated deterioration in mortgage markets that became evident last year have led to sizable losses at financial institutions and a sharp tightening in overall credit conditions. The effects of the housing contraction and of the financial head winds on spending and economic activity have been compounded by rapid increases in the prices of energy and other commodities which have sapped household purchasing power even as they have boosted inflation. Against this backdrop, economic activity has advanced at a sluggish pace during the first half of this year while inflation has remained elevated. Following a significant reduction in its policy rate over the second half of 2007, the Federal Open Market Committee eased policy considerably further through the spring to counter actual and expected weakness in economic growth and to mitigate downside risk to economic activity. In addition, the Federal Reserve expanded some of the special liquidity programs that were established last year and implemented additional facilities to support the functioning of financial markets and foster financial stability. Although these policy actions have had positive effects, the economy continues to face numerous difficulties, including ongoing strains on financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities. Let me now turn to a more detailed discussion of some of these key issues. Developments in financial markets and their implications to the macroeconomic outlook have been a focus of monetary policymakers over the past year. In the second half of 2007, the deteriorating performance of subprime mortgages in the United States triggered turbulence in domestic and international financial markets as investors became markedly less willing to bear credit risks of any type. In the first quarter of 2008, reports of further losses and writedowns by financial institutions intensified investor concerns and resulted in further sharp reductions in market liquidity. By March, many dealers and other institutions, even those that had relied heavily on short-term secured financing, were facing much more stringent borrowing conditions. In mid-March, a major investment bank, the Bear Stearns Companies Incorporated, was pushed to the brink of failure after suddenly losing access to short-term financing markets. The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy. After discussions with the Securities and Exchange Commission and in consultation with the Treasury, we invoked emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by JPMorgan Chase and Company. In addition, the Federal Reserve used emergency authorities to establish two new facilities to provide backstop liquidity to primary dealers, with the goals of stabilizing financial conditions and increasing the availability of credit to the broader economy. We have also taken additional steps to address liquidity pressures in the banking system, including a further easing of the terms for bank borrowing at the discount window and increases in the amount of credit made available to banks through the Term Auction Facility. The FOMC also authorized expansion of its currency swap arrangements with the European Central Bank and the Swiss National Bank to facilitate increased dollar lending by those institutions to banks in their jurisdictions. These steps to address liquidity pressures, coupled with monetary easing, seem to have been helpful in mitigating some market strains. During the second quarter, credit spreads generally narrowed, liquidity pressures ebbed, and a number of financial institutions raised new capital. However, as events in recent weeks have demonstrated, many financial markets and institutions remain under considerable stress, in part because the outlook for the economy and, thus, for credit quality remains uncertain. In recent days, investors became particularly concerned about the financial condition of the Government-sponsored enterprises Fannie Mae and Freddie Mac. In view of this development, and given the importance of these firms to the mortgage market, the Treasury announced the legislative proposal to bolster their capital, access to liquidity, and regulatory oversight. As a supplement to the Treasury's existing authority to lend to the GSEs, and as a bridge to the time when the Congress decides how to proceed on these matters, the Board of Governors authorized the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac should that become necessary. Any lending would be collateralized by U.S. Government and Federal agency securities. In general, healthy economic growth depends on well-functioning financial markets. Consequently, helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve. I turn now to current economic developments and prospects. The economy has continued to expand, but at a subdued pace. In the labor market, private payroll employment has declined this year, falling at an average pace of 94,000 jobs per month through June. Employment in the construction and manufacturing sectors has been particularly hard hit, although employment declines in a number of other sectors are evident as well. The unemployment rate has risen and now stands at 5.5 percent. In the housing sector, activity continues to weaken. Although sales of existing homes have been unchanged this year, sales of new homes have continued to fall, and inventories of unsold new homes remain high. In response, home builders continue to scale back the pace of housing starts. Home prices are falling, particularly in regions that experienced the largest price increases earlier this decade. The declines in home prices have contributed to the rising tide of foreclosures. By adding to the stock of vacant homes for sale, these foreclosures have in turn intensified the downward pressure on home prices in some areas. Personal consumption expenditures have advanced at a modest pace so far this year, generally holding up somewhat better than might have been expected given the array of forces weighing on household finances and attitudes. In particular, with the labor market softening and consumer price inflation elevated, real earnings have been stagnant so far this year. Declining values and equities in house have taken their toll on household balance sheets, credit conditions have tightened, and indicators of consumer sentiment have fallen sharply. More positively, the fiscal stimulus package is providing some timely support to household incomes. Overall, consumption spending seems likely to be restrained over coming quarters. In the business sector, real outlays for equipment and software were about flat in the first quarter of the year, and construction of nonresidential structures slowed appreciably. In the second quarter, the available data suggests that business fixed investment appears to have expanded moderately. Nevertheless, surveys of capital spending plans indicate that firms remain concerned about the economic and financial environment, including sharply rising costs of inputs and indications of tightening credit, and they are likely to be cautious with spending in the second half of the year. However, strong export growth continues to be a significant boon to many U.S. companies. In conjunction with the June FOMC meeting, Board members and reserve bank presidents prepared economic projections covering the years 2008 through 2010. On balance, most FOMC participants expected that, over the remainder of this year, output would expand at a pace appreciably below its trend rate, primarily because of continued weakness in housing markets, elevated energy prices, and tight credit conditions. Growth is projected to pick up gradually over the next 2 years as residential construction bottoms out and begins a slow recovery and as credit conditions gradually improve. However, FOMC participants indicated that considerable uncertainty surrounded their outlook for economic growth, and they viewed the risks to their forecast as skewed to the downside. Inflation has remained high, running at nearly a 3.5-percent annual rate over the first 5 months of this year, as measured by the price index of personal consumption expenditures. And with gasoline and other consumer energy prices rising in recent weeks, inflation seems likely to move temporarily higher in the near term. The elevated level of overall consumer inflation largely reflects a continued sharp run-up in the prices of many commodities, especially oil, but also certain crops and metals. The spot price of West Texas intermediate crude oil soared about 60 percent in 2007 and thus far this year has climbed an additional 50 percent or so. The price of oil currently stands at about 5 times its level toward the beginning of this decade. Our best judgment is that this surge in prices has been driven predominantly by strong growth in underlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded at its fastest pace in decades, leading to substantial increases in demand for oil. Moreover, growth has been concentrated in developed and emerging market economies, where energy consumption has been further stimulated by rapid industrialization and by government subsidies that hold down the price of energy faced by ultimate users. On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of the subdued supply response reflects inadequate investment and production shortfalls in politically volatile regions where large portions of the world's oil reserves are located. Additionally, many governments have been tightening their control over oil resources, impeding foreign investment and hindering efforts to boost capacity and production. Finally, sustainable rates of production in some of the more secure and accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long-term oil supplies have been marked down in recent months. Long-dated oil future prices have risen along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come. The decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices. The precise size of this effect is difficult to ascertain as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar--notably, shifts in the underlying global demand for and supply of oil--have been the principal drivers of these increases in prices. Another concern that has been raised is that financial speculation has added markedly to upward pressure on oil prices. Certainly, investor interest in oil and other commodities has increased substantially of late. However, if financial speculation is pushing oil prices above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But, in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term. Although the inflationary effect of rising oil and agricultural commodity prices is evident in the retail prices of energy and food, the extent to which the high prices of oil and other raw materials have passed through to the prices of non-energy, non-food finished goods and services seems thus far to have been limited. But with businesses facing persistently higher input prices, they may attempt to pass through such costs into prices of final goods and services more aggressively than they have done so far. Moreover, as the foreign exchange value of the dollar has declined, rises in import prices have put greater upward pressure on business costs and consumer prices. In their economic projections for the June FOMC meeting, monetary policymakers marked up their forecasts for inflation during 2008 as a whole. FOMC participants continue to expect inflation to moderate in 2009 and 2010 as slower global growth leads to a pooling of commodity markets, as pressures on resource utilization decline, and as longer-term inflation expectations remain reasonably well anchored. However, in light of persistent escalation of commodity prices in recent quarters, FOMC participants view the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast. Moreover, the currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation. If that were to occur and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policymakers is to prevent that process from taking hold. At present, accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policymakers. The possibility of higher energy prices, tighter credit conditions, and a still deeper contraction in housing markets all represent significant downside risks to the outlook for growth. At the same time, upside risks to the inflation outlook have intensified lately as the rising prices of energy and some other commodities have led to a sharp pick-up in inflation, and some measures of inflation expectations have moved higher. Given the high degree of uncertainty, monetary policymakers will need to carefully assess incoming information bearing on the outlook for both inflation and growth. In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process. I would like to conclude my remarks by providing a brief update on some of the Federal Reserve's actions in the area of consumer protection. At the time of our report last February, I described the Board's proposal to adopt comprehensive new regulations to prohibit unfair or deceptive practices in the mortgage market using our authority under the Home Ownership and Equity Protection Act of 1994. After reviewing more than 4,500 comment letters we received on these proposed rules, the Board approved the final rules yesterday. The new rules apply to all types of mortgage lenders and will establish lending standards aimed at curbing abuses while preserving responsible subprime lending and sustainable homeownership. The final rules prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher-priced loans, lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regular monthly payments. The final rules also prohibit prepayment penalties for higher-priced loans in cases in which the consumer's payment could increase during the first few years and restrict prepayment penalties on other higher-priced loans. Other measures address the coercion of appraisers' service or practices and other issues. We believe the new rules will help to restore confidence in the mortgage market. In May, working jointly with the Office of Thrift Supervision and the National Credit Union Administration, the Board issued proposed rules under the Federal Trade Commission Act to address unfair or deceptive practices for credit card accounts and overdraft protection plans. Credit cards provide a convenient source of credit for many consumers, but as the terms of credit card loans have become more complex, transparency has been reduced. Our consumer testing has persuaded us that disclosures alone cannot solve this problem. Thus, the Board's proposed rules will require card issuers to alter their practices in ways that will allow consumers to better understand how their own decisions and actions will affect their costs. Card issuers would be prohibited from increasing interest rates retroactively to cover prior purchases, except under very limited circumstances. For accounts having multiple interest rates, when consumers seek to pay down their balance by paying more than the minimum, card issuers would be prohibited from maximizing interest charges by applying excess payments to the lowest-rate balance first. The proposed rules dealing with bank overdraft services seek to give consumers greater control by ensuring that they have ample opportunity to opt out of automatic payments of overdrafts. The Board has already received more than 20,000 comment letters in response to these proposed rules. Thank you very much. I would be pleased to take your questions. " FOMC20050322meeting--160 158,MR. GUYNN.," Mr. Chairman, I’m not sure I followed all the alternatives, but let me weigh in on the draft language in cell B5 as well. If we’re going to make that kind of change in the language, I think there’s a better way to do it that will be a better transition in terms of the guidance we offer. I would suggest another alternative—I guess it’s the fifth alternative on the table—using words like “Conditional upon the current path of policy, the risks to the attainment of both sustainable growth and price stability are roughly balanced.” That does a couple of things: It seems to me linked to the path of policy that I heard most of us around the table say we are comfortable with; and it gets around the problem that Bill Poole talked about in terms of our inability to find words to describe the distribution of risk. I think something like that is a better transitional paragraph." CHRG-111hhrg51698--409 Mr. Short," On the issue of mandatory clearing of all products? I think our issue there is what I alluded to earlier in response to a question, which is that there are certainly products, derivative products, that should be cleared that are standardized, but there are also derivative products that probably aren't amendable to clearing. I think the proper framework would be to encourage clearing of standardized products that could present some level of systemic risk or have an important price transparency function in the broader marketplace, but to leave the nonstandardized, custom-tailored OTC instruments, like Mr. Taylor referred to, to the OTC marketplace. Ms. Herseth Sandlin. Mr. Chairman, a quick follow-up, if I might. So what about the types of customized derivatives? Would you support some sort of evaluation by an entity about whether they might present a systemic risk? " FOMC20050322meeting--123 121,MR. BERNANKE.," Thank you, Mr. Chairman. We are experiencing a mini-inflation scare in financial markets—a development that we need to take very seriously. The primary reason for the scare was the recent rapid increase in the prices of oil and other basic commodities. Other determinants of inflation, it should be noted, seem to be largely under control. Still-strong productivity growth and subdued wage increases have been sufficient to induce some recent deceleration in unit labor costs. At the sectoral level, recent increases in auto prices seem unlikely to continue, given the industry’s inventory overhang. And I note that this morning’s report showed a 0.9 percent decline in February in auto prices. Prices of imported consumer goods have also been remarkably tame, rising about 1 percent in the year to January despite the fall in the dollar. And the influx of low-cost apparel imports associated with the end of the Multifiber Agreement should provide more help on that front. Inflation in services is stable, and far future inflation compensation, which effectively strips out oil effects, has not risen. How serious is the inflation risk posed by rising commodity prices? One view, which, if correct, would be quite worrisome, is that commodity prices are the canary in the coal mine— indicators of easy monetary policy and building inflationary pressure. I don’t find this view persuasive, and I note that the academic literature has found essentially no support for it. Instead, recent commodity price increases seem to be largely the result of economic developments unrelated to U.S. monetary policy, which I would call supply shocks, although without disagreeing with President Poole. What we’re saying here is that China is exogenous. [Laughter] In the case of oil, for example, international agencies have recently revised downward their projections of non-OPEC March 22, 2005 57 of 116 likelihood that growth in demand this year will be disproportionately concentrated in energy- inefficient countries, such as China. The weak dollar, which I suspect is responding more to the current account situation than to monetary policy per se, is also affecting the oil price. Since 2000, oil prices have risen 98 percent in dollar terms, but they have also risen by 45 percent even in euro terms and by 76 percent in yen terms. If the supply shock interpretation is correct, then the effects on core inflation of the recent run-up should be moderate. As is well known, commodities and raw materials make up a small share of producers’ costs. For example, the staff estimates that even in a full employment situation, in which firms have some pricing power, a 1 percent increase in the core PPI for intermediate goods should result in less than a 5 basis point increase in the core CPI. By the way, I think that fact helps to reconcile to some extent the benign inflation numbers with the anecdotal reports of price increases, since many of them take place at the intermediate level. An interesting datum from last week’s survey of 22 primary dealers is that, on average, they expect core PCE inflation of 1.91 percent at an annual rate during the third quarter of this year, up only 6 basis points from what they expected for the same period as of the week before the last FOMC meeting. If we are, indeed, facing a supply shock, then to some extent the situation is analogous to where we were last spring when inflation pressures proved transitory and policy patience paid off. However, all economists have two hands. And on my other hand, I agree that there are also important differences from the situation last spring. The expansion has considerably more March 22, 2005 58 of 116 would not like to see it go much higher. Finally, futures markets suggest that this time the shocks to commodity prices are expected to be relatively more permanent than they were last time. For these reasons, the risks to both the output and inflation objectives of a slightly more aggressive policy posture seem fairly modest. My bottom line is that I support raising the funds rate by only 25 basis points today. However, I believe that it would behoove the Committee to modify the statement in a way that signals the possibility of stronger actions in the near future. Thank you." FOMC20070131meeting--170 168,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Just a few quick points. We feel somewhat better about the outlook for growth and inflation, but we haven’t really changed our forecasts for ’07 and ’08. So just as we expected over the past few cycles, we currently expect GDP to grow roughly at the rate of potential over the forecast period, which we believe is still around 3 percent, and we expect the rate of increase in the core PCE to moderate a bit more to just below 2 percent over the forecast period. We see somewhat less downside risk to growth and somewhat less upside risk to inflation than we did, but the overall balance of risks in our view is still weighted toward inflation—the risk that it fails to moderate enough or soon enough. The basic nature of the risks to both those elements of our forecast hasn’t really changed. As this implies, our forecast still has somewhat stronger growth and somewhat less inflation than the Greenbook does. The differences, however, are smaller than they have been. We see the same basic story that the Greenbook does in support of continuing expansion going forward. We have similar assumptions for the appropriate path of monetary policy—at least two, perhaps several, quarters of a nominal fed funds rate at current levels. The main differences between our view about the economy and the Greenbook’s relate first, as they have for some time, to the likely growth in hours; we’re still not inclined to build in a substantial reduction in trend labor force growth. Second, our view is that inflation has less inertia, less persistence, than it has exhibited over the past half-century. Third, we tend to think that changes in wealth have less effect on consumer behavior than does the staff. We have seen a general convergence in views in the market, as we just discussed, toward a forecast close to this view, close to the center of gravity in this room, and a very significant change in policy expectations as well. We can take some comfort from this, but I don’t think we should take too much. Markets still seem to display less uncertainty about monetary policy and asset prices and quite low probabilities to even modest increases in risk premiums than I think is probably justified. Let me just go through the principal questions briefly. Is the worst behind us in both housing and autos? Probably, but we can’t be sure yet. If we get some negative shock to income—to demand growth—we’re still vulnerable to a more adverse adjustment in housing prices with potentially substantially negative effects on growth, in part because of the greater leverage now on household balance sheets. How strong does the economy look outside autos and housing? Pretty strong, it seems. We see no troubling signs of weakness, despite the disappointment on some aspects of investment spending. What does the labor market strength tell us about the risk to the forecast? It seems obvious that on balance it justifies some caution about upside risk to growth and more than the usual humility about what we know about slack and trend labor force growth. But I don’t think it fundamentally offers a compelling case on its own for a substantial change to the inflation forecast or the risks to that forecast. Is there any new information on structural productivity growth? Not in our view. We’re still fairly comfortable with the staff view of around 2 percent or 2½ percent for the nonfarm business sector. I’m not a great fan of the anecdote, but I’ll cite just one. If you ask people who make stuff for a living on a substantial scale, it’s hard to find any concern that they are seeing diminished capacity to extract greater productivity growth in their core businesses. That’s not a general observation, just a small one. Have the inflation risks changed meaningfully in either direction? I think the recent behavior of the core numbers and of expectations is reassuring. The market doesn’t seem particularly concerned about inflation, and the market is therefore vulnerable to a negative surprise, to a series of higher numbers. Can we be confident we’ll get enough moderation with the current level of long-term expectations prevailing in markets, with the expected path of slack in the economy, and with the range of potential forces that might operate on relative prices— energy, import, and other prices? Again, I think this forecast still seems reasonable, but we can’t be that confident, and we need to be concerned still about the range of sources of vulnerability of that forecast. Another way to frame this question is, Is the inflation forecast consistent with the current expectations for the path of monetary policy acceptable to the Committee? We haven’t fully confronted that issue because we don’t get much moderation with a monetary policy assumption that’s close to what’s in the markets. But I don’t think there’s a compelling case to act at this stage in a way that forces convergence on that. In other words, how tight is monetary policy, and how tight are overall financial conditions today? I don’t think there’s a very strong case for us to induce more tightness or more accommodation than now prevails. There’s a good case for patience and for giving ourselves a fair amount of flexibility going forward, within the context of an asymmetric signal about the balance of risks and a basic judgment that we view the costs of a more adverse inflation outcome as the predominant concern of the Committee." FOMC20060328meeting--264 262,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. I think we really do have a remarkable degree of consensus around the table about the forecast, and you did a very nice job of capturing that consensus. The consensus is really quite close to the Greenbook, closer than it has been perhaps in recent meetings. The Greenbook forecast is conditioned on a monetary policy assumption that has us essentially stopping at 5 with the path pretty flat from 5 on. The question, of course, for us today is whether we want to alter current market expectations about the path of policy, and I think it is hard to find a compelling case to do so, either from what we discussed around the table or from what the Greenbook provided. The Bluebook provided alternative prisms to look at the implications of past policy. The presumption is that we don’t want to change expectations substantially because we don’t see a case for changing the current stance of monetary policy as embodied in those expectations. The question is how best to do it, and I think B is probably the closest we’re going to get to that. I agree with the concern that Sandy began with and which I think Dino echoed—that there is some possibility, maybe even a likelihood, that B is interpreted as raising the probability of not just a move in May but a move beyond May. Again, I don’t see any need to do that. I don’t think it should be our objective to try to raise the probability around June. The question really is how to avoid that. I do think that adding the sustainable growth reference in the second row and adding “possible,” as Vince explained, helps against that risk, but it probably doesn’t take away all of that risk. The problem with doing things that create the risk of pushing down the curve is that people would react to that by saying, “Well, what does that mean about how confident they are about the strength of underlying demand growth?” One consequence of an alternative that would be designed to push down that curve would be, in some sense, questions raised about how confident we are in our forecast about the underlying strength of demand growth, which I don’t think that we have a basis for signaling at this point. Is there some risk we are going to go too far? Of course there is. What are the best tools we have to assess that risk? Again, I think the Greenbook and the Bluebook give us a number of tools to assess that risk; and if the Greenbook forecast, with a monetary policy path close to what’s priced in the markets, showed a different trajectory of output growth and a different trajectory of inflation, then there would be more substantial reason for us to be concerned that the path that’s roughly priced in now creates too much risk that we would be pushing demand growth below potential over the period. And, again, I think it is hard to say that. It has been said that the output-based policy rules we use aren’t a particularly good reason to be concerned about that because of the way they are constructed. Are we too hostage to the markets in our current approach? I think that is always something to be worried about. Again, the best check against that risk is to look at the implications of these alternative policy paths for the forecast. I think it’s hard to find in the range of paths that the staff has given us significant justification for concern against that risk today. So I would support moving 25 today; and for the reasons discussed, I think B does a pretty good job of capturing the basic objective of a signal that’s fairly neutral to expectations. I’d rather take the risk at the margin that we’re pushing it up a bit than the risk that we end up pushing it down." fcic_final_report_full--375 Morgan Stanley] had consistently opposed Federal Reserve supervision—[but after Lehman,] those franchises saw that they were next unless they did something drastic. That drastic thing was to become bank holding companies,” Tom Baxter, the New York Fed’s general counsel, told the FCIC.  The Fed, in tandem with the Department of Justice, approved the two applications with extraordinary speed, waiving the stan- dard five-day antitrust waiting period.  Morgan Stanley instantly converted its  billion industrial loan company into a national bank, subject to supervision by the Office of the Comptroller of the Currency (OCC), and Goldman converted its  billion industrial loan company into a state-chartered bank that was a member of the Federal Reserve System, subject to supervision by the Fed and New York State. The Fed would begin to supervise the two new bank holding companies. The two companies gained the immediate benefit of emergency access to the dis- count window for terms of up to  days.  But, more important, “I think the biggest benefit is it would show you that you’re important to the system and the Fed would not make you a holding company if they thought in a very short period of time you’d be out of business,” Mack told the FCIC. “It sends a signal that these two firms are go- ing to survive.”  In a show of confidence, Warren Buffett invested  billion in Goldman Sachs, and Mitsubishi UFJ invested  billion in Morgan Stanley. Mack said he had been waiting all weekend for confirmation of Mitsubishi’s investment when, late Sunday afternoon, he received a call from Bernanke, Geithner, and Paulson. “Basically they said they wanted me to sell the firm,” Mack told the FCIC. Less than an hour later, Mitsubishi called to confirm its investment and the regulators backed off.  Despite the weekend announcements, however, the run on Morgan Stanley con- tinued. “Over the course of a week, a decreasing number of people [were] willing to do new repos,” Wong said. “They just couldn’t lend anymore.”  By the end of September, Morgan Stanley’s liquidity pool would be  billion.  But Morgan Stanley’s liquidity depended critically on borrowing from two Fed pro- grams,  billion from the PDCF and  billion from the TSLF. Goldman Sachs’s liquidity pool had recovered to about  billion, backed by . billion from the PDCF and  billion from the TSLF. OVERTHE COUNTER DERIVATIVES: “A GRINDING HALT ” Trading in the over-the-counter derivatives markets had been declining as investors grew more concerned about counterparty risk and as hedge funds and other market participants reduced their positions or exited. Activity in many of these markets slowed to a crawl; in some cases, there was no market at all—no trades whatsoever. A sharp and unprecedented contraction of the market occurred.  “The OTC derivatives markets came to a grinding halt, jeopardizing the viability of every participant regardless of their direct exposure to subprime mortgage-backed securities,” the hedge fund manager Michael Masters told the FCIC.  “Furthermore, when the OTC derivatives markets collapsed, participants reacted by liquidating their positions in other assets those swaps were designed to hedge.” This market was unregulated and largely opaque, with no public reporting requirements and little or no price discovery. With the Lehman bankruptcy, participants in the market became concerned about the exposures and creditworthiness of their counterparties and the value of their contracts. That uncertainly caused an abrupt retreat from the market. Badly hit was the market for derivatives based on nonprime mortgages. Firms had come to rely on the prices of derivatives contracts reflected in the ABX indices to value their nonprime mortgage assets. The ABX.HE.BBB- -, whose decline in  had been an early bellwether for the market crisis, had been trading around  cents on the dollar since May. But trading on this index had become so thin, falling from an average of about  transactions per week from January  to September  to fewer than  transactions per week in October , that index values weren’t informative.  So, what was a valid price for these assets? Price discovery was a guessing game, even more than it had been under normal market conditions. The contraction of the OTC derivatives market had implications beyond the valu- ation of mortgage securities. Derivatives had been used to manage all manner of risk—the risk that currency exchange rates would fluctuate, the risk that interest rates would change, the risk that asset prices would move. Efficiently managing these risks in derivatives markets required liquidity so that positions could be adjusted daily and at little cost. But in the fall of , everyone wanted to reduce exposure to everyone else. There was a rush for the exits as participants worked to get out of existing trades. And because everyone was worried about the risk inherent in the next trade, there often was no next trade—and volume fell further. The result was a vicious circle of justifiable caution and inaction. FOMC20060510meeting--106 104,MS. PIANALTO.," Thank you, Mr. Chairman. Based on the reports from my directors and my business contacts in the Fourth District, the relatively broad-based growth of the first quarter appears to have carried over into April. However, their comments about the balance of the year are consistent with the moderating trend of the Greenbook baseline projection. To put it in terms used by the Conference Board’s consumer sentiment measures, the current condition index is high, but the expectations index is falling. I was reminded by my staff as we were preparing for this meeting that real-time data on real economic growth are difficult to assess. At the end of our rate-increase cycle in 2000, the GDP figures were providing unreliable signals about the underlying strength of the economy. We had a second quarter that had real growth of more than 6 percent. We were forecasting, and even saw in the advance figures a very strong third quarter, and yet we had negative growth in that quarter. Comments I hear about price pressures contain some mixed messages. I don’t hear many complaints about price pressures except for the obvious ones about the energy-related costs and material shortages in construction-related businesses. However, I am hearing concerns about the persistence of these costs and the possibility that they may have negative consequences for both inflation and overall business conditions. The consequences of the energy shocks for prices are already apparent. At our November meeting, I agreed with the Board staff projection that we would, at about this time, find ourselves facing some pass-through in our core inflation measures from some of the previous energy-price increases. At that time, however, it also appeared that headline inflation would be coming down at this point. Obviously, the current Greenbook suggests that recent oil shocks have taken that scenario away from us, at least for the immediate future, and the tick-up in expected core inflation is now even further away from my comfort zone than before. That said, based on what I’m hearing from my directors and business contacts, the Greenbook’s assessment of current conditions and baseline projections going forward seem about right to me. But I sense rather significant perceived risks both that economic growth might turn out weaker than I expect and that inflationary pressures might be larger or even more persistent than I expect. If we can take any encouragement from this, it would be that similar sentiments were expressed during the run-up in oil and gas prices last fall, and those sentiments did abate fairly quickly when the energy market situation stabilized. Unlike many of my colleagues who have spoken ahead of me, I do think that the risks are weighted against both of our objectives, and, obviously, that’s not a comfortable place for a monetary policymaker to be in. Thank you, Mr. Chairman." CHRG-110hhrg41184--15 Mr. Bernanke," Okay. In my testimony this morning, I will briefly review the economic situation and outlook, beginning with developments in real activity and inflation, and then turn to monetary policy. I will conclude with a quick update on the Federal Reserve's recent actions to help protect consumers in their financial dealings. The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted, and pressures on bank capital and the continuing poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domestic product held up well through the third quarter despite the financial turmoil, but it has since slowed sharply. Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate, at 4.9 percent in January, has moved up somewhat. Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market. In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course. Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in most areas. Changes in the availability of mortgage credit amplified the swings in the housing market. During the housing sector's expansion phase, increasing lax lending standards, particularly in the subprime market, raised the effective demand for housing, pushing up prices and stimulating construction activity. As the housing market began to turn down, however, the slump in subprime mortgage originations, together with the more general tightening of credit conditions, has served to increase the severity of the downturn. Weaker house prices in turn have contributed to the deterioration in the performance of mortgage-related securities and reduced the availability of mortgage credit. The housing market is expected to continue to weigh on economic activity in coming quarters. Home builders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and in closely related industries. Consumer spending continued to increase at a solid pace through much of the second half of 2007, despite the problems in the housing market, but it appears to have slowed significantly toward the end of the year. The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in spending, as did the declines in household wealth associated with the weakness in house prices and equity prices. Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the 3 months ending in January, compared with an average increase of almost 100,000 per month over the previous 3 months. However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year. The business sector has also displayed signs of being affected by the difficulties in the housing and credit markets. Reflecting a downshift in the growth of final demand and tighter credit conditions for some firms, available indicators suggest that investment in equipment and software will be subdued during the first half of 2008. Likewise, after growing robustly through much of 2007, nonresidential construction is likely to decelerate sharply in coming quarters as business activity flows and funding becomes harder to obtain, especially for more speculative projects. On a more encouraging note, we see few signs of any serious imbalances in business inventories, aside from the overhang of unsold homes. And, as a whole, the nonfinancial business sector remains in good financial condition with strong profits, liquid balance sheets, and corporate leverage near historic lows. In addition, the vigor of the global economy has offset some of the weakening of domestic demand. U.S. real exports of goods and services increased at an annual rate of about 11 percent in the second half of last year, boosted by continuing economic growth abroad and the lower foreign exchange value of the dollar. Strengthening exports, together with moderating imports, have in turn led to some improvement in the U.S. current account deficit, which likely narrowed in 2007 on an annual basis for the first time since 2001. Although recent indicators point to some slowing of foreign growth, U.S. exports should continue to expand at a healthy pace in coming quarters, providing some impetus to domestic economic activity and employment. As I have mentioned, financial markets continue to be under considerable stress. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the financial markets in recent months. To help relieve the pressures in the market for interbank lending, the Federal Reserve, among other actions, recently introduced a term auction facility through which pre-specified amounts of discount window credit are auctioned to eligible borrowers. And we have been working with other central banks to address market strains that could hamper the achievement of our broader economic objectives. These efforts appear to have contributed to some improvement in short-term funding markets. We will continue to monitor financial developments closely. As part of its ongoing commitment to improving the accountability and public understanding of monetary policymaking, the Federal Open Market Committee, or FOMC, recently increased the frequency and expanded the content of the economic projections made by Federal Reserve Board members and Reserve Bank presidents and released to the public. The latest economic projections, which were submitted in conjunction with the FOMC meeting at the end of January, and which are based on each participant's assessment of appropriate monetary policy, show that real GDP was expected to grow only sluggishly in the next few quarters, and that the unemployment rate was seen as likely to increase somewhat. In particular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2.5 percent to 2.75 percent as projected in our report last July. FOMC participants' projections for the unemployment rate in the fourth quarter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4.75 percent projected last July for the same period. The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial turmoil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend, and the unemployment rate edging lower. The improvement reflects the effects of policy stimulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets. The incoming information since our January meeting continues to suggest sluggish economic activity in the near term. The risks to this outlook remain to the downside. Those risks include the possibilities that the housing market or the labor market may deteriorate more than is currently anticipated, and that credit conditions may tighten substantially further. Consumer price inflation has increased since our previous report, in substantial part because of the steep run-up in the price of oil. Last year food prices also increased significantly, and the dollar depreciated. Reflecting these influences, the price index for Personal Consumption Expenditures increased by 3.4 percent over the four quarters of 2007, up from 1.9 percent in 2006. Core price inflation, that is, inflation excluding food and energy prices, also firmed toward the end of the year. The higher recent readings likely reflected some pass-through of energy costs to the prices of consumer goods and services, as well as the effect of the depreciation of the dollar and import prices. Moreover, core inflation in the first half of 2007 was damped by a number of transitory factors; notably, unusually soft prices for apparel and for financial services, which subsequently reversed. For the year as a whole, however, core PCE prices increased by 2.1 percent, down slightly from 2006. The projections recently submitted by FOMC participants indicate that overall PCE inflation was expected to moderate significantly in 2008, to between 2.1 percent and 2.4 percent, the central tendency of the projections. A key assumption underlying those projections was that energy and food prices would begin to flatten out, as was implied by quotes on futures markets. In addition, diminishing pressure on resources is also consistent with the projected slowing in inflation. The central tendency of the projections for core PCE inflation in 2008 at 2.0 percent to 2.2 percent was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices. Beyond 2008, both overall and core inflation were projected to edge lower as participants expected inflation expectations to remain reasonably well anchored and pressures on resource utilization to be muted. The inflation projection submitted by FOMC participants for 2010, which range from 1.5 percent to 2.0 percent for overall PCE inflation, were importantly influenced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate, and about the timeframe over which policy should aim to attain those rates. The rate of inflation that is actually realized will of course depend on a variety of factors. Inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities, or if rates of domestic resource utilization fall more than we currently expect. Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out, or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate. Indeed, the further increases in prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggests slightly greater upside risks to the projections of both overall and core inflation than we saw last month. Should high rates of overall inflation persist, the possibility also exists that inflation expectations could become less well anchored. 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 could reduce the flexibility of the FOMC to counter shortfalls in growth in the future. Accordingly, in the months ahead, the Federal Reserve will continue to monitor closely inflation and inflation expectations. Let me turn now to the implications of these developments for monetary policy. The FOMC has responded aggressively to the weaker outlook for economic activity, having reduced its target for the Federal funds rate by 225 basis points since last summer. As the committee noted in its most recent post-meeting statement, the intent of those actions has been to help promote moderate growth over time and to mitigate the risk to economic activity. A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risk to growth, stressed financial conditions, and inflation pressures. In particular, the FOMC will need to judge 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 of real activity and inflation as well as the risks to that forecast. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. 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. Finally, I would like to say a few words about the Federal Reserve's recent actions to protect consumers in their financial transactions. In December, following up on a commitment I made at the time of our last report in July, the Board issued for public comment a comprehensive set of new regulations to prohibit unfair or deceptive practices in the mortgage market under the authority granted us by the Home Ownership and Equity Protection Act of 1994. The proposed rules would apply to all mortgage lenders and would establish lending standards to help ensure that consumers who seek mortgage credit receive loans whose terms are clearly disclosed and that can reasonably be expected to be repaid. Accordingly, the rules would prohibit lenders from engaging in a pattern or practice of making higher priced mortgage loans without due regard to consumers' ability to make the scheduled payments. In each case, a lender making a higher priced loan would have to use third-party documents to verify the income relied on to make the credit decision. For higher priced loans, the proposed rules would require the lender to establish an escrow account for the payment of property taxes and homeowners insurance, and would prevent the use of prepayment penalties in circumstances where they might trap borrowers in unaffordable loans. In addition, for all mortgage loans, our proposal addresses misleading and deceptive advertising practices, requires borrowers and brokers to agree in advance on the maximum fee that the broker may receive, and certain practices by servicers that harm borrowers and prohibits coercion of appraisers by lenders. We expect substantial public comment on our proposal, and we will carefully consider all information and viewpoints while moving expeditiously to adopt final rules. The effectiveness of the new regulations, however, will depend critically on strong enforcement. To that end, in conjunction with other Federal and State agencies, we are conducting compliance reviews of a range of mortgage lenders, including nondepository lenders. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of, and improved enforcement for, all categories of mortgage lenders. The Federal Reserve continues to work with financial institutions, public officials and community groups around the country to help homeowners avoid foreclosures. We have called on mortgage lenders and servicers to pursue prudent loan workouts, and have supported the development of streamlined, systematic approaches to expedite the loan modification process. We have also been providing community groups, counseling agencies, regulators and others with detailed analyses to help identify neighborhoods at high risk for foreclosures so that local outreach efforts to help troubled borrowers can be as focused and as effective as possible. We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue. In addition to our consumer protection efforts in the mortgage area, we are working towards finalizing rules under the Truth in Lending Act that will require new, more informative, and consumer-tested disclosures by credit card issuers. Separately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards. Using the Board's authority under the Federal Trade Commission Act, we expect to issue proposed rules regarding these practices this spring. Thank you. I would be very pleased to take your questions. [The prepared statement of Chairman Bernanke can be found on page 53 of the appendix.] " CHRG-111hhrg51698--198 Mr. Duffy," I believe, sir, that the risk can be--it is going to be minimized because of the fact that a high percentage of these credit default swaps will be able to be cleared on an exchange. Even the ones that are really toxic in nature--and I agree with Chairman Peterson, what he said, that maybe if they are too toxic they should be untradeable. We are coming up with pricing mechanisms to value those so we can go ahead and clear these products. So, it will be a small amount of outstanding credit default swaps. And, yes, there may be a couple that do go away. " CHRG-111hhrg51698--59 Mr. Gooch," I think having the instruments in a central environment where you can see everything optically is helpful for regulators so they can see where the risk lies. But, certainly, margining for credit default is very complex. I mean, I give the example of Lehman. Their senior debt was trading at 85 cents on the Friday before they went into bankruptcy, and on Monday morning it was trading at 11 cents. I don't see how you could effectively margin for that level of price move over the weekend. " CHRG-110shrg50409--111 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System July 15, 2008 Chairman Dodd, Senator Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. The U.S. economy and financial system have confronted some significant challenges thus far in 2008. The contraction in housing activity that began in 2006 and the associated deterioration in mortgage markets that became evident last year have led to sizable losses at financial institutions and a sharp tightening in overall credit conditions. The effects of the housing contraction and of the financial headwinds on spending and economic activity have been compounded by rapid increases in the prices of energy and other commodities, which have sapped household purchasing power even as they have boosted inflation. Against this backdrop, economic activity has advanced at a sluggish pace during the first half of this year, while inflation has remained elevated. Following a significant reduction in its policy rate over the second half of 2007, the Federal Open Market Committee (FOMC) eased policy considerably further through the spring to counter actual and expected weakness in economic growth and to mitigate downside risks to economic activity. In addition, the Federal Reserve expanded some of the special liquidity programs that were established last year and implemented additional facilities to support the functioning of financial markets and foster financial stability. Although these policy actions have had positive effects, the economy continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities. Let me now turn to a more detailed discussion of some of these key issues. Developments in financial markets and their implications for the macroeconomic outlook have been a focus of monetary policymakers over the past year. In the second half of 2007, the deteriorating performance of subprime mortgages in the United States triggered turbulence in domestic and international financial markets as investors became markedly less willing to bear credit risks of any type. In the first quarter of 2008, reports of further losses and write-downs at financial institutions intensified investor concerns and resulted in further sharp reductions in market liquidity. By March, many dealers and other institutions, even those that had relied heavily on short-term secured financing, were facing much more stringent borrowing conditions. In mid-March, a major investment bank, The Bear Stearns Companies, Inc., was pushed to the brink of failure after suddenly losing access to short-term financing markets. The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy. After discussions with the Securities and Exchange Commission and in consultation with the Treasury, we invoked emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by JPMorgan Chase & Co. In addition, the Federal Reserve used emergency authorities to establish two new facilities to provide backstop liquidity to primary dealers, with the goals of stabilizing financial conditions and increasing the availability of credit to the broader economy. \1\ We have also taken additional steps to address liquidity pressures in the banking system, including a further easing of the terms for bank borrowing at the discount window and increases in the amount of credit made available to banks through the Term Auction Facility. The FOMC also authorized expansions of its currency swap arrangements with the European Central Bank and the Swiss National Bank to facilitate increased dollar lending by those institutions to banks in their jurisdictions.--------------------------------------------------------------------------- \1\ Primary dealers are financial institutions that trade in U.S. government securities with the Federal Reserve Bank of New York. On behalf of the Federal Reserve System, the New York Fed's Open Market Desk engages in the trades to implement monetary policy.--------------------------------------------------------------------------- These steps to address liquidity pressures coupled with monetary easing seem to have been helpful in mitigating some market strains. During the second quarter, credit spreads generally narrowed, liquidity pressures ebbed, and a number of financial institutions raised new capital. However, as events in recent weeks have demonstrated, many financial markets and institutions remain under considerable stress, in part because the outlook for the economy, and thus for credit quality, remains uncertain. In recent days, investors became particularly concerned about the financial condition of the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. In view of this development, and given the importance of these firms to the mortgage market, the Treasury announced a legislative proposal to bolster their capital, access to liquidity, and regulatory oversight. As a supplement to the Treasury's existing authority to lend to the GSEs and as a bridge to the time when the Congress decides how to proceed on these matters, the Board of Governors authorized the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac, should that become necessary. Any lending would be collateralized by U.S. government and Federal agency securities. In general, healthy economic growth depends on well-functioning financial markets. Consequently, helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve. I turn now to current economic developments and prospects. The economy has continued to expand, but at a subdued pace. In the labor market, private payroll employment has declined this year, falling at an average pace of 94,000 jobs per month through June. Employment in the construction and manufacturing sectors has been particularly hard hit, although employment declines in a number of other sectors are evident as well. The unemployment rate has risen and now stands at 5\1/2\ percent. In the housing sector, activity continues to weaken. Although sales of existing homes have been about unchanged this year, sales of new homes have continued to fall, and inventories of unsold new homes remain high. In response, homebuilders continue to scale back the pace of housing starts. Home prices are falling, particularly in regions that experienced the largest price increases earlier this decade. The declines in home prices have contributed to the rising tide of foreclosures; by adding to the stock of vacant homes for sale, these foreclosures have, in turn, intensified the downward pressure on home prices in some areas. Personal consumption expenditures have advanced at a modest pace so far this year, generally holding up somewhat better than might have been expected given the array of forces weighing on household finances and attitudes. In particular, with the labor market softening and consumer price inflation elevated, real earnings have been stagnant so far this year; declining values of equities and houses have taken their toll on household balance sheets; credit conditions have tightened; and indicators of consumer sentiment have fallen sharply. More positively, the fiscal stimulus package is providing some timely support to household incomes. Overall, consumption spending seems likely to be restrained over coming quarters. In the business sector, real outlays for equipment and software were about flat in the first quarter of the year, and construction of nonresidential structures slowed appreciably. In the second quarter, the available data suggest that business fixed investment appears to have expanded moderately. Nevertheless, surveys of capital spending plans indicate that firms remain concerned about the economic and financial environment, including sharply rising costs of inputs and indications of tightening credit, and they are likely to be cautious with spending in the second half of the year. However, strong export growth continues to be a significant boon to many U.S. companies. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared economic projections covering the years 2008 through 2010. On balance, most FOMC participants expected that, over the remainder of this year, output would expand at a pace appreciably below its trend rate, primarily because of continued weakness in housing markets, elevated energy prices, and tight credit conditions. Growth is projected to pick up gradually over the next 2 years as residential construction bottoms out and begins a slow recovery and as credit conditions gradually improve. However, FOMC participants indicated that considerable uncertainty surrounded their outlook for economic growth and viewed the risks to their forecasts as skewed to the downside. Inflation has remained high, running at nearly a 3\1/2\ percent annual rate over the first 5 months of this year as measured by the price index for personal consumption expenditures. And, with gasoline and other consumer energy prices rising in recent weeks, inflation seems likely to move temporarily higher in the near term. The elevated level of overall consumer inflation largely reflects a continued sharp run-up in the prices of many commodities, especially oil but also certain crops and metals. \2\ The spot price of West Texas intermediate crude oil soared about 60 percent in 2007 and, thus far this year, has climbed an additional 50 percent or so. The price of oil currently stands at about five times its level toward the beginning of this decade. Our best judgment is that this surge in prices has been driven predominantly by strong growth in underlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded at its fastest pace in decades, leading to substantial increases in the demand for oil. Moreover, growth has been concentrated in developing and emerging market economies, where energy consumption has been further stimulated by rapid industrialization and by government subsidies that hold down the price of energy faced by ultimate users.--------------------------------------------------------------------------- \2\ The dominant role of commodity prices in driving the recent increase in inflation can be seen by contrasting the overall inflation rate with the so-called core measure of inflation, which excludes food and energy prices. Core inflation has been fairly steady this year at an annual rate of about 2 percent.--------------------------------------------------------------------------- On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of the subdued supply response reflects inadequate investment and production shortfalls in politically volatile regions where large portions of the world's oil reserves are located. Additionally, many governments have been tightening their control over oil resources, impeding foreign investment and hindering efforts to boost capacity and production. Finally, sustainable rates of production in some of the more secure and accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long-term oil supplies have been marked down in recent months. Longdated oil futures prices have risen along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come. The decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices. The precise size of this effect is difficult to ascertain, as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar, notably shifts in the underlying global demand for and supply of oil, have been the principal drivers of the increase in prices. Another concern that has been raised is that financial speculation has added markedly to upward pressures on oil prices. Certainly, investor interest in oil and other commodities has increased substantially of late. However, if financial speculation were pushing oil prices above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term. Although the inflationary effect of rising oil and agricultural commodity prices is evident in the retail prices of energy and food, the extent to which the high prices of oil and other raw materials have been passed through to the prices of non-energy, non-food finished goods and services seems thus far to have been limited. But with businesses facing persistently higher input prices, they may attempt to pass through such costs into prices of final goods and services more aggressively than they have so far. Moreover, as the foreign exchange value of the dollar has declined, rises in import prices have put greater upward pressure on business costs and consumer prices. In their economic projections for the June FOMC meeting, monetary policymakers marked up their forecasts for inflation during 2008 as a whole. FOMC participants continue to expect inflation to moderate in 2009 and 2010, as slower global growth leads to a cooling of commodity markets, as pressures on resource utilization decline, and as longer-term inflation expectations remain reasonably well anchored. However, in light of the persistent escalation of commodity prices in recent quarters, FOMC participants viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast. Moreover, the currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation. If that were to occur, and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policymakers is to prevent that process from taking hold. At present, accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policymakers. The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth. At the same time, upside risks to the inflation outlook have intensified lately, as the rising prices of energy and some other commodities have led to a sharp pickup in inflation and some measures of inflation expectations have moved higher. Given the high degree of uncertainty, monetary policymakers will need to carefully assess incoming information bearing on the outlook for both inflation and growth. In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process. I would like to conclude my remarks by providing a brief update on some of the Federal Reserve's actions in the area of consumer protection. At the time of our report last February, I described the Board's proposal to adopt comprehensive new regulations to prohibit unfair or deceptive practices in the mortgage market, using our authority under the Home Ownership and Equity Protection Act of 1994. After reviewing the more than 4,500 comment letters we received on the proposed rules, the Board approved the final rules yesterday. The new rules apply to all types of mortgage lenders and will establish lending standards aimed at curbing abuses while preserving responsible subprime lending and sustainable homeownership. The final rules prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher-priced loans, lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regular monthly payments. The final rules also prohibit prepayment penalties for higher-priced loans in cases in which the consumer's payment can increase during the first few years and restrict prepayment penalties on other higher-priced loans Other measures address the coercion of appraisers, servicer practices, and other issues. We believe the new rules will help to restore confidence in the mortgage market. In May, working jointly with the Office of Thrift Supervision and the National Credit Union Administration, the Board issued proposed rules under the Federal Trade Commission Act to address unfair or deceptive practices for credit card accounts and overdraft protection plans. Credit cards provide a convenient source of credit for many consumers, but the terms of credit card loans have become more complex, which has reduced transparency. Our consumer testing has persuaded us that disclosures alone cannot solve this problem. Thus, the Board's proposed rules would require card issuers to alter their practices in ways that will allow consumers to better understand how their own decisions and actions will affect their costs. Card issuers would be prohibited from increasing interest rates retroactively to cover prior purchases except under very limited circumstances. For accounts having multiple interest rates, when consumers seek to pay down their balance by paying more than the minimum, card issuers would be prohibited from maximizing interest charges by applying excess payments to the lowest rate balance first. The proposed rules dealing with bank overdraft services seek to give consumers greater control by ensuring that they have ample opportunity to opt out of automatic payments of overdrafts. The Board has already received more than 20,000 comment letters in response to the proposed rules. Thank you. I would be pleased to take your questions. FOMC20061025meeting--76 74,MS. YELLEN.," Thank you, Mr. Chairman. Five weeks have passed since our last FOMC meeting, and not surprisingly the outlook does not appear to have changed in any fundamental way. Recent data bearing on the near-term situation point to noticeably slower growth in the third quarter than we anticipated at our last meeting. However, the Greenbook has revised up its projection for growth during the current and next few quarters so that the overall effect on slack next year is roughly neutral. This forecast strikes me as plausible, but there are few data thus far to bear it out. Meanwhile, measures of consumer price inflation remain uncomfortably high, although the latest readings have been very slightly better. With regard to the pace of economic activity, there’s uncertainty in all directions. In fact, we seem to have a bimodal economy with a couple of weak sectors, and the rest of the economy doing just fine. Those two weak sectors are, of course, housing and domestic auto production. Autos seem likely to have only a short-lived effect. In the case of housing, we agree with the Greenbook assessment of housing activity and find it quite consistent with the reports of our contacts in this sector. Besides the falloff in activity, house-price increases have also slowed markedly. The Case-Shiller house-price index has been flat in recent months, and futures on this index show outright declines next year. However, equity valuations for homebuilders, as Cathy mentioned, have risen moderately in the past couple of months, following large declines over the previous year, and we interpret that as providing some indication that the expected future path of home prices has at least stopped deteriorating. Of course, housing is a relatively small sector of the economy, and its decline should be self-correcting. So the bigger danger is that weakness in house prices could spread to overall consumption through wealth effects. This development would deepen and extend economic weakness, potentially touching off a nonlinear type of downward dynamic that could trigger a recession. But so far at least, there are no signs of such spillovers. Consumption spending seems on track for healthy growth. Nonetheless, the growth estimate for the third quarter begins with a 1 and just barely. Any time a forecast is that low, it’s reasonable to consider the possibility that the economy could enter recession. So for this reason, we, like the Board’s staff, took a careful look at various approaches to assess this issue, including yield-curve-based models, past forecast errors, leading indicator models, and surveys. Our bottom line is that we agree with the basic results reported in Monday’s nonfinancial briefing. The highest probability of recession that we found, around 40 percent, was obtained from a model developed by a Board staff member. The model includes the slope of the yield curve and the level of the funds rate. An issue with this result is that long-term rates may currently be low, hence the yield curve inverted, for unusual and not very well understood reasons having to do with the risk premium. Estimates from the other approaches came in with lower probabilities. Finally, other financial developments that could presage future economic performance, like stock market movements and risk spreads, suggest some optimism on the part of financial market participants. So our sense is that, except for housing and autos, the economy appears to be doing quite well. Indeed, the recent rather sharp drop in energy prices could boost consumption spending even more than assumed in the Greenbook. While this is a possibility, it seems more likely to me that households ran down their savings to fill their gas tanks when gas prices rose and are, therefore, likely to use their recent savings at the pump to bolster their finances, at least partly. Overall, under the assumption of an unchanged funds rate, our forecast shows a beautiful soft landing, with real GDP growing at a moderately below-trend pace for a few more quarters and homing in near trend thereafter. But I must admit that we got this forecast essentially by averaging the strong and weak sides of the economy. I think that way of proceeding is reasonable, and I hope the landing happens that way. But I acknowledge there is plenty of risk. We may end up instead with either the strong or the weak side dominating the outcome. For example, if the housing market decline does not spread significantly to consumption, we could end up with a strong economy in fairly short order. However, if it does spread, the slowdown could last quite a while. Scenarios like this are nicely spelled out in the alternative simulations in the Greenbook. Which way things go is a key issue, given that we’re in the vicinity of full employment. The desired soft landing depends on growth remaining below trend long enough to offset the moderate amount of excess demand that appears to be in the economy so that inflation can trend gradually lower. The slight drop in unemployment, to 4.6 percent, in September did not help in that regard, and I should note that recent comments by our head office directors almost uniformly supported the idea that labor markets, especially for skilled workers, are tight. However, we do expect the unemployment rate to edge higher over the next year in response to sluggish growth. Our forecast for core consumer inflation comes down a bit faster than foreseen by the Greenbook. We have core PCE price inflation edging down from just under 2½ percent this year to just over 2 percent in 2007 and see a good chance that it may fall a bit below 2 percent in the following year. We see the relief on energy prices as helpful, although we keep trying to resist any temptation to overestimate the extent to which past energy price pass-through has been boosting core inflation. Inflation also may benefit from an unwinding of the earlier strong pressures on rents. Finally, as in the discussion we had earlier about the alternative Greenbook scenario, we think inflation may have become less persistent over the past decade, and this is one reason that we’re a bit more optimistic than the Greenbook about the possible degree of disinflation over the next couple of years. But on balance, I have to admit we don’t have a perfect understanding of why inflation has been so high over the past few years, and so I try to remain humble, as always, in my predictions. My bottom line is this. I see a non-negligible chance that the downside risks to the economy, emanating especially from housing, could produce a recession in coming quarters, but there’s a very good chance that the spillovers will be sufficiently modest that the economy will avoid a recession. I also see a significant chance that growth could modestly exceed potential. In that sense, the overall risks to the outlook for real GDP growth could be characterized as balanced. In addition, I see quite a bit of uncertainty about inflation going forward with the risks to my forecast probably being a bit to the high side." FOMC20081029meeting--264 262,MR. MADIGAN.," 7 Thank you, Mr. Chairman. I will be referring to the version of table 1 that was distributed to you on Monday. It is reproduced in the package before you labeled ""Material for Briefing on Monetary Policy Alternatives."" Changes in the language relative to the Bluebook version are shown in blue. Starting on the right-hand side of the table, even though members saw the economic and financial information that became available over the intermeeting period as worse than expected, they might be inclined to leave the stance of policy unchanged at today's meeting, as in alternative C. As noted yesterday, your 7 The materials used by Mr. Madigan are appended to this transcript (appendix 7). economic projections reveal that many of you anticipate that inflation pressures will diminish less quickly than the staff anticipates, and several of you noted explicitly that you thought less easing would be appropriate than was assumed in the Greenbook forecast. Also, the Committee already reduced rates in early October, responding to at least some of the adverse economic news. Moreover, the Federal Reserve has put in place additional facilities to support credit intermediation, and the Treasury and the FDIC are moving quickly with the implementation of other programs that should, with time, help stabilize financial institutions and markets and enhance the flow of credit to households and businesses. Finally, you might believe that the Congress is likely to enact a second fiscal stimulus package, possibly reducing the need for additional monetary policy accommodation. The rationale section of the statement suggested for alternative C would acknowledge the intensification of financial turmoil and the weakening of the economic outlook. However, it would also cite the range of policy actions taken in recent weeks as factors that should help over time to improve credit conditions and promote a return to moderate economic growth. The language on inflation would be essentially identical to that used in the Committee's statement earlier this month, noting that the upside risks to inflation have been reduced. The risk assessment would state explicitly that the Committee's primary concern is the downside risks to growth, suggesting a predilection for lowering rates. Nonetheless, with market participants anticipating an easing today--a 50 basis point move is seen as most likely--an announcement along the lines of alternative C would point to a much higher trajectory for the federal funds rate over the next few months than investors had expected. Short- and intermediate-term Treasury yields would likely jump, credit spreads probably would increase further, and equity prices might decline sharply. If the Committee is of the view that further policy accommodation is appropriate at this time but is also quite uncertain about the extent of rate reductions that will ultimately be required, it might be attracted to the 25 basis point easing of alternative B at this meeting. Members might have a less pessimistic outlook for the economy than that presented as the baseline in the Greenbook or might at least be quite uncertain as to the extent of the negative forces at work in the economy. At the same time, you may view the incoming information as suggesting that the 50 basis point easing earlier this month is unlikely to be sufficient to adequately balance the risks to economic activity and inflation. Given these considerations, you might see modest further easing today as appropriate and be prepared to cut rates again in coming months should developments warrant. The statement proposed for alternative B would note that the pace of economic activity appears to have slowed markedly, and it would repeat language from your early October statement indicating that the financial market turmoil is likely to exert additional restraint on spending. The announcement would also indicate that, in light of the decline in the prices of energy and other commodities, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability. As noted in a box in the Bluebook, we think that, in view of your previous policy communications, outside analysts would interpret such a statement on the inflation outlook as indicating that the Committee anticipates that overall inflation will drop to around 1� percent to 1� percent before long, a indication that would be consistent with the central tendency of your inflation projections for 2009. The risk assessment in alternative B, paragraph 4, would cite the same broad range of policy actions that was proposed in alternative C, paragraph 2. It would indicate that the predominant concern of the Committee is the downside risks to economic growth. Market participants see a 25 basis point easing at this meeting as possible, but at this point they seem to place significantly higher odds on a 50 basis point reduction. The explicit citation of downside risks to growth would suggest that further easing could be forthcoming after this meeting, but this announcement still would suggest a higher path for the federal funds rate than they anticipate. Consequently, short- and intermediate-term rates might tend to edge up after such an announcement, credit spreads might widen somewhat further, and equity prices might decline. Under alternative A, the Committee would ease policy 50 basis points at this meeting. An economic outlook along the lines of the Greenbook forecast would provide one rationale for choosing this alternative. The Greenbook forecast for aggregate demand has been slashed dramatically, importantly reflecting a sharp decline in equity prices, a steep rise in credit risk premiums, and a considerable climb in the foreign exchange value of the dollar. One metric for this revision is the Greenbook-consistent measure of the short-run equilibrium real interest rate, r*, which has been cut nearly 3 percentage points since the September meeting to a level of about minus 3 percent. That level is about 2 percentage points below the actual real funds rate defined on a consistent basis. The staff outlook for a protracted period of substantial economic slack, together with the recent plunge in energy prices, points to a considerable diminution of inflation pressures, with overall inflation falling to 1� percent next year in the Greenbook forecast--even with the Greenbook's assumption of 100 basis points of further easing by early next year. But even those who are somewhat less pessimistic about the outlook than the Board staff might view the modal outlook as having deteriorated enough, or the downside risks as having increased enough, to warrant a 50 basis point rate cut today. The rationale language for alternative A in the revised version of table 1 is similar to that for alternative B, but alternative A, paragraph 2, notes additional factors that are restraining growth. The risk assessment, too, is similar to that for alternative B, but it references the rate reduction that would be implemented today under this alternative and notes that downside risks to growth remain, without saying that the downside risks are the Committee's predominant concern. An announcement along these lines seems largely consistent with market participants' expectations, and the market reaction would likely be relatively small. Thank you, Mr. Chairman. " CHRG-110shrg50369--52 Mr. Bernanke," Well, Mr. Meltzer, who is an excellent economist and indeed who is a historian of the Federal Reserve, is concerned that the current situation will begin to look like the 1970s, with very high inflation and high unemployment. I would dispute his analysis on the grounds that I do believe that monetary policy has to be forward looking, has to be based on where we think the economy and the inflation rate are heading. And as I said, the current inflation is due primarily to commodity prices--oil and energy and other prices--that are being set in global markets. I believe that those prices are likely to stabilize, or at least not to continue to rise at the pace that we have seen recently. If that is the case, then inflation should come down, and we should have, therefore, the ability to respond to what is both a slowdown in growth and a significant problem in the financial markets. He is correct, however, that there is some risk, and if the inflation expectations look to be coming unmoored, or if the prices of energy and commodities begin to feed into other costs of goods and services, we would have to take that very seriously. I mentioned that core inflation last year was 2.1 percent, so it is food prices and energy prices, which are internationally traded commodities, which are the bulk of the inflation problem. Again, we do have to watch it very carefully, but I do not think we are anywhere near the 1970s type situation. Senator Bennett. Thank you. I wanted to get that on the record. As I look at the housing market and talk to some of my friends who are in the housing market, they tell me that the inventory is not monolithic, the inventory overhang--that is that the bulk of the overhang is in the higher-priced homes, because home builders wanted to build places where they would get the highest margin return, and if they built houses in the moderate housing area or affordable housing, their margins were not nearly as great and there were plenty of speculators willing to buy the bigger homes. And, indeed, they tell me that for affordable housing, there is, frankly, not a sufficient supply right now. They are urging me to do something on fiscal policy to stimulate people to build cheaper houses, that the housing construction would begin to catch up--not catch up. Construction levels would begin to pick up, whereas now they are dormant, waiting for the overhang to be worked off. Do you have any data that supports that anecdotal report? " FOMC20080916meeting--120 118,MS. YELLEN.," Thank you, Mr. Chairman. During the past several weeks, my head office and Branch directors have become decidedly more pessimistic about the economic outlook. My own assessment of incoming data coincides with theirs. My contacts also report that their businesses are still raising prices in response to past increases in commodity and import prices that boosted their costs. I expect as a consequence that core inflation will remain uncomfortably high for a while longer, but the marked decline in commodity prices since June reinforces my conviction that there is light at the end of this inflation tunnel. With respect to growth, our forecast is similar to the Greenbook's, with a little more weakness in the second half of this year and a little more strength in 2009. I think the risks to this forecast are decidedly skewed to the downside. I agree with the Greenbook's assessment that the strength we saw in the upwardly revised real GDP growth in the second quarter will not hold up. Despite the tax rebates, real personal consumption expenditures declined in both June and July, and retail sales were down in August. My contacts report that cutbacks in spending are widespread, especially for discretionary items. For example, East Bay plastic surgeons and dentists note that patients are deferring elective procedures. [Laughter] Reservations are no longer necessary at many high-end restaurants. And the Silicon Valley Country Club, with a $250,000 entrance fee and seven-to-eight-year waiting list, has seen the number of would-be new members shrink to a mere thirteen. [Laughter] Exports were a huge source of strength in the second quarter, but I am concerned that we cannot count on very large contributions to growth from exports going forward, now that the dollar has begun to rise and economic growth abroad has slowed, even turning negative in some important trade partners. Indeed, the growing weakness of the global outlook appears to be an important explanation for the reversion in commodity prices, and this adds a dimension of gloom to what would otherwise be a decided plus for both inflation and demand. Recent data also suggest that labor markets are weakening across the board--a development that will cast a pall on household income and spending. The interaction of higher unemployment with the housing and financial markets raises the potential for even worse news--namely, an intensification of the adverse feedback loop we have long worried about and are now experiencing. Indeed, delinquencies have risen substantially across the spectrum of consumer loans, and credit availability continues to decline. One ray of hope is that the changes at Fannie and Freddie have caused a notable drop in mortgage rates. Another is that the decline in home prices has become somewhat less steep, and we have seen an outright improvement in home inventories relative to sales. But my contacts are very pessimistic about the prospects for nonresidential construction. They note that construction is continuing on projects in the pipeline with committed funding, but new projects are all but impossible to finance. Turning to inflation, I have long anticipated and still expect that inflation will fall to more-reasonable levels in 2009. However, developments since our August meeting diminish the upside risks to this projection. The drop in oil and other commodity prices, along with the appreciation of the dollar, should work to moderate the current inflation bulge and diminish the potential for a wage�price spiral to develop. Import inflation has already begun to ease. Furthermore, we have seen a remarkable decline in inflation compensation for the next five years in the TIPS market. I would not rely heavily on this decline to support my view, but I do have to say that the decline is a lot more reassuring than the alternative. I was also encouraged by the 30 basis point drop in long-term inflation expectations in the most recent Michigan survey. I anticipate that the recent jump in the unemployment rate will place some additional downward pressure on growth in labor compensation, which has been quite low, and in core inflation. Although the jump in the unemployment rate probably partly reflects the extension of unemployment insurance coverage, a back-of-the-envelope calculation suggests that the upper bound on this effect is just a few tenths of a percent. I would agree with the Greenbook estimates. We have also examined the possibility that the increase in unemployment reflects a rise in the NAIRU due to sectoral employment shifts out of construction and finance and into other industries. Ned Phelps has argued that the sectoral shift story implies a sizable dispersion of employment growth across industries and states. But we looked at these data and found no significant increase, so I don't find this Phelps argument particularly convincing. Considering all of these factors, I expect both headline and core PCE price inflation to fall to about 2 percent for 2009 as a whole, and I see the risks to this projection as roughly balanced. With respect to policy, I would be inclined to keep the funds rate target at 2 percent today. For now, it seems to me that the additional liquidity measures that have been put in place are an appropriate response to the turmoil. I am fine with the wording of alternative B and would support President Lockhart's suggestion for change. That would seem fine to me, too. In view of the intensified financial stress and the potential for more turmoil, obviously I think we will need to be flexible in setting policy going forward, and I am very concerned about downside risks to the real economy and think that inflation risk is diminished. " FOMC20060629meeting--6 4,MR. KOS.," Yes, I think one of the interesting points about this period is that very question. Some of the high-risk assets that had been bid up are where we have the most-pronounced price moves, and that does perhaps suggest that positioning is a bigger part of the story because bond markets were relatively tame not just in the United States but also in other, overseas bond markets. So something of a risk adjustment seems to have happened. I think the interesting question is why, but it’s very, very hard to discern that. I, at least, tended to minimize the effect that uncertainty about monetary policy itself has had in causing the volatility in emerging market equities. Certainly if one takes the opposite view, then one has some explaining to do in terms of the previous couple of years when a tightening cycle was occurring. At different times there was uncertainty about the pace and extent of the tightening, and yet those markets continued to rally despite that uncertainty." FOMC20070321meeting--235 233,MS. DANKER.," Okay. Let me start with the directive on page 28 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” Now the amended assessment of risk: “In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”" FOMC20070807meeting--57 55,MS. YELLEN.," Thank you, Mr. Chairman. Data on inflation during the intermeeting period have continued to be encouraging, but the prospects for economic activity have become dicier. The results for GDP in the second quarter as a whole actually took on a positive tone, with final sales mainly accounting for the healthy growth rate. But the quarter ended on a weak note, with disappointing data for housing consumption and for orders of core capital goods. Of course, the big developments since our last meeting were in financial markets. I read them as pointing to weaker growth going forward and greater downside risk. The market for mortgage- backed securities is now highly illiquid, and there are indications that credit problems are spilling beyond the subprime sector. It thus seems likely that lending standards will tighten for a broader class of borrowers in the mortgage market. The drop in equity prices and rising rates on most risky corporate debt are further negatives for growth. There are some offsets to these negative factors, including the decline in the dollar and, most important, the steep reduction we have seen in risk-free rates. On balance, however, I expect these offsets to be only partial, providing a cushion against future weakness, because I interpret the decline in Treasury rates during the intermeeting period primarily as a reflection of weaker growth expectations and a correspondingly lower path for the expected future fed funds rate and not a consequence of the fall of the term premium. The jump in oil prices since our last meeting is a further factor weighing on aggregate demand. As a result of these considerations, I have lowered my growth forecast for the second half of this year ½ percentage point, to just over 2 percent. This rate is moderately below my estimate of potential growth, which I now put at about 2½ percent. Going beyond this year, the outlook depends on one’s assumption concerning appropriate monetary policy. I consider it appropriate for policy to aim at holding growth just slightly below potential to produce enough slack in labor and credit markets to help bring about a further gradual reduction in inflation toward a level consistent with price stability. Barring a more serious and prolonged tightening of credit market conditions or a general liquidity squeeze, I would keep the fed funds rate modestly above its equilibrium level to accomplish this goal. However, I now see the fed funds rate as well above the neutral level. So I think it likely that the fed funds rate will need to fall appreciably over the next few years. My assessment of the neutral federal funds rate declined during the intermeeting period for two main reasons—first, because of the tightening in financial conditions associated with the reassessment of risk now taking place and, second, because of the NIPA revisions, which suggest slower structural productivity growth and, in all likelihood, correspondingly slower growth in aggregate demand. I thus think that a larger decline in the fed funds rate will be needed over time than in the Greenbook baseline to achieve a soft landing. A key development during the intermeeting period was the downward revision of real GDP growth over the 2004-06 period. This adjustment reinforces the work of productivity experts at the Board and elsewhere who had previously found evidence of a slowdown in underlying productivity growth. The revision in actual productivity was big enough to lead us to lower our estimate of growth in both structural productivity and potential output, although our estimates remain above those in the Greenbook. In addition to tighter financial conditions, lower structural productivity growth was the reason that we lowered our forecast for real GDP growth to 2¼ percent in 2008. As a result, the unemployment rate edges up in our forecast, reaching nearly 5 percent by the end of next year. The modest amount of slack that this entails should help bring about the desired gradual reduction of inflation in the future. Readings on core PCE prices have been quite tame for some time now, rising only 0.1 percent in each of the past four months. Although a portion of the recent deceleration in core prices likely reflects transitory influences, the underlying trend in core inflation still appears favorable. We anticipate that the core PCE price index will rise 2 percent this year and that core inflation will gradually ebb to around 1.8 percent over the forecast period. This forecast is predicated on continued well-anchored inflation expectations and the eventual appearance of a small amount of labor market slack, as I just mentioned. For some time now, I’ve thought an argument could be made that the NAIRU was a bit lower than assumed in the Greenbook, and the new evidence that structural productivity growth has been lower than we thought for more than three years reinforces this view. It means that the relatively good inflation performance over this period occurred despite the upward pressure that must have been operating because of the deceleration in structural productivity. In any event, I also expect to see modest downward pressure on inflation in the next couple of years from the ebbing of the upward effects of special factors, including the decline in structural productivity, energy and commodity prices, and owners’ equivalent rent. In terms of risk to the outlook for growth, the housing sector obviously remains a serious concern. We seem to be repeatedly surprised with the depth and duration of the deterioration in these markets; and the financial fallout from developments in the subprime markets, which I now perceive to be spreading beyond that sector, is a source of appreciable angst. Of course, financial conditions have deteriorated in markets well beyond those connected with subprime instruments or even residential real estate more generally. It appears that participants are questioning structured credit products in general, the risk assessments of the rating agencies, and the extent of due diligence by originators who package and sell loans but no longer hold a very sizable fraction of these originations on their own balance sheets. The Greenbook has long highlighted, and we have long worried about, the possibility and potential consequences of a broader shift in risk perceptions. With risk premiums having been so low by historical standards, it would hardly be surprising to see them rise, making financial conditions tighter for any given stance of monetary policy. While it remains possible that financial markets will stabilize or even reverse course in the days and weeks ahead, the possibility that the financial markets are now shifting to a historically more typical pattern of risk pricing is very much on my radar screen. Should this pattern persist and possibly intensify, it will have very important implications for policy." FOMC20080805meeting--128 126,MR. HOENIG.," Mr. Chairman, let me say that the Tenth District probably, on the whole, performed a little better than the national average in the industries that we have; but in terms of job growth, it has slowed. At the same time, we're still adding jobs in the region, and our unemployment rate remains relatively low compared with national measures. Although wage pressures actually do show some elevation relative to our Beige Book survey, they have obviously eased a bit in recent months. But it's interesting that, as we talk and monitor the labor conditions and we talk to some of the labor unions, there is a great understanding that they're losing ground. They are going to begin entering contracts at the end of this year and in the next year, and how they approach that is extremely important because, again, they are looking and talking now about costof-living adjustments and those sorts of things, which gives me some pause. According to our manufacturing survey, our activity actually strengthened in July, although the expectations for future activity have diminished somewhat. Not surprisingly, manufacturers producing energy and agriculture and in export-related markets continue to operate at relatively high levels whereas the other areas within the District are showing some slowdown. Let me talk just a second about oil. Although oil prices have declined, as was noted, they are still high enough that capital spending and production remain elevated and look to remain so in the foreseeable future. In fact, some of our industry contacts suggest that, as long as expected prices for oil remain in the $70 to $80 range, there should continue to be a fair amount of investment in that particular sector. As you well know from reading the Wall Street Journal, we did have the SemGroup go bankrupt in the Tulsa area. It has had, I think, fairly confined effects. One of our regional banks took some pretty heavy losses. They're very well capitalized and did recapitalize some of it, so they've not been dramatically affected by it. Local producers are in the worst bind because they haven't been paid for some of the oil delivered and there's no other party to contract with for future deliveries. So that has brought a lot of uncertainty in the local area about where to provide some of this oil that they're producing. In my discussions with businesses around the District, it's interesting that there's a lot more conversation about and focus on managing your price strategy in this environment. As has been true for a while, fuel surcharges are prevalent, and firms are able to pass those along with a fair amount of ease. In addition, businesses are reporting that materials suppliers are placing 10-day to 30-day time limits on their price quotes. Finally, most price indexes in our manufacturing survey remain near historically high levels, and plans for future pass-throughs have actually intensified. Turning to the national outlook, my outlook for growth has not changed materially since the last meeting. I expect that growth will slow in the second half because of these higher energy prices, some weakness in the labor market, and sluggish activity in some of the manufacturing sectors. The fact is that the uncertainty regarding the economic outlook is considerable, and downside risk to growth in the near-term future is there. These risks are being addressed, from our perspective, by our current stance of accommodative monetary policy. So we are addressing that uncertainty. The point I would like to make is that I'm less uncertain about the outlook for core inflation. We have seen erosion in longer-term inflation expectations, and I believe inflation risks have actually risen. If core inflation rises in the second half as expected, there is a real possibility that inflation expectations will become unanchored, especially if we maintain our current accommodative stance of policy. An expected leveling-off of food and energy prices and slack in the economy could help moderate upward pressure on inflation, but I do not think they will be enough to actually bring inflation down to an acceptable level. In fact, if we maintain the funds rate at 2 percent, I think inflation is more likely to move higher than lower over the medium term, and that concerns me. Thank you. " FOMC20080318meeting--57 55,MR. LOCKHART.," Thank you, Mr. Chairman. Reports from my directors and business contacts are consistent with what others have said this morning--that overall economic growth has slowed appreciably since the beginning of the year. Pessimism about the near-term outlook has increased. At the same time, many are troubled by the continued elevation of prices and price level increases and are apparently becoming less convinced that inflation will moderate any time soon. In my view, the deliberations this morning and the decision we make must be about, first, financial system stability--the threat to the broad economy of severe financial instability-- and, second, inflation risk and the role of rate policy in response to immediate problems. One addition to the list of concerns is the continuing dollar depreciation since we met last and its role in price pressures and overall uncertainty. In the run-up to this meeting, I heard little that casts doubt on where the economy is trending. My assessment is that we have entered recession territory. Previous forecasts premised improvement in the second half on the stabilization of house prices and financial markets. Neither has materialized, nor are there early encouraging signs. In the current circumstances, financial stability must be priority one. That said, the inflation picture has become quite troubling. Headline inflation, perhaps excluding last month, has been elevated since late summer, as have measures of core inflation, though less so. The expected easing of pressures hasn't yet convincingly set in. A longer view leads to the conclusion that inflation has been relatively high, on average, since 2005. We must be mindful of this as we address financial stability concerns. I mentioned the dollar's trajectory when I listed what in my view are the relevant considerations today. I am concerned about what I perceive as growing mention of the possibility of a dollar currency crisis. Although only one conversation, I also heard mention of a developing dollar carry trade fueled by interest differentials, expected rate cuts, and possibly the view that recessionary conditions will persist for some time. Policy is often a balancing act, but I see our current constraints as tightening. The real side has entered recession in all probability. There is increasing risk to the inflation objective. Financial stability is profoundly in play, exacerbated by the trajectory of the dollar, although to be measured about this, I think the current round of financial market problems has not yet thrown the economy irreparably off balance. I intend to support a downward rate move today, but with reservations about the utility of continuing cuts in addressing financial stability problems. Discussion in the policy round may address this, but I will comment now that balancing our policy objectives in such a risk-laden environment may require decoupling rate policy from liquidity measures. Thank you, Mr. Chairman. " FOMC20060629meeting--93 91,MR. STONE.," Thank you, Mr. Chairman. Economic activity in the Third District is also moderating in the second quarter. Our pattern is similar to that of the nation, but the District had less acceleration in the first quarter and less deceleration in the second quarter. Payroll employment growth in our three states is slowing. The unemployment rate has edged up slightly over the past several months, but the unemployment rate in most of the District’s labor markets is still lower than a year ago. Our business contacts still report some difficulty in filling open positions, and a quarter of the respondents to a special question in our Business Outlook Survey of Manufacturers say that the increases in wage rates needed to attract new hires this year are higher than they were last year. Regional manufacturing activity continues to expand at a moderate pace, but the indexes for new orders and shipments were up noticeably after a one-month slump in May. Despite this improvement, our manufacturers’ expectations about future activity have deteriorated. While they still plan to add to payrolls and expand capacity over the next six months, they have moderated these plans since the beginning of the year. At the last meeting, I reported that, in contrast to other Districts, retailers in our region did not express much concern that higher gasoline prices would eat into their sales; that view has changed. Conditions in our construction sector are similar to what I reported at our last meeting. Nonresidential construction continues to strengthen, but the acceleration doesn’t appear to be as strong as elsewhere in the nation. In contrast, residential construction in our three states has been flat this year, and home sales are down. Thus far the slowing in our region looks to be an orderly process. Unfortunately, consumer prices in the Philadelphia region appear to be increasing at a faster pace than those in the nation as a whole, primarily because of a larger increase in housing costs in the Philadelphia metropolitan area than in the nation. In addition, our manufacturers report that industrial price pressures have increased in recent months. Fortunately, we do not see a similar acceleration in labor costs, although the increases we are seeing in the Northeast are somewhat higher than in other parts in the country. In summary, current conditions and the outlook in our region continue to be positive, but the rate of expansion is expected to be somewhat more modest than we’ve seen over the past year. Price pressures continue to be a concern in our region. Turning to the national front, I would characterize the outlook in a similar way. Our growth forecast is similar to the Greenbook’s for 2006. We expect a significant slowing in activity in the second quarter followed by a pickup during the second half of the year to a pace that is slightly below potential. The slowdown in housing and high gasoline prices contribute to a slowdown in consumer spending, and the lagged effects of rising short-term interest rates and higher oil prices keep real growth slightly below potential. Our forecast for 2007 differs somewhat from the Greenbook. We see growth in 2007 slightly below that in 2006, whereas the Greenbook sees growth slowing appreciably. In our view, there has been more underlying strength in the economy. For example, we attribute more of the second-quarter slowdown to temporary factors. We are more optimistic than the Greenbook about employment growth. We see nonfarm payroll growth averaging a good deal more than the Greenbook forecast. We see unemployment rising to 5.1 percent by the fourth quarter of next year. Our inflation outlook is less optimistic than the Greenbook’s partly because we see less slowing of aggregate demand. We do not see core PCE inflation decelerating next year. We think the economy has been operating and will continue to operate slightly beyond full employment over the next several quarters and that foreign price competition will ease as the dollar depreciates. So despite our view that the indirect effects of the sharp rise in energy prices will wane in 2007, we expect core inflation not to decelerate. We do see some deceleration in 2008, but that is because we built in a slightly higher path for interest rates than that in the Greenbook forecast. Of course, there are risks to the forecast. Most of them have been mentioned; but in our view, the risks to growth, even at our higher level of growth, are roughly balanced. In contrast, the inflation risks are slightly to the upside. As people have noted, core inflation has accelerated in recent months, and it is above the range I consider consistent with price stability. Should aggregate demand moderate less than expected, there is a risk that strong inflation pressures could emerge. At this point, I believe that longer-run inflation expectations remain anchored, and our forecast is predicated on monetary policy ensuring that the recent high inflation readings do not raise longer-term expectations. This is likely my last meeting, but for sure I’ll be watching carefully as we go forward. I have confidence that the Committee, along with the new Philadelphia president, will do a good job to make sure that inflation expectations remain anchored. I’d like to thank the Chairman, the participants, and the rest of this staff for how well you have treated me over the past three meetings. I have to remember that I made the statement in June 2000 that it would be my last meeting, so I say “in the foreseeable future” [laughter] it will be my last meeting. Thank you very much." FOMC20080625meeting--82 80,MR. BULLARD.," Thank you, Mr. Chairman. The District economy continues to be sluggish. Severe weather, combined with a very wet spring, is hampering agriculture in some areas. Major flooding has caused significant damage already, and the situation continues to develop. Many business contacts in the District emphasize energy costs along with some other high commodity prices as an overriding concern. Most of the descriptions I have encountered concern businesses and consumers scrambling to adjust to new pricing realities. Many contacts are reporting skittishness over the inflation outlook, fueled by dramatic increases in key commodity prices. Many contacts with deep experience in the commodities markets remain convinced that market manipulation or speculation is behind the run-up in commodity prices across the board over the past several years. This belief is widespread and deeply held. Many predict a crash in market prices of these commodities once the bubble bursts. My assessment is that this very strong belief may, by itself, have important macroeconomic implications. Businesses and households may be reacting very differently to price increases that they see as temporary, as opposed to their reaction if they view price increases as permanent and unlikely to reverse. Reports on the level of economic activity are decidedly mixed. The housing sector remains in a deep slump and subject to a widespread shakeup. Business in the energy sector continues to boom. High energy prices are affecting the logistics business, which has to try to be profitable at higher prices with reduced demand. Still, a very large retailer reports brisk activity, and a large technology firm is essentially unaffected by the macroeconomic slowdown. Recent data on the U.S. economy have been stronger than forecast, keeping economic performance weak but avoiding a particularly sharp contraction. The worst outcomes stemming from financial market turmoil have failed to materialize thus far. There is, to be sure, still some potential for additional upheaval, depending in part on the managerial agility among key financial firms. However, the U.S. economy is now much better positioned to handle financial market turmoil than it was six months ago. This is due to the lending facilities now in place and to the environment of low interest rates that has been created. Renewed financial market turmoil, should it occur during the summer or fall, would not now be as worrisome from a systemic risk perspective. In addition to this lessened risk from financial markets, I see the drag from housing dissipating during the second half of the year. Most likely we will also see a moderation in energy price increases. Output growth is, therefore, likely to be moderately stronger going forward. Policy was very aggressive during January and March of this year. This was, in part, a preemptive action, insurance against a particularly severe downturn brought on by financial contagion. This was a very real possibility, but it did not materialize. This has created a situation with more stimulus in train than would have been intended had we known the outcome in advance. This is putting upward pressure on inflation and inflation expectations in the second half of this year. Policy has to turn now to face this situation. On the long-term projections, I think it is a good idea to put down long-term projections. I am happy with any of the options. I have a slight preference for option 3. I think a trial run would be good. If the objective is to name these numbers, such as an inflation target or the potential growth of the economy, another way to do it would just be to name those numbers and not have it tied to any projection or any particular year. We could just say, ""This is what I think the inflation objectives should be. This is how fast I think the economy could grow in the absence of shocks. And this is what I think the unemployment rate would be if output were growing at potential and inflation were at target."" You could just name those numbers. You wouldn't have to say five years away or ten years away, which kind of brings in new long-run factors that you might not want to get into. Thank you. " FOMC20070807meeting--96 94,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. The balance of risks has changed since our last meeting—significantly, in my view. Overall spending by households and businesses is weaker. Housing, of course, is significantly worse, and the underlying pace of productivity growth and potential growth seems lower. In addition, financial market developments have deteriorated with a very broad based increase in risk premiums, decline in some asset prices, pockets of liquidity pressures, and some disruption in mortgage markets and high-yield corporate credit markets. These developments in financial markets, even though they represent a necessary adjustment, a generally healthy development, have the potential to cause substantial damage through the effects on asset prices, market liquidity, and credit; through the potential failure of more-consequential financial institutions; and through a general erosion of confidence among businesses and households. If this situation were to materialize and these effects were to persist, they could have significant effects on the strength of aggregate demand going forward. The process now under way in financial markets could take some time to resolve, and finding a new balance could take a while. We have modified our forecast in ways similar to the changes to the Greenbook. We have a slightly weaker second half of ’07 and a slightly lower estimate of growth in ’08 and ’09, reflecting a downwardly revised estimate of potential growth. Our growth numbers for ’07, ’08, and ’09 look roughly like 2½ rising to 2¾ percent. Our inflation forecast is essentially unchanged, with core PCE inflation moderating to slightly under 2 percent over the forecast period. Our differences with the Greenbook are not trivial, but they seem well within the somewhat greater uncertainty we now face about the outlook for growth. The negative skew in our view of the risks to the outlook suggests a somewhat downward slope to the path of the fed funds rate going forward, to the appropriate stance of monetary policy, rather than the flat path assumed by the Greenbook. So even if financial market conditions stabilize and credit markets, particularly the mortgage markets, find equilibrium relatively soon and start to open up again, the growth risks have shifted a bit more to the downside around the lower expected path. In contrast, if the disruption in credit markets persists and liquidity markets are further impaired, then we face the prospect of a significantly weaker path to aggregate demand. Inflation risks in our view, however, remain slightly tilted to the upside, but these types of risk are very different. The inflation risks are modest and manageable. We characterize them as skewed to the upside in part because of the differences across the Committee as to our desired individual long-run views about the inflation level, in part because of our differences as to what’s an acceptable period for bringing core inflation down to that objective, and in part because of different views about the structure of inflation dynamics in this economy. The risks to markets and ultimately to growth are very different. There’s a much longer negative tail in terms of the range of potential outcomes, and those risks are going to be harder for us to manage, partly because they depend on confidence. Because of these differences, I think it’s hard to counterpoise these two risks against each other and assess the balance between them. Of course, as always, we should weigh each by their probability, their effects, and our capacity to manage those effects. I think that the probability of a bad inflation outcome has diminished from what we would have said two quarters ago and the probability of an adverse growth outcome has increased. As I said, the latter risk is interesting and complicated in part because it might be harder to manage. I want to make two points in this regard. First, a number of you have said that we want to see more evidence of adverse effects on aggregate demand before we change our view about the appropriate path of monetary policy. I don’t really think that’s the right way to think about this. If we took that approach, we’d inevitably be too late. Just as we think about inflation risks by looking forward and looking at expectations, we need to be forward looking and thinking about the potential implications of these dynamics of financial markets on the growth outlook. The information we have now about what’s happening in markets and about the implications for credit markets and ultimately for confidence and demand is very stale and uneven. My second observation about this challenge is that what makes it hard is partly that you are seeing a combination of things. You are seeing a loss of confidence in the capacity of investors to assess underlying risk in mortgage markets in part because of uncertainty about what housing prices are going to do and in part because of uncertainty about correlations in losses across households. You are also seeing a collapse in confidence, as Bill described it, in how to value complex structured credit products, probably from the loss of faith in ratings and from the changes ahead in ratings methodology and in actual ratings. You’re also seeing the difficulties that investors and counterparties now have in evaluating the risk in exposure to financial counterparties, and you’re seeing in some ways reflecting all of this a diminished willingness to finance what’s relatively high quality paper. We live in a system in which risk has been transferred much more broadly, but a lot of that risk has gone to leveraged funds that have much less capacity to absorb this kind of shock without facing a lot of liquidity pressures. The combination of these things means that you’re seeing some impairment in the natural dynamic by which, when prices adjust, you have new people coming in willing to buy at those low prices. But these challenges in information and in diagnosing what’s happening in markets mean that the process is not working as quickly as you might have thought in mortgages and in high-yield corporate credit. You can see this sort of skew in the risks reflected, I think sensibly, in the change of market expectations about the fed funds rate. You can see this balance in the distribution that Bill described, where you see a sharply negative skew in expectations about the path on the downside, and you see that come also in the context of relative stability of inflation expectations. That shift of mean expectations, in the distribution, does not come with any sense that the consequence might be some erosion in confidence about our capacity to keep inflation expectations down. Now, in terms of policy, I personally wouldn’t want to lean against the change in market expectations that we’ve seen so far, even though it has moved a long way in a short time. It’s really important to give ourselves more flexibility than we now have to respond to what could be a rapidly deteriorating overall environment; that’s just pragmatically essential, given that the range of foreseeable monetary policy actions we’re likely to confront has broadened very substantially relative to where we were a quarter ago. The challenge, of course, is to figure out a way to acknowledge and to show some awareness of these changes in market dynamics without feeding the concern, without overreacting, about underlying strength in the fundamentals of the economy as a whole or in the financial system. That is a difficult balance, but I think it requires some softening of the asymmetry in our assessment of the balance of risks now. An advertisement in response to a bunch of points made so far, including by President Fisher—the Morning Call that Bill Dudley’s staff runs from New York is a very good, fairly textured prism of what’s happening across these markets. They do a good job of trying to integrate a bunch of the anecdotes and the facts, and it’s the most efficient device any of us have to check in about that evolving balance. It won’t satisfy everybody’s demand to have as much information as is out there, but it’s a fairly efficient way to get a pretty good picture, and so I commend that to you. It’s a really good, thoughtful, and reasonably deep collection of wisdom in the markets today." CHRG-110shrg50369--143 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System February 28, 2008 Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. In my testimony this morning I will briefly review the economic situation and outlook, beginning with developments in real activity and inflation, then turn to monetary policy. I will conclude with a quick update on the Federal Reserve's recent actions to help protect consumers in their financial dealings. The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted; and pressures on bank capital and the continued poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domestic product (GDP) held up well through the third quarter despite the financial turmoil, but it has since slowed sharply. Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate--at 4.9 percent in January--has moved up somewhat. Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market. In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course. Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in most areas. Changes in the availability of mortgage credit amplified the swings in the housing market. During the housing sector's expansion phase, increasingly lax lending standards, particularly in the subprime market, raised the effective demand for housing, pushing up prices and stimulating construction activity. As the housing market began to turn down, however, the slump in subprime mortgage originations, together with a more general tightening of credit conditions, has served to increase the severity of the downturn. Weaker house prices in turn have contributed to the deterioration in the performance of mortgage-related securities and reduced the availability of mortgage credit. The housing market is expected to continue to weigh on economic activity in coming quarters. Homebuilders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and closely related industries. Consumer spending continued to increase at a solid pace through much of the second half of 2007, despite the problems in the housing market, but it appears to have slowed significantly toward the end of the year. The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in spending, as did the declines in household wealth associated with the weakness in house prices and equity prices. Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the 3 months ending in January, compared with an average increase of almost 100,000 per month over the previous 3 months. However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year. The business sector has also displayed signs of being affected by the difficulties in the housing and credit markets. Reflecting a downshift in the growth of final demand and tighter credit conditions for some firms, available indicators suggest that investment in equipment and software will be subdued during the first half of 2008. Likewise, after 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 a more encouraging note, we see few signs of any serious imbalances in business inventories aside from the overhang of unsold homes. And, as a whole, the nonfinancial business sector remains in good financial condition, with strong profits, liquid balance sheets, and corporate leverage near historical lows. In addition, the vigor of the global economy has offset some of the weakening of domestic demand. U.S. real exports of goods and services increased at an annual rate of about 11 percent in the second half of last year, boosted by continuing economic growth abroad and the lower foreign exchange value of the dollar. Strengthening exports, together with moderating imports, have in turn led to some improvement in the U.S. current account deficit, which likely narrowed in 2007 (on an annual basis) for the first time since 2001. Although recent indicators point to some slowing of foreign economic growth, U.S. exports should continue to expand at a healthy pace in coming quarters, providing some impetus to domestic economic activity and employment. As I have mentioned, financial markets continue to be under considerable stress. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the financial markets in recent months. To help relieve the pressures in the market for interbank lending, the Federal Reserve--among other actions--recently introduced a term auction facility (TAF), through which prespecified amounts of discount window credit are auctioned to eligible borrowers, and we have been working with other central banks to address market strains that could hamper the achievement of our broader economic objectives. These efforts appear to have contributed to some improvement in short-term funding markets. We will continue to monitor financial developments closely. As part of its ongoing commitment to improving the accountability and public understanding of monetary policy making, the Federal Open Market Committee (FOMC) recently increased the frequency and expanded the content of the economic projections made by Federal Reserve Board members and Reserve Bank presidents and released to the public. The latest economic projections, which were submitted in conjunction with the FOMC meeting at the end of January and which are based on each participant's assessment of appropriate monetary policy, show that real GDP was expected to grow only sluggishly in the next few quarters and that the unemployment rate was seen as likely to increase somewhat. In particular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2\1/2\ percent to 2\3/4\ percent projected in our report last July. FOMC participants' projections for the unemployment rate in the fourth quarter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4\3/4\ percent projected last July for the same period. The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial turmoil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend and the unemployment rate edging lower; the improvement reflects the effects of policy stimulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets. The incoming information since our January meeting continues to suggest sluggish economic activity in the near term. The risks to this outlook remain to the downside. The risks include the possibilities that the housing market or labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further. Consumer price inflation has increased since our previous report, in substantial part because of the steep run-up in the price of oil. Last year, food prices also increased significantly, and the dollar depreciated. Reflecting these influences, the price index for personal consumption expenditures (PCE) increased 3.4 percent over the four quarters of 2007, up from 1.9 percent in 2006. Core price inflation--that is, inflation excluding food and energy prices--also firmed toward the end of the year. The higher recent readings likely reflected some pass-through of energy costs to the prices of core consumer goods and services as well as the effect of the depreciation of the dollar on import prices. Moreover, core inflation in the first half of 2007 was damped by a number of transitory factors--notably, unusually soft prices for apparel and for financial services--which subsequently reversed. For the year as a whole, however, core PCE prices increased 2.1 percent, down slightly from 2006. The projections recently submitted by FOMC participants indicate that overall PCE inflation was expected to moderate significantly in 2008, to between 2.1 percent and 2.4 percent (the central tendency of the projections). A key assumption underlying those projections was that energy and food prices would begin to flatten out, as was implied by quotes on futures markets. In addition, diminishing pressure on resources is also consistent with the projected slowing in inflation. The central tendency of the projections for core PCE inflation in 2008, at 2.0 percent to 2.2 percent, was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices. Beyond 2008, both overall and core inflation were projected to edge lower, as participants expected inflation expectations to remain reasonably well-anchored and pressures on resource utilization to be muted. The inflation projections submitted by FOMC participants for 2010--which ranged from 1.5 percent to 2.0 percent for overall PCE inflation--were importantly influenced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate and about the time frame over which policy should aim to attain those rates. The rate of inflation that is actually realized will of course depend on a variety of factors. Inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect. Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate. Indeed, the further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month. Should high rates of overall inflation persist, the possibility also exists that inflation expectations could become less well anchored. 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 could reduce the flexibility of the FOMC to counter shortfalls in growth in the future. Accordingly, in the months ahead, the Federal Reserve will continue to monitor closely inflation and inflation expectations. Let me turn now to the implications of these developments for monetary policy. The FOMC has responded aggressively to the weaker outlook for economic activity, having reduced its target for the federal funds rate by 225 basis points since last summer. As the Committee noted in its most recent post-meeting statement, the intent of those actions has been to help promote moderate growth over time and to mitigate the risks to economic activity. 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. In particular, the FOMC will need to judge 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 FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. 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. Finally, I would like to say a few words about the Federal Reserve's recent actions to protect consumers in their financial transactions. In December, following up on a commitment I made at the time of our report last July, the Board issued for public comment a comprehensive set of new regulations to prohibit unfair or deceptive practices in the mortgage market, under the authority granted us by the Home Ownership and Equity Protection Act of 1994. The proposed rules would apply to all mortgage lenders and would establish lending standards to help ensure that consumers who seek mortgage credit receive loans whose terms are clearly disclosed and that can reasonably be expected to be repaid. Accordingly, the rules would prohibit lenders from engaging in a pattern or practice of making higher-priced mortgage loans without due regard to consumers' ability to make the scheduled payments. In each case, a lender making a higher priced loan would have to use third-party documents to verify the income relied on to make the credit decision. For higher-priced loans, the proposed rules would require the lender to establish an escrow account for the payment of property taxes and homeowners' insurance and would prevent the use of prepayment penalties in circumstances where they might trap borrowers in unaffordable loans. In addition, for all mortgage loans, our proposal addresses misleading and deceptive advertising practices, requires borrowers and brokers to agree in advance on the maximum fee that the broker may receive, bans certain practices by servicers that harm borrowers, and prohibits coercion of appraisers by lenders. We expect substantial public comment on our proposal, and we will carefully consider all information and viewpoints while moving expeditiously to adopt final rules. The effectiveness of the new regulations, however, will depend critically on strong enforcement. To that end, in conjunction with other federal and state agencies, we are conducting compliance reviews of a range of mortgage lenders, including nondepository lenders. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of, and improved enforcement for, all categories of mortgage lenders. The Federal Reserve continues to work with financial institutions, public officials, and community groups around the country to help homeowners avoid foreclosures. We have called on mortgage lenders and servicers to pursue prudent loan workouts and have supported the development of streamlined, systematic approaches to expedite the loan modification process. We also have been providing community groups, counseling agencies, regulators, and others with detailed analyses to help identify neighborhoods at high risk from foreclosures so that local outreach efforts to help troubled borrowers can be as focused and effective as possible. We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue. In addition to our consumer protection efforts in the mortgage area, we are working toward finalizing rules under the Truth in Lending Act that will require new, more informative, and consumer-tested disclosures by credit card issuers. Separately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards. Using the Board's authority under the Federal Trade Commission Act, we expect to issue proposed rules regarding these practices this spring. Thank you. I would be pleased to take your questions. FOMC20070321meeting--157 155,MS. YELLEN.," Thank you, Mr. Chairman. I support the Bluebook alternative B, both leaving the federal funds rate unchanged and also the language basically as it stands. I think the current stance of policy is likely to foster an economy that gradually moves toward a soft landing of the type portrayed in the Greenbook forecast, but obviously I have become much more focused on the downside risk to economic activity since we met in January. On the inflation front, the news hasn’t much altered my view. I still think core inflation is likely to edge down this year and next, but I certainly think it’s too soon to conclude that any new lower trend has set in. And I do definitely see upside risks, given that labor markets are still somewhat tight, oil prices have risen, and the dollar has fallen. So for me, the risks do seem more balanced in the sense that there are downside risks to real activity and upside risks to inflation; and I think it is appropriate—I agree with Cathy’s comments—to reflect that in the statement. For a minute I contemplated supporting the language about the risk assessment in alternative A; but really, upon further reflection, I like alternative B very much. The shift to “future policy adjustments” from “firming” appropriately hints at downside risk, as we all recognized in our discussion yesterday. I agree with Vince that it creates greater policy flexibility for us and lets the market work in this stabilizing manner. Even so, it does retain an asymmetric bias, which I think markets expect; and I consider it reasonable because, on the whole, I do remain somewhat more concerned about inflation risk, and it is wise for our message on that to be consistent over time." FOMC20050630meeting--374 372,VICE CHAIRMAN GEITHNER.," Thank you. We’re somewhat more confident in the strength and sustainability of the expansion than we were in May. Our view is very similar to the staff forecast. We expect real GDP growth to average roughly 3½ percent over the forecast period. We expect core PCE to follow a somewhat higher path and to end the forecast period slightly higher than we expected in May, at just under 2 percent. This forecast assumes that we’ll continue to tighten monetary policy, perhaps by a bit more than foreseen in the staff forecast and than is currently priced into the market. To us, the risks to this forecast seem roughly balanced. We see no new sources of potential risk. This is not to say June 29-30, 2005 138 of 234 daunting. It’s worth noting, though, that these risks—from a cliff in housing prices to a sharp increase in household saving, to a larger and more sustained oil shock, to less favorable future productivity outcomes, to a sharp increase in risk premia or to declines in asset prices—in general are risks that we can’t really mitigate substantially ex ante through monetary policy. However, by making sure we get the real fed funds rate up to a more comfortable level we can help. The alternative strategy, to oversimplify it, would be to follow a softer path for monetary policy to provide a preemptive cushion against the negative effects on employment of a fall in housing prices, a rise in risk premia, some rise in saving and a fall in consumption, and so forth. This would, I believe, be a less prudent strategy. Although there have been persistent concerns about the vulnerability of this expansion and about some of its less robust characteristics, the two most remarkable aspects of this recovery are encouraging. The first is its resilience. So far, each episode of incipient softness has proved to be shallow in depth and short in duration. Despite very prolonged and substantial headwinds in the context of an oil shock, a large ongoing drag from net exports, a significant tightening of financial conditions, a modest withdrawal of fiscal stimulus, etc., quarterly GDP growth—as Janet said— has shown impressive stability around a 3½ percent annual rate over the last year and a half. And this is a dramatic reduction in realized macroeconomic volatility. It makes the much-heralded “great moderation” look turbulent. The second positive feature of this period has been the behavior of underlying inflation and inflation expectations. Of course, underlying inflation seems to have moved up a bit, but large changes in oil and commodity prices and import prices have produced periods of substantial acceleration in headline inflation without, at least to this point, causing more than short-lived June 29-30, 2005 139 of 234 The behavior of productivity growth and expectations about future productivity growth explain some of this. Also important, of course, is the credibility engendered by the record of the FOMC. Changes in the structure of the financial system must matter, too. There are almost surely other factors—luck for one—that are at work. Among the choices in Vincent Reinhart’s note on interest rates, I’m inclined to support the more benign assessment of the recent behavior of forward interest rates and term premia, even though these factors can’t fully explain those moves, and even though the future may prove to be more volatile and adverse than the markets now seem to expect and than those explanations would imply. So what about monetary policy going forward? There are two salient dimensions of the forecast. One, of course, is growth slightly above trend from a starting point where the remaining amount of resource slack, if any, is substantially diminished. The other is an underlying inflation rate—just to focus on the core PCE—that now seems to be running at a modest margin above 1.5 percent and that we expect will end the forecast period above 1.5 percent. And inflation expectations, at the horizon over which monetary policy operates and with reasonable adjustments to translate them into a view on the PCE deflator, are still some margin above 1.5 percent. We don’t consider this inflation forecast a cause for serious concern. We anticipate upward pressures on inflation from some firming of compensation growth and from higher unit labor costs. We expect those pressures will face the countervailing forces of relatively moderate inflation expectations, strong competitive pressures, still substantial profit margins, the potential for some increase in the labor force participation rate, and pretty strong expected future productivity growth. And yet it should matter to us that, even in a world where the nominal fed funds rate peaks June 29-30, 2005 140 of 234 meaningfully above 1.5 percent. The range of estimates in the forecasts and model simulations before us, and the expectations we can derive from the market, place the terminal rate of the nominal fed funds rate now between 3½ and 4½ or between 3¾ and perhaps 4¼ percent. These estimates have moved down a bit over the last few months, but the shape of the path has steepened a bit. I don’t think we really know how much confidence we can have in these estimates, even if the forecast unfolds as we expect today. But my view remains that we are better off following a path that would put us at the higher end of these estimates than in taking the risk of doing too little and stopping prematurely or trying to manage the communication challenges of a temporary pause when we still believe we have further to go. Thank you." FOMC20080625meeting--90 88,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. I think we face an extended period of relatively weak economic growth, quite weak domestic demand growth, and overall growth significantly below trend. I think this is both likely and necessary. It's likely because we have more weakness ahead as the housing drag continues, financial headwinds remain acute, the economy adjusts to the very large and sustained energy price shock, the saving rate increases, and global demand moderates. It's necessary to achieve a reasonable inflation outcome over the forecast period. Our central projection has the U.S. economy growing, though at a rate significantly below potential, and then recovering gradually toward trend over the next year. This is our modal forecast; and in this forecast, the economy just skirts a recession. The output gap begins to narrow over the forecast period. Housing prices begin to stabilize only late in '09, after a cumulative peak-to-trough drop of roughly 12 percent, using the OFHEO repeat sales purchase-only index. Net exports provide a significant, though fading, boost to GDP growth this year and next. We project a very gradual, very modest moderation in core inflation over the forecast period. Of course, this forecast depends on a lot of things happening. It depends on expectations remaining reasonably well contained, energy and commodity prices following the futures curve, the dollar only modestly weaker, somewhat diminished pressure on resource utilization here and around the world, and continued moderate growth in compensation and unit labor costs. Our policy assumption builds in significant tightening--a significant move up in the fed funds rate over the forecast period--though not as soon as the market now expects. The uncertainty around and risks to this central projection are substantial. On the growth front, although we believe the risks of a very deep, prolonged economic downturn have diminished--not on their own but because of the force of the policy response so far--we still think the risks are weighted significantly to the downside. The main risks remain: the ongoing stress on financial markets; the risk that this further restricts the supply of credit, exacerbates financial conditions, pushes home prices and other equity prices down more further tightening credit conditions, et cetera; a steeper-than-expected rise in the saving rate; and the adjustment to the ongoing drag from energy prices. On the inflation front, we--I think like the rest of you--see the risks ahead tilted somewhat to the upside for many obvious reasons. I think it's true that, looked at together, the mix of measures of inflation expectations suggests that private agents may have less confidence in the FOMC's commitment to price stability than they did in previous periods when total inflation was running significantly above core. So this is going to be a very challenging period for policy. It's not all terrible. Productivity growth is a little higher than we thought. Underlying inflation and long-term inflation expectations certainly could already have been showing signs of a more compelling, immediate danger. Spending has been somewhat stronger than confidence measures would have suggested. The current account balance has narrowed significantly. We are seeing very substantial changes in behavior across the U.S. economy in the consumption of energy. So there are good things to point to. But in the two dangerous areas--in the financial sector and in the global inflation environment--I think things are materially worse than at our last meeting. Again, the risk of inflation is readily apparent. Apart from the numbers, I agree with many of you who said that the alarm and concern is materially higher and materially different today across a broad range of firms in different industries than it was even as recently as two months ago. We have to be worried about intensified pressure on compensation growth even with the degree of slack that we now see in the labor market. Although firms are absorbing in margins a significant part of the increase in unit costs--and a lot of the complaining that we hear is about margins that are coming down and those that are expected to come down--I do think that firms are demonstrably able to pass on more than they would have been before. Of course, what makes it very hard for us is that the pressure on resources is coming largely from outside the United States and the other major economies, from countries that are growing significantly above trend with central banks that are not independent and are running very expansionary monetary policies. I think we are really seeing an alarming acceleration in inflation rates in large parts of the world for the first time in a couple of decades. If these countries do not tighten monetary policy sufficiently and reduce energy price subsidies materially, then we will have to be tighter than we otherwise would have to be. In the financial world, although I think it's true that the market believes there has been some significant reduction in the risk of an acute systemic financial crisis, I think we have a long period of acute fragility ahead. We're in the midst right now of more material erosion in sentiment, spreads, asset prices, balance sheet pressures, and liquidity in some markets. Overall financial conditions are probably somewhat tighter than when we last met. The financial headwinds have intensified again, and they are likely to remain intense for some time. Again, I think this is going to be a very challenging road ahead. It is important to recognize that the current stance of policy embodies not just the fed funds rate today, relative to our best measure of equilibrium, but also the expectations about policy that are now built into the Treasury curve. That policy today does not look that accommodative. If you look at the Bluebook charts and at a range of measures of real fed funds rates today relative to different measures of equilibrium, policy is less accommodative just on that simple measure than it was at the most accommodative point of the last two downturns. That said, we're going to have to tighten monetary policy, and the question is when. My sense is soon but not yet. Right now we still face a very delicate, very fine balance and have to be careful not to declare victory prematurely on the growth front or on the financial front. I think it's going to be hard for us to do that until we see that we are closer to the point at which we can confidently say that we start to see the bottom in housing prices. Also, we have to be careful not to raise expectations too much that we're on the verge of an imminent, significant tightening in policy. It is a difficult balance. We should take some comfort from the fact that the market believes we will do enough soon enough to keep those expectations down. On the projections front, I have a complicated view, Mr. Chairman. I apologize. If we are going to change, we should focus on stuff that will change things significantly. I don't see huge gains from the changes in these options to our current communication regime. If we're going to change, a trial run in the fall is fine. But I think the fall is too soon to change. We need to get through this thing. We have a very challenging period with a lot of stuff going on, and I think we need to use every molecule of oxygen in the System to get through this mess. I don't think this projections change materially helps the communication challenge in getting through this mess and may complicate it in some ways. If we are going to do something beyond our current regime, I would favor doing something slightly different from this. I would favor at least considering publishing the average of our individual views on what the desirable long-run rate of inflation is, an average of our judgments of what trend growth is today, and maybe what the natural rate of unemployment is today. We know very little about what those latter variables--trend growth and the natural rate of unemployment-- are five to ten years ahead. It is very hard for us individually to put much confidence on whatever the path is toward that point. Our current regime for aggregating our forecasts the way we do, tossing out the individuals, makes our basic forecast not particularly useful as a prism. So I would focus on doing something slightly different to change the regime, and I wouldn't do it this soon. If we're going to change, let's debate the big things and not spend too much time on things at the margin, which fundamentally aren't going to offer too much promise relative to the level of ignorance we have or relative to the complexity that people face in reading any particular meaningful value in the aggregation of our forecasts the way we now do them. " FOMC20061025meeting--40 38,MR. MOSKOW.," Thank you, Mr. Chairman. Conditions in the Seventh District appear to be quite similar to what I reported last time. Except for housing and autos, activity remains on a solid footing, and most of our contacts are relatively optimistic about the outlook. For instance, the two large temp firms we talk to regularly both reported that, although billable hours were roughly flat, their clients were upbeat about the outlook. Furthermore, demand for workers in light industry—the segment most closely tied to the national business cycle—continued to grow. In terms of wages, both temp firms noted that compensation increases have been running much higher than last year at this time. The difficulties of the Big Three automakers continue to be a problem for our region and are showing through in the national numbers for the third quarter. These difficulties don’t stem from an overall lack of demand. Light vehicle sales continue to run at a pretty healthy pace, as the Greenbook notes. To some extent, the Big Three’s difficulties are a consequence of the energy price shock. Demand has shifted away from pickups and big SUVs, which have been their bread and butter. Despite the recent gas price declines, Ford and GM told us that they do not expect a reversal of this shift anytime soon. Otherwise, the District is doing reasonably well. I heard a lot of optimism. Indeed, a few contacts explicitly described the current slowdown as similar to the brief pause in the mid-1990s, which was followed by sustained expansion. Turning to the national outlook, clearly economic activity was soft during the third quarter, but the fairly solid growth in consumption and business fixed investment indicates that at least to date we have not seen a spillover of the weakness in housing to other sectors of the economy. This is consistent with the anecdotes that I’m hearing. Looking ahead, we expect several quarters of weak residential investment, but activity in other sectors should increase roughly in line with longer-run sustainable rates. Assuming market expectations for interest rates, we see GDP growth averaging modestly below potential over the next year and a half. We think growth will be a bit above potential in ’08. In our view, the underlying fundamentals— wealth, income, interest rates, and the current level of liquidity in the economy—should support a higher level of spending than what’s in the Greenbook baseline. Of course, a major risk for our outlook is that there could be more-substantial spillovers from the housing sector. As has been noted around this table, it could take some time for the weakness in housing demand to show through to house prices. I was hoping we could get more information, but it sounds as though the research isn’t there yet. If prices do fall substantially, a reduction in wealth could have serious ramifications for consumption and spending overall. It’s hard to say when we’ll have a clearer picture as to how events are unfolding. At some point, probably before the decline in the broad measures of housing prices, we’ll likely see early evidence in either anecdotes or risk spreads. Or if the risk is overstated, we may hear of improvements from our contacts. Turning to inflation, the projections from our models have not changed much with the incoming data. They still show core PCE inflation in ’08 coming in between 2.3 and 2.6 percent, depending on the period used to estimate the models. So I continue to have the same questions I had last time regarding the interplay between such inflation rates, inflation expectations, and Fed credibility: Will continued high levels of core inflation eventually make the public doubt our resolve to maintain low and stable inflation? Even if inflation is less persistent, as some have suggested, will it settle out at rates like those in the past few years—namely, 2 percent—rather than the 1.6 percent in the Greenbook’s less-persistent inflation scenario? Are the current long-run core PCE inflation expectations, which are likely above 2 percent, just simply too high? I’m quite concerned that the answers to these questions might be “yes.” If so, and the housing spillover risks fade, then we may have to act more forcefully than the Greenbook baseline policy assumption in order to ensure that inflation is more clearly headed into the range consistent with price stability." FOMC20070918meeting--131 129,CHAIRMAN BERNANKE.," Thank you, and thank you all. Let me just briefly summarize and make a few additional comments. Financial market conditions were a key theme of our discussion today. Recent developments in financial markets have been reflected in reduced willingness to take risk and in tighter credit conditions. Bank balance sheets are a potential constraint on credit extension. Participants were unsure about how long these conditions would persist, but the repricing of risk seems likely to be persistent. The tighter credit conditions will very likely weaken an already very weak housing market, as nonprime borrowers are rationed out and jumbo mortgage borrowers pay higher premiums. Mortgage rate resets and foreclosures pose further risks. Industries related to housing are naturally showing weakness. However, creditworthy borrowers are able to obtain credit. Second-quarter and third-quarter GDP figures may be solid, but even so there have been some signs of slowing in the economy, even before the financial market developments, notably in the labor markets and in housing. Auto output is also on the weak side. Labor markets do remain tight, and in general Main Street has been far less affected thus far than Wall Street. Consumer spending continues to grow along with incomes, and net exports remain strong. Financing should continue to be available for capital investment. There were some regional differences in soundings on business confidence and expectations, but in any case, uncertainty has increased. Some of the key questions include whether the further weakness of housing will spread to consumer spending; whether credit tightness will affect sectors other than housing, including the household sector and commercial real estate; and whether the labor market will continue to slow. There is a general view that downside risks to output have increased with some very bad scenarios at least conceivable. However, others noted the resilience of the U.S. economy and the fact that previous financial crises had not necessarily reduced growth. Inflation has moderated somewhat, and more participants view the risk to inflation as closer to balance. Inflation expectations remain stable, and cyclical slowing is likely to reduce the pressure on resources. However, tight labor markets, strong foreign demand, high oil prices, and other pressures still do exist. Are there any questions or comments? Let me just make, as I said, a few extra comments here. More so than usual, we have to look forward rather than backward. We have to try to assess how these recent developments change the outlook, and that is very difficult. To me, the critical elements to look at are housing and labor markets. I think the interaction of those two sectors will determine the dynamics of the economy. There has been some discussion about the fact that in 1998 there was very little effect of the financial markets on the real economy. There was no obvious channel of effect in that episode. In this case, there is, I think, a pretty clear channel of effect through mortgage lending, and we have already seen changes in availability of mortgages and changes in cancellations, sales expectations, and the like. I would note that there are also—as you can see in the consumer confidence numbers, for example—expectations on the buyer side. If buyers think that the housing market is going to be very weak, they will be less likely to want to get into it. Finally, credit availability to homebuilders may also be an issue. So I think there is pretty much a consensus that the housing sector will take another leg down based on financial market conditions. I mention parenthetically that I have some concerns also about a few other areas, notably commercial real estate, and perhaps others like consumer credit and autos as well; but, again, I think the focus should be on housing. On the labor side, I think we can parse the job report numbers in some detail. For example, on the one hand, the August report was not quite as weak as the markets thought it was. On the other hand, it revised down some previous numbers. So overall there seems to be a sense that labor markets were slowing a bit before the financial crisis. Even so, we have been expecting weakening in labor markets for some time, and I think now that the odds of that are really quite high. I do expect to see continued expansion in construction layoffs. There are losses of jobs, obviously, in mortgage finance and other related areas. So I don’t know how quickly the labor market will weaken, but I do believe that it will weaken over the next couple of quarters. Now, those are two predictions. Then the question is, What is the interaction between those two things? I think there is potential for a negative feedback cycle, which is of some concern. If labor markets weaken, particularly if they weaken severely in certain local areas, it will hurt house prices through two mechanisms. First, house prices capitalize employment and other economic opportunities in an area, so house prices will fall as economic activity slows. Second, the demand for housing or the ability to make house payments directly depends on labor income. Working in the other direction, as house prices fall, the normal wealth effects, but also possible precautionary saving effects or other liquidity effects, could begin to affect consumer confidence and consumer spending, and we get the makings of a potential recessionary dynamic that may be difficult to head off. That is the scenario that concerns me. I don’t know if it’s the modal scenario, but I think it’s one we need to watch very carefully. Beyond that scenario, there are further tail risks. As a number of people have mentioned, most recently Governor Mishkin, these financial effects—financial accelerator effects, if you will—can be quite nonlinear. The Greenbook has a 2 percent decline in house prices in each of the next two years. It’s very possible that the decline could be greater than that. Even if it’s not greater than that, it will not be uniformly distributed around the country. In some parts of the country, house price declines will be much more significant. The nonlinearity I’m talking about has to do with the distribution of equity among families. If you have a 10 percent decline in house prices and two families, each of which has 50 percent equity in their home, then each family is going to experience basically the normal wealth effect. But if one family has 100 percent equity and the other has 5 to 10 percent equity, the effects on behavior will not be linear. There will be a bigger effect on the family that finds itself in financial stress, and the possibility exists that weakening in these markets could feed back into some of the financial problems we are seeing. So I am concerned about getting ahead of what could be an adverse dynamic between the job market and the housing market. On inflation, I think the slowing that we are likely to see will probably remove some of the upside risk that we have been concerned about. I don’t know how these housing developments will affect owners’ equivalent rent. We saw some perverse effects last time. They are still possible. A very small piece of information is that the PPI numbers yesterday actually had some favorable news in them in terms of both intermediate goods and medical costs. So the near term still looks to be fairly good. But I don’t dismiss inflation risks by any means, and we know that policy changes can work through expectations as well as through resource pressure, and so I consider that to be a serious concern. Nevertheless, I do at this point think the principal risks are to the downside, and the interaction between different components of the economy presents the biggest challenge in that respect. I will stop there. Brian, if you are ready to introduce the policy alternatives now." CHRG-111hhrg53021Oth--284 Mr. Lynch," Thank you, Mr. Chairman. Thank you, Mr. Secretary. We had a chance to chat about this a little earlier in the week. But I want to go back to the system that the President's plan envisions, where you have standard derivatives traded over an exchange, standard ones being linear in many cases, well understood. And yet you have another system right beside that parallel system for custom derivatives trading privately with far less transparency. There are a number of moral hazards here, and I want to have you address them. Number one, as the Chairman pointed out earlier, there is a big payday for the banks and for the derivative designers on the custom side of the house, much more so than on the standards side. Second, experience has shown us whenever you have a regulated system operating beside an unregulated system, the markets favor that unregulated system and the money migrates over. Third, the absence of an exchange by--the exchange serves a purpose as a pricing mechanism, and a major problem with these derivatives has been the accurate pricing of risk. And so you are putting these custom derivatives off the exchange where there will be, again, a mispricing of risk that will continue. And, last, we are still allowing these gratuitous side bets where folks can come in and take a bet where they have no interest at all in the underlying asset. And those are all moral hazards that are going to lead us to continue to have a system that has gaping holes in it. And I just don't know how I can support such a system. " CHRG-111hhrg53021--284 Mr. Lynch," Thank you, Mr. Chairman. Thank you, Mr. Secretary. We had a chance to chat about this a little earlier in the week. But I want to go back to the system that the President's plan envisions, where you have standard derivatives traded over an exchange, standard ones being linear in many cases, well understood. And yet you have another system right beside that parallel system for custom derivatives trading privately with far less transparency. There are a number of moral hazards here, and I want to have you address them. Number one, as the Chairman pointed out earlier, there is a big payday for the banks and for the derivative designers on the custom side of the house, much more so than on the standards side. Second, experience has shown us whenever you have a regulated system operating beside an unregulated system, the markets favor that unregulated system and the money migrates over. Third, the absence of an exchange by--the exchange serves a purpose as a pricing mechanism, and a major problem with these derivatives has been the accurate pricing of risk. And so you are putting these custom derivatives off the exchange where there will be, again, a mispricing of risk that will continue. And, last, we are still allowing these gratuitous side bets where folks can come in and take a bet where they have no interest at all in the underlying asset. And those are all moral hazards that are going to lead us to continue to have a system that has gaping holes in it. And I just don't know how I can support such a system. " FOMC20060328meeting--48 46,MS. JOHNSON.," We have very little information on inventories elsewhere. There are data through the International Energy Agency on inventories in countries belonging to the OECD, but they really do not tell us much, and, to be honest, I do not have them with me. The information may be buried here somewhere, but I do not know that I have it, and I will not take the time to look for it. The picture of where inventories are is generally incomplete, particularly because the major Mideast producers and the major emerging market producers are not reporting their inventories to the OECD. The inquiry is unanswerable. Now an effort, of which the United States is very supportive, is under way to improve the quality of the data in the energy markets, and that effort may some day speak to the question. Some of these inventories may be in gas tanks next to factories or next to generators; some of them are held in huge tanks in ports. The location varies hugely. All of that said, I always think that the risk premium in the oil futures curve must somehow resolve itself the way you suggest, but it is not something that happens over a short period of time. The inventory behavior is strategic; it is not the residual. It is every bit as much deliberate as anything else is. And so, as a consequence, when oil supplies seem risky—as, say, the events in Nigeria of last week or the general situation in Iran—people want to hold more inventories. So there may be upward support on that price until inventories reach the level at which people are happy, and then the price might recede; but it is not as if that price increase is somehow a purely financial phenomenon and has no economic consequences. On a fundamental basis, price is driving that inventory accumulation, and it is consistent with the inventory accumulation that people want, given that they perceive supply to be risky." CHRG-110hhrg44901--11 Mr. Bernanke," Thank you, Chairman Frank, Ranking Member Bachus, and members of the committee. I am pleased to present the Federal Reserve's Monetary Report to the Congress. The U.S. economy and financial system have confronted some significant challenges thus far in 2008. The contraction in housing activity that began in 2006 and the associated deterioration in mortgage markets that became evident last year have led to sizable losses at financial institutions and a sharp tightening in overall credit conditions. The effects of the housing contraction and of the financial headwinds on spending and economic activity have been compounded by rapid increases in the price of energy and other commodities, which have zapped household purchasing power even as they have boosted inflation. Against this backdrop, economic activity has advanced at a sluggish pace during the first half of this year, while inflation has remained elevated. Following a significant reduction in its policy rate over the second half of 2007, the Federal Open Market Committee eased policy considerably further through the spring to counter actual and expected weakness in economic growth and to mitigate downside risks to economic activity. In addition, the Federal Reserve expanded some of the special liquidity programs that were established last year and implemented additional facilities to support the functioning of financial markets and foster financial stability. Although these policy actions have had positive effects, the economy continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities. Let me now turn to a more detailed discussion of some of these issues. Developments in financial markets and their implications to the macroeconomic outlook have been a focus of monetary policymakers over the past year. In the second half of 2007, the deteriorating performance of subprime mortgages in the United States triggered turbulence in domestic and international financial markets as investors became markedly less willing to bear credit risk of any type. In the first quarter of 2008, reports of further losses and write-downs in financial institutions intensified investor concerns and resulted in further sharp reductions in market liquidity. By March, many dealers and other institutions, even those that had relied heavily on short-term secured financing, were facing much more stringent borrowing conditions. In mid-March, a major investment bank, The Bear Stearns Companies, Inc., was pushed to the brink of failure after suddenly losing access to short-term financing markets. The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy. After discussions with the Securities and Exchange Commission, and in consultation with the Treasury, we invoked emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by JPMorgan Chase & Company. In addition, the Federal Reserve used emergency authorities to establish two new facilities to provide backstop liquidity to primary dealers, with the goals of stabilizing financial conditions and increasing the availability of credit to the broader economy. We have also taken additional steps to address liquidity pressures in the banking system, including a further easing of the terms for bank borrowing at the discount window and increases in the amount of credit made available to banks through the Term Auction Facility. The FOMC also authorized expansion of its currency swap arrangements with the European Central Bank and the Swiss National Bank to facilitate increased dollar lending by those institutions to banks in their jurisdictions. These steps to address liquidity pressures, coupled with monetary easing, seem to have been helpful in mitigating some market strains. During the second quarter, credit spreads generally narrowed, liquidity pressures ebbed, and a number of new financial institutions raised new capital. However, as events in recent weeks have demonstrated, many financial markets and institutions remain under considerable stress in part because of the outlook for the economy and thus for credit quality, which remains uncertain. In recent days, investors became particularly concerned about the financial condition of the Government-Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac. In view of this development, and given the importance of these firms to the mortgage market, the Treasury announced a legislative proposal to bolster their capital, access to liquidity, and regulatory oversight. As a supplemental to the Treasury's existing authority to lend to the GSEs, and as a bridge to the time when Congress decides how to proceed on these matters, the Board of Governors authorized the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac, should that become necessary. Any lending would be collateralized by U.S. Government and Federal agency securities. In general, healthy economic growth depends on well-functioning financial markets. Consequently, helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve. I turn now to current economic developments and prospects. The economy has continued to expand, but at a subdued pace. In the labor market, private payroll employment has declined, falling at an average pace of 94,000 jobs per month through June. Employment in the construction and manufacturing sectors has been particularly hard hit, although employment declines in a number of other sectors are evident as well. The unemployment rate has risen and now stands at 5\1/2\ percent. In the housing sector, activity continues to weaken. Although sales of existing homes have been about unchanged this year, sales of new homes have continued to fall, and inventories of unsold new homes remain high. In response, homebuilders continue to scale back the pace of housing starts. Home prices are falling, particularly in regions that experienced the largest price increases earlier this decade. The declines in home prices have contributed to the rising tide of foreclosures. By adding to the stock of vacant homes for sale, these foreclosures have in turn intensified the downward pressure on home prices in some areas. Personal consumption expenditures have advanced at a modest pace so far this year, generally holding up somewhat better than might have been expected, given the array of forces weighing on households and attitudes. In particular, with the labor market softening and consumer price inflation elevated, real earnings have been stagnant so far this year. Declining values in equities have taken their toll on household balance sheets, credit conditions have tightened, and indicators of consumer sentiment have fallen sharply. More positively, the fiscal stimulus package is providing some timely support to household incomes. Overall, consumption spending seems to be constrained over coming quarters. In the business sector, real outlays for equipment and software were about flat in the first quarter of the year, and construction of nonresidential structures slowed appreciably. In the second quarter, the available data suggests that business fixed investment appears to have expanded moderately. Nevertheless, surveys of capital spending plans indicate that firms remain concerned about the economic and financial environment, including sharply rising cost of inputs and indications of tightening credit, and they are likely to be cautious with spending in the second half of this year. However, strong export growth continues to be a significant boon to many U.S. companies. In conjunction with the June FOMC meeting, Board Members and Reserve Bank Presidents prepared economic projections covering the years 2008 through 2010. On balance, most FOMC participants expected that over the remainder of this year, output would expand at a pace appreciably below its trend rate, primarily because of continued weakness in housing markets, elevated energy prices, and tight credit conditions. Growth is projected to pick up gradually over the next 2 years as residential construction bottoms out and begins a slow recovery, and as credit conditions gradually improve. However, FOMC participants indicated that considerable uncertainty surrounded their outlook for economic growth and viewed the risks to their forecasts as skewed to the downside. Inflation has remained high, running at nearly a 3\1/2\ percent annual rate over the first 5 months of this year as measured by the price index for personal consumption expenditures. And with gasoline and other consumer energy prices rising in recent weeks, inflation seems likely to move temporarily higher in the near term. The elevated level of overall consumer inflation largely reflects a continued sharp run-up in the prices of many commodities, especially oil, but also certain crops and metals. The spot price of West Texas intermediate crude oil soared about 60 percent in 2007, and thus far this year has climbed an additional 50 percent or so. The price of oil currently stands at about 5 times its level toward the beginning of this decade. Our best judgment is that the surge has been driven predominantly by strong growth in underlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded its fastest pace in decades, leading to substantial increases in the demand for oil. Moreover, growth has been concentrated in developing and emerging market economies, where energy consumption has been further stimulated by rapid industrialization and by government subsidies that hold down the price of energy faced by ultimate users. On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of the subdued supply response reflects inadequate investment and production shortfalls in politically volatile regions where large portions of the oil reserves are located. Additionally, many governments have been tightening their control over oil resources, impeding foreign investment and hindering efforts to boost capacity and production. Finally, sustainable rates of production in some of the more accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long-term oil supplies have been marked down in recent months. Long-dated oil futures prices have risen, along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come. The decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices. The precise size of this effect is difficult to ascertain, as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar, notably shifts in the underlying global demand for and the supply of oil, have been the principal drivers of the increase in prices. Another concern that has been raised is that financial speculation has added markedly to upward pressures on oil prices. Certainly, investor interest in oil and other commodities has increased substantially of late. However, if financial speculation were pushing above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But, in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term. Although the inflationary effect of rising oil and agricultural commodity prices is evident in the retail prices of energy and food, the extent to which the high prices of oil and other raw materials have been passed through to the prices of nonenergy, nonfood finished goods and services seems thus far to have been limited. But with businesses facing persistently higher input prices, they may attempt to pass through such costs into final goods and services more aggressively than they have so far. Moreover, as the foreign exchange value of the dollar has declined, rises in import prices have been greater upward pressure on business costs and consumer prices. In their economic projections for the June FOMC meeting, monetary policymakers marked-up their forecast for inflation during 2008 as a whole. FOMC participants continue to expect inflation to moderate in 2009 and 2010, as slower global growth leads to a cooling of commodity markets, as pressures on resource utilization decline, and as longer-term inflation expectations remain reasonably well-anchored. However, in light of the persistent escalation of commodity prices in recent quarters, FOMC participants viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast. Moreover, the currently high levels of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation. If that were to occur, and those revised expectations were to become embedded in the domestic wage and price-setting process, we would see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policymakers is to prevent that process from taking hold. At present, accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policymakers. The possibility of higher energy prices, tighter credit conditions, and a still deeper contraction in housing markets all represent significant downside risks to the outlook for growth. At the same time, upside risks to the inflation outlook have intensified lately as the rising prices of energy and some other commodities have led to a sharp pickup in inflation, and some measures of inflation expectations have moved higher. Given the high degree of uncertainty, monetary policymakers will need to carefully assess incoming information bearing on the outlook for both inflation and growth. In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term expectations, that the inflationary impulses are becoming embedded in the domestic wage and price-setting process. I would like to conclude my remarks by providing a brief update on some of the Federal Reserve's actions in the area of consumer protection. At the time of our report last February, I described the Board's proposal to adopt comprehensive new regulations to prohibit unfair or deceptive practices in the mortgage market, using our authority under the Home Ownership and Equity Protection Act of 1994. After reviewing the more than 4,500 comment letters we received under the proposed rules, the Board approved the final rules on Monday. The new rules apply to all types of mortgage lenders and will establish lending standards aimed at curbing abuses, while preserving subprime lending and sustainable homeownership. The final rules prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments, and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher-priced loans lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regularly monthly payments. The final rules also prohibit prepayment penalty for higher-priced loans in cases in which the consumer's payment can increase during the first few years and restrict prepayment penalties or other higher-priced loans. Other measures address coercion of appraisers, servicer practices, and other issues. We believe the new rules will help to restore confidence in the mortgage market. In May, working jointly with the Office of Thrift Supervision and the National Credit Union Administration, the Board issued proposed rules under the Federal Trade Commission Act to address unfair or deceptive practices for credit card accounts and overdraft protection plans. Credit cards provide a convenient source of credit for many consumers, but the terms of credit cards loans have become more complex, which has reduced transparency. Our consumer testing has persuaded us that disclosures alone cannot solve this problem. Thus, the Board's proposed rules would require card issuers to alter their practices in ways that will allow consumers to better understand how their own decisions and actions will affect their costs. Card issuers will be prohibited from increasing interest rates retroactively to cover prior purchases except under very limited circumstances. For accounts having multiple interest rates, when consumers seek to pay down their balance by paying more than the minimum, card issuers will be prohibited from maximizing interest charges by applying excess payments to the lowest rate balance first. The proposed rules dealing with bank overdraft services seek to give consumers greater control by ensuring that they have ample opportunity to opt out of automatic payments of overdrafts. The Board has already received more than 20,000 comment letters in response to these proposed rules. Thank you. I have would be very pleased to take your questions. " fcic_final_report_full--209 But after writing  billion in liquidity puts—protecting investors who bought commercial paper issued by Citigroup’s CDOs—the bank’s treasury department had put a stop to the practice. To keep doing deals, the CDO desk had to find another market for the super-senior tranches of the CDOs it was underwriting—or it had to find a way to get the company to support the CDO production line. The CDO desk accumulated another  billion in super-senior exposures, most between early  and August , which it otherwise would have been able to sell into the market only for a loss.  It was also increasingly financing securities that it was holding in its CDO warehouse—that is, securities that were waiting to be put into new CDOs. Historically, owning securities was not what securities firms did. The adage “We are in the moving business, not the storage business” suggests that they were struc- turing and selling securities, not buying or retaining them. However, as the biggest commercial banks and investment banks competed in the securities business in the late s and on into the new century, they often touted the “balance sheet” that they could make available to support the sale of new securi- ties. In this regard, Citigroup broke new ground in the CDO market. Citigroup re- tained significant exposure to potential losses on its CDO business, particularly within Citibank , the  trillion commercial bank whose deposits were insured by the FDIC. While its competitors did the same, few did so as aggressively or, ultimately, with such losses. In , Citigroup retained the super-senior and triple-A tranches of most of the CDOs it created. In many cases Citigroup would hedge the associated credit risk from these tranches by obtaining credit protection from a monoline insurance com- pany such as Ambac. Because these hedges were in place, Citigroup presumed that the risk associated with the retained tranches had been neutralized. Citigroup reported these tranches at values for which they could not be sold, rais- ing questions about their accuracy and, therefore, the accuracy of reported earnings. “As everybody in any business knows, if inventory is growing, that means you’re not pricing it correctly,” Richard Bookstaber, who had been head of risk management at Citigroup in the late s, told the FCIC. But keeping the tranches on the books at these prices improved the finances for creating the deal. “It was a hidden subsidy of the CDO business by mispricing,” Bookstaber said.  The company would not begin writing the securities down toward the market’s real valuations until the fall of . Part of the reason for retaining exposures to super-senior positions in CDOs was their favorable capital treatment. As we saw in an earlier chapter, under the  Re- course Rule, one of the attractions of triple-A-rated securities was that banks were re- quired to hold relatively less capital against them than against lower-rated securities. And if the bank held those assets in their trading account (as opposed to holding them as a long-term investment), it could get even better capital treatment under the  Market Risk Amendment. That rule allowed banks to use their own models to determine how much capital to hold, an amount that varied according to how much market prices moved. Citigroup judged that the capital requirement for the super-se- nior tranches of synthetic CDOs it held for trading purposes was effectively zero, be- cause the prices didn’t move much. As a result, Citigroup held little regulatory capital against the super-senior tranches. FOMC20080430meeting--56 54,MR. MADIGAN.," 2 I will be referring to the package labeled ""Material for Briefing on FOMC Participants' Economic Projections."" Table 1 shows the central tendencies and ranges of your current forecasts for 2008, 2009, and 2010. Central tendencies and ranges of the projections published by the Committee last February are shown in italics. Regarding your monetary policy assumptions (not shown) about three-fourths of the participants envisage a moderately to substantially higher federal funds rate by late next year than assumed in the Greenbook, a path perhaps similar to the one incorporated in financial market quotes. Most of you conditioned your projections on a path for the federal funds rate that begins to rise either in late 2008 or sometime in 2009, in contrast to the Greenbook path, which remains flat through 2009. Many of you were less clear whether you differed from the Greenbook path 2 The materials used by Mr. Madigan are appended to this transcript (appendix 2). over the near term; but with a little reading between the lines, it seems fair to say that most of you assumed a slightly higher funds rate over the near term. As shown in the first set of rows and first column of table 1, the central tendency of your real economic growth forecasts for 2008 has been marked down nearly 1 percentage point since January. Most of you pointed to weak incoming data, tight credit conditions, falling house prices, and rising energy prices as factors that prompted you to lower your growth expectations for this year. About half of you forecast a decline in economic activity over the first half of the year (not shown), with another quarter of you seeing a flat trajectory over that period. However, only four of you used the word ""recession"" to describe the current state of the economy. None of you has a more negative first-half outlook than the Greenbook. The downward revisions to your growth forecasts are roughly equal across both halves of 2008, and so the contour remains one of a rising growth rate over the year. Members' projections for the speed of the recovery in late 2008 exhibit considerable dispersion, with some calling for a quick return to near-potential growth supported by monetary and fiscal stimulus, and others seeing a prolonged period of weakness owing partly to persisting financial headwinds. Most of you appear to expect growth to return to near its trend rate in 2009 (column 2) and to move slightly above trend in 2010 (column 3). The Greenbook forecast for real growth in 2008 is near the low end of the central tendency of FOMC members' projections, but it is at the high end in 2009 and 2010. The second set of rows indicates that you have revised up your projections for the unemployment rate throughout the forecast period. Of those of you who provided estimates of the natural rate of unemployment, most expect unemployment to remain above the natural rate in 2010 with the others seeing a return to the natural rate. As shown in the third set of rows, your projections for headline PCE inflation in 2008 have been revised up a full percentage point, largely due to the surge in the prices of energy and other commodities. Incoming information has also prompted a small upward revision to your projections of core PCE inflation this year (the fourth set of rows). The rate of decline of core inflation in 2009 is essentially unchanged from that in the January projections, presumably reflecting the offsetting effects of the higher unemployment rates in the April projections, on the one hand, and the lagged pass-through of this year's higher food and energy prices, on the other. By 2010 the prolonged period of economic slack pushes down core inflation to around the same rates that were projected in January. Although the central tendencies for headline inflation, the third set of rows, also decline markedly over the forecast period, overall inflation is projected to be about � percentage point higher next year than you anticipated in January. Nonetheless, by 2010, headline inflation is expected to be in essentially the same range of around 1� to 2 percent that you forecasted in January. Your inflation projections for 2010 are close to their values in January, but more than half of you raised your projections for the unemployment rate in 2010 significantly more than 0.1 percent. To the extent that the higher unemployment rate projections are viewed as implying an economy operating below its potential in 2010, outside analysts may infer that you expect inflation to edge down further beyond 2010. Turning to the risks to the outlook, as shown in the upper left-hand panel of exhibit 2, a large majority of you regard uncertainty about GDP growth as greater than normal. The upper right-hand panel shows that most of you perceive the risks to GDP growth as weighted to the downside. Correspondingly, the risks to unemployment, not shown, are seen as weighted to the upside. You typically attributed the downside growth risks to the potential for sharper declines in house prices and persisting financial strains. Overall, the distributions of your views on the uncertainties and skews regarding growth are little changed from January. However, as shown in the lower panels, your perceptions of the risks regarding inflation have changed noticeably since January. As shown in the lower left panel, only half as many participants now see the degree of uncertainty regarding the inflation outlook as historically normal, and twice as many see the uncertainties as larger than usual. As indicated to the right, fewer see the risks to their outlook for overall inflation as balanced, and more see the risks as skewed to the upside. Your narratives indicate that you see the upside risks to inflation as deriving from the potential for continued increases in commodity prices, further depreciation of the dollar, and an upward drift in inflation expectations. That concludes our remarks. " CHRG-110shrg50414--48 Mr. Bernanke," Mr. Chairman, Senator Shelby, I have submitted formal written testimony for the record. With your permission, I would like to speak just a few minutes about the Treasury proposal. The Fed supports the Treasury initiative. We believe that strong and timely action is urgently needed to stabilize our markets and our economy. But I believe some clarification is needed about why this proposal could make a positive difference, and I would like to offer a few thoughts on that subject. Let me start with a question. Why are financial markets not working? Financial institutions and others hold billions in complex securities, including many that are mortgage related. I would like to ask you for a moment to think of these securities as having two different prices. The first of these is the fire-sale price. That is the price a security would fetch today if sold quickly into an illiquid market. The second price is the hold-to-maturity price. That is what the security would be worth eventually when the income from the security was received over time. Because of the complexity of these securities and the serious uncertainties about the economy and the housing market, there is no active market for many of these securities. And, thus, today the fire-sale price may be much less than the hold-to-maturity price. This creates something of a vicious circle. Accounting rules require banks to value many assets at something close to a very low fire-sale price rather than the hold-to-maturity price, which is not unreasonable in itself given their illiquidity. However, this leads to big writedowns and reductions in capital, which in turn forces additional sales that send the fire-sale price down further, adding to pressure. Meanwhile, private capital is unwilling to come in because of uncertainty about the value of institutions and because of the prospect of more writedowns. One suggestion that has been made is to suspend mark-to-market accounting and use banks' estimates of hold-to-maturity prices. Many banks support this. But doing this would only hurt investor confidence because nobody knows what the true hold-to-maturity price is. Without a market to determine that price, investors would have to trust the internal estimates of banks. So let me come to the critical point. I believe that under the Treasury program auctions and other mechanisms could be designed that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets. If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits. First, banks will have a basis for valuing those assets and will not have to use fire-sale prices. Their capital will not be unreasonably marked down. Second, liquidity should begin to come back to these markets. Third, removal of these assets from balance sheets and better information on value should reduce uncertainty and allow the banks to attract new private capital. Fourth, credit markets should start to unfreeze; new credit will become available to support our economy. And, fifth, taxpayers should own assets at prices close to hold-to-maturity values which minimizes their risk. Now, how to make this work. To make this work, we do need flexibility in design of mechanisms for buying assets and from whom to buy. We do not know exactly what the best design is. That will require consultation with experts and experience with alternative approaches. Second, understanding the concerns and the worries of the Committee, we cannot impose punitive measures on the institutions that choose to sell assets. That would eliminate or strongly reduce participation and cause the program to fail. Remember, the beneficiaries of this program are not just those who sell the asset, but all market participants and the economy as a whole. But, finally, and very importantly, this is not to say that the financial industry should not be reformed. It should be. It is critical. I agree with the Treasury Secretary. The Federal Reserve will give full support to fundamental reform of the financial industry. But whatever reforms the Congress makes should apply to the whole industry, whether they participate in this program or not. So, in summary, I believe that under the Treasury authority being requested, a program could be undertaken that will help establish reasonable hold-to-maturity prices for these assets. Doing that will restore confidence and liquidity to the financial markets and help the economy recover without an unreasonable fiscal burden on taxpayers. So I urge you to act as soon as possible. Thank you. " FOMC20060510meeting--104 102,MS. MINEHAN.," Thank you very much, Mr. Chairman. Current economic conditions are fair to good in New England. Consumers report rising confidence, at least in the current situation. Manufacturers report solid domestic and international demand. Business confidence is also good relative to the current situation. Unemployment claims and online job postings suggest continuing positive employment momentum. Northern-tier tourism was hurt by lackluster winter weather, but reportedly tourism in Boston has been quite strong. And even with the poor winter season, tax revenues have grown considerably above budget in all but Rhode Island. On the not-so-hot side, residential real estate markets apparently have slowed, particularly at the high end, with rising inventories of unsold expensive homes. Reportedly, however, more moderately priced homes continue to sell, though transaction volumes for the region as a whole are trailing off. Average selling prices for single-family homes continue to increase according to conventional home price indexes, the last ones of which we had for the final quarter of last year. More-recent anecdotes also suggest that they have been increasing. However, the rates of increase are down to single digits. To some contacts, the market, though slower, seems healthier and more realistic. From a wide range of contacts I have spoken with since the last meeting, I want to highlight three concerns. First, rising costs for energy, transportation, and raw materials are pushing price increases. These are more likely to be tolerated by customers than in the recent past. And firms that say they are unable to pass on such increases report that they expect considerable bottom-line deterioration as a result. Second, skilled labor across a wide range of industries is harder to find and expensive, though planned overall wage increases do not seem to be larger than a year ago. So there is some issue here of skilled labor versus unskilled labor differentials. Finally, there is a general worry, despite pretty good current economic conditions, that energy and energy-related costs will eat into consumer demand and, combined with the flattening in housing markets, will affect growth prospects. Now, on the national scene, our forecast is just about the same as the Greenbook’s. Growth slows for the rest of this year to next and in ’07 is slightly below potential. Unemployment rises slightly, even with continued pretty good job growth. Inflation first rises and then falls. It’s the same general forecast we’ve had for a while. But the question is where the risks to this forecast are. To me they seem to have risen, perhaps on both sides, but I’d say they’re a bit tilted to higher price growth. Q1 growth was clearly above expectations. Some of this was frontloaded into January. April employment was on the slow side; there is some evidence of slowing in housing markets, though prices continue to rise; and household wealth, including stock market wealth, is rising as well. The longer end of the yield curve has turned up, tightening financial conditions somewhat, though corporate profits remain strong and credit spreads remain narrow. It’s possible we’re seeing consumer spending slow, but business spending has strengthened. Thus, while the best guess is that the trajectory for growth is downward, how much and how fast remains uncertain and is a part more of the forecast than of the current picture. On the other hand, although incoming core inflation data have tracked only a bit above what we had expected, I’m not comfortable with what might be called the inflation atmosphere. With inflation compensation and inflation expectations rising, the dollar falling, and gasoline prices around $3 a gallon, it seems to me that inflation risks really have tilted somewhat. I know that each of these may turn out to be transitory. It’s also true that, as yet, indications of wage pressures have been mixed, and while productivity growth has been trending lower, it remains quite healthy. The global competition that characterized much of the past ten years remains healthy, and profit margins are wide enough on average to absorb the rising input costs related to a growing world. Still, anticipating core PCE price growth at 2½ percent, as the Greenbook does for this quarter, makes me at least pause. Given the six-month and the three-month rates of growth in core PCE, a slowing in rates of price growth, while expected, still is only part of the forecast. In sum, although the forecast is rosy—perhaps a bit too rosy—risks to the realization of that forecast appear to have risen. Some of these may be on the downside, but we are also at a point where estimating the economy’s remaining capacity is difficult, and the atmosphere of the inflation picture has changed. So though I don’t want to overreact or be accused of doing so, I am less sure than I was at our last meeting about both where we are and where we need to be." FOMC20070628meeting--23 21,MR. FISHER.," Mr. Chairman, I would argue that there are similarities in that, with Long-Term Capital, most of the stress-testing had been just computer-model driven. Then when actual market prices began to be quoted, you saw the deterioration. That is clearly the case here. The ABX is a technical index. For a lot of the CDO-squared market, nobody knows what the values, as opposed to the prices, really are. There is a difference between price and value. Price is what you pay; value is what you get. I suppose one charitable interpretation of this, Bill, would be that the good thing about this situation is that we actually may be creating a real market to determine value on these things or at least price relative to value. But I think the phenomena are similar, and I would argue—having been in the business, although the business wasn’t as sophisticated when I used to be in it—that this has broader dimensions than those we had before. If you look at the growth rate of these instruments—again, without any underlying sense of what you ultimately can cash in if you’re pressed—it has been a straight upcurve. The numbers are quite huge. Again, I was once a hedge fund manager—I know all the tricks that are played there, including, by the way, the valuation of underlying securities—in a day when the business was less sophisticated than it is now. I don’t feel I understand this issue. I don’t know about my other colleagues around the table, but you did kindly send someone down to brief our staff on this. They came out with more questions than they did answers, but it was very helpful. I am worried that we will be asked publicly at different intervals and perhaps starting now what our opinions and perspectives are. I’m also worried about giving the wrong answer. I wonder if there is not a way—not during this meeting but at some point— that all the principals at this table can be briefed so that we can understand and have a common approach to this issue. I don’t think the issue is contained. I do think there is enormous risk. I hope that something good comes out of this, but speaking personally, I would like to understand this better, and I hope that we all understand it very well in case a negative scenario obtains. That’s just a request." FOMC20070807meeting--28 26,MR. DUDLEY.," I guess I would characterize the situation as people having lost faith in the structured-finance product, especially the high-grade AA/AAA product that they thought was safe and therefore not subject to much market risk or liquidity risk. They found out otherwise, and so there is a total reevaluation of that market. As a consequence, since the vehicle that was used to turn non-investment-grade corporate debt and into investment-grade debt is sort of broken, now they have to sell a lot of non-investment-grade debt directly and find people who are willing to hold it. So I think about the situation as that demand has lessened at a time when supply, just by bad luck and timing, is exploding. The market should clear, because the fundamentals in the corporate sector are good as opposed to bad, but at a much higher price." CHRG-111shrg57322--1209 Mr. Blankfein," Sure. Senator Levin. It is a view of the market--this is your own filing, by the way--changing view of the market. ``For example, during most of 2007, we maintained a net short sub-prime position and therefore stood to benefit from declining prices in the mortgage market.'' That is your filing. Now, take a look at Exhibit 48,\1\ a Tax Department Presentation, October 2007. Here, on page 2, right in the middle. ``So what happened to us? A quick word on our own market and credit risk performance in this regard. In market risk - you saw in our 2nd and 3rd qtr results that we made money despite our inherently long cash positions.'' Inherently long. That is what was inherited------------------------------------------------------------------------------- \1\ See Exhibit No. 48, which appears in the Appendix on page 376.--------------------------------------------------------------------------- " CHRG-111hhrg54867--104 Secretary Geithner," Absolutely. Toxic assets are a problem for any financial system if banks don't hold enough capital against those losses and if they are unable to raise capital because the market doesn't understand the risk in those banks. And if you measured against that, you have seen dramatic amounts of new capital coming into the financial system because of disclosure in some sense we force in the system. The markets for those kind of real-estate-related loans and securities are beginning to improve. The prices have increased. There is more liquidity in part because of the programs we have set in motion. But we are just on the verge now of making the initial allocations of capital to the fund managers, and we have some authority to come in and buy those securities. But, again, the suite of these programs has already had a pretty important impact on liquidity and price in those markets, and things are starting to improve. But the best measure of this is, again, the amount of private capital that has come back into the financial system because of the disclosure we forced on the major institutions. " CHRG-111hhrg51698--12 Mr. Damgard," Thank you very much, Mr. Chairman. Chairman Peterson, Ranking Member Lucas, and Members of the Committee, I am John Damgard, President of the Futures Industry Association; and, as the principal spokesman for the U.S. futures industry, FIA is pleased to be able to testify on the Derivatives Markets Transparency and Accountability Act of 2009. But before addressing the far-reaching legislation, I want to step back and try to put it in some context. In recent months, our economy has faced unprecedented financial turbulence, leading to bankruptcies and bailouts. During that time, U.S. futures markets have performed flawlessly. Fair and reliable prices have been discovered transparently, hedgers have managed price risks in liquid markets, all trades have been cleared, customers have been paid. Not a blip. This record of excellence is the best evidence possible that the regulatory system established by this Committee works superbly well. It is also the best evidence that the Commodity Futures Trading Commission has done its job, and done it well. The Committee should take pride in both the regulatory structures you put in place and the agency that you created years ago. Other agencies should learn from the CFTC. But, in any event, a simple merger is not the answer; and, in that regard, I agree with both the Chairman and the Ranking Member. The legislation before you would build on existing regulatory structure to enhance the CFTC's current powers. We support additional special call and other transparency provisions to allow the CFTC to strengthen its market surveillance capabilities, we support additional resources for the CFTC, we support coordinated oversight of linked competitive markets, and we support looking at further ways to adapt CFTC regulation to the ever-increasing pace of market innovation. But, despite our support in those areas, FIA cannot support the bill as a whole. Our major objections rest in three areas: number one, the hedge exemption; number two, mandatory clearing of all OTC instruments; and number three, the ban on naked credit default swaps. The bill's narrow hedging definition erases decades of progress to expand the use of regulated futures markets by businesses that use futures in an economically appropriate way to manage their price risks. Those companies are not anticipating higher or lower prices. They are managing a risk of higher or lower prices that they already face. In fact, if the companies do not manage that risk, they would be speculating. But if this bill becomes law and constraining positions are imposed, then automakers could not hedge gasoline prices, agribusiness could not hedge currency prices, airlines could not hedge interest rates, and utilities could not hedge weather risk. This would be bad economic policy at a time when we need stability, not uncertainty. Mandating clearing of all OTC derivatives would lead to market uncertainty or worse. You might think that I would support clearing everything, because my regular members are the clearing members whose businesses would increase if everything were cleared. But we don't support mandatory clearing for all OTC derivatives. Some derivatives are too customized and their pricing too opaque to be cleared safely and efficiently. Making it illegal not to clear an OTC derivative would, therefore, be a recipe for economic instability and litigation. FIA believes clearing should be encouraged through capital treatment or other regulatory measures. FIA also believes that if the Committee insists on a clearing mandate, it should be coupled with a flexible CFTC power to exempt classes of instruments from that mandate. Unfortunately, the draft bill's exemptive powers are so limited we fear the CFTC would only be able to exempt a sliver of the current OTC market, leaving the rest facing intolerable legal uncertainty or the ability to do this business somewhere outside the United States. Last, we oppose the ban on naked credit default swaps. The ban would remove important liquidity from our credit markets at just the wrong time for many struggling businesses. FIA would prefer to see Congress encourage clearing of CDS instruments and provide more effective, systemic risk protections through oversight of the institutions that enter into these transactions. Mr. Chairman, FIA thanks you very much for the opportunity to testify this afternoon, and I look forward to answering any questions. [The prepared statement of Mr. Damgard follows:] Prepared Statement of John M. Damgard, President, Futures Industry Association, Washington, D.C. Chairman Peterson, Ranking Member Lucas and Members of the House Agriculture Committee, I am John Damgard, President of the Futures Industry Association. The FIA is pleased to be able to testify on the discussion draft of the Derivatives Markets Transparency and Accountability Act of 2009.Introduction FIA understands well the interest of Chairman Peterson and others in crafting this draft bill. Financial derivatives are now an integral part of our national economy and have been used by many businesses to reduce the multi-faceted price risks they face. Some of these derivatives and related market structures have evolved since Congress considered major changes to the Commodity Exchange Act in 2000. Some have even become more prominent since Congress adopted important changes to the Act as part of the 2008 Farm Bill. Given this Committee's experience and history with derivatives regulation, FIA welcomes discussion with the Committee on whether we need to bolster existing regulatory systems at this time. The draft bill is far-reaching. It would make substantial revisions to the Commodity Exchange Act that would affect trading on exchange markets as well as over-the-counter transactions. While FIA is the trade association for the futures industry,\1\ and its traditional focus has been on exchange markets, we try to take a holistic view of futures and other derivatives markets in order to advise the Committee on what our members believe would be the best public policy for our country and our industry.--------------------------------------------------------------------------- \1\ FIA is a principal spokesman for the commodity futures and options industry. Our regular membership is comprised of 30 of the largest futures commission merchants in the United States. Among our associate members are representatives from virtually all other segments of the futures industry, both national and international. Reflecting the scope and diversity of its membership, FIA estimates that its members serve as brokers for more than ninety percent of all customer transactions executed on United States contract markets.---------------------------------------------------------------------------Draft Bill FIA has analyzed the draft bill through the prism of the congressional findings that form the foundation of the Commodity Exchange Act. Congress has found that the Act serves the public interest by promoting the use of liquid and fair trading markets to assume and manage price risks in all facets of our economy, while discovering prices that may be disseminated widely. CFTC regulation fosters those interests through four core objectives: preventing price manipulation, avoiding systemic risk and counterparty defaults through clearing, protecting customers, and encouraging competition and innovation. FIA supports these Congressional findings and objectives. They are valid today as they were when first enacted. In FIA's view, some of the draft bill's provisions are consistent with these findings and objectives. We support those provisions which would strengthen CFTC market surveillance capabilities and deter price manipulation, by adapting the current regulatory systems to ever evolving market innovations. We also support the pro-competition decisions embodied or implicit in the bill's provisions. But many of the draft bill's provisions would disserve the very public interests and economic policies Congress designed the CEA to serve by draining market liquidity, making hedging more costly, curbing innovation and discouraging trading in the U.S. We can not support those sections of the bill. Attached to this testimony FIA has included a section-by-section review of the draft bill which describes our positions on its specific sections.FIA's Principal Objections To summarize our objections, FIA fears the bill would: (1) increase the cost of hedging and price risk management for U.S. businesses, a bad result at any time, but one that is particularly harmful when those same businesses are struggling to cope with a deepening recession; (2) increase price volatility by removing vital market liquidity through artificial limits or outright prohibitions on participation in regulated exchange trading and OTC transactions; (3) disadvantage U.S. markets and firms by creating inadvertent incentives to trade overseas both exchange-traded and OTC derivatives; and (4) weaken CFTC regulation by saddling the agency with responsibilities that would be resource-intensive to perform with little corresponding public benefit. Our major concerns center on provisions in sections 6, 13 and 16 of the bill. Section 6 would require the CFTC, under a cumbersome and costly advisory committee system, to impose fixed speculative position limits on all commodities traded on regulated exchanges. Today those limits are set by the exchanges for all non-agricultural commodities. No evidence exists that this position limit system has caused any market surveillance difficulties or failed to stop any market manipulation. But the bill not only usurps the exchange's powers to set the limits, it would greatly expand the application of those limits by transforming into speculators many businesses that use futures in an economically appropriate manner to reduce price risks they face. Under the bill, any business becomes a speculator if its futures position is not a substitute for a transaction in the physical marketing channel or does not arise from a change in value in an asset or liability the business owns or service it provides. Under this restrictive test, for example, automobile manufacturers will not be able to hedge gasoline prices. Yet gasoline prices often play a major role in determining what cars consumers will buy and, hopefully, manufacturers will make. No one will be able to use weather derivatives to hedge climate changes of any kind (weather is not in the physical marketing channel). Agribusinesses will be unable to hedge their foreign currency risk and airlines will be unable to hedge their interest rate risk. The list of increased, unmanaged (speculative) price risk to our economy goes on and on. FIA understands that many Members of the Committee are concerned that speculation may have artificially influenced market prices in some commodities in the last year. We are still awaiting any objective fact-finding that would support that conclusion. For now, FIA has seen no evidence to distrust the market surveillance capabilities of the CFTC, especially when armed with the new special call reporting authority as the bill provides. FIA does not believe that restricting the ability of businesses to hedge or manage price risks on regulated exchange markets is an appropriate response in any event. We do not believe it is sound economic policy to force businesses that want to use U.S. futures markets to manage their price risks to trade on overseas markets or enter into OTC derivative positions. FIA urges Chairman Peterson and the Committee to reconsider section 6. Section 13 of the bill mandates clearing of all OTC derivative transactions, unless exempted by the CFTC under strict criteria. As the Committee well knows, all derivatives transactions involve counterparty credit risk. Different methods exist to deal with that risk. One of those methods is the futures-style clearing system. FIA is a strong supporter of clearing systems. Clearing removes each party's risk that its counterparty may default. As I testified before the Committee in December, FIA's regular members--the clearing firms--provide the financial backbone for futures clearing. Our members guarantee the financial performance of every trade in the system. FIA believes the futures clearing system works exceptionally well to remove counterparty risk and to reduce systemic risk. Increasing the number of transactions submitted for clearing also should be good for my members' bottom lines. In that sense, the Committee might expect FIA to support mandatory clearing of all OTC derivatives. But we don't. While a clearing mandate may have some superficial appeal, FIA is concerned that section 13 could promote economic instability in the U.S. Most directly of concern to FIA clearing members, a mandate may force derivatives clearing organizations to clear OTC products that are not sufficiently standardized to be cleared safely. Not every derivative can be cleared. The DCOs will surely try to clear what they can clear, consistent with their risk management systems. But as the experience with CDS clearing shows, developing appropriate clearing systems takes time and an indiscriminate statutory mandate for immediate clearing of OTC products would add financial risk to clearing members as well as the financial system as a whole. In addition, mandatory clearing of credit and other derivatives could lead to uncertainty in credit and other markets at a time when we are struggling to stabilize or restart those vital economic functions. It is true section 13 authorizes the CFTC to exempt classes of OTC derivatives from the clearing mandate. As drafted, however, section 13 would severely constrict the CFTC's ability to exempt OTC transactions. FIA trusts the CFTC's experience and expertise. If clearing is to be mandated at all for any transactions, we believe the CFTC could craft a workable and specific exemption if the statutory exemption criteria are sufficiently flexible. We believe that flexibility will lead to the best national economic policy. Otherwise we fear mandatory clearing of OTC derivatives could trigger a rush to overseas OTC markets that would be counter-productive to our national economic interests. FIA strongly supports one policy decision that is implicit in section 13. We know that some would mandate exchange trading of all derivatives in the U.S. FIA opposes that anti-competitive, anti-innovation approach and is pleased the draft bill does not go down that road. Consistent with section 13, FIA believes in an open, competitive system whereby classes of derivatives are first executed on exchange or dealer trading platforms as well as bilaterally and then submitted for clearing. Exchange and dealer competition for executing derivatives trades will serve well the interests of all market participants. FIA supports that approach. Unlike section 13, the provisions of section 16 are anti-competitive and anti-innovation. It appears to ban so-called naked credit default swaps in OTC dealer markets (where all CDS transactions now occur), while allowing them on exchange markets (where today none occurs). In addition to the unfair competition feature of section 16, it would remove important liquidity from our credit markets and could operate to make credit itself more expensive for those in struggling businesses that now thirst for credit. History teaches that removing liquidity provided by speculators leads to increased price volatility and costs for hedgers. Without speculators, hedgers may be forced to pay higher prices, rather than prices discovered by competitive market forces. The ban also would invite parties to the CDS market to conduct this business overseas, outside the jurisdictional reach of the U.S. financial regulatory system. That transactional exodus would complicate the job of Federal financial regulators, making it harder, if not impossible, to monitor systemic risk. FIA understands Chairman Peterson's concern that trading in credit derivative swaps could add substantial counterparty credit risks to our economy. But developing and implementing appropriate clearing systems for these instruments should address that concern. In fact, section 13 of the bill is based on that premise. FIA believes the Committee should focus on improving the clearing provisions of section 13 of the bill, rather than banning liquidity providers from the CDS market or favoring exchanges over OTC dealers.CFTC Regulation FIA understands that Congress soon may receive proposals on financial market regulatory restructuring. In that regard, one aspect of the recent financial market turmoil must be highlighted. Despite unprecedented financial turbulence that has led to bankruptcies and bailouts, the U.S. futures markets have performed flawlessly. Fair and reliable prices have been discovered transparently. Hedgers have managed price risks in liquid markets. All trades have been cleared. Customers have been paid. Not a blip. This record of excellence in an unprecedented crisis is the best evidence possible that the regulatory system this Committee has authored for decades works superbly well. It is also the best evidence that the Commodity Futures Trading Commission has done its job and done it well. This Committee should take pride in the record of the regulatory structures you put in place and the agency you created decades ago. Any efforts to rationalize Federal financial regulation should learn from the CFTC's example and make certain to preserve the best features of the futures regulatory system. One feature of the current regulatory system that must be preserved is the exclusive jurisdiction of the CFTC over all facets of futures trading and related activities. Congress long ago determined that other Federal or state regulation should not duplicate or conflict with the CFTC's regulation of the futures markets. We know this Committee has been vigilant in protecting this important public policy which has allowed CFTC-regulated futures markets to prosper for many years. The decision by this Committee to establish an experienced and specialized agency to oversee U.S. futures markets also has worked well for decades. Yet, there is always talk that simply merging the CFTC into the SEC will cure all regulatory ills. FIA knows this Committee appreciates that such a merger would not promote the public interests served by the Commodity Exchange Act and would not resolve the public policy issues that have arisen out of the latest credit market stress. We thank the Committee for its leadership in this area.Conclusion FIA thanks Chairman Peterson and the Committee for this opportunity to share our views. We would be pleased to assist your deliberations in any way we can and to answer any questions you may have. AttachmentAnalysis of Derivatives Markets Transparency and Accountability Act of 2009Section 3--Speculative Limits and Transparency of Off-Shore Trading Section 3 has three subsections. FIA opposes the first subsection and supports the other two subsections which parallel provisions in H.R. 6604 passed by the House last year. FIA supports coordinated market surveillance for linked products offered by competing U.S. and foreign exchanges. Last session, Rep. Moran offered legislation that would have addressed these issues in a comprehensive and reciprocal manner. FIA supports that approach. section 3(a), however, could spark retaliation by foreign regulators against U.S. firms and exchanges. The Moran approach is less likely to trigger that response and has broader application. FIA supports subsections 3(b) and 3(c) which afford a safe harbor and legal certainty to CFTC-registered firms that execute or clear trades for customers on foreign exchanges even if those exchanges themselves do not comply with each and every CFTC requirement. U.S. firms should not be liable for any non-compliance by foreign exchanges. Last session, H.R. 6604 contained these provisions in a form that achieved the stated objectives. In the draft bill, important language has been inadvertently dropped from subsection 3(b). FIA would support the provision if the language from H.R. 6604 is restored.Section 4--Detailed Reporting and Disaggregation of Market Data Section 4 would add a new 4(g) of the Commodity Exchange Act. FIA has no objection to having the CFTC define index traders and swap dealers. FIA also does not oppose monthly public reporting by the CFTC of the aggregate open positions held by index traders as a group and by swap dealers as a group using the data reported under the CFTC's large trader reporting system. FIA believes the CFTC also should consider other ways to make their Commitment of Trader Reports more granular and meaningful to all market participants. FIA opposes requiring index traders and swap dealers to file ``routine detailed'' reports with the CFTC. (7:18) No other large traders--speculators or commercials--are subject to such a requirement. It should be sufficient to treat index traders and swap dealers that qualify as large traders like all other large traders for reporting purposes. FIA would also recommend the deletion of the language ``in all markets to the extent such information is available.'' (8:11-12) The aggregate information included in the COT reports should be for futures and options positions only. Otherwise market participants that refer to the COT reports will receive a distorted view of the open interest and volume composition in futures and options markets.Section 5--Transparency and Recordkeeping Authorities Section 5 has three subsections. Subsection 5(a) would require a CFTC-registered futures commission merchant, introducing broker, floor trader or floor broker to make reports and keep records as required by the CFTC for ``transactions and positions traded'' by those registered professionals or their customers in, generally, OTC derivatives transactions that are exempted from the CEA and CFTC rules. FIA does not object to giving the CFTC this authority but questions whether it is at least partially duplicative of the special call provisions provided in the second part of the section. Subsection 5(b) has two parts. First, Subsection 5(b) would require any large trader of futures contracts in a commodity to maintain books and records of transactions and positions in that commodity which are otherwise generally exempt and excluded from the CEA. FIA does not object to this provision. Second, Subsection 5(b) would codify the CFTC's power to issue special calls for books and records relating to otherwise excluded or exempt transactions under the CEA when the CFTC determines it would be appropriate for market integrity purposes. FIA supports giving the CFTC this standby authority to enhance its market surveillance capabilities as circumstances require. Subsection 5(b) also requires large traders to retain the required books and record for 5 years. These required books and records shall include the ``complete details'' of all ``such transactions, positions, inventories, and commitments, including the names and addresses of all persons having an interest therein.'' (10:8-12) FIA questions whether these statutory requirements are necessary or whether it would be preferable to grant the CFTC general authority to adopt appropriate record-keeping rules for large traders that engage in otherwise exempt or excluded transactions. Subsection 5(c) contains conforming amendments to codify that the amendments in Subsections 5(a) and 5(b) create explicit exceptions to the statutory exclusions and exemptions in the CEA. FIA supports this legal certainty.Section 6--Trading Limits to Prevent Excessive Speculation. FIA opposes section 6. FIA sees no reason to repeal the exchanges' current authority to set position limits for their markets. (Today the CFTC sets position limits only for agricultural commodities.) The CFTC retains the power to review and amend any position limit set by an exchange if those limits are set in a manner that invites price manipulation or other market integrity concerns. Any member of the public is free to submit to the CFTC at any time a recommendation for changes to an exchange set position limit or accountability level. A formal advisory committee process is costly and unwarranted. The major deficiency in section 6 is its restrictive hedging definition. If a business establishes a futures position ``which is economically appropriate to the reduction of risks in the conduct and management of the commercial enterprise,'' that business is not a speculator. Instead, the business is managing an economic risk it faces in its business. Section 6 would misclassify that business as a speculator unless it also meets the ``substitute transaction'' and ``change of held assets/liabilities'' tests to become a physical hedger. These restrictions are bad economic policy and would impose unwarranted restrictions on businesses that want to use futures markets to hedge. Section 6 also would consider a swaps dealer to be a speculator if its futures positions are established to reduce the dealer's price risk on its net swaps position simply because some of its swaps counterparties are not physical hedgers. The swaps dealer is managing its price risk prudently and doing so in a transparent market through transactions without counterparty credit risk. That swaps dealer should be subject to all the market surveillance oversight faced by all large traders. But it should not be treated as a speculator because it is not speculating; it is trading futures to reduce its price risk in an economically appropriate manner. Section 6 conflicts with the policy of promoting price risk management through exchange-traded and cleared markets. FIA strongly recommends that the Committee drop the hedging definition in section 6 and instead direct the CFTC to conduct a rulemaking to define, for position limit purposes, speculation, hedging and price risk management consistent with the public interests to be served by the CEA.Section 7--CFTC Administration FIA supports section 7's authorization of at least 200 new full time employees for the CFTC.Section 8--Review of Prior Actions FIA opposes requiring the CFTC to spend its resources reconsidering all of its currently effective regulatory actions as well as those of the exchanges to determine if they are consistent with the provisions of the bill. CFTC has not yet adopted regulations to implement the provisions enacted in the farm bill in 2008, which would enhance customer protection and market surveillance. Before reviewing past actions, FIA believes the CFTC should implement the farm bill's reforms. FIA appreciates that the CFTC is given no deadline for completing this ``prior action'' review. We are sure the CFTC will move expeditiously to implement this bill's regulatory provisions, if enacted, as well as the farm bill provisions from last year. The key is providing the CFTC with adequate resources to do the job and section 7 is an important step in this direction.Section 9--Review of Over-the-Counter Markets FIA does not oppose having the CFTC study eventually whether position limits should be imposed on exempt transactions in physically-based agricultural or energy commodities when those transactions are fungible with regulated futures contracts and significant price discovery contracts. FIA also does not oppose including in that study whether it would be good policy for the CFTC to adopt umbrella limits for futures, swaps and any other fungible transactions in such commodities. FIA would urge the Committee, however, to remove the deadlines and timelines for such studies. The CFTC should be able first to adopt and implement its rules for Significant Price Discovery Contracts as required in the 2008 Farm Bill. Then, after it has had experience with such rules, the CFTC could tackle the required study. At this point, it seems to be premature to study what contracts are fungible with SPDC contracts, especially where the CFTC has not yet implemented its SPDC authority.Section 10--Study Relating to International Regulation of Energy Commodity Markets FIA does not oppose having the Comptroller General study the international regime for regulating the trading of energy commodity futures and derivatives. Some of the terms used in the study outline should be clarified. For example, it is not clear what is meant by ``commercial and noncommercial trading'' (21:8-9). It is also not clear what constitutes ``excessive speculation'' (21:23-24) or ``price volatility'' (21:25). Last, the study contemplates a proper functioning market ``that protects consumers in the United States.'' (22:34) The phrase suggests that markets should have a downward price bias to serve the interests of consumers. FIA instead believes that markets should reflect accurately market fundamentals, including the forces of supply and demand. FIA recommends that the Committee adjust the study outline to ensure it will provide beneficial, not skewed, results for further deliberations.Section 11--Over-The-Counter Authority FIA has no objection to having the CFTC analyze whether any exempt or excluded transaction is fungible with transactions traded on a registered entity, including an electronic facility that lists a Significant Price Discovery Contract. If such fungible contracts are found, and if the CFTC also finds that such contracts have the potential to harm the price discovery process on a registered entity, section 11 provides that the CFTC may use its existing emergency authority in section 8a(9) to impose position limits on such fungible contracts. This new authority would parallel the CFTC's new Significant Price Discovery Contract authority provided in the 2008 Farm Bill. As written, however, FIA can not support this provision. FIA is concerned about the breadth of the language ``have the potential to'' (22:24) harm market integrity on registered entities. The CFTC should be empowered to use these regulatory authorities only if it finds an actual emergency condition to exist which affects trading on registered entities. Otherwise the CFTC could use a mere possibility of an impact on a registered entity to restrain or prevent competition from arising among trading facilities or dealer markets with exchange markets. FIA also believes the Committee should make clear in section 11 that the CFTC should not apply its authority to restrict fair competition.Section 12--Expedited Process FIA has no objection generally to allowing the CFTC to use expedited procedures to implement the authorities in this bill if the CFTC deems it to be necessary. FIA does not believe the authority in section 12 itself is necessary because the Administrative Procedure Act provides the CFTC and other agencies with appropriate powers to expedite the kinds of rule making actions the bill contemplates. FIA does object to this provision if it is misread to authorize the CFTC to expedite and disregard APA or even Constitutionally-required procedural protections whenever the CFTC believes it to be necessary. That sweeping and standardless grant of authority could allow the agency to disregard well-established administrative procedural protections that have been adopted for many years to ensure reasoned and impartial agency decisions.Section 13--Certain Exemptions and Exclusions Available Only for Certain Transactions Settled and Cleared Through Registered Derivatives Clearing Organizations FIA supports encouraging market participants to clear appropriately standardized derivatives transactions. But FIA does not believe that mandatory clearing of all OTC derivatives is sound public policy. Clearing should only be available to those instruments that regulated clearing facilities decide they can safely clear. To date, no clearing facility believes it could or should clear all OTC derivatives. And even if a clearing facility believed it could clear a particular class or type of OTC derivative (and some do now), FIA would want that private entity's judgment confirmed by an expert Federal regulatory body, like the CFTC. FIA believes that clearing should be encouraged with incentives, not mandates, and only when the clearing entity and its government regulator agree that the particular class of OTC derivative could be submitted safely for clearing. Mandating clearing in a vacuum and without the necessary safety and soundness predicates, as section 13 appears to do, would be most unwise. Section 13 does grant to the CFTC the authority to declare spot and forward contracts immune from the mandatory clearing requirement. (31:12-17) The CFTC's authority is appropriately broad and flexible. But given the structure of section 13 and the traditional meanings of the terms spot and forward contracts, FIA is uncertain whether most or all OTC derivatives could fall into the spot or forward category. If not, the provisions in section 13 granting the CFTC the power to exempt classes of OTC transactions from the clearing mandate become particularly important. Unfortunately, the criteria in section 13 that would guide the CFTC's exemption decisions are much too rigid and constraining. As written, the CFTC would have to find a class of derivatives is ``highly customized;'' ``transacted infrequently;'' ``serves no price discovery function;'' and ``being entered into by parties with demonstrated financial integrity.'' (29:23-30:9) It would be difficult, if not impossible, for the CFTC to craft an appropriate exemption under these mandatory criteria. The result would be that section 13 would operate as a ban on all non-cleared OTC derivatives transactions in the U.S. and an invitation to market participants to enter into OTC transactions outside the jurisdictional reach of the CEA. Removing that significant market liquidity and making transactions more opaque to U.S. regulators would be detrimental to the public interest. FIA strongly opposes section 13.Section 14--Treatment of Emission Allowances and Off-Set Credits FIA supports defining emission allowances and off-set credits as ``exempt commodities'' like all other energy-related commodities. Section 14, however, excludes these commodities from the ``exempt commodity'' definition and would treat them like agricultural commodities. FIA does not know of any public policy reason to constrain the development of market innovations, including multilateral electronic trading facilities or clearing, for trading in these instruments in these energy commodities. Achieving energy policy goals will require promoting and expanding innovation, not restricting it. The Committee should reconsider the policy implications of treating these energy commodities like agricultural commodities.Section 15--Inspector General of the CFTC FIA has no objection to creating the Inspector General of the CFTC as a Presidential appointment, subject to Senate confirmation. At the same time, we do not believe the absence of an IG appointed by the President is a weakness in the current CFTC structure.Section 16--Limitation on Eligibility to Purchase a Credit Default Swap FIA opposes the ban on naked credit default swaps. Section 16 will effectively terminate the U.S. CDS market and send it overseas. CDS transactions have fostered many economic benefits and it would be better to improve regulation and oversight of this market rather than jettisoning it to foreign shores. FIA does support the provision that defines a credit default swap and allows registered entities that list for trading or clear CDS instruments to operate without having to comply with regulatory conditions imposed by the SEC. (38:1-9) " FOMC20060629meeting--95 93,MS. YELLEN.," Thank you, Mr. Chairman. The staff presentations make abundantly clear that most of the data we have received since we met in May have been disappointing in one way or another. Recent economic activity appears to have been quite a bit weaker than expected, as exemplified by the Greenbook, which shows a significant downward revision to 2 percent growth in the current quarter and a noticeable downward adjustment to 2¾ percent in the second half of this year. However, in view of the possibility that labor and product markets may have moved a bit beyond full utilization, as well as the recent high readings on core inflation, a period of growth a bit below potential could be seen as necessary to prevent a buildup of underlying inflationary pressures. Under the assumption of one more funds rate increase at this meeting, it seems reasonable to me that growth will remain somewhat below its potential rate, that the unemployment rate will gradually trend upward to slightly above the NAIRU by the end of next year, and that core inflation will gradually move down toward my comfort zone. If things work out that way, I suppose the outcome would be nearly optimal, given that we are starting from an undesirably high inflation figure in the second quarter. My concern is that it is very difficult at this stage to rule out a much less desirable scenario in which the lagged effects of our earlier reactions restrain activity more strongly and more persistently than we now expect. We might also see further financial disruptions as a consequence of investors’ increased risk aversion, which is the bearish possibility that Dino described earlier. In other words, the question is whether the large surprise in the second quarter will be followed by a series of similar surprises later this year. I am concerned about downside risks to the real outlook, especially until we can better gauge the magnitude of the repercussions from the weakening in housing markets that now clearly is under way. The data on core inflation in recent months present the opposite concern, having been higher than expected and pushing core inflation slightly above my comfort zone over the past year. This raises the possibility that we are making systematic errors in our understanding of the fundamental forces driving inflation. The key question is whether the necessary decline in inflation requires more action from us or whether inflation is being pushed up by temporary factors that will dissipate on their own. The Greenbook, I think quite reasonably, shows core inflation edging down over the next year and a half as the effects of several temporary factors abate. One possibility in this regard is that there has been a modest pass-through from energy-price increases to core inflation and that these effects will dissipate if energy prices stabilize at today’s elevated levels. Moreover, part of the recent uptick traces to large increases in housing costs that are finally showing up in the CPI just as the housing market is slowing. As David noted in his briefing, the CPI measure of changes in housing prices for owner-occupied housing reflects movements in market rental rates rather than house prices and interest rates. After long being stagnant or even falling, rents are finally moving up. Perhaps with higher mortgage interest rates and lower expectations of house-price appreciation, speculative properties are being dumped into the market, and families in the market for housing are now more inclined to rent rather than buy, driving rents up and housing prices down. It certainly would not be surprising to see a return to a more normal relationship between rents and house prices. Such a phenomenon, if it is now playing out, would most likely be transitory rather than permanent, although it could play out for quite some time. Unfortunately, at this point it is difficult to tell how much of the recent rise in core inflation is temporary and how much is due to underlying inflation pressures like tight labor and product markets, which would suggest a more persistent problem for policy. I would feel more concerned were it not for the largely reassuring data on productivity, labor compensation, and profit margins. That said, the good news is all in the forecast, whereas the bad news is in the data. So I certainly can’t rule out the possibility that the increase in core inflation in the second quarter is the leading edge of a developing trend. In summary, I think the most likely scenario is a relatively benign one. However, we have had some rather large surprises in both output and inflation since we last met. It seems to me that, in the policy round coming up, the more important matters are the risks that growth could slow much more than now seems likely or that inflation could prove to be a more serious problem than I currently expect it to be or, for that matter, that both factors could come into play. It is unlikely that we will be able to sharpen our assessment of these risks very much until more time passes and more data become available." FOMC20080805meeting--122 120,MR. ROSENGREN.," Thank you, Mr. Chairman. The Boston forecast used for the June meeting expected that the unemployment rate would peak at approximately 5.7 percent. Unfortunately, with the July employment report, the unemployment rate has already reached 5.7 percent, and we expect the economy is likely to grow less than potential for the next several quarters. With the unemployment rate rising in the past three months by 0.7 percentage point and payroll employment declining for the past six months, I am concerned that there remains a significant risk that the second half of this year would look a lot like the ""severe financial stress"" or ""typical recession"" scenarios. My concern reflects the potential impact of further deterioration among financial institutions and financial markets that may create a significant headwind for the economy and the likelihood that economic problems are growing in other countries, which would slow one of the few bright spots in the economy--exports. Since our last meeting, much has been written about the problems at the GSEs. Concern with the viability of the GSEs and potential future losses has contributed to mortgage rates rising despite our past easing, the weak economy, and diminished demand for mortgages. With financial institutions showing little interest in lending to subprime or jumbo borrowers, the increased cost for individuals that qualify for conforming loans is likely to weaken the one part of the housing market that had been relatively resilient to financial problems to date. For potential buyers, higher interest rates and the likelihood that housing prices will continue to fall provide little current incentive to purchase a home, while the job losses are providing an immediate need for some owners to sell their homes. We need the housing market and housing prices to stabilize, which I had hoped would occur in the second half of this year, but now it looks as though it will be deferred until next year. Falling housing prices have created significant collateral damage. Liquidity problems that began one year ago remain in play. The capital-constrained financial institutions that are forced to shrink their balance sheets may pose a significant additional problem in the second half of this year. While many of the largest banks that suffered significant losses last year were able to raise additional capital fairly readily, the capital losses on newly issued bank equity may have reduced many investors' appetite for providing new capital for banks until it is clear that the economy is recovering. The falling national housing prices and problems in commercial real estate in some sectors of the economy are now affecting regional and community banking institutions, many of which are unlikely to get equity infusions and thus will be forced to shrink. A reduction in the willingness to lend, as represented by the Senior Loan Officer Opinion Survey, has often portended a reduction in credit to bank-dependent borrowers. As we get a more traditional credit crunch compounding the liquidity problems, I am concerned that credit will be less available to consumers and businesses and further slow consumption and business investment. Since the June meeting, the stock market has fallen 7 percent; and with the number of large financial institutions experiencing very elevated CDS spreads and stock prices in the single digits, the failure of one or more relatively large domestic or foreign financial institutions is a real possibility. In such an environment, the assumption of annual equity prices rising 7 percent in the rest of this year and 12 percent in 2009 as assumed in the Greenbook would seem to have some significant downside risk. Elevated unemployment rates and a flat or slightly falling trend in wage and salary inflation suggest an absence of the inflationary pressures in labor markets that would lead to rising inflation once energy and food prices stabilize. These factors give me some confidence that we will see core and total inflation in 2009 close to 2 percent. Since our last meeting, labor markets have been weaker than expected, and oil prices and many other commodity prices have fallen, in part as a result of the concern with a slowing global economy. Although total inflation measures are clearly higher than any of us would want, these readings appear to be transitory responses to supply shocks that are not flowing through to labor markets. In fact, evidence from the labor market would seem to indicate that the downside risks to the economy are affecting labor markets through job losses but are not creating an environment in which labor tries to offset supply shocks with higher wage demands. Thank you. " FOMC20060808meeting--148 146,MS. SMITH.," Yes. The directive would be, “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” Then the risk assessment is, “Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth as implied by incoming information.” Chairman Bernanke Yes Vice Chairman Geithner Yes Governor Bies Yes President Guynn Yes Governor Kohn Yes Governor Kroszner Yes President Lacker No President Pianalto Yes Governor Warsh Yes President Yellen Yes" FOMC20060510meeting--108 106,MR. STONE.," Thank you, Mr. Chairman. Economic activity in the Third District continues to advance at a solid pace. Growth in our region has been steadier than in the nation over the past two quarters. Payroll employment grew in each of the three states through March, and the three-state unemployment rate is now 4½ percent. Our business contacts in the region report increased difficulty in filling open positions. In addition, our employment diffusion index in the business outlook survey rose sharply in April. Regional manufacturing activity continues to expand at a moderate pace. In response to a special survey question in April, the majority of participants said that underlying demand for their products was increasing. On the retail side, performance looks solid. Some of that is seasonal. On the auto side, sales have picked up slightly, but we see some small dealerships actually going out of business. Our retailers have expressed less concern than I’ve heard around the table about the impact of gasoline prices on their sales going forward. While initial reports of nonresidential construction contracts in our region have declined in recent months, demand for office and industrial space in the District continues to strengthen. The office market absorption rate is rising in the Philadelphia metropolitan area, and vacancy rates are declining in both the city and the suburbs. Results of the special survey conducted by the Reserve Bank suggest that commercial construction activity is somewhat softer in our District than in the nation as a whole. Nonetheless, our contacts do see a stronger picture this year than they did last year. In the residential sector, home sales have slowed since the winter. Inventories and time on the market have increased. Demand has fallen particularly for higher-priced homes, more so than for lower-priced homes, and house-price appreciation is slowing in our region. Prices for industrial goods are rising, and construction firms are reporting some shortages of structural materials. Some area builders are starting to stockpile copper, aluminum, and steel for upcoming projects. Employers in a number of industries in our region report that they have paid higher salaries for workers this year compared with hires in similar positions last year. At this time of the year, we usually are traveling around the District and conferring with bankers and other businesses as we’re doing our annual field meetings. Over the past week, we were in the typically most depressed areas of our District—the far western part of our District—and for the first time in many years I was hearing optimism about the future and reports of an actual substantial decline in the unemployment rates in those areas. Turning to the national conditions, our economic outlook is broadly consistent with the Greenbook baseline. However, we see somewhat more economic strength and somewhat higher inflation going forward. We also note that many forecasters have also revised up their forecasts of the second quarter based on the strength of incoming data. Business spending and manufacturing continue to show strength. Notwithstanding the April unemployment report, which came in lower than expected, employment remains strong. Monthly gains have accelerated to an average of 173,000 jobs this year, compared with 165,000 last year. Employment growth will support consumer spending even as house- price appreciation slows. The rising gasoline prices will have a damping effect but probably not a dramatic one. There are no signs of a sharp retrenchment in housing. So far, the slowing has been orderly. With the economy expected to remain at full employment and with labor markets tight, we expect hourly compensation growth to accelerate over the forecast period, but not dramatically so. I recognize that higher oil prices and higher long-term interest rates pose a downside risk to growth and that the downturn in housing and the monetary policy tightening already in the pipeline could prove to be a bigger drag than anticipated. But in my view, given the underlying strength of the economy, the risks to growth are roughly balanced or perhaps even tilted modestly to the upside. I have somewhat more concern about inflation over the intermeeting period. It’s true that we haven’t seen an acceleration in core inflation measured year over year. But at shorter horizons, as has been previously mentioned, we’ve seen a marked uptick in core inflation. In addition, inflation forecasts have been revised up, reflecting the recent higher-than-expected inflation data and the view that higher oil prices might add to inflationary pressures. Longer-run inflation expectations, as measured by the TIPS and the Michigan survey, as reported earlier, are apparently up somewhat, which is troubling to me. Higher productivity growth will help to keep inflation in check. With inflation running at the top of the range that I consider consistent with price stability and with the economy operating at high levels of resource utilization, there’s a risk that stronger inflation pressures could emerge. Thank you, Mr. Chairman." FOMC20050503meeting--97 95,MR. KOHN.," Thank you, Mr. Chairman. Unfortunately, the economic and policy situation became a lot more interesting over the intermeeting period. We thought we had an emerging inflation problem; the issue was how hard to lean against it. In the event, core inflation did come in a bit to the high side, but, in addition, economic activity was appreciably weaker than I thought it would be, with both consumption and investment falling short of expectations. A greater-than-expected reaction to previous increases in energy prices seems to me the most likely culprit for both the inflation and output surprises. Perhaps the constrained reaction last summer and fall to the previous run-up in energy prices lured us into giving this factor too little weight. People may not change their behavior until prices have been high for some time and they perceive the need to build them into more permanent notions of relative prices and disposable income. Businesses, in cutting back their hiring and capital outlays, may be reacting to their perception that energy prices were in the process of taking a bigger piece out of household spending or at least to increasing uncertainty about the path of that spending. The tendency for economic activity to be disappointing in several industrial economies in recent months supports the notion of a common global thread and is consistent with the energy price explanation. And on the price side, cost pass-throughs may be easier and more readily accepted by May 3, 2005 59 of 116 I agree with the contours of the staff forecast. If energy prices remain flat, growth should pick up and core inflation should abate. We’re most likely looking at a downward adjustment in the level of demand and an upward adjustment in the level of aggregate prices, not more persistent effects on growth rates. Fundamentals continue to favor this outcome. Financial conditions remain quite accommodative and supportive of growth sufficient to resume narrowing the output gap. Foreign demand should also strengthen, as the energy price shock is absorbed. The damped growth of compensation even in the face of higher headline inflation indicates to me that appreciable slack remains in labor markets. Capacity utilization in manufacturing is still below its long-run average. In this environment, conditions in labor and product markets should help keep a lid on price increases, but the incoming data have elevated the level of uncertainty about the outlook, as many of us have remarked, and raise questions about what accounts for the recent outcomes and suggested skews around this most likely scenario. It’s difficult to identify what, other than energy prices, could be unexpectedly damping demand. But confidence has eroded, which could intensify and prolong energy-related shortfalls. We can see the decline in confidence in surveys of households and small businesses that we saw yesterday and also in financial markets, where volatility and risk spreads have risen and stock prices have fallen. Perhaps markets are better aligned with reality, but financial conditions are a little tighter than they have been, and this will restrain spending at least slightly going forward. The slowdown in the increase in investment spending is especially notable and would be a concern if it were prolonged, since that’s what most of us were counting on to sustain solid growth and declining slack over the next few quarters. The staff has interpreted the recent shortfall as reflecting in some small part more persistent May 3, 2005 60 of 116 High-frequency data, such as initial claims, and early indications of consumer demand in April suggest that the economy continues to expand at a moderate pace. But at the least, the recent data point to a greater possibility than I saw at the last meeting that growth will not be sufficient to raise resource utilization as policy accommodation is removed further. On inflation, the decline in both short- and long-run inflation compensation and in financial markets since the last meeting encourages me to think that energy price increases aren’t being propagated through this mechanism. But the surprises in the core inflation numbers do suggest some continuing risk that inflation won’t be as contained as one might otherwise have expected at given levels of resource utilization. The puzzle here in my view is the character of the competitive environment. Given slack in resource utilization and high profit margins, I would have expected businesses to have been driven—by competition and desires to expand market share—to absorb more of the cost increases. But businesses clearly remain cautious about expansion, and they have been able to raise prices to maintain very high price markups. From a policy perspective, I think we have a situation that is a bit more balanced than it was at the last meeting. Financial conditions still seem too accommodative to be consistent with the economy not overshooting the level of its potential once the effects of rising energy prices wear off. We need to be careful that nominal rates keep ahead of the now slightly higher underlying inflation. But a gradual pace of tightening now seems an even better guess than it might have been at the previous meeting, in the sense of being in the center of a distribution of possible rate paths. And that’s because a less robust economy and a larger output gap than expected should provide some May 3, 2005 61 of 116 As I tried to suggest, I think the distributions around the outcomes for inflation and output have become more skewed, but in offsetting directions with regard to their implications for policy. As we’ve been saying in our minutes and speeches, how the actual path of rates evolves will depend on the data and how some of these puzzles are resolved. But for now I would keep on our path, and I would let the public know that that’s still our best guess for how we’ll be proceeding. Thank you, Mr. Chairman." FOMC20061025meeting--13 11,MS. JOHNSON.," Once again I find myself reporting to you that movements in global oil prices are among the developments during the intermeeting period that were factors in our deliberations about the external sector. Global crude oil spot and futures prices fell further following our September projection but by differing amounts over the maturity spectrum. When we finalized the current baseline forecast, spot prices and very near term futures prices had moved down more than $4 per barrel; futures contracts that mature at the end of 2007 had recorded price declines of about $2; those maturing at the end of 2008 had price declines of about 50 cents. Indeed, for contracts maturing beyond 2009, prices actually rose such that the far-dated contract for December 2012 had moved up about $1 per barrel in price. We adjusted our projection for U.S. oil import prices by amounts similar to these changes in futures prices. The differential movement in prices implies that, even though prices have moved down all along the path through the forecast period, this path now slopes up more steeply than it previously did. So our outlook is for oil prices to rise rather sharply over the forecast period, although from a lower starting point than in the September Greenbook. The reasons for the additional decline in prices during September and October include the return of production to near previous rates at Prudhoe Bay, the absence of any sign of late-season hurricanes in the Gulf of Mexico, and awareness of current high inventory levels. These inventories are by their very nature transitory; hence, market participants seem to believe that some of the current abundant supply will diminish over time, leaving limited spare production capacity and chronic risks to production in Nigeria, Iran, Iraq, and elsewhere. Late last week, OPEC announced production cuts of 1.2 million barrels per day as of November 1. Although the size of actual cuts by individual OPEC suppliers remains to be seen, we judge that significant cuts, albeit not as large as those announced, are needed for prospective demand to be consistent with prices in the futures curve. Those prices remain elevated—around the levels expected at the start of this year. We again asked ourselves how the substantial drop in oil prices since their August peak matters for the U.S. economy. As Dave mentioned, some of the near-term variance in U.S. real GDP growth reflects the path of real imports, including oil imports. The nominal trade deficit is clearly narrowed as a consequence of lower oil prices. We expect that the average oil bill in the fourth quarter will show an improvement from the third quarter of $60 billion at an annual rate. The net trade balance on nominal goods and services will improve by just about the same amount as other trade components experience small, offsetting changes. As oil prices rise going forward, the nominal value of oil imports should move back up; but for 2007 as a whole, we expect that the total figure will be about the same as the total for this year, followed by a moderate increase in 2008. With respect to our forecast for exports, we again expect that real exports of goods and services will expand at an annual rate of about 4½ percent through early 2008 and then will accelerate slightly, to about 5 percent, over the second half of 2008. We see this pace of export growth as reflecting moderately strong growth of trade in both services and merchandise. These components in turn reflect solid average growth of around 3¼ percent in foreign real GDP. The projected acceleration in real exports in 2008 reflects a boost from relative prices as U.S. export price inflation moderates. This projected pace of export growth is somewhat below that observed in recent years, particularly in the first half of this year. To some extent, the double-digit growth of U.S. real exports early this year reflected rapid real GDP growth abroad at that time. But our models cannot explain all the strong growth, and a sizable positive residual has emerged in our model. During the first quarter, exceptionally rapid growth of real GDP was widespread abroad as most industrial countries and many emerging-market economies in both Asia and Latin America recorded particularly robust real expansion. The rapid growth moved many foreign economies closer to potential and was not sustainable over the long run. We read recent indicators of activity abroad as generally confirming our expectation that slowing from those very rapid rates would occur through the year. According to the data, among the industrial countries, Canada and Japan have GDP already decelerating in the second quarter. In contrast, the pace of expansion strengthened in the euro area; but with further tightening of monetary policy and an increase in the value-added tax in Germany to take effect at the start of next year, our outlook calls for a slowdown in growth there as well. For the emerging-market economies, the most important news is Chinese third-quarter real GDP growth, announced just after the Greenbook was distributed. Based on the data and our best estimate of a seasonally adjusted series for the level of Chinese GDP, real growth in China was at an annual rate of about 5½ percent in the third quarter from the second quarter, following two quarters of growth above 12 percent. These data are only approximate as they are inferred from the annual growth rates published by the Chinese authorities. However, it does seem clear that the measures implemented by Chinese officials to cool the economy have had some effect. We are projecting that growth going forward will return to rates between 8 and 8½ percent. Of course, the band of uncertainty around this forecast is significant. We judge growth at that pace to be consistent with Chinese potential and acceptable to Chinese officials. This picture of real output growth abroad is a benign soft landing. We are projecting slowing that does not overshoot in many foreign economies, including importantly the euro area, Japan, and China. We believe that domestic demand growth in Canada, Japan, the euro area, and Mexico will continue to sustain their domestic expansions and growth in the global economy and will underlie ongoing moderate strength in U.S. exports. With respect to the current quarter, trade data for August surprised us with the strength of exports and led us to revise up by more than 2½ percentage points our estimate of the annual rate of growth of real exports in the third quarter. The surprise was widespread across categories of merchandise trade other than computers and semiconductors and included strong exports to most of our trading partners, with the important exceptions of Canada and Mexico. With no special stories or specific components of interest, we have projected that real export growth will revert to its historical relationship with foreign output and relative prices. However, the positive surprise in August reminds us that there is upside risk to our forecast for real exports as well as downside risk should foreign growth slow more than expected. Real merchandise imports in August came in above our expectation as well. We have accommodated that surprise in part by reducing real imports projected for the fourth quarter, particularly real oil imports. All in all, our baseline forecast for the combined contribution of imports and exports to U.S. GDP growth over the forecast period is for a small negative effect during the second half of this year that becomes slightly more negative through the second half of 2008, reaching about 0.4 percentage point as strengthening U.S. real GDP growth boosts import growth above that for exports. David and I will be happy to answer any questions." CHRG-110shrg50414--230 Mr. Bernanke," Well, we will continue to evaluate. For those institutions that we supervise, we will continue to evaluate their positions, their capital, their risk management, and so on. But I think this will obviously be helpful in removing some risk from their balance sheet and allowing them to expand their lending. So I don't see any problem from this, but we will certainly keep close track of what is going on. Senator Akaka. I am also concerned about the statutory as well as regulatory aspects that what we are trying to do will affect us. So Chairman Bernanke, the Federal Reserve's statutory responsibilities focus on monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates. My question is, to what extent will the injection of this $700 billion affect your ability to meet these goals? " FOMC20080430meeting--182 180,MR. FISHER.," Well, Mr. Chairman, I was listening very carefully to Governor Kohn, as I do the rest of my colleagues. I noted your comment that it doesn't buy us much. I'm worried that it may cost us much. Had I gone first, I would have made arguments similar to those of President Plosser and President Evans. I am in favor of a pause. I think that is pretty clear. I want to stress a couple of things I mentioned yesterday because I think they're important. I am concerned about our costs regarding what I call a different kind of adverse feedback loop, which is the inflation dynamic whereby reductions in the fed funds rate lead to a weaker dollar and upward pressure on global commodity prices, which feed through to higher U.S. inflation and to cutbacks in consumption by consumers and actions by employers to offset the effects of inflation. I quoted a CEO, whom I consider to be very highly regarded, regarding his company's behavioral patterns. This is someone, by the way, who was in the business in the 1970s. He said, ""We're learning to run a business, once again, in an inflationary environment."" That quote bothers me because it shows a behavioral response. This goes beyond the issue, but I thought that comment you made yesterday about relative prices, Mr. Chairman, was very interesting. But it shows a behavioral response, and behaviors eventually become habits, and habits become trends, and I'm worried about that. There was a period when I felt that we were at risk of a repetition of the 1930s. I think the liquidity measures that we have taken--which I have fully supported, and I applaud you, Mr. Chairman, and the New York group for thinking these through with the staff--have provided the bridge that we spoke of yesterday. Don, you mentioned the 1970s. I am no longer worried about the 1930s, although I think there are tripwires out there that are very, very serious. You pointed to them in your intervention. You are right; under Bill Martin these pressures were put in place. But somebody mentioned yesterday--it may have been Vice Chairman Geithner--that he wasn't around in the 1970s. I actually sat by President Carter's side when he got lectures from a leftwing socialist named Helmut Schmidt and by a right winger named Margaret Thatcher. Their points were that you cannot risk appearing to be complacent about inflation. I worry that we risk appearing to be complacent about inflation. I am speaking within the family here, but I sense that we are giving that appearance on the outside. The question really is, Is it worth � point? What is the risk�return tradeoff here? I don't think it's worth cutting � point. I think it is worth staying where we are. I know that the markets anticipate X or Y. We had a conversation about that yesterday. I made my living in the markets. The markets come and go, and I am happy to hear Governor Kohn say that we are not influenced by the markets. I don't think we should be. Their reactions are momentary. But I just don't feel the risk�return tradeoff makes it worthwhile for a � point cut here unless we saw evidence of substantial downside slippage beyond what we are all discounting for housing, which is very negative. I have spoken about a price correction of 35 percent from peak to trough, and we're not there yet. It would have to be more negative than that to convince me to cut rates further. So, Mr. Chairman, I respectfully submit that we should pause, and that's how I plan to vote. Thank you, Mr. Chairman. " FOMC20051213meeting--86 84,MR. KOHN.," Thank you, Mr. Chairman. The news over the intermeeting period has suggested some shift in the nature of the inflation risks faced by the economy. Low and stable core December 13, 2005 53 of 100 of inflation expectations seem to imply a reduced threat from near-term feed-through of energy prices to expectations or to core inflation. At the same time, however, information on output and demand indicate that the economy remains on a growth track which is expanding a little more quickly than potential supply. And this is a trajectory that would increase pressure on resources at a time when those resources are already being fairly well employed. The reasons for the greater-than-expected momentum in output are unclear. Some of the strength may represent a more muted response to hurricane disruptions or energy prices than anticipated, but much would seem to be related to underlying strength in aggregate demand. The upward surprises in demand in the third quarter were global, not just in the United States. Increases in industrial commodity prices and sizable gains in equity prices around the world evidence widespread economic strength and expectations that it will persist. Added demand and rising equity prices have provoked little, if any, offsetting tightening in financial conditions in credit markets. Long-term interest rates globally were little changed on balance over the intermeeting period, and risk spreads out the yield curve and across risk categories continue to be low, reflecting the basically optimistic outlook of investors. Perhaps the resilience of the global economy to oil price increases and persistent expansion in global GDP, including in such laggards as Japan, are slowly increasing the confidence of non- financial businesses as well. In the United States, the growth of business investment has come into line with past relationships with the cost of capital and changes in output, though the level of investment still remains a bit lower than might be expected. As a consequence of this strength, one question is whether the current constellation of interest rates and asset prices, including expectations of the funds rate topping out in the 4½ to 4¾ percent December 13, 2005 54 of 100 neighborhood of its potential and to keep inflation stable. In the staff forecast and in the markets, such a rise in the funds rate is seen as sufficient to contain inflation, and that strikes me as a reasonable estimate, pending further information. Although long-term rates haven’t changed much for several quarters, short- and intermediate- term rates have increased quite a lot and will continue to move higher as we firm policy. These higher rates should exert increasing restraint on spending, especially for households that have been relying on borrowing at low short-term rates to short-circuit liquidity and income constraints when buying durables or houses. The slowing in consumer credit growth and mortgage loan applications in recent months may, indeed, indicate that higher short- and intermediate-term rates are beginning to bite. Moreover, perhaps as a consequence of the rise in borrowing costs, we do see some signs of a cooling in housing markets, as many of you remarked. Certainly the perceptions about housing markets of both builders and buyers have deteriorated noticeably in recent months, and the shift in attitudes may be particularly important when a significant portion of the activity in this market has been linked to investment demand. Based on these indicators and others, a slowing of house price appreciation and a moderation in construction activity next year seem to be a reasonable expectation. Such a slowing is a critical element behind the moderation in growth next year in the staff forecast, and I suspect in the market’s assessment as well. Still, we need to see more concrete evidence that this channel is working as anticipated, both in prices and in activity, before we can be confident that demand is likely to moderate. Nonetheless, the incoming information also reinforces the notion that we can afford to retain the gradual path of policy tightening as we look for signs that moderation is coming. With the upward revision to December 13, 2005 55 of 100 growth of potential. In addition, the better productivity and the downward revision to compensation data show the increase in business costs being held in check better than had been evident. And the higher rate of growth of structural productivity should help to hold down that increase in costs going forward. Moreover, the markups of price over unit labor costs have risen appreciably in the last two quarters for both nonfarm business as a whole and, within that category, for nonfinancial corporations. And those markups are close to the record highs of the mid-1990s, suggesting that businesses have some room and incentive to absorb some of the increases in labor costs that might be coming. As a consequence of these developments, I think we can be a little less concerned about the immediate threat of higher inflation, though we still need to focus on forestalling the potential for supply-demand imbalances to develop over the medium run. Thank you, Mr. Chairman." FOMC20070628meeting--134 132,MR. WARSH.," Thank you, Mr. Chairman. Regarding overall economic growth, my own macroeconomic views are not inconsistent with the central tendency of the projections that were pulled together for this meeting. I think the staff and the participants around the table deserve significant credit for being stubborn about the moderate-growth hypothesis while markets have been on all sides of it. The markets appear ready to look through the second-quarter GDP growth number, which appears to be a bit above trend. I’d say that we have gotten some credit from the markets for being stubborn and stubbornly right on our economic forecast, but they certainly haven’t given us their proxy, and I would not expect them to do so. They happen to share our views for now is what I would say, and I wouldn’t expect that situation to remain over the forecast period. Again, neither should our intention be to somehow get these curves to match over the coming several quarters. On the inflation picture, though it has improved a bit—and I am trying not to disregard very good news—I must say that it strikes me as thoroughly unconvincing. To me, inflation, in our old statement language, remains the predominant risk. I am less certain that core will continue the recent trend. I do believe that headline inflation may be telling us something in terms of secular trends around energy and food that we can’t dismiss, and the warnings from some of the other signals that we would see as rough proxies for inflation are still very real. Regarding what the financial conditions are telling us about growth, it strikes me that, from all the data we have received between our last meeting and this, financial conditions might be as different as any other sets of data that we received. My view is that financial conditions are still supportive of growth, but somewhat less so. It is hard to determine at this point how much, but let me take a stab at doing just that. Since we last met, as Bill said at the outset, we witnessed ten-year Treasury yields increase on the order of between 30 and 50 basis points. I am not uncomfortable with that incremental tightening of policy in the financial markets, but we have to be careful of what we wish for. I think the explanation from our staff here in Washington and Bill and the staff in New York is right, which is that markets have not come to a rosier view of the future. All they have really done is to take out the downside risk that came out of the first quarter. As the data came in a bit above expectations, that insurance bet that they had—that we were wrong and would have to cut rates—really lost credibility. I think their central view of the economy now is not one that roars back but one that is quite consistent with the moderate growth story. The financial markets have indeed tightened policy somewhat. Even since the time that the Bluebook was produced last week, spreads have apparently widened in addition to the risk-free rate being somewhat higher. But this is all happening in very real time, and my report a week ago would have sounded quite a bit different from the one today. We have witnessed increased term premiums and greater volatility across many, if not all, financial markets. Both the MOVE index for Treasuries and the VIX for equities are high relative to the averages of the past year but are still fairly reasonable over a somewhat broader period—say, the last five years. Term premiums I would characterize as returning to more-normal levels—but, again, not out of line with history. We have seen in the Bluebook that credit default swap (CDS) spreads and other spreads had widened, but that yet hadn’t happened in the high-yield market, where apparently there was some narrowing of spreads. That has changed rather dramatically in the past four or five trading days. I’m sure Vince will share more information on this tomorrow. But the CDS spreads really occurred first; then there was a lag to high-yield spreads. In the past two weeks, investment-grade CDS spreads have widened about 7 basis points, high-yield CDS spreads have widened about 20; a relatively new index of loan CDS spreads has widened about 65 basis points; and most, if not all, structured products, even assets wholly unrelated to the housing markets, have been undergoing some spread widening. As I mentioned, high-yield spreads appear to be catching up to CDS spreads, and with the incredible flow of deals in the market, I would guess that the trend continues. We’re seeing higher financing costs and slightly tougher terms for LBOs; the latter is a remarkable new development. M&A prices, probably for the first time since I have been sitting at this table, appear in the markets to be coming off their levels. So when auctions for properties of publicly traded companies are occurring, the price between initial indications of interest and final bids for the first time may actually be coming down. Why is that? Interest coverage ratios cannot go much below where they have been in this cycle. It is 1.2 or 1.3 times, but again, as the risk-free rate has gone up, as spreads have widened, you can buy just a little less debt for that. As a result, equity players that do not want to compromise their equity returns can pay a little less for these properties. Whether this phenomenon is very short term, like the phenomena we heard about after the tumult in late February and we returned to in the heady days of the capital markets, I do not know. This may just be a temporary preference shift toward quality and toward higher volatility and a return to the “glory” days, but I tend to think not. It is a tough call, and I reserve the right to change my judgment. I think that the new supply that’s coming into the markets, most of which needs to get priced before the markets slow down in August, will test the markets’ resilience, will test prices, and will test terms. Up to this point we have seen very little reduction in liquidity, but we are seeing a few deals being pulled from the market. Pricing power appears to be coming back to investors, and negotiations around prices and terms seem significantly more balanced than they have been in a very long time. Some of the instruments that we have sort of giggled about around this table—the pay-in-kind notes with optional cash payment— seem to have lost some traction in the market in the past week. I do not know whether they will return, but I take this new discipline in the markets as an encouraging sign. So what is going to be the resulting effect on prices, terms, and conditions? That is something we will have to judge; but financial conditions, as I said at the outset, are perhaps somewhat more restrictive than they were, but they should still be quite supportive of growth. At the outset I talked about the risk on the inflation front. Let me build on a couple of remarks that Vice Chairman Geithner made about risks now in the financial markets. If the problems that we have seen around structured products that have come out of the Bear Stearns scenario are really about the subprime markets and subprime collateral and housing, there’s not much to worry about. But to the extent that the story is really about structured products—products that have not been significantly stress-tested—then there is a risk that the financial markets may react and overreact. That scenario will bring up reputational risk issues. Even financial intermediaries that are in the agency business are relearning the lesson that agency business is not free—that there are, in fact, dissynergies from being in the principal investment business and the agency business under one marketing name. We are learning a lot about what the markets believe about the transparency of prices, particularly in times of financial distress. Of course, in times of distress, the correlations among all these assets do not look as they do in models, and that is something that will play itself out. I think that Tim rightly referenced the role of gatekeepers in the credit agencies, who I suspect are going to have a fairly rude awakening over the next six to nine months. As I also said, regarding this financial innovation, which on net is of great benefit to us, we will really see some of the products tested. Along with the products, moreover, the market participants’ behavior will be tested, perhaps in this upcoming period, as never before. So the financial markets are a friend on this, but there is greater risk than there was when we last met. Thank you, Mr. Chairman." fcic_final_report_full--201 THE MADNESS CONTENTS CDO managers: “We are not a rent-a-manager” .............................................  Credit default swaps: “Dumb question” .............................................................  Citigroup: “I do not believe we were powerless” .................................................  AIG: “I’m not getting paid enough to stand on these tracks” .............................  Merrill: “Whatever it takes” ..............................................................................  Regulators: “Are undue concentrations of risk developing?” ..............................  Moody’s: “It was all about revenue” ...................................................................  The collateralized debt obligation machine could have sputtered to a natural end by the spring of . Housing prices peaked, and AIG started to slow down its business of insuring subprime-mortgage CDOs. But it turned out that Wall Street didn’t need its golden goose any more. Securities firms were starting to take on a significant share of the risks from their own deals, without AIG as the ultimate bearer of the risk of losses on super-senior CDO tranches. The machine kept humming throughout  and into . “That just seemed kind of odd, given everything we had seen and what we had concluded,” Gary Gorton, a Yale finance professor who had designed AIG’s model for analyzing its CDO positions, told the FCIC.  The CDO machine had become self-fueling. Senior executives—particularly at three of the leading promoters of CDOs, Citigroup, Merrill Lynch, and UBS— apparently did not accept or perhaps even understand the risks inherent in the products they were creating. More and more, the senior tranches were retained by the arranging securities firms, the mezzanine tranches were bought by other CDOs, and the equity tranches were bought by hedge funds that were often engaged in complex trading strategies: they made money when the CDOs performed, but could also make money if the market crashed. These factors helped keep the mortgage market going long after house prices had begun to fall and created massive expo- sures on the books of large financial institutions—exposures that would ultimately bring many of them to the brink of failure. The subprime mortgage securitization pioneer Lewis Ranieri called the willing suspension of prudent standards “the madness.” He told the FCIC, “You had the  breakdown of the standards, . . . because you break down the checks and balances that normally would have stopped them.”  CHRG-109shrg30354--32 Chairman Bernanke," Thank you. Mr. Chairman and Members of the Committee I am pleased to be here again to present the Federal Reserve's Monetary Policy Report to the Congress. Over the period since our February report, the U.S. economy has continued to expand. Real gross domestic product is estimated to have risen at an annual rate of 5.6 percent in the first quarter of 2006. The available indicators suggest that economic growth has more recently moderated from that quite strong pace, reflecting a gradual cooling of the housing market and other factors that I will discuss. With respect to the labor market, more than 850,000 jobs were added, on net, to nonfarm payrolls over the first 6 months of the year, though these gains came at a slower pace in the second quarter than in the first. Last month, the unemployment rate stood at 4.6 percent. Inflation has been higher than we has anticipated in February, partly as a result of further sharp increases in the prices of energy and other commodities. During the first 5 months of the year, overall inflation, as measured by the price index for personal consumption expenditures, averaged 4.3 percent at an annual rate. Over the same period, core inflation--that is, inflation excluding food and energy prices--averaged 2.6 percent at an annual rate. To address the risk that inflation pressures might remain elevated, the Federal Open Market Committee continued to firm the stance of monetary policy, raising the Federal funds rate another three-quarters of a percentage point to 5.25 percent in the period since our last report. Let me now review the current economic situation and the outlook in a bit more detail, beginning with developments in the real economy and then turning to the inflation situation. I will conclude with some comments on monetary policy. The U.S. economy appears to be in a period of transition. For the past 3 years or so, economic growth in the United States has been robust. This growth has reflected both the ongoing reemployment of underutilized resources as the economy recovers from the weakness of earlier in the decade, and the expansion of the economy's underlying productive potential, as determined by such factors as productivity trends and the growth of the labor force. Although the rates of resource utilization that the economy can sustain cannot be known with any precision, it is clear that, after several years of above-trend growth, slack in resource utilization has been substantially reduced. As a consequence, a sustainable, noninflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past 3 years to a pace more consistent with the rate of increase in the Nation's underlying productive capacity. It bears emphasizing that, because productivity growth seems likely to remain strong, the productive capacity of our economy should expand over the next few years at a rate sufficient to support solid growth in real output. As I have noted, the anticipated moderation in economic growth now seems to be underway, although the recent erratic growth pattern complicates this assessment. That moderation appears most evident in the household sector. In particular, consumer spending, which makes up more than two-thirds of aggregate spending, grew rapidly during the first quarter but decelerated during the spring. One likely source of this deceleration was higher energy prices, which have adversely affected the purchasing power of households and weighed on consumer attitudes. Outlays for residential construction, which have been at very high levels in recent years, rose further in the first quarter. More recently, however, the market for residential real estate has been cooling, as can be seen in the slowing of new and existing home sales and housing starts. Some of the recent softening in housing starts may have resulted from the unusually favorable weather during the first quarter of the year, which pulled forward construction activity, but the slowing of the housing market appears to be more broad-based than can be explained by that factor alone. Home prices, which have climbed at double-digit rates in recent years, still appear to be rising for the Nation as a whole, though significantly less rapidly than before. These developments in the housing market are not particularly surprising, as the sustained run-up in housing prices, together with some increase in mortgage rates, has reduced affordability and thus the demand for new homes. The slowing of the housing market may restrain other forms of household spending as well. With homeowners no longer experiencing increases in the equity value of their homes at the rapid pace seen in the past few years, and with the recent declines in stock prices, increases in household net worth are likely to provide less of a boost to consumer expenditures than they have in the recent past. That said, favorable fundamentals, including relatively low unemployment and rising disposable incomes, should provide support for consumer spending. Overall, household expenditures appear likely to expand at a moderate pace, providing continued impetus to the overall economic expansion. Although growth in household spending has slowed, other sectors of the economy retain considerable momentum. Business investment in new capital goods appears to have risen briskly, on net, so far this year. In particular, investment in nonresidential structures, which had been weak since 2001, seems to have picked up appreciably, providing some offset to the slower growth in residential construction. Spending on equipment and software has also been strong. With a few exceptions, business inventories appear to be well aligned with sales, which reduces the risk that a buildup of unwanted inventories might act to reduce production in the future. Business investment seems likely to continue to grow at a solid pace, supported by growth in final sales, rising backlogs of orders for capital goods, and high rates of profitability. To be sure, businesses in certain sectors have experienced financial difficulties. In the aggregate, however, firms remain in excellent financial condition and credit conditions for businesses are favorable. Globally, output growth appears strong. Growth of the global economy will help support U.S. economic activity by continuing to stimulate demand for our exports of goods and services. One downside of the strength of the global economy, however, is that it has led to significant increases in the demand for crude oil and other primary commodities over the past few years. Together with heightened geopolitical uncertainties and the limited ability of suppliers to expand capacity in the short-run, these rising demands have resulted in sharp rises in the prices at which these goods are traded internationally, which in turn has put upward pressure on costs and prices in the United States. Overall, the U.S. economy seems poised to grow in coming quarters at a pace roughly in line with the expansion of its underlying productive capacity. Such an outlook is embodied in the projections of Members of the Board of Governors and the Presidents of Federal Reserve Banks that were made at around the time of the FOMC meeting late last month, based on the assumption of appropriate monetary policy. In particular, the central tendency of those forecasts is for real GDP to increase about 3.75 percent to 3.5 percent in 2006 and 3 percent to 3.25 percent in 2007. With output expanding at a pace near that of the economy's potential, the civilian unemployment rate is expected to finish both 2006 and 2007 between 4.75 percent and 5 percent, close to its recent level. I turn out to the inflation situation. As I noted, inflation has been higher than we expected at the time of our last report. Much of the upward pressure on overall inflation this year has been due to increases in the prices of energy and other commodities and, in particular, to the higher prices of products derived from crude oil. Gasoline prices have increased notably as a result of the rise in petroleum prices as well as factors specific to the market for ethanol. The pickup in inflation so far this year has also been reflected in the prices of a range of nonenergy goods and services, as strengthening demand may have given firms more ability to pass energy and other costs through to consumers. In addition, increases in residential rents, as well as the imputed rent on owner-occupied homes, have recently contributed to higher core inflation. The recent rise in inflation is of concern to the FOMC. The achievement of price stability is one of the objectives that makes up the Congress's mandate to the Federal Reserve. Moreover, in the long-run, price stability is critical to achieving maximum employment and moderate long-term interest rates, the other parts of the Congressional mandate. The outlook for inflation is shaped by a number of factors, not the least of which is the course of energy prices. The spot price of oil has moved up significantly further in recent weeks. Futures quotes imply that market participants expect petroleum prices to roughly stabilize in coming quarters; such an outcome would, over time, reduce one source of upward pressure on inflation. However, expectations of a leveling out of oil prices have been consistently disappointed in recent years, and as the experience of the past week suggests, possible increases in these and other commodity prices remain a risk to the inflation outlook. Although the cost of energy and other raw materials are important, labor costs are by far the largest component of business costs. Anecdotal reports suggest that the labor market is tight in some industries and occupations and that employers are having difficulty attracting certain types of skilled workers. To date, however, moderate growth in most broad measures of nominal labor compensation and the ongoing increases in labor productivity have held down the rise in unit labor costs, reducing pressure on inflation from the cost side. Employee compensation per hour is likely to rise more quickly over the next couple of years in response to the strength of the labor market. Whether faster increases in nominal compensation create additional cost pressures for firms depends in part on the extent to which they are offset by continuing productivity gains. Profit margins are currently relatively wide, and the effect of a possible acceleration in compensation on price inflation would thus also depend on the extent to which competitive pressures force firms to reduce margins rather than pass on higher costs. The public's inflation expectations are another important determinant of inflation. The Federal Reserve must guard against the emergence of an inflationary psychology that could impart greater persistence to what otherwise would be a transitory increase in inflation. After rising earlier this year, measures of longer-term inflation expectations, based on surveys and on a comparison of yields on nominal and inflation-index Government debt, have edged down and remained contained. These developments bear watching, however. Finally, the extent to which aggregate demand is aligned with the economy's underlying productive potential also influences inflation. As I noted earlier, FOMC participants project that the growth in economic activity should moderate to a pace close to that of the growth of potential both this year and next. Should that moderation occur as anticipated, it should also help to limit inflation pressures over time. The projections of the Members of the Board of Governors and the Presidents of the Federal Reserve Banks, which are based on information available at the time of the last FOMC meeting, are for a gradual decline in inflation in coming quarters. As measured by the price index for personal consumption expenditures excluding food and energy, inflation is projected to be 2.25 percent to 2.5 percent this year, and then to edge lower, to 2 percent to 2.25 percent, next year. The FOMC projections, which now anticipate slightly lower growth in real output and higher core inflation than expected in our February report, mirror the somewhat more adverse circumstances facing our economy, which have resulted from the recent steep run-up in energy costs and higher-than-expected inflation more generally. But they also reflect our assessment that with appropriate monetary policy and in the absence of significant unforeseen developments, the economy should continue to expand at a solid and sustainable pace and core inflation should decline from its recent level over the medium-term. Although our baseline forecast is for moderating inflation, the Committee judges that some inflation risks remain. In particular, the high prices of energy and other commodities, in conjunction with high levels of resource utilization that may increase the pricing power of suppliers of goods and services, have the potential to sustain inflation pressures. More generally, if the pattern of elevated readings on inflation is more protracted or more intense than is currently expected, this higher level of inflation could become embedded in the public's inflation expectations and in price-setting behavior. Persistently higher inflation would erode the performance of the real economy and would be costly to reverse. The Federal Reserve must take account of these risks in making its policy decisions. In our pursuit of maximum employment and price stability, monetary policymakers operate in an environment of uncertainty. In particular, we have imperfect knowledge about the effects of our own policy actions as well as of the many other factors that will shape economic developments during the forecast period. These uncertainties bear importantly on our policy decisions because the full influence of policy actions on the economy is felt only after a considerable period of time. The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choice on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still ``in the pipeline.'' Finally, as I have already noted, we must consider not only what appears to be the most likely outcome but also the risks to that outlook and the costs that would be incurred should any of those risks be realized. At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections. In particular, as the Committee noted in the statement issued after its June meeting, the extent and timing of any additional firming that may be needed to address inflation risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by our analysis of the incoming information. Thank you. I would be happy to take questions. " CHRG-109hhrg31539--9 Mr. Bernanke," Thank you. Mr. Chairman, and members of the committee, I am pleased to be here again to present the Federal Reserve's Monetary Policy Report to the Congress. Over the period since our February report, the U.S. economy has continued to expand. Real gross domestic product is estimated to have risen at an annual rate of 5.6 percent in the first quarter of 2006. The available indicators suggest that economic growth has more recently moderated from that quite strong pace, reflecting a gradual cooling of the housing market and other factors that I will discuss. With respect to the labor market, more than 850,000 jobs have been added, on net, to nonfarm payrolls in the first 6 months of the year, though these gains came at a slower pace in the second quarter than in the first. Last month the unemployment rate stood at 4.6 percent. Inflation has been higher than we anticipated in February, partly as a result of further sharp increases in the prices of energy and other commodities. During the first 5 months of the year, overall inflation, as measured by the price index for personal consumption expenditures, averaged 4.3 percent at an annual rate. Over the same period, core inflation, that is, inflation excluding food and energy prices, averaged 2.6 percent at an annual rate. To address the risk that inflation pressures might remain elevated, the Federal Open Market Committee continued to firm the stance of monetary policy, raising the Federal funds rate another three-quarters of a percentage point to 5\1/4\ percent in the period since our last report. Let me now review the current economic situation and the outlook in a bit more detail, beginning with developments in the real economy and then turning to the inflation situation. I will conclude with some comments on monetary policy. The U.S. economy appears to be in a period of transition. For the past 3 years or so, economic growth in the United States has been robust. This growth has reflected both the ongoing reemployment of underutilized resources as the economy recovered from the weakness of earlier in the decade and the expansion of the economy's underlying productive potential as determined by such factors as productivity trends and growth of the labor force. Although the rate of resource utilization that the economy can sustain cannot be known with any precision, it is clear that after several years of above-trend growth, slack in resource utilization has been substantially reduced. As a consequence, a sustainable noninflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past 3 years to a pace more consistent with the rate of increase in the Nation's underlying productive capacity. It bears emphasizing that because productivity growth seems likely to remain strong, the productive capacity of our economy should expand over the next few years at a rate sufficient to support solid growth in real output. As I have noted, the anticipated moderation in economic growth now seems to be under way, although the recent erratic growth pattern complicates this assessment. That moderation appears most evident in the household sector. In particular, consumer spending, which makes up more than two-thirds of aggregate spending, grew rapidly during the first quarter, but decelerated during the spring. One likely source of this deceleration was higher energy prices, which have adversely affected the purchasing power of households and have weighed on consumer attitudes. Outlays for residential construction, which have been at very high levels in recent years, rose further in the first quarter. More recently, however, the market for residential real estate has been cooling, as can be seen in the slowing of new and existing home sales and housing starts. Some of the recent softening in housing starts may have resulted from the unusually favorable weather during the first quarter of the year which pulled forward construction activity, but the slowing of the housing market appears to be more broad-based than can be explained by that factor alone. Home prices, which have climbed at double-digit rates in recent years, still appear to be rising for the Nation as a whole, though significantly less rapidly than before. These developments in the housing market are not particularly surprising as the sustained run-up in housing prices, together with some increase in mortgage rates, has reduced affordability and thus the demand for new homes. The slowing of the housing market may restrain other forms of household spending as well. With homeowners no longer experiencing increases in the equity value of their homes at the rapid pace seen in the past few years, and with the recent declines in the stock prices, increases in household net worth are likely to provide less of a boost to consumer expenditures than they have in the recent past. That said, favorable fundamentals, including relatively low unemployment and rising disposable incomes, should provide support for consumer spending. Overall, household expenditures appear likely to expand at a moderate pace, providing continued impetus to the overall economic expansion. Although growth in household spending has slowed, other sectors of the economy retain considerable momentum. Business investment in new capital goods appears to have risen briskly, on net, so far this year. In particular, investment in nonresidential structures which had been weak since 2001 seems to have picked up appreciably, providing some offset to the slower growth in residential construction. Spending on equipment and software has also been strong. With a few exceptions, business inventories appear to be well aligned with sales, which reduces the risk that a build-up of unwanted inventories might actually reduce production in the future. Business investment seems likely to continue to grow at a solid pace, supported by growth in final sales, rising backlogs of orders for capital goods, and high rates of profitability. To be sure, businesses in certain sectors have experienced financial difficulties. In the aggregate, however, firms remain in excellent financial condition, and credit conditions for businesses are favorable. Globally, output growth appears strong. Growth of the global economy will help support U.S. economic activity by continuing to stimulate demand for our exports of goods and services. One downside to the strength of the global economy, however, is that it has led to significant increases in the demand for crude oil and other primary commodities in the past few years. Together with heightened geopolitical uncertainties and the limited ability of suppliers to expand capacity in the short run, these rising demands have resulted in sharp rises in the prices of which these goods are traded internationally, which in turn has put upward pressure on costs and prices in the United States. Overall, the U.S. economy seems poised to grow in coming quarters at a pace roughly in line with the expansion of its underlying productive capacity. Such an outlook is embodied in the projections of members of the Board of Governors and the presidents of Federal Reserve Banks that were made around the time of the FOMC meeting late last month, based on the assumption of appropriate monetary policy. In particular, the central tendency of those forecasts is for real GDP to increase about 3\1/4\ percent to 3\1/2\ percent in 2006, and 3 percent to 3\1/4\ percent in 2007. With output expanding at a pace near that of the economy's potential, the civilian unemployment rate is expected to finish both 2006 and 2007 between 4\3/4\ percent and 5 percent, close to its recent level. I turn now to the inflation situation. As I noted, inflation has been higher than we expected at the time of our last report. Much of the upward pressure on overall inflation this year has been due to increases in the prices of energy and other commodities, and in particular to the higher prices of products derived from crude oil. Gasoline prices have increased notably as a result of the rise in petroleum prices as well as factors specific to the market for ethanol. The pickup in inflation so far this year has also been reflected in the prices of a range of goods and services as strengthening demand may have given firms more ability to pass energy and other costs through to consumers. In addition, increases in residential rents as well as in the imputed rent on owner-occupied homes have recently contributed to higher core inflation. The recent rise in inflation is of concern to the FOMC. The achievement of price stability is one of the objectives that make up the Congress' mandate to the Federal Reserve. Moreover, in the long run, price stability is critical to achieving maximum employment and moderate long-term interest rates, the other parts of the Congressional mandate. The outlook for inflation is shaped by a number of factors, not the least of which is the course of energy prices. The spot price of oil has moved up significantly further in recent weeks. Futures quotes imply that market participants expect petroleum prices to roughly stabilize in coming quarters. Such an outcome would, over time, reduce one source of upward pressure on inflation. However, expectations of a leveling out of oil prices have been consistently disappointed in recent years, and as the experience of the past week suggests, possible increases in these and other commodity prices remain a risk to the inflation outlook. Although the costs of energy and other raw materials are important, labor costs are by far the largest component of business costs. Anecdotal reports suggest that the labor market is tight in some industries and occupations, and that employers are having difficulty attracting certain types of skilled workers. To date, however, moderate growth in most broad measures of nominal labor compensation and the ongoing increases in labor productivity have held down the rise in unit labor costs, reducing pressure on inflation from the cost side. Employee compensation per hour is likely to rise more quickly over the next couple of years in response to the strength of the labor market. Whether faster increases in nominal compensation create additional cost pressures for firms depends in part on the extent to which they are offset by continuing productivity gains. Profit margins are currently relatively wide, and the effect of a possible acceleration in compensation in price inflation would also depend on the extent to which competitive pressures force firms to reduce margins rather than to pass on higher costs. The public's inflation expectations are another important determinant of inflation. The Federal Reserve must guard against the emergence of an inflationary psychology that could impart greater persistence than what could otherwise be a transitory increase in inflation. After rising earlier this year, measures of expectations, based on surveys and on a comparison of yields on nominal and inflation-indexed government debt, have edged down and remain contained. These developments bear watching, however. Finally, the extent to which aggregate demand is aligned with the economy's underlying productive potential also influences inflation. As I noted earlier, FOMC participants project the growth in economic activity should moderate to a pace close to that of the growth of potential both this year and next. Should that moderation occur as anticipated, it should help to limit inflation pressures over time. The projections of the members of the Board of Governors and the presidents of the Federal Reserve Banks, which are based on information available at the time of the last FOMC meeting, are for a gradual decline in inflation in coming quarters. As measured by the price index for personal consumption expenditures excluding food and energy, inflation is projected to be 2\1/4\ percent to 2\1/2\ percent this year and then to edge lower to 2 percent to 2\1/4\ percent next year. The FOMC projections, which now anticipate slightly lower growth in real output and higher core inflation than expected in our February report, mirror the somewhat more adverse circumstances facing our economy which have resulted from the recent steep run-up in energy costs and higher-than-expected inflation more generally. But they also reflect our assessment that with appropriate monetary policy, and in the absence of significant unforeseen developments, the economy should continue to expand at a solid and sustainable pace, and core inflation should decline from its recent level over the medium term. Although our baseline forecast is for moderating inflation, the committee judges that some inflation risks remain. In particular, the high prices of energy and other commodities in conjunction with high levels of resource utilization that may increase the pricing power of suppliers of goods and services have the potential to sustain inflation pressures. More generally, if the pattern of elevated readings on inflation is more protracted or is more intense than currently expected, this higher level of inflation could become embedded in the public's expectations and in price-setting behavior. Persistently higher inflation would erode the performance of the real economy and would be costly to reverse. The Federal Reserve must take into account these risks in making its policy decisions. In our pursuit of maximum employment and price stability, monetary policymakers operate in an environment of uncertainty. In particular, we have imperfect knowledge about the effects of our own policy actions as well as of the many other factors that will shape economic developments during the forecast period. These uncertainties bear importantly on our policy decisions because the full influence of policy actions on the economy is felt only after a considerable period of time. The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take into account the possible future effects of previous policy actions, that is, of policy effects still in the pipeline. Finally, as I have noted, we must consider not only what appears to be the most likely outcome, but also the risks to that outlook and the costs that would be incurred should any of those risks be realized. At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all of our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections. In particular, as the committee noted in the statement issued after its June meeting, the extent and timing of any additional firming that may be needed to address inflation risks will depend on the evolution of the outlook for both inflation and economic growth as implied by our analysis of the incoming information. Thank you. I would be happy to take questions. " FOMC20080625meeting--77 75,MR. PLOSSER.," Thank you, Mr. Chairman. In the Third District, as anticipated, manufacturing activity, residential construction, and employment have remained weak. Nonresidential construction has now softened, although vacancy rates in Philadelphia and around the District remain relatively low. Retail sales remain sluggish. Bank lending has been restrained. The outlook among our business contacts, however, varies significantly by sector. Manufacturers expect a rebound in activity over the coming six months, and residential real estate contacts report that they believe market conditions may be near bottom, although they expect any recovery to be slow. Interestingly enough, it is the same sort of anecdotal evidence that President Lockhart referred to. Now, it is hard to know whether it is just mostly wishful thinking or whether there is something real there--although his saying it and my saying it sort of reinforces it a little. But it is the first time that I have heard such news in a very, very long time. Retailers are quite pessimistic, however, because they are expecting the increase in energy prices to limit sales, especially among lower-income customers, despite the tax rebates. Despite the soft economic conditions, the most prominent concern that we have heard from our business contacts across a variety of industries is the run-up in commodity prices and other prices. Thus far, firms have resisted passing along their rising costs to customers, to the extent that they could, but many firms tell us that they have gone as far as they can on holding the line on their own prices and plan to raise prices further in the next few months. Some firms are including general cost-increase clauses in their new contracts. Earlier we saw various sorts of fuel surcharges added onto prices, but now contracts are being written in a way that includes broad cost-adjustment increases. This is still only anecdotal evidence although it has been referred to--I think President Fisher made a couple of comments in this regard. But it may be yet another early warning sign that inflation expectations cannot remain in check indefinitely in this current environment. In June, the prices-paid index in our business outlook survey of manufacturers rose to the highest level it has been since 1980. Manufacturers and firm contacts across a wide range of industries say that they expect their input prices and the prices of their own goods to increase further over the next six months. They see no abatement of price pressures in the near term or medium term and are very pessimistic about inflation. The national economic situation is similar to what I see in my own District, and it is an uncomfortable situation for all of us. The data we have received on economic activity over the intermeeting period have come in slightly better than I expected, but the continued price increases, particularly in oil and commodities, have been a very unpleasant development. Certainly, economic conditions remain weak, and the recent positive news may prove to be transitory. From the financial side, credit spreads have fallen, bond issuance has risen, and it appears that financial market functioning has at least improved. In my view, although downside risks to growth remain, the tail risk of a very bad outcome has clearly been diminished. I expect GDP growth to come in around 1.7 percent this year--only marginally higher than my April projection--before picking back up to trend of around 2.7 percent in 2009-10. Despite the upward revisions in the Greenbook baseline, my forecast remains somewhat more optimistic for growth in 2008 and 2009 than the Greenbook. In fact, my forecast is similar to the Board staff's ""upside risk"" alternative scenario, which essentially removed the downward adjustment factors the staff added to build in more recession-like features caused by the financial turmoil and other factors not captured in their baseline model, which is what Dave was mentioning earlier. My concerns about the inflation outlook have increased since our last meeting. I am not alone. Inflation has become a predominant concern for many businesses and consumers, and you only have to read the newspapers to see that. Obviously, monetary policy cannot control the price of energy, but we do have a responsibility to act to keep broad-based inflation under control. Contributing to the increase in inflation risk is not only the surge in energy and other commodity prices; it is supported also by our own accommodative stance of monetary policy. Short-term inflation expectations and headline inflation measures are up significantly since our last meeting. So far, core inflation increases have been modest, and long-term inflation expectations remain, although volatile, within a tolerable range. But if we continue to maintain the real funds rate well below zero, despite inflation that is well above acceptable levels, can we really expect inflation expectations to remain anchored? We must remember that longer-term inflation expectations tend to lag inflation not to lead it. If we wait until these measures rise, we will be too late. Apropos of President Evans's question about wages, I have been troubled by stories in the press suggesting that we can be less concerned about inflation than we were in the 1970s because wages haven't risen and labor unions are less prominent. These stories suggest that the wage�price spiral caused the unanchoring of inflation expectations in the '70s. But I think this gets the direction of causation backwards. In my view, the story of the '70s was that the public lacked confidence in the central bank's commitment to price stability--it didn't believe the central bank would take the necessary steps to bring inflation under control. As a consequence, inflation expectations rose and wages rose. It was the higher inflation and the lack of credibility that led to higher wage demands. The key to avoiding such a situation, in my view, is maintaining the credibility that the Fed has worked so hard to achieve. The Board staff memo on optimal monetary policy in the context of higher oil prices illustrates the importance of maintaining credibility, and I want to thank the staff for their efforts in this regard. I think it was an excellent piece of work. As they clearly say, the critical factor in containing inflation through an expectations channel is the belief that policymakers will always adhere to a full-commitment rule. When the central bank is unable or unwilling to commit in a credible manner to future policy actions or to a long-run inflation goal, the result is both higher inflation and lower output. In the real world, of course, full commitment can never absolutely be achieved. But beliefs about which regime better approximates reality are informed by the actions taken by the central bank to maintain its commitment to price stability. I believe that the FOMC has done a good job with our words--including FOMC statements, minutes, and speeches--in helping to anchor longer-term expectations. I believe the Chairman's speech at the Boston Fed conference earlier this month delivered a well-articulated and important message about the importance of keeping longer-term inflation expectations anchored. But our credibility rests on more than just words. We must act in a way that is consistent with our hard-earned reputation, or our credibility could soon vanish. To underscore our words, we should take actions and take back some of the insurance we have put on in the context of elevated downside tail risks. Given recent economic developments and the improvement in financial market functioning, coupled with our accommodative stance of policy, it seems pretty clear to me that, if the economy continues to evolve as it has over the past couple of months, we should move to raise the funds rate. This is also the view of market participants, whose expectations for policy have steepened considerably over the intermeeting period. My forecast, therefore, incorporates a monetary policy path that is steeper than the one in the Greenbook. I assume that the funds rate will reach 2.75 percent by the end of 2008 and move up to 4.5 percent by the end of 2009. This steeper funds rate path is necessary, in my view, to deliver inflation that is declining back toward our goal. Regarding the suggestion by the Subcommittee on Communications on lengthening the forecast period, I think it can be a very useful device, and I support it. My preference, however, is for option 2, although I think option 1 could work just as well. I'm for option 2 partly because I, too, am less confident about forecasting whatever the dynamic adjustment process happens to be, and so just going to year 5 I think would be useful. Omitting year 4 is not omitting any information that is terribly informative, as far as I am concerned. I am a little reluctant to go to some longer-term average like five-to-ten years because I think that muddles the communication picture and may signal a weakening of our commitment about the timeframe over which we think we can really achieve some objective. So I am most comfortable with option 2, or I could be happy with option 1 as well. Thank you, Mr. Chairman. " FOMC20080430meeting--206 204,VICE CHAIRMAN GEITHNER.," Okay, but it is a surprising gap. So I think it would be worth some time to think through that. Obviously we also disagree about how inflation works in the United States, how relative price shocks take effect, and what we should respond to in that sense. That would be worth a little time, too. Again, it is a surprise to me. We sit here to make monetary policy, and we haven't talked much about this basic core question: How should we judge the stance of policy? It would be worth some attention. I just want to end by saying something about the dollar. My basic sense about the dollar-- and I'm very worried about this dynamic now--is that it has been trading more on concern about tail risk in the economy and in the financial system than anything else. As I said yesterday, if you look back to when there has been an increase in perceived tail risk, however you want to measure it--credit default swaps on financials or something like that--and the two-year has fallen sharply or we have had a big flight to quality, those have been the periods that have been most adverse to the dollar. Now, it is not a consistent pattern, but I think it's basically right; and I think it gives an important illustration that what goes into a judgment about whether people hold dollars and U.S. financial assets has to do with a lot of things. It has a lot to do with confidence that this Committee will reduce the tail risk in the financial system and the economy to tolerable levels. It also has a lot to do with confidence in our willingness to keep inflation stable over a long period, but it's not only that. Again, we have had a pretty good experiment in that proposition over the past year or so. My sense is that the biggest risk to the dollar, since I'm pretty confident that this Committee is going to make good judgments about inflation going forward, is in the monetary policy of other countries. The real problem for us now is that we have a large part of the world economy--in nonChina, non-Japan Asia and the major energy exporters--still running a monetary policy that is based on the dollar as nominal anchor. That has left them with remarkably easy monetary policy and a pretty significant rise in asset-price inflation. The transition ahead for them as they try to get more independence for monetary policy and soften the link to the dollar is going to carry a lot of risk for us because the market is going to infer from that a big shift in preferences for the currencies that both governments and private actors in those countries hold. As that evolution takes place in their exchange rate and monetary policy regimes the risk for us is that the market expects a destabilizing shift in portfolio preferences, which people might infer is also a loss of confidence in U.S. financial assets. I think that's a big problem for us. It's not clear to me that it means that we should run a tighter monetary policy against that risk than would otherwise be appropriate because I don't think it buys much protection against that risk. I just want to associate myself with all the concerns said about the dollar in this context. The judgment that goes into confidence and people's willingness to hold U.S. financial assets is deeply textured and complex, and it has a lot to do with confidence in this Committee's capacity to navigate the perilous path between getting and keeping down that tail risk and preserving the confidence that inflation expectations over time will stay stable. So I support alternative B and its language. " FOMC20080805meeting--113 111,MR. BULLARD.," Thank you, Mr. Chairman. Economic activity in the Eighth District has remained roughly stable during the summer. Activity in the services sector has increased slightly, and except for the auto industry, manufacturing activity is also stable to slightly higher. Automotive contacts reported a variety of plans to lay off workers or to idle production, and at least three automotive parts suppliers will close plants in the District. Contacts in the auto industry are not optimistic that production will increase in the short term. Retail and auto sales have softened in recent weeks, and some District retail contacts have expressed concerns about summer sales. Many contacts continue to emphasize commodity price levels as a key factor in business decisions. They are concerned both about the necessary business adjustments, given the new pricing structure, and about the implications for the overall level of inflation going forward. The residential real estate sector continues to decline. Across four of the main metropolitan areas in the District, home sales through May declined about 18 percent compared with 2007, whereas single-family construction permits declined about 40 percent. The number of foreclosures in the St. Louis area in the second quarter increased to about 6,300 filings, up about 77 percent from last year. I am impressed, however, with the regionalism in the foreclosure situation, as some areas of the nation continue to have far higher foreclosure rates than others. In contrast with the generally positive reports in commercial real estate activity for the earlier part of 2008, recent reports have indicated more uneven conditions in the nonresidential real estate sector across the District. Turning to the national outlook, I was encouraged by the recent GDP report for the second quarter, which showed growth at an annual rate of 1.9 percent. Real final sales increased at an annual rate of 3.9 percent. It now appears that the worst quarter associated with the current episode of financial turmoil was probably the fourth quarter of 2007, when the economy abruptly stalled. The slow- or no-growth period was through the winter, with the economy gradually regaining footing through the spring and summer. If there were no further shocks, I would expect the economy to grow at a more rapid rate in the second half of this year. But there has been another shock--namely, substantial increases in commodity and energy prices. I think it's important to be careful not to confuse the effects of this latter shock with the effects of the housing-sector shock. My sense is that the level of systemic risk associated with financial turmoil has fallen dramatically. For this reason, I think the FOMC should begin to de-emphasize systemic risk worries. My reasoning is as follows. Systemic risk means that the sudden failure of a particular financial firm would so shock other ostensibly healthy firms in the industry that it would put them out of business at the same time. The simultaneous departure of many firms would badly damage the financial services industry, causing a substantial decline in economic activity for the entire economy. This story depends critically on the idea that the initial failure is sudden and unexpected by the healthy firms in the industry. But why should this be, once the crisis has been ongoing for some time? Are the firms asleep? Did they not realize that they may be doing business with a firm that may be about to default on its obligations? Are they not demanding risk premiums to compensate them for exactly this possibility? My sense is that, because the turmoil has been ongoing for some time, all of the major players have made adjustments as best they can to contain the fallout from the failure of another firm in the industry. They have done this not out of benevolence but out of their own instincts for self-preservation. As one of my contacts at a large bank described it, the discovery process is clearly over. I say that the level of systemic risk has dropped dramatically and possibly to zero. Let me stress that, to be sure, there are some financial firms that are in trouble and that may fail in the coming months or weeks depending on how nimble their managements are at keeping them afloat. This is why many interest rate spreads remain elevated and may be expected to remain elevated for some time. These spreads are entirely appropriate for a financial system reacting to a large shock. But at this point, failures of certain financial firms should not be regarded as so surprising that they will cause ostensibly healthy firms to fail along with them. The period of substantial systemic risk has passed. Of course, we have also endured a bout of systemic risk worries stemming from the operations of the GSEs. However, my view is that the recent legislation has addressed the systemic risk component of that situation as well. Because of these considerations, my assessment is that the chances of unchecked systemic risk pushing the U.S. economy into a severe downturn at this point are small, no larger than in ordinary times. Unfortunately, while the threat from this source is retreating, another threat is upon us-- namely, a substantial shock from increased energy and certain commodities prices, which is leading many to forecast slower growth during the fall. Real automotive output subtracted 1.1 percentage points from real GDP growth in the second quarter. Many contacts seem to attribute this largely to consumer reaction to increased gasoline prices. If this is true, then it seems to me that some of the most visible reaction to this shock may have already occurred, being pulled forward into the second quarter. Labor markets have been weak, but I am not as pessimistic as most on this dimension. So far this year, the U.S. economy has shed about 387,000 nonfarm payroll jobs as compared with a drop in employment of 402,000 jobs during the first seven months of 2003 or 315,000 during the first seven months of 2002. Neither of these latter two episodes is associated with the recession label. These two years might provide better historical guides to the behavior of today's economy than those associated with the recession label, such as 2001, 1990�91 or 1980�82. This is one reason that I think the labeling game can mislead us in our thinking about the economy. The main contribution that the FOMC can make to the economy is to keep inflation low and stable. The headline CPI inflation rate is running close to 5 percent measured from one year earlier. The University of Michigan survey of inflation expectations one year ahead reflects this reality with the most recent reading at 5� percent. The June CPI annualized inflation rate was a 1970ssounding 13.4 percent. Of course, much of this is due to energy prices. Still, with these kinds of numbers we're going to have to do more than talk about inflation risks. Thank you. " CHRG-111shrg57322--262 Mr. Sparks," Well, I think you are referring to the ACA transaction, the Abacus transaction that has been discussed. Any CDO--well, let me tell you how we, at Goldman Sachs, when CDOs were constructed, they were not constructed in a vacuum. Typically, we knew people who had investment criteria that they wanted to fill and wanted to invest in various parts of the capital structure with various underlying assets at various prices. At the same time, we had to get that risk, which means somebody had to sell the risk to create it. That could be done in cash form. It could be done in synthetic form. So I think it is helpful to note that these deals were not created in a vacuum. In that particular transaction, the function of providing the risks to it is from Goldman Sachs Capital Markets, I believe is the correct entity. I would like to check it, but I am pretty sure that is correct. That Goldman actually provided the risk, meaning went short into the Abacus ACA transaction. Goldman Sachs then, in its hedging of its positions, laid that risk off to a client that Goldman knew wanted to take that. So, I am trying to be specific on that question, Senator. Senator Pryor. Right, but so let me ask again: Goldman sold a synthetic collateralized debt obligation without disclosing that a hedge fund manager, John Paulson, helped design the CDO and was betting against the CDO. Did you disclose to your customers there that John Paulson was on the other side of this transaction and he had helped put it together? " CHRG-111hhrg52397--289 Mr. Scott," Let me pursue just a moment if I may, I am reading your statement and just to clarify, you state that, ``Clearing all over-the-counter derivatives and the trading of over-the-counter derivatives on a transparent electronic platform may provide additional risk management and potentially additional price transparency. However, forcing all over-the-counter derivatives to be cleared and traded on the exchange would likely have many unintended consequences.'' Can you give us a little clarity there? It seems as if you are saying on the one hand that it is good but on the other hand there are some bad things that will happen? " FOMC20071031meeting--52 50,MS. YELLEN.," Thank you, Mr. Chairman. Over the past week or so, we have been following the devastating fires in Southern California. They have burned over 500,000 acres, destroyed nearly 2,000 homes, and inflicted seven deaths and sixty injuries. These were large fires, even by California standards, but they were by no means the largest in recent memory; and, of course, the loss of life and economic costs pale compared with Katrina. While the fires have seriously affected the lives of many individuals, they do not seem likely to show up in the macroeconomic data. Turning to the national economy, developments since we met six years—six weeks ago—actually, it seems like just two weeks ago—[laughter] generally have been favorable and the risks to the outlook for growth have eased somewhat. But I think it is too early to say that we are out of the woods. The inflation news has continued to be favorable, but some upside risks have become more prominent. With respect to economic activity, we have raised our forecast for growth in both the third and the fourth quarters in response to incoming data, even though the pace of deterioration in the housing sector has been more severe than we expected and the problems associated with housing finance seem far from resolution. We agree with Greenbook that residential investment is likely to continue its severe contraction for at least a few more quarters. We also agree with Greenbook that the rest of the economy has held up reasonably well, at least so far. Exports have been strong, and while business fixed investment seems to be slowing, it should still make a robust contribution to growth in the second half of this year. With respect to consumer spending, most aggregate data suggest only a modest deceleration so far. Such readings help to allay our concerns about potential spillovers from housing to consumption, but they don’t completely assuage them. Survey measures of consumer confidence are down sharply since the financial turmoil began, and most indexes of house prices show outright declines. Given the current state of the housing and mortgage markets, bigger declines going forward are a distinct possibility. Indeed, the Case-Shiller futures data for house prices point to larger declines in the months ahead. A sharp drop in house prices would likely crimp consumer spending over time through wealth and collateral effects. Some of my directors and other contacts are also raising warning flags about consumer demand. For example, the CEO of a large well-known high-end retailer said that the company’s sales are softening and that the company is having to work diligently to control inventories. In his view, the consumer has pulled back. The CEO of a Southern California bank observed a number of his clients talking about a drop in discretionary consumer purchases. The bottom line is that consumption spending seems to be all right for the time being, but there is a real risk that households may cut back on spending more than expected in response to higher oil prices, a slower economy, and economic uncertainty. I agree with President Rosengren’s assessment of financial markets. Strains appear to have eased a bit on balance since our September meeting, with interbank lending markets showing some improvement and spreads on asset-backed commercial paper declining. But structured credits related to mortgages remain quite troublesome, and liquidity conditions and Treasury bill markets are still at times strained. My impression is that, despite having moved in a positive direction over the past six weeks, these markets remain vulnerable to shocks, and so the economy remains at risk from further financial disruptions. Both survey evidence and anecdotal evidence have confirmed that banks are tightening lending standards across the board. Tighter terms and conditions are being applied to a range of business lending, including commercial real estate, and on most household lending from prime and nonprime mortgages to auto and home equity loans. The main financial variables that are commonly included in formal macroeconometric models appear to have changed since the onset of the financial shock—say, in late June—in ways that should have roughly offsetting effects. Oil prices are markedly higher, which should restrain consumer spending, and the stock market is roughly unchanged since June in spite of the financial turmoil. A weaker dollar should have a positive influence on growth. Mortgages rates on jumbo loans and the rates facing the riskiest corporate borrowers are higher, but many private borrowing rates are down because of the decline in Treasury yields. Of course, the current levels of Treasury yields, as well as the stock market and dollar, reflect at least in part the market’s expectation that the Committee will ease the stance of monetary policy at this meeting. Underlying our forecast is the policy assumption that the Committee will cut the funds rate another 25 basis points at this meeting. In assessing the appropriate path of the stance of policy, I took a number of considerations into account. First, core consumer inflation currently is at a level that I consider consistent with price stability. Second, unemployment is very near my best estimate of the full employment rate. In the context of a Taylor-type rule, these considerations imply that the real funds rate should be near its neutral level. In fact, any version of the Taylor rule you prefer, with whatever rates you want to put on inflation versus the gap, will give you the same recommendation because all the terms are zero and drop out, except for one—the equilibrium real rate. Of course, we cannot know the level of the real equilibrium rate with certainty. Defined in terms of the PCE price index, our best estimate is in the range of 2 to 2½ percent, which is well below the current real rate of about 3 percent. I would like to highlight two additional points here. First, the actual real rate has been boosted over the past six months or so by declines in short-term inflation expectations, whether one measures them by lagged inflation, by surveys of expected inflation over the next year or so, or by forecasts of inflation including the Greenbook forecast. Second, one important aspect of the financial turmoil is that it probably represents in part a movement toward a more reasonable pricing of risk, as seen in the rise in risk spreads. This development tends to push the equilibrium real funds rate down toward the lower portion of the range I just cited. The bottom line is that in my view, even without the contractionary effects of recent financial developments, an appropriate stance of monetary policy would involve further declines in the fed funds rate. I have assumed that the funds rate drops to 4½ percent by the end of this year and to 4¼ by the end of next year. My assumed path ends in the same place and embodies the same medium-term assumption concerning neutral as FRB/US, on which the extended Greenbook forecast relies. The only difference concerns timing. We assume a more rapid path to the long run than the Greenbook does. Our forecast shows real GDP growth gradually picking up to around 2½ percent, our estimate of potential, by the end of next year. However, given that the financial shock is not yet resolved, I think the downside risks to this forecast predominate. With regard to inflation, I expect core PCE inflation to remain around 1¾ percent over the next several years. The probable appearance of a small amount of labor market slack is likely to help hold down inflation. In addition, I expect that, with inflation remaining below 2 percent, inflation expectations will edge down as well, reinforcing our success. I hope that this result will be aided by the release of our extended forecasts and the greater awareness of where we would like to see inflation settle down. I see the risk to my inflation forecast as moderate and mainly to the upside in view of recent increases in oil and food prices, declines in the dollar, and a slower rate of structural productivity growth. So, in summary, I think the most likely outcome is that the economy will move forward toward a soft landing. I see downside risks to economic activity and some upside risks to inflation. But in view of continuing questions about the effects of the financial market shock, I am more concerned about the activity side of things right now." FinancialCrisisReport--420 BBB Index Only BBB Index + CDS BBB- Index Only BBB- Index + CDS All BBBs Index Only All BBBs Index + CDS 06-2 BBB- Index Equiv 06-2 BBB- Idx Eq (MRMA) 06-2 BBB- Index Equiv -2,000,000,000 -4,000,000,000 -6,000,000,000 Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. Derived from Goldman Sachs document, GS MBS-E-012890600. 70 65 60 (w/Cash) 06-2 BBB- Index Price BBB bucket includes BBB+ CDS Notionals: refers to current notionals Positive notionals: long risk CDS: 2005 / 2006 vintages only Index Price FOMC20070131meeting--199 197,MR. PLOSSER.," Thank you, Mr. Chairman. I’ll start off by saying that today I favor maintaining the federal funds rate at 5¼ percent. As we discussed yesterday and we learned this morning, the picture that seems to be emerging from the latest economic information is one of reasonably strong underlying growth, which has been temporarily weakened by housing and autos. Given that temporary weakness, I think it would be premature to raise rates today; but I am not confident that core inflation will continue to decelerate in the coming quarters, and that could risk our credibility. The level of inflation continues to be higher than I’d like to see, and in my forecast we may not see a return to price stability unless monetary conditions are tightened further. Although I don’t think today is the day to do it, I do want us to consider tightening if we see growth accelerating back to trend more quickly than in the Greenbook. I say this not because I think that growth will put upward pressure on inflation but because the associated equilibrium real rates that are implied by that higher growth, which we are beginning to see in the marketplace, will eventually force our hand. As I mentioned in my remarks on the economy at the past two meetings, I have been of the mind that a somewhat slower economy, combined with a constant funds rate, might be sufficient to ensure a decline in core inflation. As the economy strengthens, that scenario becomes a little less likely. If the economy continues to strengthen, a failure to act not only puts our price stability goal at risk but also risks our credibility with the public. Thus it would be ill-advised to suggest in our statement that we are finished acting for a while, and therefore I would not favor the language that Bill Poole circulated last week. My preference is for the language describing the rationale given in alternative C in table 1 of the Bluebook. The rationale in alternative C, including both sections 2 and 3, is really not more hawkish than the language of alternative B, yet it’s more concise and comes closer to my views on the current state of the economy. Indeed, since under alternative B, section 3, or alternative C, section 3, we would be making sizable changes in the language from our last statement, I also think that it’s appropriate at this time to purge the language about the high level of resource utilization having the potential to sustain inflation pressures or lower oil prices to mitigate core inflation. All the recent work on the forecasting of medium-term and longer-term inflation that I have seen says that these Phillips-type models don’t help us forecast core inflation very well. The FRB/US model of the Greenbook looks as though it has very flat tradeoffs, certainly in the near term anyway; so I think it would be useful to change our language at this point. I have not been a fan of that language, but in the past I was persuaded that we should leave it so as to avoid unnecessary changes that might confuse the public. But since we are considering changes at this time, I would favor going with alternative C, which gets rid of this language. I’m happy to continue with the risk assessment that we had last time, eliminating the word “nonetheless,” although frankly I would not greatly resist actually going with the assessment of risk in alternative C. Thank you, Mr. Chairman." CHRG-111hhrg55814--359 Mr. Foster," Thank you. My questions are in regard to subtitle (f) on risk retention during the asset-backed security process. And it is my reading of it that you have very wide authority to set it not just at 10 percent, but to eliminate it entirely or make it significantly higher. My concerns are with the macroeconomic effects and possible politicization of this. It is obvious this could exert a very powerful, and possibly beneficial, damping influence on, for example, real estate price bubbles. If someone had said several years ago that, look, you are securitizing out of Las Vegas, you don't have to put 10 percent down but 25 percent down, it could have had a very beneficial macroeconomic effect. And so my question is, how do you anticipate this will actually be exercised? Do you anticipate varying the risk retention by asset class? By industry sector? By geographical region, in the case of mortgage securitization? Governor Tarullo? " CHRG-111hhrg54867--271 Secretary Geithner," We can't take that risk. And I don't think that is a risk now we face. I mean, we have an independent Federal Reserve whose job is to make sure that we keep prices low and stable over time, growth sustainable. And they are committed to doing that. They have an exceptionally good record of doing that over time because they are independent. But, as a country, on the fiscal side, we are going to have to go back to living within our means to bring these deficits down. But our big risk still at the moment is that we make sure we have a recovery under way that is led by private demand. And we want that to be strong enough and sustainable before we step on the brakes. Again, you know, the big lesson of the United States in the 1930's and Japan in the 1990's, countries throughout history, was to move too quickly out of the hope it was all going to be okay, and put on the brakes in a way that deepened the recession, raised the ultimate costs of recovery. We need to make sure we avoid that risk. But you are absolutely right to emphasize the importance, and no one feels more strongly about it than I do, about the importance that we go back to living within our means and that we walk back these exceptional measures necessary to fix the crisis as quickly as possible. And if you look at what we have done, you are already seeing dramatic reduction in the amount of support the government is providing to the financial system as we, you know, see things starting to improve. " CHRG-109shrg30354--127 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System July 19, 2006 Mr. Chairman and Members of the Committee, I am pleased to be here again to present the Federal Reserve's Monetary Policy Report to the Congress. Over the period since our February report, the U.S. economy has continued to expand. Real gross domestic product (GDP) is estimated to have risen at an annual rate of 5.6 percent in the first quarter of 2006. The available indicators suggest that economic growth has more recently moderated from that quite strong pace, reflecting a gradual cooling of the housing market and other factors that I will discuss. With respect to the labor market, more than 850,000 jobs were added, on net, to nonfarm payrolls over the first 6 months of the year, though these gains came at a slower pace in the second quarter than in the first. Last month, the unemployment rate stood at 4.6 percent. Inflation has been higher than we had anticipated in February, partly as a result of further sharp increases in the prices of energy and other commodities. During the first 5 months of the year, overall inflation as measured by the price index for personal consumption expenditures averaged 4.3 percent at an annual rate. Over the same period, core inflation--that is, inflation excluding food and energy prices--averaged 2.6 percent at an annual rate. To address the risk that inflation pressures might remain elevated, the Federal Open Market Committee (FOMC) continued to firm the stance of monetary policy, raising the Federal funds rate another \3/4\ percentage point, to 5\1/4\ percent, in the period since our last report. Let me now review the current economic situation and the outlook in a bit more detail, beginning with developments in the real economy and then turning to the inflation situation. I will conclude with some comments on monetary policy. The U.S. economy appears to be in a period of transition. For the past 3 years or so, economic growth in the United States has been robust. This growth has reflected both the ongoing reemployment of underutilized resources, as the economy recovered from the weakness of earlier in the decade, and the expansion of the economy's underlying productive potential, as determined by such factors as productivity trends and growth of the labor force. Although the rates of resource utilization that the economy can sustain cannot be known with any precision, it is clear that, after several years of above-trend growth, slack in resource utilization has been substantially reduced. As a consequence, a sustainable, noninflationary expansion is likely to involve a modest reduction in the growth of economic activity from the rapid pace of the past 3 years to a pace more consistent with the rate of increase in the Nation's underlying productive capacity. It bears emphasizing that, because productivity growth seems likely to remain strong, the productive capacity of our economy should expand over the next few years at a rate sufficient to support solid growth in real output. As I have noted, the anticipated moderation in economic growth now seems to be under way, although the recent erratic growth pattern complicates this assessment. That moderation appears most evident in the household sector. In particular, consumer spending, which makes up more than two-thirds of aggregate spending, grew rapidly during the first quarter but decelerated during the spring. One likely source of this deceleration was higher energy prices, which have adversely affected the purchasing power of households and weighed on consumer attitudes. Outlays for residential construction, which have been at very high levels in recent years, rose further in the first quarter. More recently, however, the market for residential real estate has been cooling, as can be seen in the slowing of new and existing home sales and housing starts. Some of the recent softening in housing starts may have resulted from the unusually favorable weather during the first quarter of the year, which pulled forward construction activity, but the slowing of the housing market appears to be more broad-based than can be explained by that factor alone. Home prices, which have climbed at double-digit rates in recent years, still appear to be rising for the Nation as a whole, though significantly less rapidly than before. These developments in the housing market are not particularly surprising, as the sustained run-up in housing prices, together with some increase in mortgage rates, has reduced affordability and thus the demand for new homes. The slowing of the housing market may restrain other forms of household spending as well. With homeowners no longer experiencing increases in the equity value of their homes at the rapid pace seen in the past few years, and with the recent declines in stock prices, increases in household net worth are likely to provide less of a boost to consumer expenditures than they have in the recent past. That said, favorable fundamentals, including relatively low unemployment and rising disposable incomes, should provide support for consumer spending. Overall, household expenditures appear likely to expand at a moderate pace, providing continued impetus to the overall economic expansion. Although growth in household spending has slowed, other sectors of the economy retain considerable momentum. Business investment in new capital goods appears to have risen briskly, on net, so far this year. In particular, investment in non-residential structures, which had been weak since 2001, seems to have picked up appreciably, providing some offset to the slower growth in residential construction. Spending on equipment and software has also been strong. With a few exceptions, business inventories appear to be well-aligned with sales, which reduces the risk that a buildup of unwanted inventories might act to reduce production in the future. Business investment seems likely to continue to grow at a solid pace, supported by growth in final sales, rising backlogs of orders for capital goods, and high rates of profitability. To be sure, businesses in certain sectors have experienced financial difficulties. In the aggregate, however, firms remain in excellent financial condition, and credit conditions for businesses are favorable. Globally, output growth appears strong. Growth of the global economy will help support U.S. economic activity by continuing to stimulate demand for our exports of goods and services. One downside of the strength of the global economy, however, is that it has led to significant increases in the demand for crude oil and other primary commodities over the past few years. Together with heightened geopolitical uncertainties and the limited ability of suppliers to expand capacity in the short run, these rising demands have resulted in sharp rises in the prices at which those goods are traded internationally, which in turn has put upward pressure on costs and prices in the United States. Overall, the U.S. economy seems poised to grow in coming quarters at a pace roughly in line with the expansion of its underlying productive capacity. Such an outlook is embodied in the projections of members of the Board of Governors and the Presidents of Federal Reserve Banks that were made around the time of the FOMC meeting late last month, based on the assumption of appropriate monetary policy. In particular, the central tendency of those forecasts is for real GDP to increase about 3\1/4\ percent to 3\1/2\ percent in 2006 and 3 percent to 3\1/4\ percent in 2007. With output expanding at a pace near that of the economy's potential, the civilian unemployment rate is expected to finish both 2006 and 2007 between 4\3/4\ percent and 5 percent, close to its recent level. I turn now to the inflation situation. As I noted, inflation has been higher than we expected at the time of our last report. Much of the upward pressure on overall inflation this year has been due to increases in the prices of energy and other commodities and, in particular, to the higher prices of products derived from crude oil. Gasoline prices have increased notably as a result of the rise in petroleum prices as well as factors specific to the market for ethanol. The pickup in inflation so far this year has also been reflected in the prices of a range of nonenergy goods and services, as strengthening demand may have given firms more ability to pass energy and other costs through to consumers. In addition, increases in residential rents, as well as in the imputed rent on owner-occupied homes, have recently contributed to higher core inflation. The recent rise in inflation is of concern to the FOMC. The achievement of price stability is one of the objectives that make up the Congress's mandate to the Federal Reserve. Moreover, in the long run, price stability is critical to achieving maximum employment and moderate long-term interest rates, the other parts of the Congressional mandate. The outlook for inflation is shaped by a number of factors, not the least of which is the course of energy prices. The spot price of oil has moved up significantly further in recent weeks. Futures quotes imply that market participants expect petroleum prices to roughly stabilize in coming quarters; such an outcome would, over time, reduce one source of upward pressure on inflation. However, expectations of a leveling out of oil prices have been consistently disappointed in recent years, and as the experience of the past week suggests, possible increases in these and other commodity prices remain a risk to the inflation outlook. Although the costs of energy and other raw materials are important, labor costs are by far the largest component of business costs. Anecdotal reports suggest that the labor market is tight in some industries and occupations and that employers are having difficulty attracting certain types of skilled workers. To date, however, moderate growth in most broad measures of nominal labor compensation and the ongoing increases in labor productivity have held down the rise in unit labor costs, reducing pressure on inflation from the cost side. Employee compensation per hour is likely to rise more quickly over the next couple of years in response to the strength of the labor market. Whether faster increases in nominal compensation create additional cost pressures for firms depends in part on the extent to which they are offset by continuing productivity gains. Profit margins are currently relatively wide, and the effect of a possible acceleration in compensation on price inflation would thus also depend on the extent to which competitive pressures force firms to reduce margins rather than pass on higher costs. The public's inflation expectations are another important determinant of inflation. The Federal Reserve must guard against the emergence of an inflationary psychology that could impart greater persistence to what would otherwise be a transitory increase in inflation. After rising earlier this year, measures of longer-term inflation expectations, based on surveys and on a comparison of yields on nominal and inflation-indexed government debt, have edged down and remain contained. These developments bear watching, however. Finally, the extent to which aggregate demand is aligned with the economy's underlying productive potential also influences inflation. As I noted earlier, FOMC participants project that the growth in economic activity should moderate to a pace close to that of the growth of potential both this year and next. Should that moderation occur as anticipated, it should help to limit inflation pressures over time. The projections of the Members of the Board of Governors and the Presidents of the Federal Reserve Banks, which are based on information available at the time of the last FOMC meeting, are for a gradual decline in inflation in coming quarters. As measured by the price index for personal consumption expenditures excluding food and energy, inflation is projected to be 2\1/4\ percent to 2\1/2\ percent this year and then to edge lower, to 2 percent to 2\1/4\ percent next year. The FOMC projections, which now anticipate slightly lower growth in real output and higher core inflation than expected in our February report, mirror the somewhat more adverse circumstances facing our economy, which have resulted from the recent steep run-up in energy costs and higher-than-expected inflation more generally. But they also reflect our assessment that, with appropriate monetary policy and in the absence of significant unforeseen developments, the economy should continue to expand at a solid and sustainable pace and core inflation should decline from its recent level over the medium term. Although our baseline forecast is for moderating inflation, the Committee judges that some inflation risks remain. In particular, the high prices of energy and other commodities, in conjunction with high levels of resource utilization that may increase the pricing power of suppliers of goods and services, have the potential to sustain inflation pressures. More generally, if the pattern of elevated readings on inflation is more protracted or more intense than is currently expected, this higher level of inflation could become embedded in the public's inflation expectations and in price-setting behavior. Persistently higher inflation would erode the performance of the real economy and would be costly to reverse. The Federal Reserve must take account of these risks in making its policy decisions. In our pursuit of maximum employment and price stability, monetary policy makers operate in an environment of uncertainty. In particular, we have imperfect knowledge about the effects of our own policy actions as well as of the many other factors that will shape economic developments during the forecast period. These uncertainties bear importantly on our policy decisions because the full influence of policy actions on the economy is felt only after a considerable period of time. The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth. In formulating that outlook, we must take account of the possible future effects of previous policy actions--that is, of policy effects still ``in the pipeline.'' Finally, as I have noted, we must consider not only what appears to be the most likely outcome but also the risks to that outlook and the costs that would be incurred should any of those risks be realized. At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections. In particular, as the Committee noted in the statement issued after its June meeting, the extent and timing of any additional firming that may be needed to address inflation risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by our analysis of the incoming information. Thank you. I would be happy to take questions. FOMC20080109confcall--13 11,MR. STOCKTON.," 2 Thank you, Mr. Chairman. Earlier today along with Bill Dudley's materials we circulated a note describing some of the revisions that we have made in our projection since the December forecast. I should caution the Committee 2 The materials used by Mr. Stockton are appended to this transcript (appendix 2). that this projection has not been the result of running the complete machinery that sits behind the staff's forecast. Rather, we've done our usual, I hope, careful job of doing the near-term adding up, and then we've used the model simulations and rules of thumb to adjust our medium-term outlook to reflect changes in the data and changes in the conditioning assumptions that we've taken on board here. That said, I do feel reasonably comfortable that what we're showing you here puts us in the right ballpark in terms of how the data and how changes in some of the major conditioning assumptions are likely to affect the forecast that we will be showing you in a few weeks. Several key features of note in this revised forecast: Growth in real GDP in the fourth quarter of last year has been revised up by a noticeable amount. However, we will revise down growth in real GDP in both 2008 and 2009 also by a noticeable amount. Unemployment runs higher throughout the projection period. Despite that higher level of the unemployment rate, total and core inflation are higher in 2008 than in our December forecast because of sharply higher oil prices incorporated in this forecast. Inflation is roughly unchanged in our 2009 projection. So let me touch briefly on each of these elements. As you can see in the table, we've revised up our estimate of GDP growth in the fourth quarter from a forecast that was basically flat at the time of the December meeting to an increase of about 1� percent at an annual rate. Much of that revision reflects the stronger retail sales data that we received shortly after the last FOMC meeting as well as the stronger consumption of services that we received in the personal income release late last month. In addition, the incoming data on construction put in place for November were much stronger than we anticipated for nonresidential structures and for state and local construction. Not all the data that we've received, however, have been on the positive side. Housing continues to outflank us on the low side. Both starts and permits for November came in well below our forecast, and sales of new homes were much weaker than we'd expected. We now think the trough in housing starts, which we still see as likely to occur in the first half of this year, will be deeper than our previous forecast and by a considerable amount--nearly 10 percent deeper is what we've built into this revised provisional forecast. The other major negative surprise was the employment report for December. Private payrolls contracted by 13,000 last month. We'd been expecting an increase of about 50,000. Moreover, the unemployment rate jumped 0.3 percentage point in December. That increase was certainly eye-catching from our perspective. As we noted in the handout, higher average hourly earnings offset the weaker employment so that the labor income actually is not too much different than we had expected at the time of the December forecast. Still the labor market appears to us to have softened noticeably last month, and we've taken signal from that and revised down expected employment growth going forward. Our forecast for economic growth in the first quarter is unrevised at an annual rate of � percentage point. We do carry a little more momentum in consumer spending and a little more momentum in nonresidential structures into the first quarter, but that is offset by the substantial downward revision that we're making to the housing forecast. Beyond the near term, we've had a lot of negative influences to contend with. I've already noted that we've taken down our housing forecast. That revision alone was sufficient to knock another tenth off GDP growth in 2008, bringing the total subtraction of housing from GDP growth in this projection in 2008 to � percentage point. Oil prices are about $6 per barrel higher on average than was incorporated in our December forecast. The impact of those higher oil prices on purchasing power and consumption are large enough to reduce projected GDP growth in both 2008 and 2009 by a tenth each year. I should note that households are on the verge of experiencing another stiff increase in gasoline prices over the next couple of months, and households are probably not yet aware that that's on the way, except for those that actually follow oil futures markets--I assume that's a relatively small group. We've lowered the path for equity prices by 7 percent in this forecast. About half of that revision reflects the change that occurred since we put the December Greenbook to bed. The forecast that I circulated today doesn't include yesterday's decline or today's increase. We basically used Monday's close. The other half of the decline in equity prices that we've built into this baseline forecast currently reflects the fact that, for purposes of this provisional forecast, we made no change in our assumption about the path of the federal funds rate from our December Greenbook. Obviously, the December path assumed no change in the funds rate at the January meeting. That would come as a significant disappointment to the markets, and by our normal calibration, we estimate it would take about 3� percent off the level of equity prices going forward. So that gets us to the 7 percent. House prices have come in a touch lower than we had forecast. We have also lowered our projection on the level of house prices about 1 percentage point in this forecast. Taken together, those lower equity prices and the lower house prices take 0.1 off growth in 2008 and 0.2 off GDP growth in 2009. Turning to the labor market, the jump in the unemployment rate in December in combination with our weaker outlook for growth in real GDP going forward has led us to raise our projected level of the unemployment rate to 5.2 percent at the end of 2008 and 5.3 percent at the end of 2009. As for prices, the recent news on inflation has been disappointing. Total and core PCE prices came in above our expectations in November. As can be seen in our table, we've raised our estimate of total PCE price inflation in the fourth quarter to 4 percent, and we've increased our estimate of core PCE price inflation to 2.7 percent. Both those figures are � percentage point above our estimates in December. Some of the upward revision in the core price measure is due to higher figures for nonmarket prices, but market-based prices were higher than we had expected as well. Going forward, the higher oil prices that I referenced earlier also leave a clear imprint on projected inflation. We've raised our headline price inflation to 2.4 percent in 2008, up 0.4 percentage point from our previous projection. With energy prices expected to edge off in 2009, total PCE inflation recedes to 1.7 percent. For core inflation, we've added 0.1 percentage point to our projection this year, reflecting the indirect effects of higher energy prices. Our forecast for core inflation in 2009 is unchanged. Some lingering indirect effects from higher energy costs are offset in this forecast by a wider margin of slack in resource utilization. Let me just say a few words about how the risks to the forecast have changed. I believe that the adjustments that we have made to this provisional forecast actually are quite reasonable in light of the developments and the data that we have been contending with, but I'd have to admit that the downside risks to our projection have become more palpable to me. Despite a year of nearly continual downward revision, we just can't seem to get in front of the contraction in housing. The steep descent in sales and construction of new homes has not let up, and there seems to me to be more downside risk than upside risk to our house-price projection. Another area of concern would be the recent readings on the labor market, which have been very soft. Although quite volatile on a week-to-week basis, initial claims for unemployment insurance and insured unemployment have been trending up. Moreover, both the payroll survey and the household survey deteriorated noticeably in December. As I noted earlier, private payrolls contracted last month, and a jump of 0.3 percentage point in the unemployment rate in a single month is rare, though not unprecedented, outside of recessions. The steep decline in the manufacturing ISM in December was both unexpected and of a magnitude well outside the normal volatility in the data. The drop in consumer confidence has pretty much matched our expectations, and it didn't continue to worsen in December; but the total drop that we have seen in recent months is similar to drops seen before previous recessions. Any one of these indicators taken by itself would not be especially troubling; but taken together, they certainly deserve attention. We are not ready to make a recession call yet. The spending data still have exceeded our expectations by a noticeable margin, especially consumer spending. Motor vehicle sales at a 16.2 million unit rate in December certainly don't look like a recessionary development, and business spending has slowed but certainly not slumped thus far. Furthermore, the anecdotes--at least my read of the anecdotes--still seem more consistent with the weak economic growth that we are projecting rather than outright contraction. But at this point we do feel as though we are on very high alert. I'd be happy to take any questions from members of the Committee. " FOMC20070807meeting--195 193,MS. DANKER.," I’ll read the directive wording from the Bluebook and the balance of risk assessment from Brian’s handout. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent. “Although the downside risks to growth have increased somewhat, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.” Chairman Bernanke Yes Vice Chairman Geithner Yes President Hoenig Yes Governor Kohn Yes Governor Kroszner Yes Governor Mishkin Yes President Moskow Yes President Poole Yes" FOMC20080130meeting--114 112,MS. LIANG.," We have revised this forecast up quite a bit since the first time we looked at this maybe in June or August, in part because of lower house prices and tighter credit conditions. The model requires as inputs defaults and prepayments, and the prepayment rates have been fairly slow but not zero. The 2006 vintage, as it approaches its first reset, has been that 20 to 25 percent are able to prepay. They are able to find something. So we don't want to assume that none of them will be able to. The model would approach both of those, so that is the positive side. The downside is that our forecast, with the national house-price assumption of roughly minus 7 over the forecast period, does imply house-price declines on the order of minus 20 percent a year or more in California, Florida, and some other places. That does leave the loan-to-value ratio, as I mentioned, pretty high for many borrowers. We have never had this kind of episode, so we have to make a judgment about the point at which subprime borrowers walk away from their houses. The current assumption is that at about 140 percent we just say you are out; but it has to be almost an assumption that, if by then you hadn't defaulted, we would push you out. So there is an upside. On the other hand, saying 40 percent of the outstanding stock will default over two years sounds like a big projection as well. So we tried to balance. There are risks on both sides, for sure. " CHRG-111hhrg58044--185 Mr. Royce," The FTC concludes that risk-based pricing benefits the majority of market participants. The observation I would make is that if there is a flaw in the marketplace in terms of anti-competitive pricing or the availability of insurance, we should look at the fragmented antiquated regulatory model that exists in the United States that is unlike that anywhere else in the world, where we have this regulatory model overseeing the industry where we have 50 different markets instead of one national market, and I think recent estimates put that cost of the fragmented State-based system at $14 billion in higher premiums every year for consumers. If we could focus instead on enhancing competition, instead of unnecessarily limiting tools in the marketplace, it would be much better for the consumer, although I am sure many of our elected State insurance commissioners would have to find other things to focus on. It would certainly move us into a national market for insurance. It would certainly not only reduce the costs but produce a much more competitive industry, especially when you look at what Europe is doing right now as it goes to one market for all of Europe for insurance. " fcic_final_report_full--34 In , news reports were beginning to highlight indications that the real estate market was weakening. Home sales began to drop, and Fitch Ratings reported signs that mortgage delinquencies were rising. That year, the hedge fund manager Mark Klipsch of Orix Credit Corp. told participants at the American Securitization Forum, a securities trade group, that investors had become “over optimistic” about the mar- ket. “I see a lot of irrationality,” he added. He said he was unnerved because people were saying, “It’s different this time”—a rationale commonly heard before previous collapses.  Some real estate appraisers had also been expressing concerns for years. From  to , a coalition of appraisal organizations circulated and ultimately deliv- ered to Washington officials a public petition; signed by , appraisers and in- cluding the name and address of each, it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets. “The powers that be cannot claim ignorance,” the appraiser Dennis J. Black of Port Charlotte, Florida, testified to the Commission.  The appraiser Karen Mann of Discovery Bay, California, another industry vet- eran, told the Commission that lenders had opened subsidiaries to perform ap- praisals, allowing them to extract extra fees from “unknowing” consumers and making it easier to inflate home values. The steep hike in home prices and the un- merited and inflated appraisals she was seeing in Northern California convinced her that the housing industry was headed for a cataclysmic downturn. In , she laid off some of her staff in order to cut her overhead expenses, in anticipation of the coming storm; two years later, she shut down her office and began working out of her home.  Despite all the signs that the housing market was slowing, Wall Street just kept go- ing and going—ordering up loans, packaging them into securities, taking profits, earning bonuses. By the third quarter of , home prices were falling and mortgage delinquencies were rising, a combination that spelled trouble for mortgage-backed securities. But from the third quarter of  on, banks created and sold some . trillion in mortgage-backed securities and more than  billion in mortgage- related CDOs.  Not everyone on Wall Street kept applauding, however. Some executives were urging caution, as corporate governance and risk management were breaking down. Reflecting on the causes of the crisis, Jamie Dimon, CEO of JP Morgan testified to the FCIC, “I blame the management teams  and . . . no one else.”  At too many financial firms, management brushed aside the growing risks to their firms. At Lehman Brothers, for example, Michael Gelband, the head of fixed income, and his colleague Madelyn Antoncic warned against taking on too much risk in the face of growing pressure to compete aggressively against other investment banks. An- toncic, who was the firm’s chief risk officer from  to , was shunted aside: “At the senior level, they were trying to push so hard that the wheels started to come off,” she told the Commission. She was reassigned to a policy position working with gov- ernment regulators.  Gelband left; Lehman officials blamed Gelband’s departure on “philosophical differences.”  FOMC20080805meeting--134 132,MR. WARSH.," Thank you, Mr. Chairman. I have no material changes to report in my view on the overall state of financial stability, growth, or inflation; but as I talked about at the last meeting, it still is likely to be a long, hot summer, and we're only about half over with it. I'll talk first about financial institutions--make maybe four or five points--and then turn quickly to the economy and inflation. First, on financial institutions, I think the body blow that the financial markets and the real economy have taken because of the turmoil at the GSEs is not complete. It is easy for those of us in Washington to forget that bill signings don't always solve problems. I'd say, if the last thing that happens on GSEs is that the bill was signed two weeks ago and action isn't taken in the coming weeks and months, then I would be surprised if we could get through this period without more GSE turmoil finding its way onto the front pages. Second, in terms of financial market conditions, the fall in oil prices and the rest of the energy complex is, indeed, good news, but it strikes me that it has camouflaged an even tougher period for financial institutions than would otherwise be the case. That is, financial institutions somehow look a little more resilient, but I think part of that is only because of the negative correlation that's developed in recent times between equity prices of financials and oil prices. The financial institutions themselves strike me as being in worse condition than market prices would suggest. Third, capital raising, as we have long talked about, is essential to the fix among financial institutions. The way I best describe capital raising over maybe the last nine months is that the first round of capital raising, which was in November and December, was really the vanity round. This consisted of very limited due diligence, sovereign wealth funds signing up, issuers relying upon their vaunted global brands, and capital being raised in a matter of days. The second round probably took us to the spring, a round that I'd call the confessional round. [Laughter] In this round, financial institutions said, ""Oh my, look at these real write-downs that I have. Look at the need for this real capital raising, and here I'm telling you, the investors, all that I know."" But the second and third confessions usually have less credibility than the first. The third round is the round that we're in the middle of, which I think of as the liquidation and recap round, likely to be the hardest round to pull off. It is likely to force issuers of new shares or of new forms of preferred stock to be asking of themselves and their investors the toughest choices. They have to assess the strength and durability of their core franchises. I think that this will be happening in very real time. So the circumstance of an investment bank that Bill mentioned at the outset I don't think will be the sole case of this. This liquidation and recap round is later than would be ideal from the perspective of the broader economy, but it is absolutely needed. Until we see how it occurs, it's hard for me to be much more sanguine that the capital markets or the credit markets will be returning to anything like normal anytime soon. Let me make a fourth broad point about financial institutions. Because of these different phases of capital raise, I think management credibility among financial institutions is at least as suspect as it has ever been during this period. Even new management teams that have come in have in some ways used up a lot of their credibility. It would be nice to believe that they have taken all actions necessary to protect their franchises and their businesses, but most stakeholders are skeptical that they've taken significant or sufficient action. At the end of the day, no matter where policy comes out in terms of regulatory policy from the Fed and other bank regulators or accounting policy from the SEC or FASB, it strikes me that those changes in policy are less determinative of how things shake out. That is, management credibility is so in question that the cure is not likely to come from accounting rules or regulators but from the markets' believing that what management says is what management believes and will act on it. As a result, I think that many of these financial institutions are operating in a zero-defect world, which is posing risks to the real economy. Fifth, let me make a final point about financials. We've all talked a lot about the effect of different curves for housing prices on the financial institutions themselves. I don't mean to give short shrift to any of that, but I would say that the level of uncertainty and associated risks of their non-housing-related assets are now very much a focus. According to July 2008 data, of credit currently being extended by banks, only about 20 percent is for residential real estate. Only about 9 percent is for consumer credit. So that leaves the balance in areas where these financial institutions and their management teams have to be asking themselves whether the weaknesses that are emerging in the real economy will place uncertainty over assets that have nothing to do with housing. That's a major downside risk for financial institutions and has not been much of a focus of shareholder and stakeholder concerns. There are two open issues that will guide some of our thinking, at least with respect to these credit markets. First, as we talked about a little last night with the presidents, are the embedded losses so great at such a critical mass of institutions with management credibility so low that many more than currently expected might be unable to survive? This is a question that I'm not sure I know the answer to. Second, despite the concerns about the effect of the credit markets on the broader economy that I talked about, our monetary policy may not be terribly well suited to be fixing those problems, and financial institutions may not be terribly sensitive to the extent we decide that we should change the stance of policy. Taking all that into account, let me say a couple of words about growth and inflation. First, on the economic growth front, given my views of what's happening in the credit markets, it's very hard for me to believe that the economy will get back to potential anytime soon. There are continued financial stresses that could last through year-end, and in there could be an upside surprise. Still, all things considered, my base case has second-half growth still above staff estimates owing in part to the productivity we've seen in recent months and the remarkable resiliency of this economy. If we look beyond that horizon, though, toward the Greenbook forecast in 2009 and beyond, I must say I don't really see the inflection point to take us back to economic growth of 2.2 percent or whatever the Greenbook suggests. I think we're going to be in this period of belowtrend growth for quite some time. My own view is that, when the Congress comes back after its August recess, we will be in the middle of a big debate on ""Son of Stimulus"" and that the stimulus probabilities have moved up quite materially. However, it is not at all obvious to me that it will do much in terms of helping the real economy. Outside the United States, I share the view of Governor Kohn, which is that I'd expect global GDP, particularly GDP among advanced foreign economies, our major trading partners, to continue to disappoint, making the remarkable addition of net export growth to our own GDP likely to dissipate. Turning finally to inflation, my view is that inflation risks are very real, and I believe that these risks are higher than growth risks. I don't take that much comfort from the move in commodity prices since we last met. If that trend continues, then that would certainly be good news; but I must say I don't feel as though inflation risks have moved down noticeably since we last had this discussion. The staff expects food prices to continue to be challenging; that is certainly my view. The staff also expects core import prices to fall rather precipitously. I'm a little skeptical of that view. I think it's possible, but I don't really see the catalyst for that given what we see about changes in input prices overseas and given expectations of the dollar in foreign exchange markets. So with that, I think that the inflation risks are real, and I'll save the balance of my remarks for the next round. Thank you, Mr. Chairman. " FOMC20070807meeting--132 130,MR. KOHN.," Thank you, Mr. Chairman. Like the others, I think keeping the federal funds rate where it is is the right thing to do. We need, as others have said, to watch the situation carefully and see how it evolves. I think we’re trying to do two things with this statement, as others have remarked. One is to make people aware that we’re aware that a major market event has occurred and to say that we’re looking at it and trying to assess its implications for the outlook but that it hasn’t really—not yet, anyhow—caused a major change in our fundamental assessment of where the economy is going. The second thing we are trying to do is make sure that we have a flexible platform we can move from over the next couple of meetings or even, should it become necessary, in the intermeeting period. So one can see this going in lots of different directions—the markets getting much more turbulent with implications for the outlook and we need to move in the intermeeting period or things settling down and we go back to inflation as the predominant risk. The incoming data on demand and production remain consistent with the central forecast. As I and some others noted, we could end up coming out of this and easing policy somewhere down the road, but not right away. I thought the language of alternative B did both of those things. It acknowledged the situation. It reinforced the sense that moderate growth going forward was where we thought things were going because we added the “supported by solid growth in employment and incomes and a robust global economy.” So we have some rationale for that, which we didn’t have before. I also thought that paragraph 4 was a really accurate reading. I was actually a little surprised through the go-round just how, almost universally, people said that the downside risks to output have increased but that they were still most concerned about inflation. So I thought that paragraph 4 turned out to be presciently—on the part of the Chairman, Brian, or whoever drafted it—a really accurate view of where the Committee was. My concern about moving the first piece of that into paragraph 2 is that then we have one risk in paragraph 2. We haven’t done that before, right? The risks to output and to inflation have all been talked about in paragraph 4. Another risk is in paragraph 4, the risk to inflation, and that is an asymmetry of how we discuss risks. It was intended to soften the risk, but I think it strikes me as creating a precedent that in the future will be hard to live with, when some risks are in some paragraphs and other risks are in other paragraphs. Another thing we could do is move the inflation risk into paragraph 3 and not come down one way or another. But I think the Committee wants to come down on the inflation side—in terms of predominant risk or main risk—and the Committee isn’t quite ready to go to balance. So it seems to me that paragraph 4, as written, really captured the center of gravity of the Committee. So I am in favor of that. One word on the moral hazard and the concern about being seen as reacting: I am not worried about it. I think we have kept our eye, through the past twenty years, on the macro environment. We have adjusted policy to stabilize the economy, to bring inflation down, and we were pretty darn successful in all of that. Asset prices go up, and asset prices go down. Anybody who bought a lot of high-tech stock, betting on the Greenspan put, is still waiting to recover their money. [Laughter] I don’t think it ever existed. I really don’t care what people say; I care about what we do, and we just need to keep our eye on those macro implications. Now, as I said in my presentation, I think the connection between the financial markets and the macroeconomy is pretty complicated and runs through confidence and other things, too. But I’m not really worried about a moral hazard from acting. Should markets continue to be turbulent and we see that turbulence in the future—I agree with the Vice Chairman that we have to be forward looking in this—such turbulence has the potential for adversely affecting the economy. I think we should go ahead and act. I think we basically did the right thing in ’87 and ’98, and I don’t think we need to apologize for it. Thank you, Mr. Chairman." CHRG-111shrg50564--43 Chairman Dodd," Thank you very much. Senator Warner. Senator Warner. Thank you, Mr. Chairman. Dr. Volcker, I have got three questions, and I think they follow up on both the Chairman's and Senator Shelby's approach. It seems from the report a clear understanding that there needs to be some level of regulation of some of these institutions that fell between the cracks. Yet it seems that even though major money center banks that clearly were regulated followed the market to start putting out these same kind of complex new instruments, your term of ``over the top financial engineering.'' I guess on a going-forward basis, as we move forward to some new structure, even with regulation and transparency, is that going to be enough or should there be some point of an evaluation, almost a societal value evaluation, of some of these instruments, whether the extra ability to price that risk down to the last decimal point is worth all of the side risks that we have seen taking place by some of these instruments? " CHRG-111shrg50814--10 Mr. Bernanke," Well, Mr. Chairman, it is going to depend on individual circumstances. I am afraid it is the case that some people will find that their assets are not, at this point, adequate to allow them to retire as they had planned. Many people have suffered from losses in asset values. It is in part related to a correction relative to perhaps inflated asset values, particularly in the housing market, prior to this time. But we are also seeing very heavy risk aversion and liquidity premiums, that is, people are just very, very averse to risk at this point and that is also driving down asset prices. So I understand that this is a very difficult situation for savers as it is for workers and homeowners, and all I can say is the Federal Reserve is committed to doing everything we can to restore economic stability. I do believe that once the economy begins to recover, we will see improvements in financial markets. In fact, I think those two things go very closely together. " FOMC20071031meeting--84 82,CHAIRMAN BERNANKE.," Thank you. Thank you everyone. Let me try to summarize this discussion. It is a little harder than usual. Broadly, the macroeconomic news came in slightly better than expected during the intermeeting period. Housing has been very weak, as expected; but consumption, investment, and net exports were relatively strong in recent months. In the aggregate data, there is yet no clear sign of a spillover from housing. Most participants expect several weak quarters followed by recovery later next year. The risks remain to the downside but may be less than at our last meeting. One issue, given all these factors, is determining the equilibrium short-term interest rate. Financial market conditions have improved somewhat since our last meeting, with investors discriminating among borrowers and with the process of price discovery proceeding. There was general agreement that conditions are not back to normal and that it would be some time before that happened. Some suggested that a risk of relapse remains, should credit quality worsen or further bad news be disclosed. Lending conditions have tightened, particularly for mortgages, and securitization remains impaired. There is not yet much evidence that this tightening is affecting business borrowing, however, although financial conditions may have somewhat increased uncertainty among business leaders. Views on how consumption would evolve were mixed. Consumer sentiment is on the weak side, house prices are down, and oil prices are up, which suggests some weakening ahead. However, the labor market remains reasonably solid, which should support consumer spending. Anecdotal information about consumer spending was unusually mixed. Some saw evidence of growing weakness in consumption. This evidence included weak reports from shippers and credit card companies. Others saw the consumer side as slowing a bit but generally healthy. Investment, including investment in commercial real estate, may also be slowing somewhat; but again, the evidence is mixed. Manufacturing growth appears to be moderating. Other sectors— including energy, agriculture, high-tech, and tourism—are doing well. Core inflation has moderated, and there was generally more comfort that this improvement would persist. There was less concern expressed about tightness in labor markets and wage pressures. Energy prices and food prices could lead total inflation to rise, perhaps even into next year, and there is the risk of pass-through to the core. Similar concerns apply to the dollar and to export prices. Some, but not all, TIPS-based measures of inflation expectations have risen, and survey-based measures have been stable. Most participants saw inflation risks to the upside, but at least some saw them as less pressing than earlier this year. That is my summary. Comments? Well, again, as usual, it is hard to be the last person to speak, but let me make just a few comments. First, as always, the Greenbook was very thoughtful. The authors have done a good job of balancing the risks, and I find their forecast very plausible as a modal forecast. Housing does seem to be very weak, of course, and manufacturing looks to be slowing further. But except for those sectors, there is a good bit of momentum still in the economy. Having said that, I think there is an unusual amount of uncertainty around the modal forecast, maybe less than in September but still a great deal. Let me talk briefly about three areas: financial markets, housing, and inflation. A lot of people have already spoken about financial markets. Market functioning certainly has improved. Our action in September helped on that. For example, commercial paper markets are working almost normally for good borrowers, the spreads are down, and volumes are stable. One concern that we had for quite a while was that banks would be facing binding balance sheet constraints because of all the contingent liabilities that they had—off-balance-sheet vehicles, leveraged loans, and so on. That problem seems to be somewhat less than it was. Some of the leveraged loans are being sold off, some of the worst off-balance-sheet vehicles are being wound down. So there is generally improvement in the financial market, certainly. In the past couple of weeks there has been some deterioration in sentiment, and I see that as coming from essentially two factors. First, there were a number of reports of unusually large and unanticipated losses, which reduced the confidence of investors that we had detected and unearthed all the bad news. This problem will eventually be resolved, but clearly we still have some way to go to clarify where people stand. The other issue, which I think is more pertinent to our discussion, is about economic fundamentals. There was a very bad response, for example, to Caterpillar’s profit report, and so the market is appropriately responding to economic fundamentals as they feed through into credit concerns. From our perspective, one of the key issues will be the availability of credit to consumers and firms going forward. My sense—based on my talking to supervisors, looking at the senior loan officer survey, and talking to some people in the markets—is that banks are becoming quite conservative, and that is what Kevin said. It is not necessarily a balance sheet constraint but more a concern about renewed weakness in markets. It is also a concern about the condition of borrowers, about credit risk, and the demands of investors for very tight underwriting. Now, of course, tight underwriting is not a bad thing; it is a good thing. But from our perspective, we need to think about its potential implications for growth and, if you like, for r*. The biggest effect of the tighter underwriting, of course, has been on mortgage loans, although we have seen a bit of improvement in the secondary market for prime jumbos, which is encouraging if that continues. This is the area in which vicious-circle effects, which Vice Chairman Geithner and others have talked about, is most concerning. House prices, according to the Greenbook, are projected to fall 4½ percent over the next two years. Clearly, there is some downside risk to that. If house prices were to fall much more, that would feed into credit evaluations, into balance sheets, back into credit extension, and so on. So I think there is a risk there, as Governor Kroszner and Governor Mishkin also discussed. The corporate sector is not much of a problem. Good firms are issuing debt without much problem. I don’t really have much read on small business, but I have not heard much complaining in that area either. With respect to consumers, my guess is that we are going to see some effects on consumers. Certainly, home equity loans and installment loans have tightened up. We can see that in the senior loan officer survey. We don’t see that yet for credit cards, but since a lot of credit cards are used by people with subprime credit histories, I suspect that we will see some tightening there. So I do expect to see some effect on consumers from credit conditions. As has already been mentioned, an area we also need to note is commercial real estate. Financing conditions have already tightened there quite considerably, and spreads are much wider. The senior loan officer survey shows the tightening of terms and conditions that matches previous recessions, and CMBS issuance has dropped very significantly. You can debate whether or not this tightening is justified by fundamentals. On the one hand, vacancy rates remain low, and rents are high. On the other hand, it is still also true that price-to-rent ratios are quite high. If you calculate an equity risk premium for commercial real estate analogously to the way you calculate one for stocks, you would find that it is at an unusually low level, which would tend to suggest that prices may fall. So it is uncertain, I would say. Certainly one area in which we might see further retrenchment in commercial real estate is the public sector: Tax receipts are slowing, and that might affect building decisions. So I do think this is another area in which we will be seeing some effects from credit tightening. I should be clear—the Greenbook already incorporates a considerable slowdown in commercial real estate, but that means it will no longer offset the residential slowdown. I just want to make one comment about housing, which I think we all agree is a central source of uncertainty, both for the credit reasons I have discussed and in terms of prices, wealth, and other issues. Let me just make one point that I found striking anyway, which is that—at least from the Greenbook—the forecast of a strengthening economy by next spring and the second half of next year is very closely tied to the assumption that housing will turn around next spring. In particular, if you look at all the final demand components for the economy, other than housing, in 2007 those components contributed 3.5 percentage points to GDP. According to the Greenbook forecast, in 2008 all those components together will contribute 2.0 percentage points to GDP. So the fact that GDP doesn’t slow any more than 0.6 comes from the assumption that the negative contribution of housing next year will be much less than it was in this year. It is certainly possible—again, I think the Greenbook authors have done a good job of balancing the risks. But as we have noted, we have missed this turn before, and it could happen again. So let me just note that as an important issue. If we do miss on that turn, the other forecast errors for consumption and so on obviously would be correlated with that miss. Finally, let me talk for a moment about inflation. I want to share the concerns that some people have noted. If you wanted to be defensive about inflation, you could point out that the movement in oil prices and the dollar and so on is in part due to our actions. But it is also due to a lot of other things—for example, the dollar in broad real terms is about where it was in the late ’90s. In that respect, it is perhaps about where it should be in terms of trying to make progress on the current account deficit. Similarly, with oil, a lot of other factors besides monetary policy are involved. That said, I share with Governor Warsh the concern that the visibility of these indicators day after day in financial markets and on television screens has a risk of affecting inflation psychology. I do worry about that. I think we should pay attention to that. So I do think that is a concern, and we obviously need to take it into consideration in our policies, in our statements, and in our public remarks. I have one more comment on housing before ending. In thinking about the turnaround for housing next year, Governor Kroszner talked about resets and those sorts of issues. We spend a lot of time here at the Board thinking about different plans for refinancing subprime borrowers or other borrowers into sustainable mortgages. We have looked at the FHA and other types of approaches. A very interesting paper by an economist named Joseph Mason at Drexel discusses, at a very detailed institutional level, the issues related to refinancing, in terms both of the servicers’ incentives and of the regulatory perspective. Mason points out that there are some serious regulatory problems with the massive refinancing effort, including consumer protection issues, because refinancing can be a source of scams. There are also issues of safety and soundness because refinancing can be a way to disguise losses, for example. If you read that paper, I think you will be persuaded—at least I am becoming increasingly persuaded—that a significant amount of refinancing will not be happening and that we will see substantial financial problems and foreclosures that will peak somewhere in the middle of next year. So I think that is an additional risk that we ought to take into account as we think about the evolution of housing. Those are just a few comments on the general outlook. Let me just note, we will adjourn in a moment. There will be a reception and a dinner, for those of you who wish to stay. There will be no program or business, so if you have other plans, feel free to pursue them. A number of pieces of data, including GDP, will arrive overnight, and we will begin tomorrow morning with a discussion of the new data. Perhaps that will help us in our discussion of policy. Thank you. The meeting is adjourned. [Meeting recessed] October 31, 2007—Morning Session" CHRG-111hhrg51698--158 Mr. Gooch," Yes, sir. I am certainly in favor of free markets, but to some extent maybe I have been painted into a corner as somehow not being supportive of this proposed regulation. My strong position here today, and in my opening statement, was in this concept of disallowing naked credit derivatives, because of my knowledge about the market and my concern that you will kill the CDS market. That might be one of Mr. Greenberger's goals, but that it would be a big mistake for the American economy. Right now, as we know, it is very difficult for anyone to borrow money. The banks aren't lending. But some corporations can still issue debt. But one of the things that is going on in the marketplace right now is those debt issuances are very often now tied to CDS prices. Without the willing sellers of CDS that are your speculators, if you like, but I call them risk takers, who are willing to sell that credit risk, you take away a huge portion of willing lenders. They are synthetic lenders. When they sell a credit default swap, they are not lending the money, but they are a synthetic lender. They are effectively underwriting the risk. " FinancialCrisisInquiry--138 It might go to zero, right? I think the point he made about institutional investors taking risks was—was actually a good one. And I actually think that the press is barking up the wrong tree with that argument. I don’t think you’ll get anywhere with that argument, you know, from my perspective. The thing that I disagree with—when I heard this morning that Morgan Stanley had changed their compensation plans to allow their risk managers to make as much as their traders. I think that’s a horrible idea. OK? If you have a risk manager out there that is—that is supposed to be reining in risk, the only way you make money at these firms is to take risks. OK? If he has—if he’s incentivized to get paid as much as the trader, he is going to be more incentivized to let things go. I think that—that income inequality between a risk manager and a trader creates some avarice within the firm that needs to exist. They just missed it the first time. I think if you force it the other way, it’s going to be a big, big mistake. You’ll have bigger problems, not smaller problems. So those are two key points that I heard this morning that I—that I wanted to reiterate. SOLOMON: May I raise one more? It involves the clearinghouse. They all seem to be in favor of the clearinghouse. This is really revelation to me, as it must be to you. Yes, there should have been a clearinghouse three years ago. It was clear. It was evident. Many of us wrote about it. The reason you don’t have a clearinghouse is that the price will go down. It’ll be like May Day 1975 where the commissions went from 25 cents. We all thought they would go to 16 cents. They went to 8 cents. It took about three days. So the spreads will go down. They can be—you said they were 90 percent customized. The folks... BASS: No, standardized. FOMC20080109confcall--44 42,MR. KOHN.," Thank you, Mr. Chairman. I certainly share your concern that the current federal funds rate is too high. You said that you thought we had about offset the effects of tighter credit and declining house prices on demand. I'm not so sure that we have actually done enough to make that offset. Certainly, if you look at the staff forecast, we haven't. They have the unemployment rate rising to 5� percent, half a point over the NAIRU, at the current funds rate, which suggests to me that the current funds rate is substantially above neutral, not at neutral. If you look at the market--and, President Fisher, I assure you I am not going to get pushed around by the market--I do think the market is telling you that there are a lot of people out there who think that the funds rate has to drop 100-plus basis points more, and they don't think that will be consistent with a pick up in inflation. Now, they could be wrong. I'm sure they probably are and often are. But I think there is some signal there about the degree of pessimism out there about underlying demand that we shouldn't throw away entirely just because it is coming from the market. So in my view, policy is probably still restrictive rather than neutral. I don't think we fully adjusted to the deteriorating condition we saw in December. What we saw then was that the credit constriction had spread and would be bigger and more prolonged than we had thought previously. We saw a steeper, more intense housing decline, with multiplier�accelerator effects, and wealth effects on the decline in house prices. We saw the beginning of spillovers to other sectors, and I don't think our 25 basis points really adjusted to all that new information. Moreover, the incoming information, although it hasn't lowered the near-term GDP, does imply weaker growth going forward. With regard to the labor market, it is true that it is one month, but it is three different sources of data--the household survey, the establishment survey, and the initial claims--all telling us the same thing. Now, we will get more information over the next couple of weeks on at least the initial claims part of that and the continuing claims. I think we should treat the labor market information as more than just one series for one month. It's three series for one month, and there is probably a little more weight there. In addition, the new orders and the ISM survey, housing, and stock market wealth have declined substantially since the meeting. So I would say, obviously, we have no insurance. I'm not even sure we're at neutral, and I see the downside risks that you, Mr. Chairman, Dave Stockton, and many others have talked about, particularly from the credit markets and credit conditions. I agree that the inflation situation is somewhat concerning. Now, some people have cited the increase in the staff's inflation forecast for 2008 of 0.4 percentage point; but of course that's the energy price situation. I think so far through this cycle the feed-through of energy prices into core inflation has been pretty darn low. The staff has built in a little here. Inflation expectations do remain anchored. To be sure, the core inflation numbers came in a little higher, so they're a little worrisome, too. I think there is going to be less pressure on resources than we thought. The unemployment rate is higher, capacity utilization will be lower, and I think the competitive pressures are going to constrain compensation and prices. As somebody pointed out, the fact that even at a 4� percent unemployment rate we really have seen very little, if any, pickup in labor costs suggests that my concern about that occurring at a 5 and a 5� percent unemployment rate would be very, very low. If the staff is right--and, of course I just heard the Romers lecture me about how the staff was right and the Committee wasn't--[laughter] then a 50 basis point decline would just about put interest rates at neutral. It wouldn't be accommodative, and therefore, I don't think would be particularly inflationary. I agree with everyone else. If I thought that a decline in rates would increase the most likely forecast for inflation--put it on an upward track--that would be unacceptable. Or if I thought a decrease in rates would increase inflation expectations, which would then give legs to an increase in inflation, that would not be acceptable either. But I think a decrease in rates at this time under these circumstances doesn't really have that risk. It does shift the balance of risks a bit. If you take a little of the downside risk out of growth, you are presumably taking some of the downside risk out of inflation, maybe shifting that risk on inflation at the same time. But I think a substantial decrease in interest rates at this time would not shift those risks on inflation so that they would deviate from the general path over the next couple of years that most of us saw in our projections in October. So I'm not as concerned as President Lacker about that. In sum, I agree that we need to reduce rates substantially just to get close to buying insurance. I would do it sooner rather than later. I would have been prepared to support an intermeeting move today. I think the data are weak enough; we are far enough behind the curve. To me, looking at the equity market declines, what we have seen since the middle of December is a bit of a loss in confidence in the financial markets that we will do enough soon enough to keep the economy on an even keel. So I think there has been a palpable deterioration in confidence in the Federal Reserve out in the financial markets. I am concerned that we are going to get three weeks of bad news and that the erosion of confidence will just gather steam. But I see the issues and the negatives also. An orderly FOMC process is to be protected. We are at risk of scaring the markets or looking as though we are lurching. I think we are at risk, if we move, of creating market dynamics such that they would constantly be in volatility and on alert as to when the next intermeeting move is. So there are a bunch of negatives here; and I guess on balance the case for moving--especially if it's not supported generally by the Committee because I think it has to be supported generally by the Committee--is not overwhelming. Obviously, I am prepared to wait and make a substantial move at the meeting, but I agree that you should signal something in your speech tomorrow that we are likely to move against the emerging economic weakness. I don't think, President Fisher, that a speech that the Chairman makes after consulting with the whole FOMC is comparable to the speeches we make as individuals. He doesn't have the risk of misleading the market when he has heard from all of us at the same time. This is a very different situation from the situation that many of us were in during the previous intermeeting period. Thank you, Mr. Chairman. " FOMC20070628meeting--115 113,MS. MINEHAN.," Thank you, Mr. Chairman. The pace of growth in New England, at least as measured by employment, remains below that of the nation. Indeed, since the trough of the last recession, New England’s jobs have grown at less than half the pace of the nation as a whole. Some of this is the traditionally slower pace of job formation in the region, and some is undoubtedly the result of the kind of industries— telecommunications and technology more generally—that were hardest hit in the 2001 recession and have yet to recover fully. But some of it also revolves around issues of supply. Almost every firm, large or small, comments on the difficulty of finding skilled labor. There is also reason to believe that, at least relative to the rest of the nation, the supply versus demand imbalance may be a particular issue in the region. This comes from the Conference Board’s online job-posting measure, which for some time has shown New England as having the highest number of advertised job openings relative to the size of the labor force. Contacts report that they are willing to offer—and do offer— higher pay to get the skills they need, but finding the workers is harder to do and takes longer than earlier in the cycle. Another issue that came up again in our round of contacts is the pervasive rise in the cost of almost any metal, but especially copper and aluminum. Contacts at one very large diversified company speculated about China’s stockpiling valuable metals. Whatever the cause, worldwide demand is strong, and prices are rising for all types of metal inputs. Some firms report progress in passing on those price increases. Indeed, larger manufacturing companies appear to be buoyed, if not driven, by strength in foreign markets. One firm reported that their booming aircraft business required such long hours and continued stress on skilled workers to figure out ways to meet demand that employee turnover had tripled. Not surprisingly, year-over-year manufactured exports for the region rose in the first quarter. Elsewhere, news in the region has been fairly positive, with business confidence rising and commercial real estate markets good and improving throughout. Residential real estate markets remain slow. Regardless of what measure is used, the region’s home prices appear to have slowed more than the nation’s. However, although we had led the nation—this is not something in which you want to lead the nation—in the rate of rising foreclosure initiations, especially for those related to subprime mortgages, the pace of this growth has subsided. Indeed, initiations of subprime foreclosures went down in the region most recently. Moreover, in the most recent data on home sales, the Northeast was a bright spot. I have speculated before that the New England residential real estate market could be bottoming out. Such thoughts may remain in the category more of a hope than a certainty, but perhaps the pace of decline is slowing. Finally, while consumer confidence has been bouncy recently, probably from concerns about gasoline prices, demand seems reasonably strong as gauged by local retailers. Software and IT firms are showing considerable strength, and at least in our region, so is temporary help. Coincident indicators of regional health also show solid growth for all six states. In sum, the region appears to be doing fairly well; and except for residential real estate, there are perhaps growing signs of price and resource pressures, in that regard not unlike the nation as a whole. Turning to the nation, I was pleased to see that incoming data validated the substantial pickup in second-quarter growth that we, along with the Greenbook, had forecasted. Indeed, outside of residential investment, incoming data have depicted an economy that is growing at a relatively healthy pace. Data on shipments and orders of capital goods have improved, consumer demand seems relatively well maintained despite high gas and soft home prices, and payroll data show little sign of dwindling labor demand. Markets have at last decided to adopt the Committee’s more positive outlook on economic prospects, and credit was repriced as a result. I view this event as healthy. It has tempered our GDP forecast slightly, but the continued ebullience of equity markets is an important offset. As I noted at our last meeting, we find ourselves a bit more optimistic than the Greenbook about trends in residential real estate, based on new housing starts and data on new home sales most recently, and we have moderated the pace of decline of residential investment for the second quarter just a bit relative to our May forecast. The April value of nonresidential construction put in place was a clear positive as well. The health of the rest of the world continues to surprise, and we, like the Greenbook, expect little drag from net exports over the forecast period. Turning to projections for 2008 and 2009, the factors shaping our outlook haven’t changed much. We continue to see output accelerating mildly as the housing situation moderates and more of the underlying strength of the economy shows through. This is tempered a bit both by rising long-term interest rates and by our expectations that consumers will mend their ways a bit—consume less and save more. This hasn’t shown signs of happening yet. By the end of 2009, GDP is about at potential, unemployment has ticked up a bit but remains below 5 percent, and core inflation moves down gradually to 2 percent—again, not much change and certainly within the central tendency of members’ forecasts. One obvious risk to this forecast lies in housing, as everybody has said. But as I noted at our last meeting, the longer there are no obvious spinoffs from the subprime problem to the wider economy, the more that particular risk seems to ebb. Indeed, as we have yet to see the saving rate pick up with the moderation in consumption over what would be expected by the fundamentals, there may be some upside to growth. Pressures from abroad—worldwide expansion of somewhat larger size than we expected—do raise some upside issues, both for growth and for inflation. On the inflation side, it is true that the April and May core data were encouraging. However, those numbers were dominated by temporary rather than permanent effects, at least in our view. So we haven’t moderated our forecast of core inflation, as have the Greenbook authors, albeit they moderated it only in a very minor way, and I remain concerned about upside risks. Headline CPI inflation has been strong. The unemployment rate and widening concerns about input costs suggest that pressures to raise prices might have grown, and strong growth worldwide affects not only input prices but the value of the dollar as well. If anything, since our last meeting, I think that risks related to growth have abated and have become more balanced and risks regarding inflation have grown. Thus, as we look over the next two and a half years, our forecast sees policy staying somewhat restrictive given the inflation risks and then easing a bit in late 2008 or 2009 to a level closer to its equilibrium rate. Finally, continuing some thoughts I began to articulate at our last meeting, as we think about policy, we also need to be concerned about financial stability. This is particularly true given what we’ve seen in the markets for credit derivatives. We’ve talked before about how high levels of liquidity and low interest rates worldwide cause much reaching for risk, much reaching for return, and related risk-taking. While the Bear Stearns hedge fund issue may well not have legs, the concerns regarding valuation of the underlying instruments do give one pause. Can markets adequately arrive at prices for some of the more exotic CDO tranches? What happens when the bottom falls out and positions thought to be at least somewhat liquid become illiquid? Is there a potential for this to spread and become a systemic problem? Maybe not, and I am not advocating our taking any action as a central bank. But I do think the size of the credit derivatives market, its lack of transparency, and its activities related to subprime debt could be a gathering cloud in the background of policy. Thank you." FOMC20080430meeting--102 100,MS. PIANALTO.," Thank you, Mr. Chairman. Regardless to whom I talk with these days, the conversation quickly turns to both the fragile condition of financial markets and the spectacular rise in energy and commodity prices. I had hoped that one of these problems would have gone away by now, but clearly that is not how conditions have unfolded since our last meeting. The bankers with whom I talked are paying close attention to their capital and liquidity positions. They remain concerned about wide bid�asked spreads and low trading volumes in a broad array of securities markets. Indeed, the repercussions of financial turmoil appear to have touched every channel of credit intermediation. It appears that a rewiring of credit channels is simply going to take some time to work out. The most significant financial news coming out of the Fourth District is the $7 billion investment of new capital into National City Bank. National City is the country's tenth largest commercial bank, and its problems with mortgage-related credits are now well known. National City still has much work to do to clean up its balance sheet, just as many other financial institutions with impaired capital positions must do before they can stand on solid ground again. Although the fragile state of the financial sector represents a pretty sizable risk to my economic outlook, the National City situation, along with other stories I'm hearing, suggests that modest progress is being made. With regard to District business conditions, the stories I hear remain downbeat. Commercial builders are reporting mixed though generally positive first-quarter numbers. But their expectations for retail sales in the stores that they lease out across the country have deteriorated, and they are fairly pessimistic about 2008 growth prospects. One large national commercial developer whom I talked with told me that, for the first time in his 45-year career, his company has seen sales declines in March in every retail center that they own across the country. The manufacturers I talked with indicated moderate first-quarter revenue growth as export markets, especially in Asia and Eastern Europe, are still helping to sustain production despite weak domestic demand. At the same time, manufacturers report intense commodity price pressures, and they report little resistance as they attempt to pass along the rising cost of commodities to their customers. The projection I submitted for this meeting shows real GDP growth under 1 percent in 2008, with virtually all of that growth coming in the second half of the year. This is a decidedly more pessimistic projection than the one I submitted in January but not materially different from the outlook when we met just six weeks ago. I have, however, boosted my headline inflation projection for 2008 compared with what I submitted in January, and it is somewhat higher than what I was estimating when we met in mid-March. Although I am still projecting that the slack in the economy will be sufficient to bring the core inflation number under the 2 percent threshold sometime next year, I am now anticipating a little more pass-through of commodity prices into core measures than I thought probable six weeks ago. Indeed, every time I see commodity prices ratcheting up, I become less confident that slack alone will be able to prevent an upward drift in the inflation trend. To be clear, I think the downside risks that we face in the real economy remain substantial, and I am inclined to believe that some insurance against those risks is probably warranted. But in taking such a step, I am inclined to judge that the downside risks we face in the real economy will be roughly in balance with the upside risks that we face from a rising inflation trend. Thank you, Mr. Chairman. " FOMC20080625meeting--73 71,MR. LOCKHART.," Thank you, Mr. Chairman. I would like to start with some anecdotal feedback from the region. As you know, we have a lot of Branches, so we have a lot of directors, and we ask our directors a lot of questions. The anecdotal feedback from our 44 directors about the second half can be characterized as subdued. Almost all reported that they expect economic activity to be flat or slower, and I took special note that these expectations deteriorated in June after having actually improved a bit in May. The residential housing situation in the District resembles the national picture. Both sales and new construction are weak. High levels of inventories are being exacerbated by foreclosures, which are adding to downward pressure on prices. However, there are tentative signs of a bottom forming. Our survey of Realtors across the District indicates that the pace of decline of single-family home sales may be abating. Industry contacts tell us that foot traffic and buyer interest are picking up, particularly in Florida, although I would say that what constitutes progress in Florida would not be considered very encouraging elsewhere. Nevertheless, our view is that the beginning of an adjustment process is under way, but the end of the process looks to be a long way off. Some further home-price deterioration is likely to accompany this bottoming process. Credit conditions in the District continue to tighten because of perceived risk and also liquidity pressure on our banks. Our banks indicate that the process of deleveraging continues, which is affecting lending for residential real estate and, to some extent, commercial real estate. We are also hearing from several sources that funding of community banks is becoming an increasing problem because of their previous dependence on wholesale and correspondent bank sources. Higher energy prices are, not surprisingly, affecting our outlook. Hospitality industry contacts, for instance, expressed concern about low summer bookings. Although most tourist destinations have reported solid activity to date, few expect this to continue. The reacceleration of energy and commodity price inflation has businesses focused on cost pressures. Several business contacts indicated that price increases had been relatively easy to pass through and make stick in this environment. I wouldn't say that it's widespread yet, but I do hear some reports that businesses are expecting wage increases to eventually reflect the recent increases in the cost of living. This could be a significant factor, particularly in service price inflation. This and other anecdotal input has colored my outlook for the national economy for the balance of the year and into 2009. I have revised up my forecast for headline inflation in 2008 and 2009 by 50 and 25 basis points, respectively. I am also assuming that the recent inflationary pressures from elevated energy and food prices will unwind more slowly than I previously projected--a view reinforced by expectations expressed by my District contacts. Like everyone else, I am deeply concerned that inflation expectations seem to be rising and that expectations of general price inflation, reflecting second-, third-, and fourth-order effects of recent oil and commodity price rises, risk becoming institutionalized. I am prepared in the near term to think tactically regarding the conflict between growth and employment policy objectives and inflation objectives; but sustained inflationary pressures that extend well into the fourth quarter and rising expectation readings may force, at least on my part, a more strategic look at the tradeoff. I would like to talk for a moment about financial markets. I made a number of calls during the intermeeting period, and the growth-versus-inflation tactical dilemma is complicated further by a very mixed picture in financial markets. My contacts all acknowledge improved conditions since mid-March, but discussion of the current market circumstances and the outlook had a sort of half-full/half-empty quality. My contacts, taken together, pointed to several positives, including the health of the corporate loan market, improved CDO pricing, the readiness of forming distressed funds to buy asset-backed securities, alt-A mortgage demand, the growing perception that subprime loss estimates have been overstated, and some comment on Goldman's Cheyne deal, which they believe will help create price determination for certain securities. At the same time, these contacts cited areas of continuing or worsening weakness, including: HELOCs and second mortgages; option ARMs and alt-A hybrids; indirect auto, given the collateral value of SUVs in current circumstances; in contrast to CDO pricing, CDO squared pricing is very weak and deteriorating; the obvious concern about the growing liquidity issues of regional banks; and the view that the auction rate securities market valuations, given illiquidity, are suggesting that this market has little probability of returning to normalcy. Overall, my contacts in financial markets were encouraged but expressed worries over still-substantial downside potential. Let me turn now to my national forecast compared with the Greenbook forecast. The Atlanta projections for the national economy are broadly similar to those of the Greenbook. We have the same general narrative of slow growth for the balance of the year followed by a gradual pickup through 2009 and 2010. My projections for headline and core inflation are virtually identical to the baseline Greenbook projections. However, I believe that there may be less disinflationary pressure than seems implicit in the Board staff's forecast. As a consequence, the fed funds rate path that supports my inflation outlook is well above the Greenbook's at the end of 2009 and 2010. We are 75 basis points higher at year-end 2009 and 100 basis points higher at year-end 2010. Notwithstanding the upward revision of the first-quarter GDP number and the better expectations for this quarter, I still believe the near-term risks to growth are weighted to the downside. At the same time, as suggested by my revised forecast, I see the risks to our inflation objective as weighted to the upside. On the subject of the long-term projections, I favor the third approach, which is three years plus long-term averages, and certainly would be comfortable with approach number 2. I'm generally dubious about the ability to do actual forecasting for the outyears, even as near-term as the third year. So I really don't favor approach number 1. My experience, in the brief time I have been with the Fed, has at least personally been, shall I say, challenging from the point of view of forecasting. I tend to think of the long-term projections as being roughly equivalent to our targets or policy goals. In fact, the approach we have generally taken with our three-year forecasts is making the outyear approaching at least what we would consider to be the trend rate for growth and the employment and inflation objective. So I think long-term projections really do amount to more-explicit targeting, and very likely the first question we get when we come out of the blocks--if we have this kind of approach--will be, Is this your target? I am comfortable saying ""yes"" to that question and, therefore, would support the third approach. Thank you, Mr. Chairman. " CHRG-110shrg38109--41 Chairman Bernanke," The whole picture. The Federal Reserve contributes to setting overall financial conditions, which in turn stimulates spending by consumers and businesses on the product of our companies. If spending is growing more quickly than the underlying productive capacity for a sustained period, we risk creating inflation which will then make it more difficult to sustain a healthy expansion over a longer period of time. So we are looking for evidence that consumption spending and other components of spending growth are exceeding the underlying capacity. In doing so, we look at a wide variety of indicators, including the strength of various spending components, measures of resource utilization, which include not only capacity utilization and unemployment, but also many indicators in labor markets and capital markets. We also look very much at prices because they are the canary in the coal mine. If prices begin to rise, that is indicative that there is too much demand given the amount of supply. We do not have any fixed speed limit in mind when we think about the economy going forward. We do not have any fixed number for the unemployment rate. But rather, we are looking at the overall balance of supply and demand, looking at the evolution of inflation, and trying to ensure that there is a reasonable balance between demand and supply so that our economy can continue to grow at a sustainable, moderate pace going forward. Senator Shelby. Is your economic goal here basically price stability? " FOMC20050503meeting--172 170,MR. STOCKTON.," Just briefly, the special topic at the June meeting will be the question of May 3, 2005 103 of 116 has developed. The lineup is Josh Gallin and Andreas Lehnert here at the Board. They are going to present our views on the probability and potential magnitude of an asset price misalignment in residential real estate markets. And they’re also going to talk about how that might unwind if, in fact, there is some overvaluation. They will address the issues of whose balance sheet the risks reside on and what the consequences might be for household and financial institutions should we get a more serious retrenchment in house prices. Dick Peach from the New York Fed is going to offer a more skeptical assessment of those bubble concerns, and Glenn Rudebusch and John Williams of the San Francisco Fed have agreed to discuss what, if any, consequences there might be from conditions in the housing market for your monetary policy. We’re going to post the presentations at least a week in advance, and we’ll also post any supporting materials as they become available." CHRG-111hhrg48867--38 Mr. Silvers," Thank you, Congressman Kanjorski. Good morning, and good morning to Ranking Member Bachus and the committee. My name is Damon Silvers. I am associate general counsel of the AFL-CIO, and I am the deputy chair of the Congressional Oversight Panel. My testimony today though is on behalf of the AFL-CIO, and though I will refer to the work of the panel on which I am honored to serve together with Congressman Hensarling, my testimony does not reflect necessarily the views of the panel, its chair, or its staff. The AFL-CIO has urged Congress since 2006 to act to reregulate shadow financial markets, and the AFL-CIO supports addressing systemic risk. The Congressional Oversight Panel made the following recommendations with respect to addressing systemic risk, recommendations which the AFL-CIO supports: First, there should be a body charged with monitoring sources of systemic risk in the financial system. The AFL-CIO believes that systemic risk regulation should be the responsibility of a coordinating body of regulators chaired by the Chairman of the Board of Governors of the Federal Reserve System. This body should have its own staff with the resources and expertise to monitor diverse sources of systemic risk in institutions, products, and markets throughout the financial system. Second, the body charged with systemic risk management should be a fully public body, accountable and transparent. The current structure of regional Federal Reserve banks, the institutions that actually do the regulation of bank holding companies, where the banks participate in the governance, is not acceptable for a systemic risk regulator. Third, we should not identify specific institutions in advance as too big to fail but, rather, have a regulatory framework in which institutions have higher capital requirements and pay more on insurance funds on a percentage basis than smaller institutions which are less likely to be rescued as being too systemically significant. Fourth, systemic risk regulation cannot be a substitute for routine disclosure, accountability, safety and soundness, and consumer protection regulation of financial institutions and financial markets. Consequently, the AFL-CIO supports a separate consumer protection agency for financial services rather than having that authority rest with bank regulators. And here we see this consumer protection function as somewhat distinct from investor protection, which the SEC should do. Fifth, effective protection against systemic risk requires that the shadow capital markets, institutions like hedge funds and private equity funds and products like credit derivatives, must not only be subject to systemic risk-oriented oversight, but must also be brought within a framework of routine capital market regulation by agencies like the SEC. We can no longer tolerate a Swiss cheese system of financial regulations. And finally, there will not be effective reregulation of the financial markets without a global regulatory floor. That ought to be a primary goal of the diplomatic arms of our government. The Congressional Oversight Panel urged that attention be paid to executive compensation in financial institutions. This is an issue of particular concern to the AFL-CIO that I want to turn to now in the remainder of my testimony in relation to systemic risk. There are two basic ways in which executive pay can be a source of systemic risk. When financial institutions' pay packages have short-term pay horizons that enable executives to cash out their incentive pay before the full consequences of their actions are known, that is a way to generate systemic risk. Secondly, there is the problem that is technically referred to as risk asymmetry. When an investor holds a stock, the investor is exposed to upside and downside risk in equal proportion. For every dollar of value lost or gained, the stock moves proportionately; but when an executive is compensated with stock options, the upside works like a stock but the downside is effectively capped. Once the stock falls well below the strike price of the option, the executive is relatively indifferent to further losses. This creates an incentive to focus on the upside and be less interested in the possibility of things going really wrong. It is a terrible way to incentivize the managers of major financial institutions, and a particularly terrible way to incentivize the manager of an institution the Federal Government might have to rescue. This is highly relevant, by the way, to the situation of sick financial institutions. When stock prices have fallen close to zero, stocks themselves behave like options from an incentive perspective. It is very dangerous to have sick financial institutions run by people who are incentivized by the stock price. You are basically inviting them to take destructive risks, from the perspective of anyone like the Federal Government, who might have to cover the downside. This problem today exists in institutions like AIG and Citigroup, not just with the CEO of the top five executives, but for hundreds of members of the senior management team. A further source of assymetric risk incentive is the combination of equity-based compensation with large severance packages. As we have learned, disastrous failure in financial institutions sometimes leads to getting fired but rarely leads to getting fired for cause. The result is the failed executive gets a large severance package. If success leads to big payouts and failure leads to big payouts but modest achievements either way do not, then there is a big incentive to shoot the moon without regard to downside risk. These sorts of pay packages in just one very large financial institution can be a source of systemic risk, but when they are the norm throughout the financial services sector, they are a systemwide source of risk, much like unregulated derivatives or asset-backed securities. Consequently, this is an issue that the regulators of systemic risk ought to have the authority to take up. I thank you for your time. [The prepared statement of Mr. Silvers can be found on page 136 of the appendix.] " FOMC20070918meeting--151 149,MR. KOHN.," Thank you, Mr. Chairman. I’ll be glad if you don’t tell how many years of experience I have around this table. [Laughter] I support the action and the language of alternative B for the reasons that have been given by many others around this table. I think that the odds favor a significant reduction in aggregate demand owing to the financial conditions we’ve all been talking about. I agree with Governor Mishkin that part of the disruptive effects of the financial conditions are the small chance of a very adverse effect—the sort of interactions you were talking about, Mr. Chairman. Holding back and doing just 25 in that context would be a mistake. Going ahead and doing 50 will largely relieve some uncertainty. With regard to some of the comments about language, the discussion of credit conditions in financial markets in paragraph 2, I guess my read of what we talked about today was just this, and it seems to me that the way it is now is very transparent. It’s a nice replication of the discussion we have had, and so I don’t see a need to subtract language about financial markets from this. With regard to the balance of risks in paragraph 4, also consistent with our discussion is the sense that there’s a huge amount of uncertainty about how things are going to evolve, both the markets and the effect on the economy. I don’t feel as though I know enough to say that the risks are balanced. I don’t know. The range of outcomes is just too wide, and there’s very little central tendency in it. So I’d be very uncomfortable with a statement saying that I kind of thought the risks were balanced. I am much more comfortable with a statement that says there is a lot of uncertainty out there and that’s uncertainty around the economic outlook. So I think the current language in paragraph 4 is also a nice representation of the discussion we had today and consistent with our ignorance. I’m not concerned about the moral hazard issues. I think our job is to keep the economy at full employment and price stability and let asset markets fluctuate around that. There will be winners and losers. That’s fine. The Congress told us to have maximum employment and stable prices, and that’s what we should be about here. Sometimes that means you need to move to keep employment maximum or prices stable, and we need to take account of the asset markets but not worry about the effects of those actions on asset markets per se. Holding back—inertia—because of concerns about moral hazard would be a serious mistake. We shouldn’t hold interest rates higher than they need to be in order to impose additional cost on borrowers to teach lenders a lesson. Too many innocent bystanders would be hurt in that process. Thank you, Mr. Chairman." FOMC20080121confcall--23 21,VICE CHAIRMAN GEITHNER.," Mr. Chairman, of course, I support your recommendation. I think it is the right thing to do. Even with this move, I think we are likely to have to move significantly further. It is hard to know how much more and what the optimal timing of further actions is going to be. It is very important, in the context of a move, that we signal--as your statement does--that we will do what is necessary to provide a meaningful degree of accommodation, a meaningful degree of insurance against a more adverse set of financial and economic outcomes. If we were to wait until the meeting, we would be taking just too much risk. I think it would be irresponsible to take the risk that we would see a substantial further deterioration in confidence and in market prices, which would do substantially more damage to market functioning than we have witnessed so far. I think you said on January 9, Mr. Chairman, that the risk we have to worry about is not so much that we have simply a mild, short, and shallow recession but that we face a much deeper and more protracted economic downturn with much more damage to the financial system that would ultimately require, if it were to happen, much more action in terms of monetary policy with perhaps more-adverse consequences for future incentives and for the economy as a whole. I think that that is a risk we have to worry about. It is very hard to judge what the probability of that risk is. None of us can know for sure what the next nine days would be like if we did not act. None of us can know the probability that the market will work through this stuff on its own. It is a matter of judgment, and I think your judgment on this is right. I strongly support it. I just would say again, although I don't think any of us can support this with hard, quantifiable evidence, that conditions are so fragile and so tenuous now that by not acting tomorrow morning we would be taking an irresponsible risk that we would see substantial further erosion in confidence. That would put us in a much weaker position to mitigate these risks going forward. " FOMC20070131meeting--316 314,MS. DANKER.," I’ll read the directive from page 25 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” The risk assessment: “The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” Chairman Bernanke Yes Vice Chairman Geithner Yes Governor Bies Yes President Hoenig Yes Governor Kohn Yes Governor Kroszner Yes President Minehan Yes Governor Mishkin Yes President Moskow Yes President Poole Yes Governor Warsh Yes" fcic_final_report_full--304 MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS CONTENTS The Federal Reserve: “When people got scared” ................................................  JP Morgan: “Refusing to unwind . . . would be unforgivable” ...........................  The Fed and the SEC: “Weak liquidity position” ...............................................  Derivatives: “Early stages of assessing the potential systemic risk” .....................  Banks: “The markets were really, really dicey” ..................................................  JP Morgan’s federally assisted acquisition of Bear Stearns averted catastrophe—for the time being. The Federal Reserve had found new ways to lend cash to the financial system, and some investors and lenders believed the Bear episode had set a precedent for extraordinary government intervention. Investors began to worry less about a re- cession and more about inflation, as the price of oil continued to rise (hitting almost  per barrel in July). At the beginning of , the stock market had fallen almost  from its peak in the fall of . Then, in May , the Dow Jones climbed to ,, within  of the record , set in October . The cost of protecting against the risk of default by financial institutions—reflected in the prices of credit default swaps—declined from the highs of March and April. “In hindsight, the mar- kets were surprisingly stable and almost seemed to be neutral a month after Bear Stearns, leading all the way up to September,” said David Wong, Morgan Stanley’s treasurer.  Taking advantage of the brief respite in investor concern, the top ten American banks and the four remaining big investment banks, anticipating losses, raised just under  billion and  billion, respectively, in new equity by the end of June. Despite this good news, bankers and their regulators were haunted by the speed of Bear Stearns’s demise. And they knew that the other investment banks shared Bear’s weaknesses: leverage, reliance on overnight funding, dependence on securitization markets, and concentrations in illiquid mortgage securities and other troubled assets. In particular, the run on Bear had exposed the dangers of tri-party repo agreements and the counterparty risk caused by derivatives contracts. And the word on the street—despite the assurances of Lehman CEO Dick Fuld at  an April shareholder meeting that “the worst is behind us”  —was that Bear would not be the only failure. FOMC20061025meeting--51 49,MR. PLOSSER.," Thank you, Mr. Chairman. Our regional economic story is similar to that of the national economy. Regional activity has slowed in the third quarter, mainly because of the housing sector. In general, our business contacts expect the regional economy to continue to expand, albeit at a modest pace. Price pressures remain elevated in the Third District but have not strengthened over the intermeeting period. Turning to the individual sectors, manufacturing activity in our region has softened over the past two months. The index of general economic activity in our business outlook survey, which turned slightly negative last month, remains slightly negative this month, indicating basically not much change since September. However, there were some positives in the October survey that were not in the September report. In particular, there was a rebound in the indexes of new orders and shipments, suggesting slightly positive growth in our respondents’ firms. Also, manufacturing executives were much more optimistic this month about future activity, with most indicators rebounding from their September low readings. This optimism is consistent with President Moskow’s comment about the optimism of some executives that he has observed. Now, consistent with the slowdown in activity, payroll employment growth in our three states slowed in the third quarter to an annual rate of about 0.7 percent, compared with 1.1 percent in the nation. The unemployment rate, which had been running under the national rate for the past three years, has now moved up to that rate. Still, our business contacts as well as respondents to our manufacturing survey continue to cite difficulty in finding qualified workers as one of their major business concerns. As in the nation, the housing sector in our region continues to decline. We’ve seen some slowing in the value of nonresidential contracts as well over the past three months. But these data are quite noisy, and I think it’s too early to read much of a turning point into the nonresidential construction sector for our region at this point. Office vacancy rates continue to edge down, and the net absorption of office space continues to be positive. Consumer spending continues to hold up well in our region. We saw a pickup in retail sales in September, except for autos. Area retailers told us that their sales had increased in recent weeks, and their back-to-school sales exceeded their expectations. Their view is that continued growth at that pace depended on consumer confidence, which for the mid-Atlantic region increased in September, no doubt because of the decline in oil prices. The Fed’s current economic activity indexes indicate a slowing in activity in our region over the past three months, especially in New Jersey, which has shown the sharpest deceleration. As of August, year-to-date average growth in these indexes (weighted by gross state product) for our three states has been about 1.8 percent, compared with 3 percent for the United States. Over the past three months, regional growth has slowed to about 0.6 percent. The leading indicators for our three states also have moved down this year, suggesting only modest growth over the coming six to nine months. On the inflation front, consumer prices in the Philadelphia region continue to rise at a pace faster than that of the nation. The faster pace is due mainly to the larger increases in shelter prices in the Philadelphia metro area compared with those in the United States. On a more positive note, while area manufacturers continue to report higher production costs, these cost increases have been less widespread in recent surveys than earlier in the year. The index of prices paid in our manufacturing survey has declined for the past three months, and the index of prices received was down significantly in October. So while the levels of these indexes remain high, indicating continued inflationary pressures, some solace may be found in the less elevated levels of these indicators, at least in recent months. For the national economy, my outlook is not much different from what it was at the last meeting. Real GDP growth in the second quarter was revised down to 2.6 percent, as has been noted, and the data received to date suggest that growth in the third quarter was even weaker, perhaps 1 to 1½ percent. I expect some rebound in the fourth quarter and, like President Minehan, was pleased to see the upward revision in the fourth-quarter forecast in the Greenbook. The main source of the slowdown, of course, is the fall in the demand for housing. Manufacturing also softened in the third quarter compared with its robust pace earlier in the year. About half of that slowdown was due to autos, and I expect some rebound there, too, in the fourth quarter. Trade subtracted from growth in the third quarter relative to the second quarter, but again, as has been pointed out, I expect that to be less of a drag in the fourth quarter than it was in the third. So aside from housing, most other sectors of the economy, including consumer spending and business investment, are holding up, even in the Philadelphia region in the Third District. They aren’t growing as rapidly as they were in the first part of this year, but they are growing somewhat below trend, and they continue to expand. If the slowdown in housing continues to be an orderly one, without large spillovers as has been frequently mentioned, I would not characterize that correction as unwelcome. Housing activity has been at an unsustainably high pace in recent years. Of course, at this point we cannot rule out the possibility that the correction in housing from the unsustainably high pace of activity that we’ve seen over the past few years will derail the expansion. But so far, we have not seen spillovers of housing into other sectors. In particular, we have not seen any retrenchment by the consumer for the most part. The moderation we’ve seen in consumer spending after the strong first quarter is largely in line with expectations. Real disposable income growth remains healthy, and we have been lucky with two positives—the decline in gasoline prices and the rise in the stock market. We’ve had some hopeful news on the inflation front over the intermeeting period, but the level of inflation continues to concern me. As we anticipated at the time of our last meeting, the drop in energy prices led to a significant deceleration in headline inflation for September. Although the twelve-month change in core CPI actually edged up to 2.9 percent, a rate that I consider well above price stability, it may be beginning to stabilize. But, frankly, a lot of uncertainty remains, and it is dangerous, to my mind, to rely too heavily on one month’s numbers. Some of the acceleration of core inflation over the past year was likely due to the pass-through from energy prices, as we discussed before. So if oil prices fall or continue to stabilize, then acceleration of core inflation from this source will likely dissipate. However, we’ve seen energy prices retreat only to move back up again, so I don’t think we should become too sanguine. Indeed, the inflation picture remains uncertain. I’ll be more comfortable when we begin to see twelve-month core inflation begin to decelerate. To the extent that some of the acceleration in inflation was fueled by very accommodative monetary policy over the past five years, we still need to consider whether monetary policy has firmed enough to remove the cumulative effects of the past policy accommodation to get inflation back down to a level consistent with price stability in a reasonable time so that our credibility is not at risk. The longer we allow that deviation from price stability to persist, the higher the risk to our credibility and the higher the risk that recent high inflation readings will raise longer-term inflationary expectations. So far, long-run expectations have been stable, and shorter-run expectations have fallen with oil prices. Nevertheless, I think the Fed’s commitment to price stability deserves our protection. One thing to note going forward, though, is that if economic growth remains below trend for a while, then there’s an implicit firming of monetary policy, even without changing the nominal interest rate. Given our economic outlook and the risks to that outlook, at this point that may be actually the most desirable path. Thank you, Mr. Chairman." FinancialCrisisInquiry--590 BASS: One thing we talk about around our office is the brevity of financial memory. I think it’s only about five years when you look back through the financial marketplace. So, but to answer your first question with regard to where we are today as what is still a systemic problem, it’s what Mrs. Born is focused on up there and OTC derivatives. We have to nail those down. We have—absolutely need to get not only a clearing house, but a data repository put together so that the appropriate regulator, whoever we deem to be that appropriate regulator can see everything. Right now no one knows anything. You have to go in institution-by-institution, fund-by- fund. And these are just contracts between a buyer and a seller. There needs to be a clearinghouse, a repository and price transparency because I think that will eliminate an January 13, 2010 enormous amount of systemic risk. And when you require collateral to be posted to enter transactions it will self police the size of that marketplace. So that’s what I think is the biggest risk. FOMC20050630meeting--8 6,MR. GALLIN.,"3 Thank you. My presentation begins on the third page of the handout you received. It seems that everybody is talking about house prices, and the upper panel of your first exhibit shows why: House prices, adjusted for general inflation, have risen at a rapid pace in recent years and did not even pause during the last recession. Indeed, the real rate of appreciation has increased, and the most recent readings have been at annual rates greater than 7 percent. By comparison, the average annual increase in real house prices during the past 30 years is only about 1¾ percent. The next two panels illustrate some of the eye-popping gains that have been recorded in selected metropolitan areas. For example, as shown in the middle left panel, real house prices increased about 16 percent in San Francisco and 30 percent in Las Vegas during the four-quarter period ending in the first quarter; as shown to the right, the most recent gain was 13 percent in New York and 20 percent in Miami. Rapid price appreciation has sparked debate about whether housing has become overvalued, and the popular press is filled with stories suggesting that it has. As summarized in the lower left panel, anecdotes suggesting that the housing market is overheated include those about increased speculation, purchase decisions that are perhaps too dependent on rosy assessments of future appreciation, and increased reliance on novel forms of financing without full recognition of the associated risks. Although these anecdotes are suggestive, they do not provide a benchmark for valuing housing. Two approaches that do provide a benchmark are listed to the right. One is to ask if housing is affordable for a typical family. Some analysts have argued that prices are too high relative to incomes, while others say low interest rates have kept required monthly mortgage payments affordable. Another approach is to ask if house prices are properly aligned with rents. I have pursued both approaches in my research, and have concluded that rents provide a preferable benchmark for valuing housing. I will therefore focus my prepared remarks on this approach. June 29-30, 2005 5 of 234 price of a house should reflect the appropriately discounted stream of expected rents; high prices could be justified by high rents or by low carrying costs, which include interest payments, net taxes, and depreciation. But if prices appear unusually high relative to rents and carrying costs, one might conclude that housing is overvalued. As highlighted to the right, I have implemented the framework using repeat- transactions price indexes from the Office of Federal Housing Enterprise Oversight [OFHEO] and Freddie Mac and the tenants’ rent index from the consumer price index. I made several adjustments to these series to address some of the shortcomings of the published data. As you will see in Dick Peach’s presentation, he and I disagree about the best way to measure house prices. I would be happy to discuss the issue during the question period. That said, the red line in the middle panel shows the estimated price-rent ratio for the stock of housing, and the black line shows the estimated real carrying cost of housing. The first point to note is that the measured price-rent ratio is currently higher than at any earlier time for which we have data. Moreover, the run-up in prices appears to be far greater than can be explained by carrying costs, at least if we use the historical relationship between the two series as our guide. Although theory suggests a tight link between carrying costs and the price-rent ratio, the data suggest that the actual link is more tenuous. At the simplest level, while the price-rent ratio is at a historical high, the carrying cost is not at a historical low. More formally, regression analysis suggests that prices are about 20 percent too high given rents and carrying costs. One might reasonably ask what this potential 20 percent overvaluation portends for house prices. The lower panel summarizes the historical experience on this question. The panel shows a scatter plot of the price-rent ratio (on the horizontal axis) and changes in real house prices over the subsequent three years (on the vertical axis); the panel also includes a fitted regression line. As I mentioned a moment ago, carrying costs are only slightly correlated with the price-rent ratio. Thus, their effects can be excluded from the chart without materially affecting the results. June 29-30, 2005 6 of 234 then, real prices actually increased more than 20 percent, and the price-rent ratio rose to about 27—literally off the chart. To give an impression of what has happened in local markets, the upper panel of your next chart summarizes housing-market conditions for four metropolitan areas: San Francisco, New York, Chicago, and Miami. The panel displays the deviation of each city’s price-rent ratio from its long-run level in the second quarter of 1979 (the red bars), the fourth quarter of 1989 (the black bars), and the first quarter of 2005 (the green bars). The numbers above the bars indicate their height. The first two episodes represent previous peaks of the price-rent ratio at the national level. The third episode is where we are now. The numbers below the red and black bars show the performance of real house prices in each city in the three years following each episode. For instance, as shown by the red bar, the price-rent ratio in San Francisco was 7 percent above its long-run level in the middle of 1979. During the subsequent three years, real house prices there fell 5 percent. At the end of 1989 (the black bar) the price-rent ratio in San Francisco was 15 percent above its long-run level, and real prices there fell 12 percent during the subsequent three years. The most recent reading for San Francisco indicates that the price-rent ratio is now further above its long-run level than in either 1979 or 1989. The price-rent ratios suggest that housing is overvalued in the other three cities as well, but to differing degrees. Although the price-rent ratio in New York is elevated, housing does not look much more overvalued there than it did in the late 1980s. House prices appear elevated relative to rents in Chicago as well, but it is Miami that stands out as the most overheated of the four markets shown here. June 29-30, 2005 7 of 234 The middle right panel shows the implications of these two models for the four- quarter percent change in real house prices at the national level during the Greenbook forecast period. The basic model—in green—suggests that house prices will decelerate in the coming two years, but that they will still rise faster than their long-run average of about 1¾ percent per year. Thus, even a model that ignores the long-run relationship between the levels of prices and rents predicts a slowdown in house-price appreciation. Still, housing would become slightly more overvalued relative to rents at the end of the forecast period. The error-correction model—in red—calls for prices to decelerate more in the coming two years, with real prices actually edging down a bit in 2006. In this scenario, housing would be about 15 percent overvalued at the end of the forecast period. Note that the June Greenbook forecast—the black line—lies between the two model simulations. To sum up, the statistical evidence that I have presented today provides support for the view that the price-rent ratio can be a useful tool for summarizing housing valuations. The price-rent ratio is currently very high by historical standards, suggesting that housing might be overvalued by as much as 20 percent. Historical experience suggests that the change in real house prices going forward will be slower than in recent years. Unfortunately, the evidence cannot rule out either further rapid gains in house prices for a time or a more rapid correction back to fundamentals. Just as the price-dividend ratio is an imperfect tool for forecasting stock prices, the price-rent ratio should be considered only a rough guide to valuations in the housing market. Thank you." FOMC20050322meeting--121 119,VICE CHAIRMAN GEITHNER.," Careful. [Laughter] The near-term outlook appears more favorable to us, as it does to everybody else. We have moved up our forecast to reflect stronger­ than-anticipated underlying growth and somewhat greater price pressure. On the expectation that we will move the fed funds rate up at the somewhat steeper path now priced in the market, we now expect real GDP to grow at a roughly 4 percent pace in real terms this year before moderating to around 3½ in 2006. And with this tighter monetary policy assumption, we expect core PCE to come in a bit above 1½ percent but not above 2 percent. As this implies, we are very close to the Greenbook on the broad outlines of the story and quite close in the components, too. We have a bit more investment and less consumption and a little March 22, 2005 54 of 116 growth and unit labor costs a bit softer. But overall we have a very similar view to the staff forecast on the broad forces supporting the expansion. And we are quite comfortable, as a result, with the case this story presents for tightening policy further and for signaling more tightening to come. We see the risks as roughly balanced around this slightly higher path for growth and inflation. If there’s a case for asymmetry or less balance in our uncertainty, it seems more likely to be on the upside than on the downside. The rise in the two- to five-year inflation expectations in TIPS, in the face of what is otherwise reasonably encouraging news on inflation fundamentals, bears careful monitoring. We now face a lower probability that the core PCE will come in at 1½ percent rather than above, and this itself suggests a higher path for the nominal fed funds rate. The anecdotal stories seem to have improved alongside the strengthening of private forecasts. Our Empire State Survey shows greater confidence—greater optimism about the next six months—than we’ve seen in some time. I think we should be relatively comfortable, therefore, with both the direction and magnitude of the change since our last meeting in market expectations regarding the likely path of the fed funds rate. I would be somewhat more comfortable if the market were pricing in a somewhat higher probability of a 50 basis point move at some point in the near term. I say this not because I think we can make the case now that we will need to move by 50 basis points any time soon but simply because we need to make sure that we have the flexibility to do so. One of the consequences of the structure of our statements these days, at least until very recently, is that the markets have responded to stronger data or more inflation risks by raising the probability of another 25 basis point increase beyond the next meeting or two, but not by pricing in any significant probability of a steeper slope than 25 per meeting. This has contributed to a remarkable reduction in uncertainty about monetary policy expectations, which in turn has March 22, 2005 55 of 116 premia across financial markets. Part of this is due to fundamentals, but part seems due to our monetary policy signal. At the margin, this implied ceiling on the slope of the path toward equilibrium raises the possibility that we will be perceived at some point as taking some risk of getting behind inflation expectations. Buying some insurance against this prospective small cloud on our credibility is prudent risk management. This argues for adjusting our statement to condition or qualify “measured,” and for doing so ahead of when we might be forced to. This makes sense even if we don’t want to significantly steepen the implied path at this point. Buying this flexibility now may entail some modest steepening in the path, but some risk in that direction is worth it. The additional benefit in gradually exiting from the “measured pace” language as we approach equilibrium, of course, is that it will prepare the ground for a flatter path when that proves appropriate. Greater confidence in the sustainability of the main forces driving the expansion suggests that the greatest risks to the forecast, apart from some shock, still lie in the imbalances we face in our economy. Those imbalances are evident in the combination of the sustained rise in household debt, the projected increase in public debt, and the deterioration in our net international position. This probably argues for trying to get the real fed funds rate up to a more positive level than might otherwise have seemed appropriate. That will help provide more traction—or at least some traction, since we don’t see much traction yet—to the process of adjustment, allowing the forces of gravity to contribute to a more gradual unwinding of these internal and external imbalances and reducing some of the risk in the forecast. A more contractionary fiscal policy stance would make this less necessary, but this does not now seem in prospect. Thank you. March 22, 2005 56 of 116 [Coffee break]" FOMC20080916meeting--106 104,MR. MADIGAN.," 2 I will be referring to the package labeled ""Material for FOMC Briefing on Monetary Policy Alternatives and Trial Run Survey Results."" The results of the survey are shown in exhibit 2. In the interest of time, I will not cover them this morning. The Subcommittee on Communications plans to be in touch with the Committee on this issue over the upcoming intermeeting period. The first page of the package reproduces the version of table 1 that you received yesterday afternoon. This version includes three policy alternatives. As in the Bluebook, alternative B would leave the stance of policy unchanged at this meeting, and alternative C would involve a 25 basis point firming today. However, alternative A now entails a 25 basis point policy easing rather than the unchanged funds rate that was specified in the Bluebook version of this alternative. I will begin by discussing alternative C. The discussion at your last meeting suggested that you generally saw the next move in policy as likely to be a firming, a point that was explicit in the minutes of the meeting. Even though market volatility and financial strains have increased notably in recent weeks, you might view those developments as having only limited implications for the economic outlook and hence see economic fundamentals as continuing to suggest that policy should soon be firmed. Inflation has been well above the rates that Committee members judge as appropriate for the longer run, and despite lower oil prices and greater slack in labor markets, there remains considerable uncertainty about how soon and how much core inflation will slow. In these circumstances, you may believe that a firming of policy is appropriate. Under the version of alternative B distributed yesterday evening, the Committee would hold the target funds rate constant at this meeting, and the statement would suggest that the Committee sees the risks to growth and inflation as roughly balanced. You may believe that this combination is appropriate for this meeting if your modal outlook for the economy has not changed much since the last meeting and if you judge that the upside risks to inflation have diminished, given the sharp drop in energy prices, the decline in indicators of inflation expectations, and the greater economic slack implied by the recent unexpectedly sharp jump in the unemployment rate. You might also believe that the downside risks to growth have increased as a result of the recent increase in financial strains. But at the same time, you may want 2 The materials used by Mr. Madigan are appended to this transcript (appendix 2). to let the dust settle a bit before concluding that these developments warrant an adjustment in your policy stance. In particular, you may think there is a good chance that the latest enhancements to the Federal Reserve's special liquidity facilities will help keep markets functioning and mitigate the risks to growth. Relative to the Bluebook version, the language of alternative B has been revised in three material ways. First, B2 now notes that ""strains in financial markets have intensified."" Second, the clause ""some indicators of inflation expectations have been elevated"" has been dropped from B3 in view of the recent declines in inflation compensation and survey measures of inflation expectations. Finally, the first sentence of B4 has been revised to suggest that the Committee now sees the significant risks to growth and inflation as roughly balanced. Given market participants' expectation that the funds rate could trade soft to the target for a time in light of recent developments, gauging exactly what is built into markets for the outcome of today's meeting is difficult. But earlier this morning, market prices appeared to incorporate high odds of at least a 25 basis point easing today or possibly more. Thus markets might well see a decision to keep the funds rate constant and to make no appreciable change to the language of the statement as signaling less concern about financial developments than they anticipated. If you saw recent developments as significantly boosting the downside risks to growth or noticeably lowering the modal outlook, you might consider easing the federal funds rate 25 basis points at this meeting, as in alternative A. The rationale language for this action would begin by noting that strains in financial markets have increased significantly and would go on to indicate that the policy action should help to promote moderate growth over time. The Committee would cite the recent decline in energy and other commodity prices and the increased slack in resource utilization as factors that are expected to foster a moderation of inflation. The risk assessment would indicate that ""the downside risks to growth have intensified, but the upside risks to inflation remain a concern to the Committee."" With a policy easing largely built into markets, shorter-term interest rates would likely decline modestly in response to such an action, depending on how much is built in, or they might be little changed. As the Chairman indicated earlier in the meeting, adjustments to the statement could be considered in light of the further volatility in markets over the past day. Thank you, Mr. Chairman. " FOMC20060920meeting--127 125,MR. PLOSSER.," Thank you, Chairman Bernanke. Overall, economic activity continues to expand in the Third District. The consensus in the regional business community is for moderate growth in the months ahead, but some sentiment has turned more cautious in the intermeeting period. We have seen a slowdown in regional manufacturing activity over the past month. Our business outlook survey, which remains confidential until noon tomorrow, weakened somewhat in September with general activity falling just barely into the negative area, at -0.4, from an 18.5 number in August. This is the first negative reading we’ve seen since April 2003. The diffusion indexes for shipments, new orders, and unfilled orders also turned slightly negative. I don’t want to read too much into one survey. The April 2003 dip was very short-lived, and we saw a similar pattern in our survey in the mid-1990s, when growth slowed but then picked back up again fairly quickly. Part of the slowdown in manufacturing is at firms that supply the housing industry, reflecting a slowdown in residential real estate, which has become more pronounced in our District since our last meeting. Building permits and home sales were down in July and August. Inventories of homes on the markets, like much of the nation, continue to increase. House-price appreciation has slowed, but we have not yet seen outright declines. Despite an increase in cancelled sales of new homes, builders generally indicate that their backlogs will keep them relatively busy through the rest of the year. However, some real estate contractors have begun to lay off employees in anticipation of slower activity. A pickup in activity in nonresidential real estate markets has been helping to offset the decline in residential construction. Office vacancy rates continue to edge down, and net absorption of office space continues to be positive. However, over the next year, some moderation in nonresidential building construction in our three states is expected. In response to a special question in our manufacturing survey this month, about one-third of the firms report that they plan to lower their expenditures on new structures next year compared with this year. Only one-tenth of our firms expect to raise spending on structures. When we asked a similar question a year ago, about half the firms expected to raise their expenditures on structures in 2006, and, in fact, we did see that this year. For other categories of capital spending, however, firms by a large margin anticipate expenditures in ’07 to be the same as or higher than those in ’06. At some small banks in our District there has been a recent pickup in nonperforming loans, which is concentrated in their commercial real estate portfolios. Conditions in other sectors of our region are little changed since our last meeting. Retail sales of general merchandise edged up, but sales of back-to-school merchandise, especially fall apparel, did not seem to meet manufacturers’ expectations. Payroll employment continues to expand in our three states at a somewhat slower pace than in the nation as a whole, which is typical of the region. The unemployment rate, which had edged down slightly in June, edged back up in July but remains below 5 percent. While many employers continue to report difficulties in filling positions, the Philadelphia staff’s forecast is for employment in our region to grow at a pace of about 1 percent over the next year, slightly lower than this year. Unemployment rates in the region are expected to increase modestly maybe over the next year. Growth continues at a moderate pace, but we see little indication of receding price pressures in the District. The index of prices received in our manufacturing survey edged up in September. There was some minor moderation in prices paid, but that index remains at an extremely high level. Employers in a number of industries in the region report that wage and salary levels have been moving up at a somewhat faster pace than they did a year ago. Turning to the national economy, my view is not much different than it was at our last meeting. My main concern remains the outlook for inflation and the risk it poses for our credibility. In my view, the Fed’s most important contribution to a healthy economy is achieving and maintaining price stability. As expected, incoming data continue to indicate a moderation in growth to potential or somewhat below potential. On the negative side, housing has weakened more sharply than many expected, and auto production seems to be turning down for the rest of the year. On the positive side, as has already been mentioned by a number of others, business investment and corporate profits remain firm. Employment continues to rise at a moderate pace. The revised wage and salary data are now more consistent with the strength in consumer spending that we’ve seen, and continued growth in income and perhaps lower gas prices will help offset the possible negative effect that we may see from a deceleration in housing prices. On balance, I am somewhat more optimistic than the Greenbook about the growth side of the economy. I, too, see growth somewhat below potential over the next four quarters, but that’s driven predominantly by a slowdown in the near term—that is, in 2006. Then I see a return to potential more or less in 2007, although my estimate of potential is probably slightly higher than the Greenbook’s estimate. Now, given the level of precision of our output measurements and forecast of potential GDP growth, I’m really not overly concerned about the forecast at this point. The adjustment in the housing sector to more-sustainable levels is forecast to occur without triggering a recession and without triggering much of an increase in unemployment. I believe we should not attempt to stand in the way of that happening. It’s a mistake to think that the forecasted moderation in growth will bring inflation back to a level consistent with price stability. Indeed, the Greenbook’s baseline forecast of core PCE inflation remains above 2 percent through the end of 2008. Even in the alternative Greenbook simulation of a slump in housing, in which aggregate demand weakens and real GDP growth slows to just 0.6 percent in 2006 and barely above 1 percent in the first half of 2007, core inflation hardly changes and remains above 2 percent in 2008. Thus, it seems to me that language from us in the press that indicates that moderating growth will help to restrain inflation is not really consistent with our forecast. I think it imputes a degree of precision to an estimated Phillips curve that we just don’t have. Over the intermeeting period, we have had some hopeful news on the inflation front. Core CPI inflation has not accelerated further in the past two months, and oil prices seem to be down. Thus, headline inflation, as I pointed out, is likely to be way down in September, and we will seem quite omniscient. The measure of expected inflation over the ten-year period in our Survey of Professional Forecasters has not changed—it remains at 2½ percent. The August rise in the Michigan survey of one-year-ahead inflation expectations seems to have been reversed in the preliminary September numbers, largely because of the decline in oil prices. However, both compensation per hour and unit labor costs have been trending up, not down as the earlier data suggested, although I will note that the usefulness of the compensation numbers in predicting inflation is quite weak. Although core inflation has stabilized, its level is still above our so-called comfort zone. To my mind, the inflation outlook is quite uncertain. We do not yet know if the positive developments in oil prices will stick or not. I hope they will, but certainly we’ve seen energy prices retreat only to move back up again, and the hurricane season isn’t over yet. Thus, we should not become too sanguine about inflation from one or two data points. Moreover, we do not know if the upward revision to labor compensation will pass through to core inflation, as built into the Greenbook baseline, or if measures of medium-term inflation expectations will continue to decrease. What we do know is that core inflation has been above 2 percent for two and a half years and is expected to be there, according to the forecast, for another two years. Put another way, there is little evidence in the forecast that policy actions to date will bring core inflation back below 2 percent before sometime in 2009. I think that should concern us. I see two inflation scenarios as being plausible, and I struggle with which one I believe to be the correct one. In the first scenario, core inflation is elevated primarily because of transitory factors, like the pass-through of higher oil prices, and reflects an adjustment to these changes in relative prices. As oil prices stabilize, assuming that they do, we’d expect to see core inflation presumably fall and fall faster than indicated in the baseline Greenbook forecast. The Greenbook forecast appears to me to incorporate an assumption of relative price stickiness that is inconsistent with some recent studies on microdata. Thus, in this scenario, I see inflation falling, perhaps more in line with the Greenbook’s alternative scenario of less persistent inflation. This story is appealing and plausible to me, but it rests on the transitory nature of the current measures of inflation. Even in this most desirable of scenarios—seeing inflation fall back to 2 percent or slightly less in 2007—we have to recognize that we will have essentially ratified a higher price level driven by oil price increases, and we should ask ourselves whether or not we are comfortable with that. In the other scenario, stimulative monetary policy during the past five years has been a major contributor to the rise in core inflation. In this case, we wouldn’t expect to see a deceleration of core inflation until monetary policy has firmed enough to take out the cumulative effects of that accommodation. The Committee has now moved rates up considerably from historical levels. If potential growth is now lower, as the staff indicates, the equilibrium real rate may be slightly lower, suggesting that monetary policy may be slightly firmer now than previously thought. Even so, it has only recently reached that level. But given the imprecision with which we estimate potential output or equilibrium real rates, I really don’t take much comfort from such measurements. Thus, to my mind, there is a significant risk that policy is not yet firm enough to achieve the desired outcome. Regardless of which of these two scenarios you think more likely, I think we must be concerned that our credibility and the consequences of allowing inflation to remain above our comfort zone for so long are at question. If scenario 1 comes to pass and inflation falls faster than suggested by the Greenbook baseline, then we would all breathe easier. But that scenario seems largely a bet on oil prices and on the presumption that past accommodative policy is not playing any role, and that makes me nervous. I would much prefer to believe that scenario 1 is the operational one. However, again, I find it hard to believe that a four-year to five-year period is transitory, so I have to consider the alternative. If the first scenario is wrong and inflation evolves as in scenario 2, then our credibility is seriously at risk if we fail to take further steps to curtail price increases. We might be lucky. But we might risk finding ourselves in a situation in which inflation expectations become unhinged, making it more costly to bring inflation back down. As has been mentioned, in the Greenbook alternative forecast in which inflation expectations become unanchored, inflation remains near 3 percent with only a slight decline in 2008, and growth slows below 1¾ percent next year and remains well below trend through the forecast period. To me, 3 percent inflation and 1½ percent real growth is not a comfortable place to be and would make restraining inflation in the future even harder for us. I’d like to conclude my remarks by thanking the Board staff for their research on inflation dynamics and the possible reduction in the level of persistence in recent years. I think this is an important area for research, but I encourage the staff to continue its work to try to identify structural models of these dynamics in addition to reduced-form models. I agree with the staff that the monetary policy implications of the reduced-form findings presented in the memo depend on how one chooses to interpret them. The results presented by the staff and others suggest that, since 1990, inflation has become less persistent and appears to be less related to other macro variables as well. We do not know whether these changes are due to a more aggressive stance of monetary policy against inflation and to our credibility or to fundamental changes in the domestic or world economy. If we suppose that lower inflation persistence is due to enhanced policy credibility, then it is incumbent upon this Committee to maintain that credibility. That is, we should not expect inflation persistence to remain low if the Fed acts in a manner that is inconsistent with its commitment to price stability or risks its credibility by neglecting to take actions that return the economy to price stability in a reasonable period of time. We shouldn’t ignore the fact that the longer we allow deviations from price stability to persist, the higher is the risk to our credibility and the higher is the risk that recent high inflation readings will raise longer-term expectations, thereby putting us in a very awkward position a year from now. Thank you." FOMC20070131meeting--126 124,MS. MINEHAN.," Thank you very much, Mr. Chairman. The New England regional economy continues to grow at a moderate pace with relatively slow job growth, low unemployment, and moderating measured price trends. Consumer and business confidence is solid, and while retail contacts reported an uneven holiday season, manufacturers were generally upbeat about business prospects. Skilled labor continues to be in short supply and expensive. In every one of the New England states, there is concern over the long-run prospects for labor force growth, given their mutual low rates of natural increase, out-migration of 25 to 34 year olds, and dependence on immigration for labor force growth. New England is an expensive place in which to live, and concerns abound about how to attract and retain the highly skilled workers that are needed for its high preponderance of high value added industries. Obviously, there’s nothing new or particularly cyclical about the foregoing comments. But I’ve been to quite a few beginning of the year “let’s take stock of things” conferences in all the states recently, so perhaps I’ve become more impressed than usual by the medium-term to long-term challenges facing the region. In the short run, however, the positive overall trend of the regional economy does seem to be a powerful offset to the continuing decline in real estate markets. At our last meeting it seemed as though New England’s real estate problem was more significant than that in the rest of the country. But now it appears that both are similarly affected whether one looks at prices, sale volumes, inventory growth, or declining construction. As with the nation as a whole, there are signs of stabilization; but at least in New England, making any judgment about the imminent revival of real estate markets in midwinter is foolhardy at best. On the national scene, the data have been more upbeat since our last meeting. Apparently the holiday season was a bright one, with consumption likely growing at a pace of more than 4 percent in the last quarter. That’s remarkably strong given the continuing decline in residential real estate and proof—to reiterate what President Stern said—that the U.S. economy continues to be unusually resilient. Supporting consumption are tight labor markets, lower energy prices, tighter though still reasonably accommodative financial conditions, strong corporate profits and some signs of revival in business spending after declines related to housing and motor vehicle expenditures, and continuing strong foreign growth. Even inflation has moderated a bit, with three-month core price increases in both the PCE and the CPI trending down. Our forecast in Boston and that of the Greenbook are virtually indistinguishable. The last quarter of ’06 was stronger than expected. The first quarter of this year will be slightly better as well, but after that, the trajectory remains the same as it has been for the past two or three meetings. An increasing pace of growth in ’07 and ’08 as the housing and motor vehicle situations unwind, a slight rise in unemployment, and a fall in core PCE inflation to nearly 2 percent by the end of the forecast period. In many ways, this is the definition of perfection, a forecast that is seemingly getting better each time we make it, with growth a bit higher, unemployment a bit lower, and inflation ebbing slightly more. The underlying mechanics that produce this outcome are relatively straightforward, but I wonder whether we should have a heightened sense of skepticism about such a halcyon outlook. Let me focus on two reasons for such skepticism. First, all other things being equal, inflation could be less than well behaved. One reason that inflation ebbed in earlier forecasts was that slower growth brought about a small output gap and rising unemployment. Now, the output gap is virtually eliminated, and unemployment remains below 5 percent. Ebbing inflation is solely the product of recent favorable inflation readings, which are assumed to persist: lower energy prices, declining import prices, and falling shelter prices. It’s hard to tell at this point whether the recent readings on core inflation are the result of fundamentally lower inflation pressures or just luck or maybe a combination of the two. I think a similar range of uncertainty applies to oil prices and the strength of the dollar. With virtually no output gap, it seems to me that, while the baseline best guess might be lower inflation, for all of the reasons discussed in the Greenbook one should approach that analysis with some caution. Second, demand could well be stronger. The baseline forecast assumes that consumers somehow get the message some of us have been trying to deliver about the need for an increase in private saving. The saving rate moves from a negative 1 percent to a positive 1 percent, the highest saving rate in several years. As I noted before, I have to ask myself why this is likely to happen over the next coming months when it hasn’t in the wake of the housing situation in 2006. Clearly, the downturn in residential real estate, an important political issue in all our Districts and certainly devastating for subprime borrowers in particular, hasn’t affected consumer spending in general. In fact, household net worth as a share of disposable income remains quite high, buoyed in part by a likely overestimate of real housing values but also by rising equity markets. The timing of the needed increase in the personal saving rate could well be further out in the future, creating some version of the buoyant consumer alternative scenario instead of the baseline. Again, with no output gap, the potential for increased inflationary pressure is obvious. In sum, the Greenbook forecast remains in my view the most likely baseline. There are downside risks, as I mentioned before, for the seven alternative scenarios do anticipate some downside risks; but if the housing situation is beginning to stabilize, I find it hard to believe that broader anxiety about it will affect business spending or the consumer as some of these scenarios contemplate. The bigger risk may well be that business spending picks up in light of consumer strength, unemployment stays low, growth exceeds our current projections, and resource pressures become more intense. I am concerned that risks to inflation have grown somewhat since our last meeting. I think I’m still in a “wait and see” mode, as I do believe there are downside risks to the evolution of housing markets. But if the Greenbook growth forecast is right, the best risk management on our part may have to be to seek tighter policy sooner rather than later." CHRG-111hhrg51698--54 Mr. Marshall," Thank you, Mr. Chairman. Mr. Gooch, in your testimony you said that if the major investment houses had failed, in your opinion, the clearinghouses, the various futures exchanges, would have failed as well. That would mean CME, Mr. Duffy. I think that was what Mr. Gooch had in mind. You also have this statement, since the large banks and prime brokers represent the bulk of the clearing capital at risk, it makes sense that a clearing solution provided by those banks with a high degree of transparency on pricing and mark-to-market makes the most sense. Could you elaborate a little bit about that? " CHRG-111hhrg51698--354 Mr. Taylor," We have a number of products for cotton producers and cotton textile mills tailored to their specific price risk needs. So there are a number of those things. I don't think it is particularly significant, but it is very helpful for them to manage their costs. You know, options markets, there are only five cotton options per year, and an element of the cost of those options is the time value. So we have products that tailor that time-value cost to that specific need. I don't think that disclosing positions, aggregating positions, in our market would have any negative impact on prohibiting people from participating. " CHRG-111hhrg48867--188 Mr. Price," So you believe it is appropriate for the government to determine whether or not a CEO knows whether the right and left hand know what they are doing? Ms. Jorde. Well, I think it is important that the company is not so large that their failure will bring back everybody under the house of cards. That is what I am facing as a community banker. I am paying hundreds of thousands of dollars now for FDIC insurance premiums to cover the risks of the systemically largest institutions. And I think that, before we figure out who is going to be the regulator, we need to identify the criteria of what this regulator is going to do-- " FOMC20070509meeting--51 49,MR. MOSKOW.," Thank you, Mr. Chairman. Conditions in the Seventh District have improved modestly since my last report. The overall pace of business activity is still rather restrained, but we have seen some pickup in our manufacturing sector. The key issues regarding the national outlook are the same as the ones the last time we met. How will the residential investment puzzle settle out, and can we explain this puzzling weakness in business fixed investment? Based on the data that we’ve received since March and my contact calls this round, I’ve become somewhat more optimistic about investment and somewhat more pessimistic about housing. At the same time, higher gasoline prices have the potential to weigh on consumer spending. So on balance our growth projection for ’07 and ’08 is a bit lower than it was in March. We now think that growth will average moderately short of potential over the remainder of ’07 and then run close to potential in 2008. However, our GDP numbers are a bit higher than the Greenbook’s, reflecting both a smaller shortfall from potential this year and a somewhat higher assumption about the rate of potential output growth. Indeed, there has been some good news regarding the near-term outlook. First, the international outlook continues to improve. Many of our contacts noted exceptionally strong demand from abroad, particularly for capital goods. Second, although we’ve been actively looking for spillovers from the problems with subprime mortgages, we have not yet seen major effects on pricing or the supply of credit in other markets. That is not to say that we have not heard of any effects. One of our directors, the CFO of a major national homebuilder, noted that tighter underwriting standards are reducing housing demand somewhat outside the subprime sector. Consumers still appear to have ample access to financing. For example, the head of GM noted that banks were making more auto loans with six- or seven-year maturities in order to lower monthly payments for liquidity-strapped consumers. Finally, as I noted earlier, we feel a bit more confident in our assumption that the weakness in BFI will turn out to be relatively transitory. I don’t want to make too much out of one month’s noisy data, but the latest readings on capital good orders and the PMI (purchasing managers’ index) were encouraging, and most of the comments from my business contacts have been positive in this regard. The impression I have from these discussions is that the pause in investment spending is showing early signs of ending; but this is very early, and we clearly need to keep monitoring developments carefully. Beyond the near-term cyclical developments, the changes in structural productivity in the Greenbook highlight an important source of risk to the longer-run outlook for sustainable non- inflationary growth, as Janet just discussed. There is a lot of uncertainty about the components of structural productivity. In our view, we haven’t seen enough evidence yet to mark down structural productivity as much as the Greenbook has. Consequently, our estimate of potential output growth is a bit higher than that of the Greenbook. With regard to inflation, the incoming information has caused the forecasts from our indicator models to come down a bit. They now project that core PCE prices will rise 2¼ percent this year and 2.1 percent in ’08. But we do not see any progress beyond that. If we carry our models out to ’09, they have inflation staying at 2.1 percent, higher than my preferred range. Furthermore, I see some upside risks to this forecast. Neither our GDP projection nor the Greenbook’s generates any meaningful resource slack over the projection period, and then there are the higher costs for energy and other commodities and increases in import prices. So we will be relying heavily on stable expectations to keep inflation in check. I believe we are currently achieving some implicit tightening of policy by keeping rates on hold during this period of sluggish activity, but this restraint will wane if the real economy returns to potential by early next year as we expect. So I continue to think that the risks to price stability dominate the risks to sustainable growth." FOMC20080625meeting--75 73,MR. ROSENGREN.," Thank you, Mr. Chairman. Despite some encouraging data recently, the Boston Fed economic outlook continues to see the economy growing below potential over the next several quarters, further weakening in labor markets, and core PCE trending down in response to excess capacity. Overall, our forecast has not changed significantly since our April meeting. I view recent strength in consumer spending indicators as largely borrowing from the second half of this year. This view is supported by the assessment that, apart from the fiscal stimulus, consumption fundamentals--income, wealth, and employment--remain on the weak side. Taking on board some of the increase in the May unemployment rate, our forecast has the unemployment rate peaking at a slightly higher rate than at the last meeting. In this respect, we are similar to many other forecasters. The May Blue Chip forecast had unemployment peaking at 5.6 percent. The June Blue Chip forecast for unemployment peaks at 5.7 percent. While the Greenbook has the unemployment rate peaking at 5.7 percent, as it did in April, it has the unemployment rate at 5.6 percent at the end of 2009--0.1 percent higher than the April Greenbook. So at least as measured by the unemployment rate, there seems little improvement in the outlook since the April meeting. As in the Greenbook, residential investment in our forecast continues to be a drag on the economy in 2009, and consumption holds up primarily as a result of the fiscal stimulus package, which is in part offsetting the negative impact of significantly higher oil prices on consumption. A major uncertainty remains whether further home-price declines will have a more negative effect on residential investment and consumption than we currently have in our forecast. Similarly, I would view financial market conditions as not having changed significantly since our April meeting. The three-month LIBOR�OIS spread remains quite high by historical standards at roughly 70 basis points, where it has been trading since the April FOMC. The Dow Jones, S&P 500, and Nasdaq indexes have all declined since our April meeting. Investment banks, such as Merrill Lynch and Lehman Brothers, are now trading substantially below where they were trading at our April meeting and below where they traded during the middle of March when Bear Stearns experienced difficulties. Stock prices for large regional banks have declined as they have needed to increase loan-loss reserves, raise new capital, and reduce dividend payments. I continue to be concerned that we have more, significant difficulties ahead for many financial institutions. First and second mortgages and home equity lines of credit are deteriorating at many banks as falling home prices and job losses create problems that have now spread to some prime residential products. I would characterize financial markets as remaining fragile. The past two TAF auctions still produced stop-out rates above the primary credit rate, and financial markets remain susceptible to event risk. The recent flurry of articles on Lehman before their announcement of their capital infusion highlights continued concerns about investment banks, despite our new liquidity facilities. As a result, I continue to view the downside risk of further financial shocks as being significant. Core PCE inflation has trended lower during this quarter, bringing the four-quarter change for the past year to 2.1 percent. Given that the Boston Fed forecast expects significant excess capacity over this year, we forecast that core PCE inflation will be slightly below 2 percent in 2009. If food and energy prices stabilize, we expect total PCE to converge to core PCE. We have experienced significant food and energy shocks, and oil prices continue to be higher than our expectations. I would be quite concerned should the serially correlated surprises in food and energy become embedded in inflation expectations and wages and salaries. But a critical element to my forecast is that total PCE inflation converges to core PCE as wage and salary increases remain largely unaffected by the supply shocks. In the data to date, wage and salary increases have not trended up in response to the supply shocks, and my expectation is that excess capacity in labor markets and continued competition from abroad make it unlikely that the relative change in food and energy prices will become embedded in labor contracts. For the intermediate term, I remain focused on core PCE rather than total PCE for several reasons. First, monetary policy is unlikely to have much effect on food and energy prices, which are responding, among other developments, to the impact of natural disasters such as flooding in the Midwest and manmade disasters such as ongoing political difficulties in Nigeria and the Middle East. Second, statistical evidence provided by our research department seems to indicate that over the past 20 years, when total and core inflation diverge, total has tended to converge to core and not the opposite. Third, while inflation expectations are difficult to model, the lack of an upward trend in wages and salaries seems consistent with worker expectations being driven by core rather than total inflation. While the supply shocks may have increased the upside inflation risks, the downside risks to the economy and financial markets remain quite elevated. In my view, we need more time and data to determine with greater confidence which of these risks poses the greatest danger to the economy. In terms of the options, I am comfortable with either 1 or 3. I have a slight preference for option 1. It is not that difficult for us to extend our forecast out five years. I actually think it would be easier to explain to the public than option 3, and I think explaining to the public is one of the main goals of expanding the forecast. But I could be happy with either option. " CHRG-109shrg24852--39 Chairman Greenspan," Well, that is a good question. First of all, the portfolios did not exist in any substantial form prior to, say, 1990. Yesterday, I was asked why I have not previously raised the issue. Let me answer this very simply. It has taken me quite a good deal of time to disentangle the very complex structure of these institutions to really understand how they work, what motivates them, and where the sensitive points are. When I first looked at this situation, I knew what the stock of the debt was and the types of risks that held. But I was not aware of how sensitive their profitability was between securitizing and selling mortgages that they purchased and the amount that they accumulated in their portfolio. It is only fairly recently that it finally became clear to me that that was basically how the system works, and I must say that it was a revelation in certain respects. The more I have looked at it since, I am impressed at how quickly, once they realized in the early 1990's how important a vehicle this was to profitability, how aggressively they pursued it. Senator Bunning. Last question. Do you believe energy prices have stabilized, or do you believe consumers and businesses can expect lower or higher energy prices? " CHRG-111hhrg51698--67 Mr. Cota," Yes. With regard to risk of customers and those sorts of issues, that risk did present itself. In July, prices had stayed where they were at. Just my possible margining of positions would have created a huge cash-flow issue that most banks would not have loaned into. Generally what banks will do is they will loan on the basis of inventory and assets, the principal asset being the receivables. They took a look at the amounts required at that point for our industry; it would have been multiples of company values. So the bank also looks at what the underlying company value is, because the receivables go to a zero value if you don't stay in business, so that is a risk. On the positive side of how it affects banking, it is the largest banks that have dried up the liquidity in our markets. My market region, actually the small business banks and the small banks in our region are deposit-based lending, so they have tons of money. They are actually encouraging me to go out and do additional work right now to deploy capital that they need to put to work. It is only the large financial institutions that didn't have prudent reserves in order to be able to do that. So the impacts and risks are there. I think that if you are prudent, and you don't necessarily give authority to Congress, but to the CFTC, we can get more of those credit requirements that would lend itself to prudent business relationships. " FOMC20061025meeting--202 200,MS. YELLEN.," Thank you, Mr. Chairman. I support keeping rates unchanged. On the wording, I guess I lean slightly toward B+ over B, but it’s not a matter that I feel strongly about, and I could certainly accept either alternative. I remain quite uncertain about how the various forces in the economy are going to play out. As I said in the economic go-round, I think that, if we maintain the current stance of policy, most likely we will get the desirable features of a soft landing with inflation coming down gradually. But I do think there are substantial risks for output growth. I guess they’re balanced around moderate growth, but I remain concerned about a downside that would include a period of sustained and significant weakness. On the inflation front, I do think that the risks remain tilted in the direction of higher inflation both because I’m uncertain just how the inflation process is working and because, while I believe inflation will come down, I don’t have confidence in the scenario underlying it. If we don’t get the play-out of the downside housing risks, I think there is some probability that growth will actually be sufficiently strong that we’ll get some upward pressure on inflation from the labor market. We’re going to learn a lot by December. A lot of data are coming out that will bear on growth, inflation pressures, the labor market, and so forth. It clearly makes sense to wait. I guess I’m slightly attracted to B+ over B because I think the language more clearly suggests an upward bias for future rate changes and that does reflect my view of the risks to inflation and the likely path of policy. At a minimum, it seems to push back a bit against the market’s view that we’re going to be unwinding rather quickly. But I take the arguments that have been made around the table for B as opposed to B+. I’m not sure that there really is much to be gained by changing the language we have in place on this, and leaving it alone may be the wiser course at the end of the day. On section 2, I think that Governor Kohn made a good argument for changing that language. Again, I could go either way. Finally, on section 3, I prefer the wording in alternative A to that in alternative B. Referring to the high level of prices of energy and other commodities, given that we’ve had a substantial decline in energy prices, really does seem a bit out of date and a bit out of touch." FOMC20060920meeting--195 193,MS. DANKER.," I will be reading the language from page 25 of the Bluebook directive first. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” Then the risk assessment: “Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” Chairman Bernanke Yes Vice Chairman Geithner Yes Governor Bies Yes President Guynn Yes Governor Kohn Yes Governor Kroszner Yes President Lacker No Governor Mishkin Yes President Pianalto Yes Governor Warsh Yes President Yellen Yes" FOMC20061025meeting--55 53,MR. HOENIG.," Mr. Chairman, I’ll start with the District this time, and I will tell you that conditions in the District remain generally good. Energy activity remains strong, both in the traditional sectors, such as gas, oil, and coal, and in our new sector called ethanol. [Laughter] They are booming, I’m afraid. Despite the recent decline in energy prices, we are not yet hearing, in talking to different producers in the region, about any significant pullback in energy production. In part, this situation reflects a prevailing view right now among those producers that the weakness in energy prices is likely to be temporary. However, if energy prices remain at current levels or move lower at a sustained rate, I think we will then see some pullback in retail activity and so forth—more than we’ve seen so far. In other areas of the District economy, we saw some softening in manufacturing activity in the third quarter, but our manufacturing survey shows that businesses remain mostly optimistic about future hiring and capital expenditure plans. Housing activity has certainly slowed across the District. However, we have received few reports of unusual weakness in our recent meetings with directors and economic advisory council members. So it is slowing but shows no sign of collapse, at this point anyway. We have also seen, with the decline in energy prices, strengthening in District retail sales activity and a sharp rebound in expectations for retail activity in the fourth quarter—except for domestic auto sales. Labor markets remain firm across the District. Unemployment rates are low, and our directors and other contacts continue to report shortages of skilled labor across the District. District agricultural conditions remain rather mixed. Drought continues to affect much of the western part of our region. However, livestock and crop prices have been supported by strong world demand and lower supply, so those farmers who are able to bring in a crop are doing quite well. Turning to the national economy, I think that the recent decline in energy prices will provide important support to the near-term outlook. Currently, I see second-half growth of around 2 percent, rebounding to between 2½ and 3 percent as we get into next year. Generally speaking, I am more optimistic than the Greenbook, both in the near term and for the next year. Indeed, with the current financial conditions that others have talked about, I don’t envision the pullback in consumer spending and business investment spending that the Greenbook has projected at this point. One area that is worth discussion—and Dave talked about it a bit in responding to a question—is the employment outlook, an area for which the Greenbook continues to have, as Dave said, a different perspective. Although demographic forces will clearly work in the direction of slower labor force growth in the coming years, I’m not as convinced that the slowdown will be as sharp or as sudden as the Greenbook suggests right now. I say that because I want to be cautious about viewing the recent slowing in monthly employment growth as being driven by these demographic factors. I believe the recent slowing in employment largely reflects some employer caution about the economic outlook, combined with the effects of weakness in housing and retail sales. Support for this view can be found in the recent slowing of growth in temporary help that has been reported to us. Should the economic growth pick up, as I anticipate, we should begin to see some stronger employment numbers as we get into next year. As to the effects of demographics—again, I think they are going to play a very important part, but another significant factor to keep in mind is the educational composition of the labor force and the skills composition as we move forward in terms of labor demand, because that’s the shortage we’re always hearing about. Now, returning to the near-term outlook, the recent decline in energy prices has helped to counter the effects of housing weaknesses. Consequently, the downside risk to the outlook has diminished somewhat. However, because we have not necessarily seen the bottom of the housing market, I do believe that that is an important downside risk to the economy. Finally, let me share some of my perspective on the inflation outlook. My overall views on inflation have not changed materially since the last meeting. I continue to expect core CPI inflation to moderate from about 2.8 percent to about 2.5 percent next year and, similarly, core PCE inflation to moderate from about 2.3 percent to 2.1 percent. A significant fall in prices for oil and gasoline and natural gas in recent weeks has already begun to show through to overall inflation. I believe this is a positive development in helping to ensure that inflation expectations remain anchored and perhaps in helping to moderate core inflation next year. Although the decline in energy prices has reduced the upside risk to inflation somewhat, I agree with others that core inflation does remain too high, and I think we have to keep that in mind as we consider our policy options. Thank you." FOMC20070131meeting--154 152,MR. HOENIG.," Thank you, Mr. Chairman, now that I have everyone’s attention, [laughter] I’m going to start with some information on the District and then talk briefly about the national economy from my perspective. Let me begin by saying that the District’s activity did slow over the second half of 2006 in line with the national economy itself. The slowdown was most apparent in housing and manufacturing. However, the most recent data that we have from November and December indicate a pickup in some of the activity. Moreover, reports from our directors and our business contacts suggest a considerable degree of optimism among them going forward, more than we expected actually. One area in which we are seeing signs of improvement is housing itself. While new construction activity does remain subdued in our region, sales activity has picked up, and the inventory situation appears to be improving in our major markets. Nonresidential construction remains strong and is offsetting some of the weakness on the residential side. District employment growth has risen in recent months, and labor markets remain tight for us. In addition to continuing shortages of skilled workers in a large number of technical and professional areas, we have recently received reports that the hospitality and recreational sectors are experiencing difficulty in finding lower-skilled workers as well. We have also received numerous reports from directors in District businesses indicating higher year-end wage and salary increases. The situation in agriculture is somewhat mixed. The sharp increases in crop prices, especially corn, driven by exports of ethanol and exports of corn itself, have caused the USDA to boost estimates of 2007 farm income rather significantly. However, higher crop prices are also eroding profitability of livestock producers and processors in our region, which is a fairly important sector. One important sector in which activity appears likely to slow in 2007 is energy. The District economy has benefited tremendously over the past few years from the rise in energy prices, which has spurred increased production of traditional products—and that includes oil, gas, and coal—as well as alternative fuels like ethanol and biodiesel. According to reports from a couple of our directors, however, the recent decline in energy prices has already led to a reduction in drilling activity and is likely to cause some cutbacks in new investment in alternative fuels as well. Turning to the national outlook, I, like others, have noted the recent strength in the economy and have raised my estimates of growth for the fourth quarter and somewhat raised them for the first quarter. I continue to expect growth to rise over 2007 modestly toward what I think is potential, in the neighborhood of 3 percent. However, now I expect it to occur a little more quickly than I did at the December meeting. Accordingly, recent economic information has led me to reassess the balance of risks to the outlook. I believe the downside risks from the further slowing of housing have diminished somewhat. Moreover, I share the view that the recent weakness in manufacturing activity reflects a better balancing of production and inventories rather than a fundamental weakness. Going forward, the improved outlook for energy prices should support consumer spending by improving consumers’ disposable income, and we may see additional fiscal stimulus resulting from the more-favorable budget positions of the state and local governments. Finally, in terms of the inflation outlook, my views have not changed materially since the last meeting. I’ve been encouraged by the recent inflation data, and I continue to expect inflation to decline over the forecast period. I expect the core CPI to be in the 2.3 percent range and core PCE inflation to be about 2 percent for 2007. However, as others have noted, core inflation is too high, and considerable uncertainty remains about whether the recent progress will be sustained. Particularly, it is not clear how the opposing trends of lower energy prices and greater resource pressures may play out over the next few quarters. Consequently, it seems to me that there is upside risk to the inflation outlook. Thank you." FOMC20071031meeting--205 203,CHAIRMAN BERNANKE.," Thank you. Thank you all. Well, it has been said many times, but this is very, very close, and I’ve thought about it quite a bit, obviously. I have a lot of sympathy for President Plosser’s very clear analysis. There have been good data since the last meeting. We have talked about the importance of spillovers. We have not so far seen evident spillovers from housing into other sectors. We did take a preemptive action in the last meeting. Inflation is a concern. I think not immediately, but some of the factors like input costs are there, and market expectations alone are obviously not a reason to move. All of those things are valid, and I have thought about all of them. So why do I favor a cut? Most of the arguments have been made. The downside risks are quite significant, if the housing situation, including prices, really deteriorates. I think part of the difference between what the market sees about housing and what we see is that we are a little more sanguine about price behavior than the market is, and a decline in prices has effects both on consumers and on the credit system. So I think that risk is fairly important and may swamp some of the other issues. There is some new information that is relevant. The senior loan officer survey and other information suggest that credit conditions are tightening and that this will have an effect, I believe, in some significant markets, certainly including housing. Other information, like consumer sentiment and consumers’ views of the labor market, suggests some slowing and some weakening. The decline in sentiment in the markets in the past two weeks is very interesting. On one level I feel as though we failed to communicate somehow; however, I don’t know exactly where the mistake was. The markets seem to be responding to information about earnings reports and projections of future activity and so on, both in the financial sector and in the real sector, and as a number of people have said, I don’t think we can entirely ignore that information. So I think there are some good reasons on the real side to take out a bit more insurance, as has been said. I agree with the Vice Chairman that the credit markets probably could stand the surprise, but they have become somewhat more uncertain, and I think their basic problem is macro uncertainty. It has to do with concerns about tail risk, and that is something that we can, I think, address a bit. The point has been made a number of times, first by President Yellen, that the current rate could be construed as being slightly restrictive and that creates an argument for a somewhat lower rate. An additional argument is that the core inflation rate has come down some since last year, and so the real federal funds rate on that basis has gone up. Finally, an argument that I would bring to you is about tactics, and the Vice Chairman also alluded to this. Most of the paths that we submitted include a path for policy that is perhaps slightly lower than the current one, and the question is how we do this. If we take alternative B, which I think is the most obvious alternative, on the one hand we don’t take an action and on the other hand we express alarm about the economy and say we’ll probably be cutting in the future. That makes calibrating how the longer-term expectations will respond to that very difficult. I think it would, on balance, tighten expectations a bit because we didn’t act, but it does create some uncertainty. The advantage of alternative A, even as we take a cut, is that we will, I hope, curb expectations for sustained additional cuts through several mechanisms. First, in the economic growth paragraph, we have switched language from actions “intended to help forestall”—very indirect—to “should help forestall,” suggesting that we are now more confident in our ability to prevent bad outcomes in the economy. Second, we have—and this will certainly be noticed—taken note of energy and commodity prices, among other factors, and we have highlighted our concerns about inflation. Third, the rough balance of risks certainly indicates that we are not eager to cut again quickly unless the data clearly support it. So a lot of this is tactical, about how to take control of expectations— you know, how to manage the market’s views of our policies. And I just felt a bit more comfortable with taking the action but then using that to recalibrate our balance of risks. For what it is worth, 75 basis points of easing has been pretty much the standard Fed medicine for financial crises ever since 1970 or so; in that respect we are in good company. That’s my recommendation—25 basis points with alternative A. Any questions or comments?" FinancialServicesCommittee--61 Mr. L EIBOWITZ . Our circuit breakers actually triggered perfectly well. The problem is that in the current U.S. market regulations, the other venues don’t have to obey us when we are in a circuit breaker mode. Mr. S COTT . I see. Mr. L EIBOWITZ . So it worked perfectly well for our market and for any other markets that observed our circuit breaker. However, it clearly shows a failing in our market if another market doesn’t have to follow that circuit breaker. So that is why we have agreed on marketwide circuit breakers. But I would agree with Mr. Duffy that this doesn’t end the con- versation. We have to continually look at ways that we can safe- guard the market, that we can make sure the technology is doing what it is supposed to be doing, and that we don’t, sort of, go down this path. Mr. S COTT . My final point on this, and I will be finished, is: If we go with this circuit breaker, marketwide, stock by stock, from each of you very quickly, is there any downside? Is there anything we have to worry about if we go this way? Mr. N OLL . I think, very quickly on that point, I think the only downside is the true price discovery is not being found. Mr. S COTT . I am sorry? Mr. N OLL . The true price discovery could be interfered with. So I think it is important for us, as we design these marketwide, stock-by-stock circuit breakers, if we do so, that we want to make sure that buyers and sellers are able to find each other in an effi- cient and fair fashion but that we aren’t otherwise closing off price discovery inadvertently. Because the impact of that closing it off will re-effect itself when the stock starts to trade again, and you will have this cascading effect as opposed to true price discovery. Mr. S COTT . All right. Thank you. Mr. D UFFY . I do believe that Mr. Noll is correct, but I also believe that price discovery is done throughout a period of the trading ses- sion, not on a microsecond. So you do need to discover price over a period of time and let everybody participate. So I hear what he is saying, but at the same time I don’t completely agree with that. Mr. S COTT . All right. Mr. Leibowitz? Mr. L EIBOWITZ . I think it is incumbent upon us to build these cir- cuit breakers in a way that helps the market function properly, go through the auction process, which is what is supposed to happen, and give the market a chance to pause and establish the right price. I think Mr. Noll is right. If we don’t do a good job of it, then we will be in the same place we were. But it is incumbent on us, as exchanges, to work together to make that process work properly. Mr. S COTT . Thank you very much. My time is way past. I thank the rest of the committee for my indulgence. Ms. Biggert? Mrs. B IGGERT . Thank you, Mr. Chairman. Mr. Duffy, in your testimony, you talked about the stop price logic. You also highlight a number of risk management controls used at CME in addition to the circuit breaker rules. FOMC20080625meeting--29 27,MR. SHEETS.," 2 Thank you, Mr. Chairman. Given that developments in global commodities markets have continued to have influential effects on our forecast for domestic activity and prices, we felt that it would be useful for me to lead off with the international portion of the chart show, which will include a discussion of these markets. Following my remarks, Larry and Bill will present our outlook for the U.S. economy. As shown in the top panel of your first exhibit, total foreign real GDP growth (line 1) stepped down from an average pace of 4� percent in the first three quarters of 2007 to around 3 percent in the fourth quarter of last year and the first quarter of this year. We see growth abroad as likely to decline to 2.2 percent in the current quarter and to pick up only slightly in the second half of the year. Next year, with the expected firming of U.S. activity and diminishing headwinds from the financial turmoil, foreign growth should rise back to a 3� percent pace. Growth abroad was just a bit stronger in the first quarter than we had anticipated, but the composition of that growth came as more of a surprise. Canadian GDP (line 3) posted a slight contraction, reflecting a continuing downturn in exports and stagnant investment. In contrast, the pace of activity in Japan (line 4) and the euro area (line 5) was much more vigorous than we had expected, including a 6� percent surge in Germany. Nevertheless, recent data for these economies point to much weaker growth in the second quarter. As shown in the middle left panel, Japanese manufacturing output 2 The materials used by Messrs. Sheets, Slifman, and Wascher are appended to this transcript (appendix 2). has declined recently, and labor market conditions have softened. For the euro area (the middle right), various indicators are showing weakness, including retail sales and the purchasing managers' index. As highlighted in the bottom panel, growth in the emerging market economies is expected to step down over the next few quarters but should remain relatively resilient, especially compared with the weak performance of these economies during the U.S. recession earlier this decade. Many of the EMEs were particularly vulnerable to the high-tech- and manufacturing-led downturn that occurred at that time, and fundamentals in the EMEs are now stronger than was then the case. In addition, Chinese domestic demand has remained quite robust of late, and this has likely helped to support growth in emerging Asia. As shown in the top left panel of exhibit 2, oil prices have continued to soar with the spot price of WTI closing yesterday at $136 per barrel. The far-dated futures price has climbed to about the same level. Our forecast for the path of oil prices is now roughly $50 a barrel higher than at the time of the January chart show. Divining the causes of this staggering rise in oil prices is no doubt ground on which angels fear to tread, but we continue to assert bravely that the primary driver of higher oil prices is constrained (and price inelastic) oil supply coupled with relatively strong (and price inelastic) oil demand. These deep features of the oil market--along with stressed geopolitical conditions in many oil-producing countries, rising production costs, and concern about the reliability of medium- to long-run supply--have sent oil prices spiraling upward. As shown in the last column of the middle table, the increase in oil prices appears to have contributed to modest declines in oil consumption in the advanced economies, including the United States (line 3). But oil consumption has continued to move up in the emerging market economies, especially in China (line 5) and the Middle East (line 6). Consumers in many EMEs have been shielded from rising prices by government fuel subsidies. The economic and fiscal costs of such subsidies are becoming increasingly burdensome, however, prompting some countries (including China late last week) to allow domestic fuel prices to move toward world levels. As seen on the top right, oil inventories in OECD countries have declined over the past year and a half. Unfortunately, little information is available about the behavior of inventories outside of OECD countries. The bottom left panel shows that the rise in global oil production since 2004 has significantly lagged the expansion of world GDP (weighted by oil consumption); indeed, production has remained relatively flat during most of that period. Notably, however, the lack of oil production is not due to geological constraints. Data on years of proved reserves (shown on the bottom right) are at roughly the same level as a decade ago. But those reserves are now concentrated in areas where production is constrained by acute geopolitical risks, uncertainty about property rights, inadequate investment, and high production costs. Turning to your next exhibit, nonfuel commodity prices have also risen significantly on average since your last chart show, with most of the increase coming in the first few months of the year. Here, too, we believe that the elevated level of prices is a result mainly of strong and sustained global demand, lagging supply responses, and rising production costs. Consistent with this observation, inventories of key commodities, shown in the middle left panel, have trended down in recent years. It bears emphasizing, however, that nonfuel commodity prices certainly have not moved in lockstep with each other. As seen in the bottom left panel, the price of corn has surged to new highs, supported by ethanol demand and, more recently, as adverse weather in the Midwest has endangered a substantial fraction of this year's crop. In contrast, the price of wheat has fallen back from its recent peak, as improved growing conditions in Australia seem likely to boost supply. For metals, the price of zinc has moved down significantly since its peak in late 2006, as new smelters have come on line. The price of copper has moved sideways--but at a high level--over the past two years, as prospective increases in supply have not yet materialized. A number of other explanations for the recent run-up in oil and other commodity prices have also been advanced, including the possibility that increased purchases by ""speculators"" in commodity futures markets may be playing an important role. Given the magnitude of the financial flows into these markets, we are hesitant to slam the door completely on this explanation, but our work finds little supporting evidence. As noted on the top right, prices of a number of commodities that are not traded in futures markets have also risen substantially. Second, a sustained increase in demand by investors would suggest that inventories should be rising; instead, as I have noted, inventories are now relatively tight. Finally, we see no evidence that the positions taken by noncommercial traders in futures markets actually predict commodity prices; for example, such positions for light sweet crude oil on the New York Mercantile Exchange have been roughly flat since mid-2007. Two other frequently cited explanations for the rise in commodity prices are the depreciation of the dollar and declines in interest rates. The middle-right panel shows the correlation of the broad nominal dollar with oil prices and with an index of nonfuel commodity prices. Both correlations are negative over most of the sample, implying that depreciations of the dollar have tended to happen at the same time as rises in commodity prices. While these correlations have become more negative since mid-2007, they remain within the ranges seen in recent years, and interpreting the direction of causality for this relationship is difficult. Also, as Bill noted, the dollar has been relatively stable over the past several months, but oil prices have continued their upward climb. Similar plots of correlations of interest rates with commodity prices (shown on the bottom right) are quite noisy and fail to point to any clear conclusions. As shown in exhibit 4, the run-up in commodity prices has continued to lift headline consumer price inflation in both the advanced foreign economies and the emerging markets. We expect that inflation abroad will remain elevated in the near term but eventually move back down as slower global growth reduces pressures on resources and as commodity prices flatten out (consistent with quotes from futures markets). Of course, one clear risk to these projections is that commodity prices may, yet again, confound our expectations and continue rising. Another risk is that the high rates of inflation now being recorded may become embedded in inflation expectations. As shown in the top right panels, measures of long-term inflation compensation have recently edged up in the euro area and increased more markedly in Canada. In recent weeks, major foreign central banks have intensified their inflation-fighting rhetoric. Notably, the ECB has warned that it may raise rates at its next meeting; and in the United Kingdom, Mervyn King--in his letter to the Chancellor--underscored his determination to ensure that inflation remains contained. As shown on the bottom left, we now assume that both the ECB and the Bank of England will raise rates in the second half of this year, compared with the near-term cuts we had anticipated in the April Greenbook. In addition, we now see the Bank of Canada keeping policy on hold. In the emerging market economies, including Mexico and China (the bottom right panel), increases in inflation have largely been driven by rising food prices, which account for a substantial share of consumer expenditures. Policymakers in the EMEs have taken steps to slow the rise in food prices, with some countries introducing price controls and export bans on agricultural goods. But officials have also relied on more-orthodox policies to combat inflation, including raising policy rates and hiking reserve requirements. Indeed, over the intermeeting period, monetary policy was tightened in a range of emerging market economies, including Mexico, Brazil, China, India, Russia, and Hungary. As shown in the top left panel of exhibit 5, the path of the broad real dollar is now just a little weaker than we anticipated at the time of the January chart show. We continue to expect the dollar to depreciate at an annual rate of 3 percent through the forecast period, reflecting persisting downward pressures associated with the current account deficit. This depreciation is projected to come largely against emerging market currencies (including the Chinese renminbi), which have moved less since the dollar's peak in early 2002. It's safe to say that core import price inflation (on the right) has come in substantially higher than we projected in January. Incorporating the BLS monthly data for April and May, we now see core import prices in the second quarter surging at an annual rate of 10� percent, the fastest rise in two decades. This increase, which comes on the heels of an 8 percent jump in the first quarter, was heavily concentrated in material-intensive goods and suggests a much more rapid and, perhaps, stronger effect from the run-up in commodity prices than we saw in the past. Conditional on nonfuel commodity prices flattening out, core import price inflation should decline to less than 2 percent next year. Finally, summing up what these developments mean for U.S. activity, we now see the contribution from net exports to U.S. real GDP growth (line 3 in the table) as likely to exceed 2 percentage points in the second quarter, as exports expand at a smart pace (supported by the lower dollar) and imports contract sharply. This marked weakness in imports reflects both a steep drop in real oil imports and a continued decline in imports of core goods (reflecting sluggish U.S. GDP growth and rising prices of imported commodities). The positive contribution from net exports moderates to � percentage point in the second half of this year and to � percentage point in 2009. While the pace of export growth is projected to remain strong, at above 7 percent, imports should gradually accelerate as the U.S. economy recovers. Larry will now continue our presentation. " FOMC20070131meeting--172 170,MR. KOHN.," Thank you, Mr. Chairman. In preparation for submitting my forecast, I looked at my previous forecasts—a humbling but instructive experience usually. [Laughter] Going back a year, I found that, based on the staff’s estimate for 2006, inflation and growth had each turned out within a quarter point of my projections. I’m quite certain that this is not a consequence of any particular expertise on my part. Rather, it is indicative that, in a broad sense, the economy is performing remarkably close to our expectations. President Poole was making this point. Even going back a few years to when we started to remove accommodation, despite large fluctuations in energy prices in recent years, huge geopolitical uncertainties, and a housing boom and bust the dimensions of which we really didn’t anticipate three years ago, the economy is in the neighborhood of full employment, and core inflation is at a fairly low rate by historical standards. Now, the surprises last year were the surge of inflation in the spring and early summer. That has not been entirely reversed. The extent of the slowdown in productivity growth, both in terms of trend and of actual relative to the lower estimated trend, and the related decline in the unemployment rate suggest that we are entering 2007 with a higher risk of inflation than I had anticipated a year ago. Given this risk, it is especially important that economic growth be no greater and perhaps a little less than the growth rate of potential, and that is my forecast—a small uptrend in the unemployment rate. The issue I wrestled with was how fast the economy will be growing when the drag from housing abates. In early December, the debate might have been about whether demand would be sufficient to support growth as high as potential. But given the stabilization of housing demand, the strength of consumption, and ongoing increases in employment, I asked myself whether we might not find the economy growing faster than its potential beginning in the second half of 2007 and in 2008, thereby adding to inflation pressures. A couple of forces, however, gave me a little comfort in supporting my projection of only moderate growth. One is the modest restraint on demand from the recent rise in interest rates, especially the restraint on the housing market, and the dollar exchange rate. Another is the likelihood that consumption will grow more slowly relative to income and will lag the response to housing as housing prices level out and as energy prices begin to edge higher. Consumption late last year was probably still being boosted substantially by the past increases in housing wealth and by the declines in energy prices, which combined with warm weather to give a considerable lift to disposable income. On the housing wealth factor, I think our model suggests that it takes several quarters for a leveling out in housing wealth to build into consumption. In fact, the data through the third quarter suggest that prices were really just about leveling out in the third quarter. So it may be a little early to conclude that, just because we’re not seeing a spillover from the housing market to consumption, there isn’t going to be any. I expect some, though modest, spillover. Moreover, some of the impulse in the fourth quarter was from net exports. These were spurred in part by a temporary decline in petroleum imports and an unexpected strength in exports. Those conditions are unlikely to be sustained. In addition, business investment spending has been weaker than we anticipated. Now, I suspect this is, like the inventory situation, just an aspect of adapting to a slower pace of growth, and investment will strengthen going forward. But it does suggest that businesses are cautious. They are not anticipating ebullient demand and a pressing need to expand facilities to meet increases in sales, and their sense of their market seems worth factoring into our calculations. Finally, the fact that I would have been asking just the opposite question seven weeks ago suggests that we’re also putting a lot of weight on a few observations, [laughter] whether regarding the weakness then or the strength more recently. I do continue to believe that growth close to the growth rate of potential will be consistent with gradually ebbing inflation. For this I would round up the usual suspects, reflecting the ebbing of some temporary factors that increased inflation in 2006. One factor is energy prices. Empirical evidence since the early 1980s to the contrary notwithstanding, the coincidence that President Lacker remarked between the rise and fall in energy prices in 2006 and the rise and fall in core inflation suggests some cause and effect. The increase in energy prices into the summer has probably not yet been completely reversed in twelve-month core inflation rates, so I expect some of that to be dying out as we go into the future. Increases in rents are likely to moderate as units are shifted from ownership to rental markets. The slowdown in growth relative to earlier last year seems to have made businesses more aware of competitive pressures, restraining pricing power. When we met last spring, we had a lot of discussion about businesses feeling that they had pricing power—that they could pass through increases in costs. I haven’t heard any of that discussion around the table today. The recent slowdown in inflation is encouraging but not definitive evidence that the moderation is in train. The slowdown could have been helped by the decline in energy prices, and that decline won’t be repeated. Goods prices might have been held back by efforts to run off inventories, and that phenomenon, too, would be temporary. As I already noted, the initial conditions—the recent behavior of productivity and the relatively low level of the unemployment rate—suggest upward inflation risks relative to this gentle downward tilt. To an extent, the staff has placed a relatively favorable interpretation on these developments. They haven’t revised trend productivity down any further. They expect a pickup in realized productivity growth over this year. They see a portion of the strength in labor markets as simply lagging the slowdown in growth—a little more labor hoarding than usual as the economy cools, along with some statistical anomalies. Thus, in the Greenbook, the unemployment rate rises, and inflation pressures remain contained as activity expands at close to the growth rate of potential. President Yellen at the last meeting and Bill Wascher today pointed out two less benign possibilities. One is that demand really has been stronger, as indicated by the income-side data, and that the labor and product markets really are as tight as the unemployment rate suggests. In this case, the unemployment rate wouldn’t drift higher with moderate growth. Businesses might find themselves facing higher labor costs and being able to pass them on unless we take steps to firm financial conditions. The second possibility is that trend productivity is lower. In this case, actual productivity growth might not recover much this year. Unit labor costs would rise more quickly. Given the apparent momentum in demand, we might be looking at an even further decline in the unemployment rate in the near term. Now, my outlook is predicated on something like the staff interpretation, but I think these other possibilities underline the inflation risks in an economy in which growth has been well maintained. Thank you, Mr. Chairman." CHRG-110shrg50409--112 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKEQ.1. Inflation: Mr. Chairman, I have great concerns about inflation. Inflation degrades consumer's purchasing power and reduces the value of many investments, including people's homes. Additionally, continued food and energy price increases can have negative effects on consumer confidence and potentially unhinge inflation expectations. How large of a shift in expectations would the FOMC have to see before it began to tighten the target for the Federal Funds rate? Please comment on whether you have observed a pass-through of higher input prices for commodities and energy in the form of higher prices for finished goods?A.1. The inflationary effects of the sharp increases in oil and agricultural commodity prices earlier this year are clearly evident in the retail prices of energy and food. In particular, the PCE price index for food and beverages increased almost 6 percent over the 12 months ending in August 2008, while the PCE price index for energy moved up 28 percent over that same period. The acceleration in the price indexes for these two components of spending accounted for much of the pickup in the 12-month change in the overall PCE price index to 4.5 percent in August 2008 from 2 percent over the 12 months ending in August 2007. It appears that, to some extent, the earlier increases in the prices of oil and other raw materials have been passed through to the prices of non-energy, non-food finished goods and services. Prices for consumer items that have a high energy content--such as airfares and other transportation services, housekeeping supplies, and household operations--have moved up noticeably this year; moreover, energy and other basic input costs could well have pushed up prices for a range of other items for which the direct effect of commodity prices is more difficult to identify. In the aggregate, the PCE price index excluding food and energy rose at an annual rate of 2.6 percent over the 12 months ending in August 2008, about one-half percentage point faster than over the 12 months ending in August 2007. Thus far, however, we have not seen the sort of run up in labor compensation and inflation expectations that could lead to a deterioration in the longer term outlook for inflation. In particular, although some indicators of inflation expectations have increased, long-term inflation expectations still appear to be reasonably well anchored. Indeed, given the recent sharp declines in the prices for crude oil and other commodities and the weakening in economic conditions, the FOMC believes that inflation is likely to moderate later this year and in 2009. Of course, the Committee will continue to monitor the incoming information on inflation and inflation expectations carefully.Q.2. Update on Bear Stearns: Chairman Bernanke, the Federal Reserve created a limited liability corporation (Maiden Lane LLC) to acquire and manage certain assets from Bear Stearns, with the goal of maximizing repayment of the original loan back to the Federal Reserve Bank of New York. We all hope that this loan will be repaid in its entirety through the sale of these assets over time. How has the value of the Bear Stearns portfolio changed over time? In the few months since this transaction occurred, has anything changed that would lead to a reassessment of potential losses?A.2. As indicated in the Federal Reserve's weekly H.4.1 statistical releases, the fair value of the net portfolio holdings of Maiden Lane LLC was $29.816 billion as of March 14, 2008, $28.893 billion as of June 26, 2008, and $29.018 billion as of June 30, 2008. The Federal Reserve will publish in the H.4.1 statistical release an updated fair value of the net portfolio holdings of Maiden Lane LLC as of the end of each calendar quarter. The fair value of the net portfolio holdings of Maiden Lane LLC was $26.979 billion as of November 26, 2008, which reflects valuations as of September 30, 2008. As more fully explained in my testimony before the Committee on April 3, 2008, the Federal Reserve decided to finance a portion of Bear Stearns' assets to facilitate the acquisition of the firm by JPMorgan Chase to address the severe consequences that likely would have resulted from a disorderly liquidation of the firm in the unusually fragile circumstances that then prevailed. In taking this action, the Federal Reserve consulted closely with the Treasury Department. In order to maximize the returns to the Federal Reserve and the taxpayer, the Federal Reserve has engaged an independent portfolio management firm to professionally manage the assets held by Maiden Lane LLC. The assets will be managed with a long-term time horizon of at least 10 years. Although the value of the portfolio declined between March 14, 2008, and June 30, 2008, given the long-term time horizon for the portfolio it is too early to estimate what, if any, net losses might result from the eventual liquidation of the portfolio. Importantly, as previously announced, JPMorgan Chase will bear the first $1 billion of any losses on the collateral pool.Q.3. Negative Real Interest Rates: Chairman Bernanke, real interest rates appear to be negative at present, since the nominal short-term rate is lower than inflation. Does having a negative real rate of interest during a period of increased inflation harm the Fed's ability to work towards maintaining price stability? For how long can the Fed run a negative real interest rate before inflation pressures grow to dangerous levels?A.3. The FOMC has judged the current level of short-term interest rates as appropriate in light of its statutory objectives of maximum employment and price stability. Relatively low real short-term interest rates are currently necessary to counter the adverse effects of the broad range of factors restraining aggregate spending and output. Such factors include severe strains on financial markets and institutions, tight credit conditions, the ongoing housing correction, and elevated energy prices, which reduce households' discretionary income. As such, we do not believe that the current low level of real short-term interest rates is likely to have an adverse effect on the economy. Clearly, the highly accommodative stance of monetary policy cannot be maintained indefinitely. But, in view of the expectation for inflation to decline, such a stance is appropriate for a time to help foster moderate economic growth in the face of the range of factors that is restraining growth. The Committee believes that inflation is likely to moderate later this year and during 2009 as the effect of recent sharp drops in the prices of energy and other commodity prices shows through to broad price indexes and as slack in the economy resulting from slower economic growth reduces pressure on resources.Q.4. FOMC Statement Bias: Mr. Chairman, in the FOMC's most recent statement, the Committee seemed to shift its bias away from concerns over slower growth, towards concern about inflation and inflation expectations. Would you elaborate on what this shift means for future policy decisions? Additionally, how long would inflation rates have to stay elevated for the Committee to display unambiguous bias towards alleviating inflation concerns?A.4. In conducting monetary policy, the Committee carefully monitors ongoing developments in the economy and financial markets that influence the outlook for the economy and inflation. From time to time, the Federal Reserve adjusts its policy stance in view of the evolving economic outlook and risks to the outlook. After each meeting, the Committee issues a statement that explains any adjustment to its policy stance and characterizes the outlook for economic growth and inflation. In the period before the June meeting, incoming economic data had indicated that economic growth in the second quarter was stronger than had been expected. Also, financial market conditions appeared to have improved somewhat, although markets clearly remained under stress. Meanwhile, oil prices had increased further. In these circumstances, the Committee judged at its June meeting that the downside risks to growth diminished and the upside risks to inflation had increased. An important uncertainty in the outlook for inflation is whether the current elevated level of total inflation may lead to upward pressure on longer-term inflation expectations. At present, although some indicators of inflation expectations have increased, long-term inflation expectations still appear to be reasonably well anchored. However, the Committee is monitoring inflation and inflation expectations very carefully. ------ FOMC20071211meeting--152 150,MS. PIANALTO.," Thank you, Mr. Chairman. I favor a 25 basis point cut in our fed funds rate target and the language in alternative B. More losses at financial companies, in combination with uncertain year-end funding pressures, obviously have unsettled financial markets again. As I said earlier, sentiment about business conditions next year have become considerably more pessimistic in the past few weeks. In this environment, leaning toward caution and providing the added short-term liquidity that markets appear to need makes sense to me. Although I can see the arguments for a 50 basis point adjustment in our policy rate, I am inclined to think that a lesser policy response is called for. As others have indicated, it may be that a 25 basis point action is going to prove to be insufficient, and another cut might be necessary. But I am also mindful that efforts to address the problems that are affecting the real economy have the potential to aggravate inflation expectations. Indeed, by some cuts of the TIPS data and from a few reports that I am receiving from business contacts about rising commodity prices and rising import prices, inflation expectations may be tugging on their anchor just a bit. Given these considerable uncertainties, I think smaller moves are preferable to larger ones. At this time, I simply can’t assess with any useful precision how to weigh the risks we face, only that the risks we face are very difficult. Consequently, I favor the language expressed in alternative B as it is currently written. Thank you, Mr. Chairman." CHRG-111shrg50815--119 ZYWICKI Q.1. Access to Credit: A potential outcome of the new rules could be that consumers with less than a 620 FICO score could be denied access to a credit card. Such an exclusion could affect 45.5 million individuals or over 20 percent of the U.S. population. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.1. This is the most worrisome aspect of well-intentioned consumer credit regulations that will have unintended consequences of driving borrowers, especially credit-impaired borrowers, to other less-attractive forms of credit. Those who ore unable to get a credit card will likely be forced to turn to alternatives such as payday lending. Those unable to get credit from a payday lender will likely be forced to turn to pawn shops. And those who are unable to gain access to pawn shop credit may find themselves unable to get legal credit at all. Consumers often have emergencies or necessities for which they need credit. For instance, a young person needs credit to start a life away from home--clothes for a job, furniture for an apartment, etc. Consumers may have emergencies such as car repairs, for which they will have to find credit somewhere. If good credit is not available consumers will turn toward less-attractive terms of credit instead. Q.2. Benefits of Credit Card Use: Professor Zywicki, in previous testimony you suggested growth in credit cards as a source of consumer credit has replaced installment lending, pawnshops, and payday lending. I am concerned that the newly finalized rules may result in a lack of available consumer credit. I believe that there were clearly some egregious practices that the Federal Reserve and others should appropriately eliminate, but many who have criticized the credit card industry for facilitating excessive consumer debt, fail to point out the benefits of open access to consumer credit. Does the consumer benefit from access to open ended consumer credit over other less regulated forms of credit such as pawn shops, payday lenders, and installment lending? A.2. Consumers absolutely benefit from access to open-ended consumer credit. The dramatic growth in credit card use in recent decades testifies to this fact. Installment lending, such as retail store credit is limited because it requires consumers to ``buy'' goods and credit as a bundle. Personal finance company loans are typically both more expensive for the buyer to apply for, offer higher interest rates and other costs, and impose a rigid repayment schedule. A borrower also might be unable to get a personal finance company loan at the moment that he needs it. Payday lending and pawnshops are obviously inferior to credit cards and these other options. Credit cards offer consumers many benefits that these other products do not. Credit cards have flexible use and repayment terms. Borrowers can pay as much as they want and can switch easily among alternative card issuers. They are also generally acceptable, thereby allowing the unhooking of the credit transaction from the goods transaction. This allows consumers to shop more vigorously in both markets. General-acceptance credit cards also permit small businesses to compete on an equal footing with large businesses and department stores by relieving those small businesses of the risk and cost of maintaining their own in-house credit' operations. According to one survey conduct by the Federal Reserve, 73 percent of consumers report that the option to revolve balances on their credit cards makes it ``easier'' to manage their finances versus only 10 percent who said this made it ``more difficult.'' Durkin, Credit Cards: Use and Consumer Attitudes at 623. Q.3. Risk-Based Pricing: Banks need to make judgments about the credit-worthiness of consumers and then price the risk accordingly. Credit cards differ from closed-end consumer transactions, such as mortgages or car loans, because the relationship is ongoing. I am concerned by the Federal Reserve's new rules on risk-based repricing for a couple of reasons. First, without the ability to price for risks, banks will be forced to treat everyone with equally stringent terms, even though many of these individuals perform quite differently over time. Second, without a mechanism to reprice according to risk as a consumer's risk profile changes, many lenders will simply refuse to extend credit to a large portion of the population. Do you believe that consumers will have access to less credit and fewer choices because of the Fed's new rule? If so, is this a desirable outcome? A.3. This is likely to be the case, for exactly the reasons stated. If lenders are permitted only to reduce interest rates but not raise them, they will have to charge a higher interest rate to all borrowers to compensate for this risk. Moreover, this would give borrowers an opportunity to reduce their interest rates by switching to another card but lenders would be unable to raise interest rates in response to a change in the borrowers risk profile. Credit cards are structured as revolving debt for a reason: unlike other loans, it amounts to a new loan every month. Thus, every month the borrower has the option to switch to another, lower-interest card. Q.4. Bankruptcy Filings: As the recession worsens, many American families will likely rely on credit cards to bridge the gap for many of their consumer finance needs. Mr. Levitin and Mr. Zywicki, you seem to have contrasting points of view on whether credit cards actually force more consumers into bankruptcy, or whether credit cards help consumers avoid bankruptcy. Could both of you briefly explain whether the newly enacted credit card rules will help consumers avoid bankruptcy or push more consumers into bankruptcy? A.4. By making credit cards less-available and less-flexible, new stringent regulations will likely push more consumers into bankruptcy. Consumers in need of credit will seek that credit somewhere. Reducing access to good credit, like credit cards, will force these borrowers into the hands of much higher-cost credit, such as payday lenders. Moreover, credit cards are especially valuable because they provide a line of credit that the borrower can access when he needs it, such as when he loses his job and has medical bills. By contrast, if the borrower is required to apply for a bank loan after a job loss, he is likely to be rejected, which will accelerate his downward spiral. Moreover, credit cards are valuable in that they can be used to purchase almost any good or service. Again, the flexibility of credit cards is valuable to consumers. Q.5. Safety and Soundness and Consumer Protection: I believe firmly that safety and soundness and consumer protection go hand-in-hand. One needs only to look at the disaster in our mortgage markets, for clear evidence of what happens when regulators and lenders divorce these two concepts. A prudent loan is one where the financial institution fully believes that the consumer has a reasonable ability to repay. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.5. Yes. But not all safety and soundness issues related to consumers are also consumer protection issues. For instance, there were obviously a number of ordinary homeowners who essentially decided to act like investors with respect to their homes by taking out nothing-down, no-interest mortgages and then walking away when those homes fell into negative equity. If the consumers failed to understand the terms of those mortgages, then that is a consumer protection issue. If, however, the consumer consciously made this choice to speculate and the lender made the loan anyway, then while this would trigger a safety and soundness concern it is difficult to see how this would amount to a consumer protection issue. Q.6. Subsidization of High-Risk Customers: I have been receiving letters and calls from constituents of mine who have seen the interest rates on their credit cards rise sharply in recent weeks. Many of these people have not missed payments. Mr. Clayton, in your testimony you note that credit card lenders have increased interest rates across the board and lowered credit lines for many consumers, including low-risk customers who have never missed a payment. Why are banks raising interest rates and limiting credit apparently so arbitrarily? Does this result in low-risk customers subsidizing people who are high-risk due to a track record of high-risk behavior? A.6. Did not respond by publication deadline. Q.7. Effects on Low-income Consumers: I want to put forward a scenario for the witnesses. Suppose a credit card customer has a low income and a low credit limit, but a strong credit history. They use their credit card for unexpected expenses and pay it off as soon as possible, never incurring late fees. With the new regulations approved by the Federal Reserve, banks will be restricted in their use of risk-based pricing. This means our cardholder could see his or her interest rates and fees increased to pay for the actions of other card holders, many of whom have higher incomes. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.7. Interference with risk-based pricing makes it more difficult for lenders to tailor prices to the details of the behavior of particular consumers. As a result, lenders have to price card terms on less fine-grained assessments of risk. This leads to pricing risk across broader categories of borrowers, and in turn, increases the cross-subsidization among consumers. I can see no good policy reason why this should be encouraged. Q.8. Restriction on Access to Credit: One suggestion being made in order to encourage students not to become overly dependent on debt is to restrict access to credit to individuals under the age of 21. Mr. Zywicki, could you explain for the Committee the potential benefits and detriments of this policy? A.8. Benefit: A potential benefit, in theory, is that some younger consumers may avoid getting into debt trouble. I am not aware of any rigorous empirical evidence of how common this is. Detriments: There are several detriments: (1) LStudents who do not have access to credit cards may be tempted to take out more in the way of student loans. Because repayment on student loans is deferred until after graduation, this could cause students to take on more debt than they would if they had to pay some of their balance every month. (2) LEmpirical studies find that one major reason that causes students to drop out of college is a lack of access to credit. Many students eventually tire of ``living like a student,'' i.e., living in dorms and eating dorm food and Ramen noodles. They want an opportunity to have some sort of normal life, to go out to dinner every once in a while. Many students use credit responsibly and maturely and can have a happier student life experience if they have access to a credit card. (3) LMany students need access to credit. Although under the age of 21, many students essentially live on their own in off-campus apartments and the like. They need credit cards to pay for food, transportation, and the like. Thus, the rule sweeps far too broadly. (4) LSince the early 1990s, the fastest-rising debt on household balance sheets has been student loan debt. Students routinely graduate with tens of thousands of dollars in student loan debt. By contrast, very few students have more than a few thousand dollars in credit card debt. If Congress wants to seriously help indebted students, it should investigate the extraordinary level of student loan debt being accumulated. While credit cards can be a problem in some cases, the scope of the problem is dwarfed by the deluge of student loan debt. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM LAWRENCE CHRG-111shrg54589--114 Mr. Griffin," I think the question that you were posing about capital and will the regulation of this market increase the amount of capital required in the marketplace, the answer to that question is not as clear-cut as one might imagine. The reason for it is because of today's silly market structure. If I buy credit protection from Goldman Sachs, I am likely to eliminate my economic risk but not my counterparty risk by closing that contract out with Morgan Stanley. I will still be posting margin as a customer to both of those firms. It is incredibly inefficient. If I had a central clearinghouse, I would open the contract with Goldman, clear it through a clearinghouse, close it with Morgan Stanley, clear it through a clearinghouse, and I would have no capital as a customer out the door any longer. I would actually have capital that comes back to me net-net. I think it is a very important concept to understand when we think of clearinghouses, this will not in any way necessarily increase the amount of capital demanded of the system as a whole because of the tremendous efficiency inherent in netting. The other key concept that we should keep in mind is that price transparency will most favor the smaller, less frequent users of derivatives. Citadel, is one of the world's largest alternative asset managers. We can price all of the derivatives that we commonly trade with a great degree of precision, but we have a tremendous investment in infrastructure to do so. For smaller companies, that is outside their range of capability. But on an exchange, a visible exchange traded price gives the CFO of a small company confidence that he is getting a fair deal, and part of what we want our capital markets to do is to create confidence in all Americans that our markets are fair, they are transparent, and they are just, because that reduces the cost of capital for every company in America. Senator Johanns. You know, Mr. Griffin--and I will wrap up with this, Mr. Chairman, I appreciate your patience--nobody is going to disagree with your last speech. Boy, that is about as motherhood and apple pie as we can possibly get. Nobody disagrees with that. It is like I said. I just want to know if this is where we are headed, what impact is it going to have on the marketplace from the very small to the very large? My experience is the very large survive and they get bigger. " FinancialServicesCommittee--18 There are procedures on that contract, and I want to mention four quick procedures that are risk-management procedures to en- sure the orderliness of the market. First, electronic trading systems on all of the markets for these contracts reject orders priced outside of a narrow band, about a 1 percent band up or down. Second, the exchanges actually have maximum order sizes. Con- gressman Royce mentioned something from years ago, but today, only about a $100 million transaction can be entered. The average transaction, though, in the E-Mini is about $330,000 in size. Third, exchanges have something that limit stop-loss orders, and I can get more into that in the testimony. Fourth, they also have something which is a market pause, a 5- second pause if the order book gets out of balance. In fact, last Thursday, that 5-second pause occurred exactly when the market bottomed. In terms of the preliminary review, we are looking at millions of trades. The CFTC, fortunately, has all of the trading data entered into our systems by the very next morning because under our act, we are able to get that from the exchanges. I think it would be good, and I know the SEC is working on that, but the staffs of our agency, the SEC, and the exchanges have looked at it and it is a very ongoing process. Let me mention four things, though. May 6th started turbulent. You can think of an airplane in turbulent skies. It was very turbu- lent that day with the economic news emanating out of Europe. Volatility pricing was pricing up. It had actually gone up about 60 percent interday from Wednesday to Thursday on some measures. Further, the futures markets and other markets are so inter- twined that stock index futures looked to other price signals from all of the other markets, and there were a lot of markets coming in with signals that were showing risk premiums were widening. Currency markets were volatile, and small capitalization equity se- curities began declining sharply. Between 2:00 p.m. and 2:20 p.m. East Coast time and by 2:24 p.m. East Coast time, there were 8 securities that were exchange-traded securities that were already off 50 percent in the preceding 24 minutes. Other price signals started to come in after 2:30 p.m.—some of the large markets started to delink under what is called a self-help program that you will hear about a little later, NASDAQ and some of the others. So some of these signalings kept coming in. Our own review of trading data shows that somewhere starting around 2:40, some of the most actively traded participants in the futures market, the high-frequency traders, started to limit their participation around 2:42, 2:43, and so forth; and that is exactly when that V was happening as some people were limiting or even withdrawing from the market. Another factor, in the midst of this, one large investor executed a hedging transaction, a bona fide hedging transaction in the E- Midi, in the size that on normal days would move through the mar- ket. It was about 9 percent of the volume during the period down and up. But that was also—and may have had some participation within this. FOMC20051101meeting--117 115,MS. YELLEN.," Thank you, Mr. Chairman. At our last meeting I was optimistic that we would avoid a brush with stagflation despite the higher energy prices and the setback in production November 1, 2005 35 of 114 optimistic view. Although considerable uncertainty still clouds the outlook, I regard reports on both real economic activity and inflation to be generally encouraging. On the real side, it now appears more likely that the disruptions caused by the hurricanes will be transitory. Oil and wholesale gasoline prices, for example, have fallen below their August levels before Katrina. Furthermore, rebuilding has been gathering steam quickly, and spending outside of the Gulf region remains robust. In the Greenbook, the effect of this encouraging news about the underlying vigor of the economy has been held in check by the assumption of tighter financial conditions, so the path for GDP is little revised. With respect to the prospects for inflation, I remain more optimistic than the baseline Greenbook projection. David suggested in his remarks that it was possible to make a case for inflation doing better than the Greenbook projection, and I will pursue that case now. Certainly, the latest data have been favorable. Over the six months ending in September, the core CPI increased only 1.3 percent at an annual rate, while the core PCE price index was up 1.5 percent. These data raise the question: Where is the energy price pass-through? PCE energy prices have been rising at double digit rates for more than a year, but they have left remarkably little imprint on core inflation. At our last meeting, I described some econometric evidence showing that since the early 1980s, changes in real oil prices have not had an appreciable effect on core inflation. Today I thought I would cite some reports from our business contacts that appear to be generally in line with this result. They do note that there has been some success in passing energy cost increases down the supply chain but, given competitive pressures and the lack of pricing power, they tell us that the buck usually stops before the consumer. I thought I would give you an example inspired by the season. A large pumpkin grower/ November 1, 2005 36 of 114 materials. She reports that she can pass these costs on to the small retailers she serves, but they are not able to charge consumers more for retail pumpkin products. So this Thanksgiving you need not worry about paying more for your pumpkin pies. Obviously, forecasting beyond that is hazardous, but looking out toward Christmas, I thought I would note that one of the country’s largest growers of poinsettias is on our Advisory Council, and he is highly confident that there will be little pass- through of energy costs into retail poinsettia prices. [Laughter] Also in contrast to the Greenbook, I see no significant pressure for higher inflation coming from increased inflation expectations. In particular, despite the surge in energy costs this year, current estimates of inflation compensation, both over the next five years and the subsequent five- year period, remain at the same average level that prevailed during the first half of this year. A further sign that inflation expectations remain well contained can be found in the continued subdued growth of wages and salaries. Last Friday’s reading on the ECI [Employment Cost Index] I thought revealed no evidence of any pass-through of higher headline inflation or higher inflation expectations to labor compensation. So I see no indication of the ’70s style wage-price spiral in the offing. Overall, I judge our credibility to be very much intact. Of course, our credibility going forward does depend on continued vigilance. The economy now appears to be close to full employment, with a good deal of momentum. And annual core inflation, at least as judged by the core PCE measure, remains near the upper end of my comfort zone and, arguably, inflation risks are tilted somewhat to the upside. So with respect to policy, I support at a minimum the removal of any remaining policy accommodation. The Bluebook shows that the funds rate has finally entered a November 1, 2005 37 of 114 comfortable with a policy position toward the center of this zone. So a few more increases, including one today, seem to me likely to be required. In implementing monetary policy, it seems to me that actions matter, but so do words, and I wanted to briefly open up the question of the statement. I think for today the words of alternative B should suffice, but Vincent has repeatedly suggested, and a number of you have emphasized, that we need to consider how to modify the statement language. Several elements of this statement have expiration dates that are quickly approaching. So I think it’s an important issue for us to discuss. As we go forward, I see three problems with using the kind of language that is in alternative B. First, it refers to policy accommodation, which will arguably soon be exhausted. Second, it refers to a “measured pace,” when at some point presumably we will reach a stopping point in this tightening cycle. And, third, it now contains a near-tautological balance of risk statement that I think serves no obvious policy purpose. Of course, these three problems could be fixed at different meetings. For example, if the inflation picture sours, the “measured pace” language could continue to be used well past the elimination of the policy accommodation phrase. As Governor Gramlich feared, the balance of risk statements could outlive us all! [Laughter] Still, trying to fix all of these three problems at once has some appeal, and I thought that alternative C did just that. It eliminates the balance of risk statement and the policy accommodation language; and it substitutes a new forward-looking policy statement for the “measured pace” phrasing. My main criticism of alternative C is that it jettisons any mention of the conditionality of our actions on future data, and I believe such conditionality is always worth highlighting and particularly deserving of emphasis now, toward the end of our tightening cycle. I believe that a good model for future statements would have three sections: a policy decision, November 1, 2005 38 of 114 be nuanced—tailored to prevailing circumstances and explicitly conditional—and it should not include a formulaic balance of risk statement. Let me give a concrete example based on alternative C. If the Committee believes, for example, that further tightening remains necessary once policy is no longer accommodative, it could state, following the rationale section, that “under these conditions the Committee perceives that further policy firming is likely to be necessary,” or “will be necessary,” or “might be necessary.” “Nonetheless, the Committee will respond to any changes in economic prospects to fulfill its obligation to maintain price stability and foster sustainable growth.” Once the Committee feels that further tightening is not necessary, it could state that “under these conditions the Committee perceives that the current stance of monetary policy will likely remain appropriate going forward. Nonetheless, the Committee will respond to any changes in economic prospects, and so forth, to fulfill its obligations.” In any case, I hope that this proposal might be useful in jump-starting our discussion of these issues." FOMC20080121confcall--17 15,MS. YELLEN.," Thank you. I strongly support your proposal for a 75 basis point funds rate cut today, and I like the proposed wording of the statement. The outlook has deteriorated, not only since December but since our conference call. The downside risks have clearly increased. I think the risk of a severe recession and credit crisis is unacceptably high, and it is being clearly priced now into not only domestic but also global markets. Even so, I put the stance, as best I can judge it, of monetary policy within the neutral range. Policy should be clearly accommodative. We also need a cushion against severe downside risks. We need strong action, and your speech has prepared the markets for actions of this sort. At this point, they are expecting at our next meeting more than 50 percent odds of a 75 basis point cut. An intermeeting move will be a surprise, but I think it will show that we get it and we recognize we have been behind the curve. I think it will be assumed with this statement and action today that we will move somewhat further as well at our next meeting. That is something we should recognize--the statement creates that expectation. " FOMC20050630meeting--328 326,MS. BIES.," Thank you, Mr. Chairman. Steve, I want to ask some questions about your exhibits 8 and 9, having to do with the high-yield debt market. If I put together the middle left panel of exhibit 8 and the middle right panel of exhibit 9, I begin to get worried about whether the market is pricing for risk appropriately. The upper left chart on exhibit 9 shows that defaults jumped in the 2001-2003 period. From your chart, it looks like those bonds were issued in 1997 and 1998, and it appears that that was the last time spreads were so skinny. We’re back to skinny spreads now. We’ve got another bump-up in issuance. And I know banks are easing credit standards. Is the market being too sanguine about the inherent risks in these? If there’s something like a three-year cycle, should we expect to see in 2006 another jump in high-yield defaults?" CHRG-111hhrg48674--144 Mr. Bernanke," That is a very good question and one we take very, very seriously. In the near term, inflation looks to be very low. In fact, we are seeing disinflation, so we don't see inflation as anything like a near-term risk. However, it is certainly the case that when the economy turns around, which it will, and begins to grow again, that in order to avoid inflation, the Fed will need to undo its balance sheet expansion, need to bring down these programs, or use other methods to sterilize the effects of our programs on the money supply. We understand that. We will look at it very carefully. That is one of the chief things we look at at our FMOC meetings. We want to be sure that whatever actions we take, which under the current circumstances will not be inflationary given how slack the economy is and how commodity prices have come down and so on, we want to be sure that when the time comes, we will be able to tighten appropriately to make sure that inflation does not in fact become a problem. I am entirely persuaded that stable prices are critical for long-term economic health, and we at the Federal Reserve are absolutely committed to assuring that. " FOMC20080318meeting--70 68,MR. PLOSSER.," Well, I've been supportive of those, and I want to compliment the New York Desk and the people who have worked on this because I think they are very innovative. I'm not clear how successful these instruments will be, and they are not without their own set of risks of creating some potentially dangerous expectations regarding future Fed behavior, which eventually we must deal with. But I think they are worth trying as long as they are removed in due course. I can also support a further narrowing of the spread between the funds rate and the primary credit rate, although I would eventually like to see a review of what we think that spread ought to be in more normal times and what our exit strategy might be like as we move toward that. Giving some thought down the road to that I think would be helpful. So while I believe that we have appropriately reduced the funds rate in response to the worsening economic outlook for the real economy, I am less convinced that reducing the funds rate further will do much to stem the liquidity problems in the market or to lower risk premiums. Uncertainty about valuations seems to be the root cause of liquidity problems. The price discovery process needs to continue, and it may take a while. In this case, I think the Fed needs to continue to do its job to reassure markets that it will act as an appropriate lender of last resort, but we must be careful that a lower funds rate, if that is the path we take, doesn't become just a form of forbearance that contributes to delaying the necessary writedowns and the price discovery process itself. Yes, the financial markets can have spillovers to the real economy to which the Fed needs to react with monetary policy, and I believe we have. At the same time, we need to keep focused on both parts of our mandate. We put our credibility at risk if we do not do so, and this would be a cause for severe problems later when we may need to act to regain it. We will have to face the fact at some point that we will disappoint the markets with their ever-increasing forecast of a lower funds rate. Thank you, Mr. Chairman. " FOMC20071211meeting--121 119,MR. MADIGAN.,"2 Thank you, Mr. Chairman. I will be referring to the draft announcement language in table 1, which is unchanged from the version distributed in the Bluebook and which is included in the package labeled “Material for FOMC Briefing on Monetary Policy Alternatives.” As shown in section 4 of the left-hand column, following the October meeting the Committee issued a statement that concluded that the upside risks to inflation roughly balanced the downside risks to growth, suggesting that the Committee saw reasonably good odds that, after 75 basis points of easing, the stance of policy would foster sustainable economic growth and price stability over time. As many of you have noted, however, events over the intermeeting period have undermined this view. The staff and the markets have interpreted incoming information as pointing to a distinctly weaker outlook for the economy. As Dave discussed, the staff has lowered its forecast for aggregate demand in light of deteriorating conditions in financial markets, incoming data on spending and output that were weaker than expected, and the higher path for energy prices suggested by futures markets. That weaker forecast for aggregate demand was reflected in a 70 basis point decline in the Greenbook-consistent measure of the equilibrium real federal funds rate, which placed it about 40 basis points below the current real federal funds rate. These developments have prompted the staff to tilt down its assumed trajectory for monetary policy, with a 25 basis point easing at this meeting and another ¼ point move in 2009. The assumed easing is not quite fast enough to offset the adverse shock to aggregate demand, and a small degree of economic slack consequently emerges over the next year or so that was not present in the October Greenbook. That slack can be seen as purposeful, as the staff has also interpreted incoming information as implying a modest adverse shock to aggregate supply: Recent inflation data and higher energy prices point to higher total and core inflation in the third and fourth quarters and, in the staff forecast, over the next few quarters as well. Given the restraint on inflation resulting from the projected emergence of modest slack, the staff judges that its assumed path for monetary policy will leave total inflation and core inflation, respectively, at the same 1.7 percent and 1.9 percent annual rates in 2009 that were projected in the October Greenbook. Should the Committee find the staff forecast persuasive as a modal forecast, view that outcome as satisfactory, and see the risks around that projection, while perhaps larger than previously, as not sharply skewed in either direction, it might be inclined to ease policy by the quarter point assumed in the staff forecast and adopt a statement along the lines shown as alternative B in table 1. Like the staff, members might see the incoming evidence as suggesting that the outlook for real activity has weakened and perhaps that the downside risks to growth have increased. The deterioration in financial markets, in particular, might be a source not only of a downward revision to your outlook but also of a greater sense of uncertainty about prospects for aggregate demand. The financial system is dealing with significant 2 Materials used by Mr. Madigan are appended to this transcript (appendix 2). credit losses and resulting capital erosion and constrictions on balance sheet capacity. The eventual effect of those problems on the availability of credit to households and firms is unknown. In particular, the potential interactions of financial stress with real economic developments, especially those in the housing sector, are difficult to assess. In view of these considerations, as shown in section 2 the suggested rationale language for alternative B would state that economic growth is slowing; would cite softening in recent spending data; and would indicate that financial strains have increased in recent weeks. While the Committee may see significant downside risks to spending, it might also remain worried about the potential for an increase in inflation pressures and might view inflation risks as having risen a bit over the past six weeks. The recent inflation picture looks slightly less benign than it did earlier. Moreover, the increase in oil futures prices suggests that energy prices could continue to boost overall and core inflation. Members may also view downward pressure on the dollar as likely to persist. The language shown in section 3 would continue to cite the same concerns about inflation that the Committee has recognized in recent statements. In circumstances of increased risks to growth and continued substantial inflation risks, the Committee might, as back in September, prefer not to express an overall assessment of the balance of risks. As shown in section 4, the Committee could say that “recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation.” However, if the Committee’s predilection is that further easing will probably be necessary but it still wishes to underscore its concern about inflation, you could insert a sentence after the first sentence in section 4 saying that “on balance, the Committee sees downside risks to growth as having increased, but it must also remain attentive to the upside pressures on inflation.” Most dealers expect you to couple a ¼ point easing today with an assessment that the risks are skewed to the downside. But even the version without an explicit risk assessment probably would be read as consistent with further policy easing going forward, particularly since you eased in October following a statement in September that was comparable to the one shown in section 4. It might be worth noting that many market participants expect the Federal Reserve to augment its monetary policy action today with some announcement regarding the discount window—for example, a reduction in the primary credit spread. As the Chairman noted earlier today, the absence of such a reference in today’s announcement could prompt some investor disappointment; but given your monetary policy action under alternative B, the effect on market interest rates seems likely to be limited, and presumably, any effect today will be reversed tomorrow. If the Committee is already persuaded that the economic outlook has weakened more sharply than in the Greenbook or if it has become significantly more concerned about the downside risks to growth, it might prefer the 50 basis point easing of alternative A. The Committee might see the larger move at this time as warranted particularly by risk-management considerations. The Greenbook presented two alternative scenarios—a “greater housing correction” and a “credit crunch”—that illustrate downside risks and suggest that the Committee may need to ease markedly further over coming quarters. In the case of the credit crunch scenario, for example, the estimated version of the Taylor rule calls for a funds rate that troughs at 2.6 percent, well below the low point currently built into market interest rates. As shown in the second column, the language suggested for alternative A explicitly cites both a weaker outlook and greater downside risks in explaining the relatively large policy move. As in alternative B, the language on inflation would be nearly unchanged from that employed in October. But in section 4 of alternative A, the Committee would indicate a judgment that—following the further reduction in interest rates—the upside risks to inflation roughly balance the downside risks to growth. Or the risk language shown in red in section 4 of alternative B could instead be employed under alternative A; this might be appropriate if the Committee felt that the same elevated risks that motivated it to ease 50 basis points also suggested that it was difficult to weigh the remaining risks after the action. In either case, short- and intermediate-term market interest rates would likely decline noticeably under alternative A. In contemplating the pros and cons of alternative A, one consideration might be whether the Committee views this combination of sharp easing and the associated language, particularly the version coupled with an inconclusive risk assessment, as likely to lead market participants to worry about what information the Committee might have that would lead it to take such a substantial step, and so undermine investor confidence. If, in contrast, the Committee saw the downside risks to growth as somewhat greater but was not yet convinced that the outlook had deteriorated substantially and remained concerned about inflation prospects, it might consider implementation of alternative C. As indicated in the right-hand column, under this alternative the Committee would maintain the stance of policy at this meeting but conclude that the downside risks to growth now are the predominant concern. With overall inflation on the high side and upward pressures stemming from energy prices and dollar depreciation, members might be concerned that policy easing could go too far. The stance of policy has already been eased 75 basis points despite only limited evidence to date that economic weakness is spreading to a significant degree beyond the housing sector. Indeed, as some of you suggested, the incoming indicators of slowing growth over the intermeeting period may be broadly in line with what you expected in October. If so, the Committee may feel that its monetary policy actions to date—and, at the margin, the establishment of the TAF as well as swap lines with foreign central banks—probably will provide sufficient insurance that financial problems will remain contained and will not greatly restrict the availability of credit to households and businesses. Thus members may believe that further easing is not and probably will not be necessary. Indeed, members may find worrisome the prescription of the optimal control simulation in the Bluebook that a slight degree of policy firming would be appropriate over coming quarters if the Committee were pursuing a 1½ percent long-run objective for inflation. Even with such unease about inflation prospects, though, the Committee may be sufficiently concerned about the current threat to growth to judge that, on balance, the risks are tilted to the downside with an unchanged stance of policy. I will conclude by responding belatedly to a question that President Evans posed at the last meeting. He asked what the experience has been with including an indication of downside risks in the policy statement. In particular, would markets likely see such a risk assessment as signaling a likelihood of an imminent policy easing? Answering the question on the basis of the historical record is not entirely straightforward, partly because the Committee’s practices have evolved over time; as President Evans noted, it has been only since 1999 that the Committee has released a risk assessment or some other form of a tilt along with its announcement. Despite some qualifications, the basic answer seems to be, not surprisingly, that the risk assessments have been predictive of future Committee action. The experience from December 2000 through January 2002 makes this point clearly. During that period, at fourteen meetings in a row the Committee indicated that “the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.” In eleven of those fourteen instances, that indication was followed by a policy easing at the next meeting. Later, toward the end of 2002, one of two indications of downside risk was followed by an easing, and in June 2003, a different balance of risks—one concerned with disinflation—was followed by an easing. All in all, it seems reasonable to judge in current circumstances that maintaining the stance of policy while assessing that the risks are tilted to the downside, as under alternative C, would lead market participants to continue to put high odds on future policy easing. But the absence of policy action at this meeting despite nearly unanimous expectations of policy easing would mean that the expectation of a downtilt in rates would begin from a notably higher level and might be less steep, prompting a significant upward shift in short- and intermediate-term interest rates. That concludes my prepared remarks." fcic_final_report_full--134 At one meeting, when things started getting difficult, maybe in , I asked the CFO what the mechanical steps were in . . . mortgage-backed securities, if a borrower in Des Moines, Iowa, defaulted. I know what it is if a borrower in Bakersfield defaults, and somebody has that mort- gage. But as a package security, what happens? And he couldn’t answer the question. And I told him to sell them, sell all of them, then, because we didn’t understand it, and I don’t know that we had the capability to understand the financial complexities; didn’t want any part of it.  Notably, rating agencies were not liable for misstatements in securities registra- tions because courts ruled that their ratings were opinions, protected by the First Amendment. Moody’s standard disclaimer reads “The ratings . . . are, and must be construed solely as, statements of opinion and not statements of fact or recommen- dations to purchase, sell, or hold any securities.” Gary Witt, a former team managing director at Moody’s, told the FCIC, “People expect too much from ratings . . . invest- ment decisions should always be based on much more than just a rating.”  “Everything but the elephant sitting on the table” The ratings were intended to provide a means of comparing risks across asset classes and time. In other words, the risk of a triple-A rated mortgage security was supposed to be similar to the risk of a triple-A rated corporate bond. Since the mid-s, Moody’s has rated tranches of mortgage-backed securities using three models. The first, developed in , rated residential mortgage–backed securities. In , Moody’s created a new model, M Prime, to rate prime, jumbo, and Alt-A deals. Only in the fall of , when the housing market had already peaked, did it develop its model for rating subprime deals, called M Subprime.  The models incorporated firm- and security-specific factors, market factors, regu- latory and legal factors, and macroeconomic trends. The M Prime model let Moody’s automate more of the process. Although Moody’s did not sample or review individual loans, the company used loan-level information from the issuer. Relying on loan-to-value ratios, borrower credit scores, originator quality, and loan terms and other information, the model simulated the performance of each loan in , scenarios, including variations in interest rates and state-level unemployment as well as home price changes. On average, across the scenarios, home prices trended up- ward at approximately  per year.  The model put little weight on the possibility prices would fall sharply nationwide. Jay Siegel, a former Moody’s team managing di- rector involved in developing the model, told the FCIC, “There may have been [state- level] components of this real estate drop that the statistics would have covered, but the  national drop, staying down over this short but multiple-year period, is more stressful than the statistics call for.” Even as housing prices rose to unprecedented lev- els, Moody’s never adjusted the scenarios to put greater weight on the possibility of a decline. According to Siegel, in , “Moody’s position was that there was not a . . . national housing bubble.”  FOMC20080430meeting--95 93,MR. ROSENGREN.," Thank you, Mr. Chairman. Without judgmental adjustments, the Boston Fed forecast is somewhat more optimistic than the Greenbook. As in the Greenbook, our GDP is weak in the first half of this year, though neither of the first two quarters actually turns negative. Our slightly more optimistic forecast assumes that consumption and business fixed investment are weak, but not as weak as in the Greenbook, and then the fiscal and monetary stimuli are sufficient for the economy to pick up in the second half of this year. In a sense, the Greenbook represents another mode in the forecast distribution with probability roughly equal to our forecast. The big risk to our forecast is that the financial turmoil and housing price declines, which are not fully reflected in the Boston model, result in a greater drag on the economy. Such an outcome would largely close the gap between the Greenbook and our forecast. In short, the downside risks to our forecast are appreciable. With a monetary policy assumption similar to the Greenbook's, we have core PCE below 2 percent in 2009, but the unemployment rate remains well above the NAIRU even at the end of 2010. If we sought to keep inflation below 2 percent but did not want an extended period in which the unemployment rate was above the NAIRU, our model would require more easing than currently assumed in the Greenbook. Since the last meeting, the economic data have remained weak. Private payroll employment declined by approximately 100,000 jobs on average over the past three months, and the unemployment rate increased 0.3 percentage point. In addition, the labor market weakness was widespread across industries. Such labor market weakness is likely to aggravate an already troubling housing story. To date, falling housing prices have disproportionately affected subprime borrowers and those who purchased securitized products. However, if housing prices continue to decline rapidly, that will begin to affect more prime borrowers and a wide array of financial institutions. Smaller financial institutions that were largely unaffected by the financial turmoil last August are beginning to see increases in delinquencies, and those with outsized exposures in construction loans are now experiencing significant duress. Commercial real estate loans are also now experiencing increased delinquencies. Like the Greenbook, I am concerned that commercial real estate may be the next sector to experience problems. However, the biggest concern remains that rising delinquencies and falling housing prices cause a much higher rate of mortgage defaults than we have experienced historically. Should these mounting problems become more pronounced, we are likely to see credit availability for small- and medium-sized businesses affected. That sector has not to date been significantly affected by the financial turmoil. Many financial indicators have improved since the last meeting, as was highlighted in Bill's report. The stock market has moved up. Many credit spreads have narrowed. Treasury securities and repurchase agreements are trading in more-normal ranges, and credit default swaps for many financial firms have improved. Nonetheless, several ominous trends remain in financial markets. The LIBOR�OIS spread has widened, so borrowers tied to LIBOR rates have seen those rates rise more than 25 basis points since the last meeting. Similarly, the TAF stop-out rate in the last three auctions was higher than the primary credit rate, providing another indicator that banks remain in need of dollar term funds. Finally, the asset-backed commercial paper market is once again experiencing difficulties. Rates on asset-backed commercial paper have been rising, and there is a risk that more of the paper will end up on bank balance sheets. Higher food and energy prices are both a drag on the economy and a cause for concern with inflation. But despite the extended sequence of supply shocks, I do not see evidence that inflation expectations are no longer anchored. Labor markets do not indicate that the commodity price increases are causing wage pressures, and such pressures are even less likely if the unemployment rate continues to increase. Many of the financial indicators of inflation, such as the five-year-forward rate, have fallen significantly from their peaks earlier this year. Finally, core PCE over the past year has been 2 percent, and most econometric-based forecasts expect that the weakness we are experiencing should result in core and total PCE inflation at or below 2 percent next year. Overall, the downside risks to demand that I listed in the outset seem the more compelling cause for concern. Thank you. " FinancialCrisisInquiry--70 GEORGIOU: Or it might require more capital raising on your part to expand your business. MACK: Possibly, but we’ve raised a lot of capital and have very high tier-one ratios. It could. GEORGIOU: Right. MACK: The other part about a put back to us—you mentioned if the security has not performed. Again, there is a short period of time, oftentimes. If there is information that comes out right after a new issue has been priced, there are times that new information comes back and there is a put back. But to extend that over a long period of time is putting all of the risk on the underwriters. And some of you—some of you broadly, not the panel here— may think that’s the right way to do it, but that would curtail our business dramatically and I think hurt the capital markets in the United States and also on a global basis. GEORGIOU: Mr. Blankfein could you comment on any of—any mechanism to—to put on the originators some responsibility for the... BLANKFEIN: I think it would be hard—hard to organize. I mean, we don’t—directionally, trying to put some of the—more onus on the issuers, on the originators is probably a good idea. Some of these elements, you know, you can go back and forth on. I think the way the origination process and syndication process is designed; we’re not supposed to be in conflict. We’re not supposed to have a stake in it. In other words, if we were going to originate a security and we were going to end up with some of it, we would have incentive to have the security sold at a lower price than the higher price. And a lot of securities laws are designed to make us not have a conflict with the—with the client that’s originating. But that’s neither here nor there. If the overall theme is should there be some skin in the game. That could be a theme worth pursuing. The issues that John Mack brought up are all considerations that we’d have to take account of— clogging up balance sheets, having a conflict with your clients, because now, all of a sudden, you’re not just someone trying to find the right price between a seller of a security—the person who needs the capital—and the investing public. You’re now a member of the investing public. CHRG-111shrg54589--77 Mr. Whalen," I agree with many of the things that have been said in previous testimony and I am very encouraged by what I hear. I hope you will take this as an initial fact finding session today because I think it is important that the Congress build a complete public record on this issue and that will take some time. You have heard a lot about centralized clearing. I don't think anybody is opposed to that. It makes sense. It is part of the evolution of markets. Whenever financial markets start, the first few people who figure out an opportunity never want standardization. They don't want too many people to know what they are doing because they are harvesting the biggest returns that you will ever see in that new market. And over time, as the crowd gets bigger, they all agree that standardization and a certain degree of consistency is important for the participants. This is the way all of our markets have evolved in this country over the last century or more. But I would tell you that I think that clearing is a bit of a canard. I don't think it really is the problem. I think it is part of the problem. It was manifest in many ways over the last few years. I also think that a lot has been said today about information, about a lack of transparency. And again, who disagrees with transparency? It is like motherhood and apple pie. Everybody is for it. But I think in working with our clients and talking through these issues--and my views on these issues have changed over the last 20 years, I will be the first to admit, that is part of the learning process--but I think that everything we deal with today, the systemic risk, the concern that is felt by buy-side investors today who are basically on strike--hinges on valuation. Investors don't want to know about any of these toxic products until the sell side of the street meets their concerns about transparency and price discovery--I particularly appreciate Ken's comments from Citadel. I totally agree with what they are saying. But to me, the basic problem is not with most of the over-the-counter derivatives for currencies or interest rates. These are all fine. They have a visible cash-basis market that everybody can see, the buyer and the seller. Both parties can validate the derivative contract price immediately. Where I think we have a big problem that may not be surmountable is when you allow the investment community to create derivatives where there is no visible cash market. In other words, we are creating the derivative of something that can only be validated with a model. And as we all know, all models are always wrong. They are right at a certain point in time, but if they are not dynamic, the next day, the next week, the next month, it is off base. So I think the key question we have to ask, and this goes back to the basic principles that underlie all of the futures and forward OTC markets in our country, is if you can't see a real price, a cash price and a price that reflects volume, reflects a large community of interest so that that price means something, how do you validate a derivative that is supposedly based on that asset? Classic example, single name credit default swaps. These products essentially let you create a hedge for a corporate bond that is illiquid, or even a completely illiquid loan for that corporation. Now, CDS is a wonderful thing. Everybody in the market agrees, this is a great facility to have, to be able to hedge an exposure with a short position that I can't create in a cash market. I can't borrow that bond to deliver it against a short position. It is illiquid. So we have decided that instead of that price that we don't see, that we can't observe, we are going to use models instead. I think that is a very tenuous, speculative basis for a derivatives market. Now, there may be a certain class of market participants who can participate in such activities, but I think for federally insured banks, for pension funds, for State and local agencies, that is probably a bridge too far. I am a simple guy. I started off in the early, early days of asset swaps and currency swaps working in the London office of Bear Stearns in the mid-1980s. But the beautiful thing about that time is that you never had any question what the swaps were worth. And frankly, I don't even worry about customization. If I have a visible cash basis, I don't mind if someone wants to customize a contract. I don't see what the problem is there. But the problem I do see is that when you allow sophisticated organizations that are a lot smaller than most of us to create vehicles that cannot be validated in the cash marketplace, we have created risk that I think is very, very difficult to address, and particularly for the vast majority of companies and individuals who really are not competent to make investment decisions without professional advice. I have worked as a supervisor of investment bankers, traders, and researchers, and things like suitability and ``know your customer'' mean something to me. I worked for two firms that have very large retail branch networks and we always had to ask ourselves the question when we priced a deal, were we serving the banking customer and were we serving the retail investors that we were going to release securities to when we did a deal. We had a duty to both sides of the trade. And it is that basic element of fairness, not just transparency, not just functionality and risk management, but fairness that I think this Committee has to think about. I look forward to your questions. " FOMC20050630meeting--361 359,MS. MINEHAN.," Thank you, Mr. Chairman. New England continues to expand but probably more slowly than the nation. At our last meeting, I spoke of a couple of bumps along the road to a stronger regional economy. Those bumps remain—in particular, rising concerns about slow job growth, rapidly growing input costs, the strength of demand, and the availability of skilled June 29-30, 2005 121 of 234 Moreover, with the base realignment and closure (BRAC) proposals by the Pentagon now public, there are clear challenges to be faced in both Connecticut and Maine, which together bear about half of the related job losses for the whole nation. While there will be extensive efforts in Washington by New England legislators to modify the BRAC results through the work of the BRAC Commission, judging by the outcome of the last four rounds of base closures, little will change. This will be particularly difficult for Maine, with its smaller and less differentiated economy. And I expect the news of the MBNA/Bank of America merger won’t go over well in Maine either. So it’s not hard to see why the general tone in New England seems a bit on the soft side. Employment in our District is growing but at a slower pace in May than in the three previous months. Unemployment has edged up, and most other indicators of economic health show only modest growth. Indeed, business confidence has trended down sharply, and commercial real estate markets remain sluggish across the region. Regional manufacturers—those contacted for the Beige Book, those who sit on our New England Advisory Council, or those who participate in our economic forums—are for the most part experiencing rising demand and volume growth. But they view increases in costs as a particular impediment. They see the costs of raw materials of all sorts, including energy and transport, as problems. And they believe passing on such costs is difficult, except when they have unique or technologically advanced products. Many talked about margin pressures and, as compared to the last several meetings, fewer talked about pricing power. Perhaps this is because energy surcharges already have been implemented and accepted but other pricing changes are proving more difficult. Health care costs are a concern as well. And the rising costs—or unavailability of—necessary June 29-30, 2005 122 of 234 To end the regional discussion on a little more positive note, there are industries that are clearly doing well. As a generic category, the leisure and hospitality industry is growing. Tourism is solid and hotel margins are good. Retailers are more optimistic as well, though the wet weather in May dampened sales [laughter] and caused inventory levels to rise. Many software companies are facing good demand for their products, and business service firms say that job markets are tightening, especially for technology workers. And I’d have to say that in my 11 years of reading the notes on Beige Book discussions, I’ve never seen a description of the business outlook quite like the one I read in our recent notes, which was, I quote, “Crazy, busting at the seams.” That was the case for one very large regional producer of aircraft integrated systems. For this company, demand from the airlines for retrofits and for fuel management and diagnostic systems has taken off, literally. [Laughter] So, not everything is growing slowly in New England. Turning to the national scene, there is clear evidence that the economic softening we noted at the last meeting has reversed course, at least partially. The so-called soft patch in the first quarter is in the process of being revised away with the changes to net exports and inventory levels. And while the second quarter will suffer some from the unwinding of auto inventories, there does seem to be a solid pattern of underlying growth. Looking further ahead, there is very little difference between our forecast in Boston and that in the Greenbook. Through late ’05 and into ’06, we continue to see an evolving handoff from policy-stimulated, consumer-led growth to a solid pace of underlying demand led by increased business spending that is being driven by relatively sound fundamentals. Incoming data, while June 29-30, 2005 123 of 234 We, like the Greenbook, see four-quarter growth rates in both 2005 and 2006 in the mid- threes, unemployment close to the staff’s estimate of full employment, and both core CPI and core PCE edging downward. This isn’t terribly different from our outlook at the previous meeting. But while some aspects of the earlier soft patch have gone away, new or perhaps more sharply drawn risks have emerged. In particular, oil prices continue to surprise on the upside. This could both dampen growth and contribute more to inflation than we currently expect. The baseline forecast sees inflation moderating over the next year and a half, but that assumes that oil prices flatten and don’t continue their upward climb. By the end of the forecast period, some slack remains, but there are risks on the upside that resource pressures could occur sooner. Indeed, some compensation measures may be hinting at this, and slowing productivity could also contribute. Risks exist on the downside as well, in particular that the drag of higher energy prices will slow worldwide growth even further, working to create greater slack here in the United States. The other major area of risk, as I see it, involves a wide array of asset and financial variables. We’ve discussed whether there is a housing bubble or just symptoms of froth in some markets. While much of the rise in house prices can be explained by rising incomes and demographics, low interest rates clearly have been a contributing factor. They have also contributed to what most market practitioners view as a sense of reaching for risk in markets and to relatively narrow credit spreads. The complications of some of the newer, more intricate, and untested credit default instruments caused a bit of market turmoil recently. This was far from a systemic event, but it does I think illustrate the fact that nasty surprises can occur when markets overdo. I found the papers prepared by Vincent and his colleagues on the conundrum of low 10-year June 29-30, 2005 124 of 234 more credence in the low 10-year yield as a signal of increased financial ease rather than potential economic weakness. But the case for both interpretations I thought was well made. For both these major risks—rising oil prices and excesses in asset and financial markets— there are possible downside effects on growth and upside effects on inflation and market volatility. So how should policy react? Or, more pointedly, when should we pause from our “measured pace” to assess where things are? Given the Greenbook forecast and reasonable assumptions about remaining slack, one could look at the downside risks and say that a pause should occur sooner rather than later. But one could also look at the upside risks and decide a pause should come at a later point. Frankly, I think the latter course is less costly. That is, if we err on the side of tighter policy, easing can be done quickly if it’s necessary—and at little relative cost. Higher rates, if approached sensibly and cautiously, will help to wring out of the system some excesses and protect against unexpected surges in inflation. If we stay too accommodative for too long, then the price of correction in terms of economic growth may well be higher. But, really, pausing is not the question for today. I think our best course of action should be to repeat what we’ve done over the last several meetings and move the funds rate up. I know we’ll have more to say later about the language in the statement, but for now let me emphasize once again that I think saying what we did and why we did it should be enough. I know there will be no desire to change the statement in any fundamental way until we take a pause or decide to move faster. That may be wise, and it has worked pretty well so far. But I continue to believe that there is a risk in continuing to imply that we know more than we do about what the future course of policy will need to be. June 29-30, 2005 125 of 234" FOMC20071031meeting--12 10,MR. MADIGAN.,"2 I will be referring to the package labeled “Material for FOMC Briefing on October Projections.” The table shows the central tendencies and ranges of your current forecasts for 2007 and the next three years. Where available, the central tendencies and ranges of the projections last published by the Committee―those submitted for inclusion in the July Monetary Policy Report―are shown in italics. 2 Materials used by Mr. Madigan are appended to this transcript (appendix 2). Notably, a majority of you conditioned your current projections on an easing of monetary policy, with most of that majority apparently seeing lower rates as appropriate either imminently or within the next six months or so. Even with that assumed easing, your GDP growth forecasts for 2007 have been marked down slightly since last June, and your outlook for next year has been revised down more substantially. Many of you noted that last summer’s NIPA revisions led you to lower your estimate of potential GDP growth. Most of you cited the intensification of the downturn in housing markets, the turmoil in financial markets, and higher oil prices as factors leading you to scale back your expectations for actual growth in 2007 and 2008, though some participants commented that rising net exports could provide support to aggregate demand. The central tendency of the economic growth forecasts for 2008 is now 1.8 percent to 2.5 percent, below the central tendency of 2½ percent to 2¾ percent in June. Perhaps partly because you expect easing whereas the staff assumed an unchanged stance of policy, the central tendency of your economic growth projections is above the Greenbook forecast of 1.7 percent for real economic growth in 2008. That difference may also reflect your somewhat more optimistic view of potential growth. It is worth noting that the divergence among your views concerning the outlook for next year has widened substantially: The width of the central tendency, for example, at nearly ¾ percentage point, is about three times that in the June projections. The downward revision to the outlook for GDP growth was mirrored in a small upward revision to the unemployment rate: The central tendency of the projections for unemployment at the end of this year is around 4¾ percent, and it centers on a rate just under 5 percent at the end of next year. Based on the comments that some of you have made about sustainable rates of unemployment and on your longer-run unemployment projections, many of you apparently predict the emergence of a small amount of slack by the end of next year. With incoming data on core inflation a bit better than you had expected and with some slack likely next year, the central tendency of your projections for core PCE inflation is down noticeably for 2007 and is a shade lower for 2008; most of you now see core inflation below 2 percent in both years. Your near-term forecasts for total PCE inflation are higher than those for core inflation, reflecting surging energy prices and, in some cases, an expectation of continued brisk increases in food prices. With regard to the uncertainties in the outlook, most of you see the risks to growth as tilted to the downside—even with an assumed easing of policy—and judge that the degree of uncertainty regarding prospects for economic activity is unusually high relative to average levels over the past twenty years. Your commentaries highlighted downside risks arising from the possibility that financial market turmoil and tighter credit conditions could exert unexpectedly large restraint on household and business spending and that the downturn in housing could prove even steeper than currently anticipated. A slight majority perceived the risks to total inflation as broadly balanced, and a more sizable majority judged that the risks to core inflation are in balance; in both cases, those in the minority saw the risk to inflation as tilted to the upside. As the experience in the September trial run highlighted, the Committee’s policy statement will need to be reviewed carefully for potential inconsistencies with the risk assessments submitted with the projections. I will return to that issue tomorrow. Turning to the longer-horizon forecasts, you expect real GDP growth of around 2½ percent and unemployment slightly above 4¾ percent in both 2009 and 2010. Judging from your forecast narratives, these projections are close to your estimates of the economy’s potential growth rate and the level of the NAIRU. The former is a bit higher than the staff estimate of about 2.1 percent potential growth, and the latter is close to the staff estimate. For 2009 and 2010, all of your core inflation forecasts are in a range of 1½ to 2 percent. A couple of you expect rising prices of food and energy to keep total inflation above 2 percent in 2009, but all of your forecasts for total inflation are within a range of 1½ to 2 percent in 2010. Many of you state that you view your projections for inflation in 2010 as consistent with price stability." CHRG-111hhrg56776--134 Mr. Hensarling," On the next panel we are going to hear from Dr. Meltzer, who is sitting over your left shoulder there. I notice he was kind enough to quote me in his testimony, so I'm going to return the favor. I have looked through his testimony. He says, ``Setting up an agency to prevent systemic risk without a precise operational definition is just another way to pick the public's purse. Systemic risk will forever remain in the eye of the viewer. Instead of shifting losses onto those that caused them, systemic risk regulation will continue to transfer costs to the taxpayer,'' which clearly, again, takes us back to the whole question of ``too-big-to-fail.'' So, I guess I have a two-part question here, and that is, is the concept of a systemically significant firm really in the eye of the beholder? And if so, in order for you to execute your charge of maximum employment and price stability, is it not counterproductive to have any type of designation of a fund that creates the impression, again, that there are firms that are ``too-big-to-fail?'' Is there not another method--a resolution authority, as you have argued for--that would avoid creation of an explicit fund? And would there not be--could not the proper application of capital and liquidity standards be used in order to avoid the designation of ``too big-to-fail,'' but essentially solve the problem? " FOMC20061025meeting--237 235,VICE CHAIRMAN GEITHNER.," I am, as I think the center of gravity in this Committee is, somewhat uncomfortable with the amount of moderation that the Greenbook expects to see in core PCE inflation, and I’m somewhat uncomfortable with the view that, with the markets’ expectations for the fed funds rate, we’re going to see enough moderation of inflation. We can’t be that confident—even if the fed funds rate stays constant, as the Greenbook suggests, over the next few quarters—that we will get the right amount of moderation. So I think the range of plausible outcomes for monetary policy is likely above the path that’s now priced into the markets, maybe somewhat above the assumption that underpins the Greenbook. I’m not confident that we can effectively alter those expectations or calibrate our signal in a way that can engineer that kind of desirable change two to three quarters out in the expected path of the fed funds rate. I don’t think there’s a good case for moving policy today, of course. I think the first sentence in C is sort of what we meant in August, and if we had used it then, I’d be in favor of using it today. But I don’t think there’s a strong case for putting it in today on the grounds that I don’t know that, on the basis of the evidence we’ve seen over the past five weeks, we can justify what would be interpreted as a significant firming in the signal the Committee is sending. I also think it has the slight disadvantage of maybe being harder to extricate ourselves from than the current formulation. Having said that, I think the signal needs to be asymmetric and the risks are still asymmetric. We should be more worried about the risk that inflation doesn’t moderate enough than we should be worried about the other risks to the forecast. I would be reasonably comfortable with the changes to sections 2 and 3 that Don proposed. I have some uneasiness about whether section 2 as modified conveys the sense that, if you look through the adjustment we’re seeing so far, we have growth strengthening from the pace in the second and third quarters to a level that’s at or close to potential, and I do think the sense we want to convey is pretty close to what Charlie, Bill Poole, and perhaps Kevin in a sense said. But I just don’t think we can at this time wade into a characterization of potential or what’s sustainable without the risk that we’d regret the formulation that we used. So on the grounds that I don’t have a better alternative, I would support the modifications to sections 2 and 3 and leave the risk assessment in section 4 unchanged. I think that will leave us in a pretty good position. We should be pretty comfortable with where we are, but I do think the plausible scenarios for what we’re likely to do with the fed funds rate lie above what’s now priced in the market and maybe above the assumption that underpins the Greenbook forecast." FOMC20060131meeting--77 75,MR. STOCKTON.," That sounds like a reasonable sensitivity. As you know, we have presented this effect in the past. It’s a little larger than the effects that we get when we run our model, which would be measured more around ¼ percentage point to ½ percentage point. Now, you may recall that last June John Williams presented some simulations of various housing-price scenarios. Our relatively small effects come from just simulating a lower path for the price of housing, and as you know, our model has a relatively low marginal propensity to consume out of housing wealth, one that is similar to that out of overall household wealth. It’s not difficult to imagine upping those effects. If one wants to assume that, instead of the three and a half cents on the dollar effect that we have incorporated in our model, the marginal propensity to consume was around five to seven cents on the dollar, those effects would obviously be increased. The second potential channel that our straightforward model simulations don’t account for is that a lower path for housing prices could be accompanied by some hit to consumer sentiment. There would be an outsized effect on consumer spending if households really became more pessimistic given the downturn in what is an asset with a high profile in their portfolios. And the third possibility that John explored in his simulations was related to one of the alternative simulations we show this time around: If weakening in house prices and housing activity occurred when the term premium was widening back out, you would then have the effects not only directly on the housing-sector side, which could be amplified, but also on other forms of interest sensitive spending. So I think there are some pretty wide confidence intervals. The numbers that you cited are bigger than our standard simulation, but seem reasonable and in the ballpark if one wants to make a few adjustments in some of the assumptions that we made. As I contemplate our outlook and the things that I worry about the most on the domestic side of the economy, I’d say the housing sector is clearly one of the biggest risks that you’re currently confronting." FOMC20070509meeting--89 87,CHAIRMAN BERNANKE.," Thank you. Let me try to summarize the discussion around the table and take any comments on the summary, and then I would like to add just a few thoughts. Broadly speaking, the outlook of most participants has not substantially changed since March. Housing remains weak, and it is the greatest source of downside risk. Whether the demand for housing has stabilized remains difficult to judge, in part because of subprime issues. It is also unclear whether builders will seek to return inventories to historical levels, and if so, at what rate. There is yet no indication of significant spillover from housing to other sectors, although that remains a risk. The downside risks to investment have moderated since the last meeting, although investment seems unlikely to be a strong driver of growth. The inventory cycle is now well advanced, and production is strengthening. Consumption growth seems likely to moderate, reflecting factors such as weakness in house prices and high energy prices. However, the labor market remains strong, particularly in the market for highly skilled workers. Incomes generated by the labor market, together with gains in the stock market and generally accommodative financial conditions, should provide some support for consumption going forward. Financial markets are priced for perfection, which implies some risks on that score. Foreign economies remain strong and should be a source of support, although some are undertaking monetary tightening. Overall, the economy is in a soft patch and will likely grow below trend for a while. Growth should return to potential later this year or in 2008, depending on the evolution of the housing market. The rate of potential growth remains hard to pin down. Several participants seem a bit more optimistic than the Greenbook on potential growth and the NAIRU, although there are risks. Inflation has improved a bit, and most see continued but very slow moderation. However, there are upside risks to inflation, including compensation, the dollar, energy prices, and a slowing in productivity. Moreover, a rise in inflation from current levels would be costly, particularly if it involved unhinging inflation expectations. Vigilance on inflation must, therefore, be maintained. Overall the risks and uncertainties seem a bit less pronounced than at the last meeting, and participants seemed relatively comfortable with the outlook. Although there are some potentially significant downside risks to output, arising particularly from the housing sector and the possible spillover to consumption, the group still appears to view a failure of inflation to moderate as expected to be the predominant risk to longer-term stability. Are there any comments or questions? Hearing none, I will just add a few points. First, following President Yellen, I think that the tension between slow growth and a strong labor market remains central to understanding what’s going on. Okun’s law is supposed to work better than this. [Laughter] I looked at recent history. Over the past twenty years or so, there has been no exact parallel to what we are seeing now. There was a jobless recovery in ’91-’93 in which unemployment remained high even though growth was picking up, and we had a midcycle slowdown in ’95 and ’96, which was relatively short and not very severe, in which the unemployment rate got temporarily ahead of growth. So there have been some deviations. Interestingly, after the 2001 recession, despite lots of talk about jobless recoveries, Okun’s law worked pretty well. So we are in an unusual situation—instead of a jobless recovery, we have growthless job growth. [Laughter] Interpreting this correctly is very important. The staff forecast essentially assumes that Okun’s law will revert to historical tendency. I think that assumption is reasonable, particularly since the staff is not exceptionally optimistic about potential growth and, therefore, that particular source of error is moderated. That would suggest that labor hoarding is probably a good part of what is happening here. If there is one area in which labor hoarding appears to be significant, it would be construction, as President Yellen mentioned. I asked the staff to do a simple study of this relationship, to which Dave Stockton referred. Andrew Figura and Adam Looney of the Board’s staff performed a regression analysis in which they regressed all construction employment against all investment in structures quarterly with lags going back to 1985. The reason to look at all construction in terms of both employment and production is that there is a lot of substitutability between those two categories. That regression approach should also account for unmeasured labor, including undocumented workers and the like. In this analysis they found that employment is roughly proportional to construction activity, but with substantial lags, which again is somewhat surprising. Indeed, the model fits well through the fourth quarter of ’06 but then begins to underpredict significantly in the first quarter of ’07. If this model is correct, then given what is already in the pipeline in terms of reduced construction activity and then going on with the forecast in the Greenbook, we should begin to see fairly significant declines in construction employment on the order of 30,000 per month over the next year, which would be sufficient in itself, with all else being equal, to add 0.2 to 0.3 to the unemployment rate. So if labor hoarding explains the failure of Okun’s law, then we may soon see some gradual rise in the unemployment rate, which would also be consistent with the view that the staff has taken that a good bit of the slowdown in productivity is cyclical. It is actually fairly difficult to calculate the contribution of the construction sector to productivity because it involves not just construction workers but also upstream production of various kinds. But one estimate, which comes from discussions with the Council of Economic Advisers, had the implication of employment hoarding in construction being about ½ percentage point on productivity growth. We will see how that develops. Even though I believe, as does the staff, that we will see some softening in the labor market, I should say that the evidence is still quite tentative. We saw a bit of weakness in the last labor report, but unemployment insurance claims remain low, and we do not really see a significant indication. The other major issue is the housing market. Again, as a number of people pointed out, this is an inventory-cycle problem. The two main determinants of an inventory cycle are (1) what the level of final demand is and (2) how quickly you move to bring inventories back to normal. There does seem to have been some step-down in final demand over the past few months. Assuming that homebuilders would like to get not all the way to but significantly toward their last ten years’ inventories by the end of 2008 implies fairly weak construction, not only in the second quarter but going into the third quarter as well. Only in the fourth quarter will we see a relatively minor subtraction from GDP. That’s also relatively speculative, but residential construction does seem fairly likely to me to be more of a drag than we previously thought and to continue to be a problem into the third quarter. There will also be a slowdown in consumption. We have been having rates near 4 percent, which is certainly not sustainable. We already see indications that consumption may be closer to 2 percent in the second quarter. I think the house-price effects are going to show up. Gasoline prices will have an effect. The labor market is strong, but it is going to slow a bit. So it looks to me as though underlying growth is roughly 2 percent and will be so for a couple of quarters to come. Notice in the thinking about the underlying case that there has been quite an asynchronicity between private domestic final demand and production lately. For example, for the second quarter we expect to see weaker private domestic final demand but probably a stronger GDP number because of rebounds in net exports and the like. But we should look past that—those are just quarter-to-quarter variations—and observe that growth is moderate, an observation that is supported by the sense that industrial production and manufacturing seem to be picking up. To summarize, I think that the notion of moderate growth with some uncertainty and with return toward potential later in the year or early next year is still probably about the right forecast. On inflation, there’s the famous stock market prediction that prices will fluctuate. That seems to be true also for inflation. I mentioned at the last meeting that the monthly standard deviation in inflation numbers is about 0.08, and so between 0.1 and 0.3 there is not necessarily a whole lot of information. We have a few pieces of good news. I think vacancy rates are rising for both apartments and single-family homes. At some point we will begin to see better progress on owners’ equivalent rent and shelter costs. Also, the quarterly average of medical cost increases was much more moderate than in the first two months, which suggests that maybe this risk is not as serious as it may have looked. However, as many people pointed out, there are a number of negatives, including the dollar, energy, food prices, commodity prices, and most importantly, the labor market. The compensation data remain quite mixed—in particular, the ECI, which was a very soft headline number. The 1.1 percent quarterly wage and salary number, or 3.6 percent for twelve months, is now more or less consistent with what we’re seeing in average hourly earnings. If productivity falls below 2 percent, then we are beginning to get to a range in which unit labor costs will be putting pressure on inflation. So I am quite comfortable with the view expressed around the table that, although inflation looks to be stabilizing and perhaps falling slowly, there are significant risks to inflation and we should take those very seriously. Very much a side point—I did have some interesting discussions with the staff about the role of the stock market in the forecast. This is not the staff’s fault, but there is a sort of tension in how the stock market is treated. On the one hand, the stock market is assumed to grow at 6½ percent from the current level. On the other hand, the forecast has profit growth going essentially to zero by the third quarter but interest rates coming up. Those two things are a little hard to reconcile. The difficult problem is which way you should go to reconcile it. On the one hand, it could be that the forecast is right, and therefore the stock market will in fact be weaker; that will have implications for stability, for consumption, and so on. On the other hand, perhaps we should be taking information from the stock market in making our forecast. So it is a very difficult problem, and I just wanted to point out the tension that we will have to see resolved over the next few quarters. One partial resolution is that, as has been noted, the stock market and the economy as a whole can be decoupled to some extent because of overseas profits. This is an interesting example of how financial globalization is creating stability for domestic consumption—you know, decoupling domestic consumption from domestic production. Again, we had a very good discussion with the staff about this issue, and I think it is just something we will need to think about going forward. In summary, in the last meeting we felt that uncertainty had risen. There has been perhaps a slight moderation of those concerns at this point—a little less inflation risk, a little less growth risk. Nevertheless, the balance of risks with inflation being the greater still seems to me to be a reasonable approach. Let me now turn to Vincent to begin the policy go-round." CHRG-109shrg26643--130 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System February 16, 2006 Mr. Chairman and Members of the Committee, I am pleased to be here today to present the Federal Reserve's Monetary Policy Report to the Congress. I look forward to working closely with the Members of this Committee on issues of monetary policy as well as on matters regarding the other responsibilities with which the Congress has charged the Federal Reserve System. The U.S. economy performed impressively in 2005. Real gross domestic product (GDP) increased a bit more than 3 percent, building on the sustained expansion that gained traction in the middle of 2003. Payroll employment rose 2 million in 2005, and the unemployment rate fell below 5 percent. Productivity continued to advance briskly. The economy achieved these gains despite some significant obstacles. Energy prices rose substantially yet again, in response to increasing global demand, hurricane-related disruptions to production, and concerns about the adequacy and reliability of supply. The Gulf Coast region suffered through severe hurricanes that inflicted a terrible loss of life; destroyed homes, personal property, businesses, and infrastructure on a massive scale; and displaced more than a million people. The storms also damaged facilities and disrupted production in many industries, with substantial effects on the energy and petrochemical sectors and on the region's ports. Full recovery in the affected areas is likely to be slow. The hurricanes left an imprint on aggregate economic activity as well, seen, in part, in the marked deceleration of real GDP in the fourth quarter. However, the most recent evidence--including indicators of production, the flow of new orders to businesses, weekly data on initial claims for unemployment insurance, and the payroll employment and retail sales figures for January--suggests the economic expansion remains on track. Inflation pressures increased in 2005. Steeply rising energy prices pushed up overall inflation, raised business costs, and squeezed household budgets. Nevertheless, the increase in prices for personal consumption expenditures excluding food and energy, at just below 2 percent, remained moderate, and longer-term inflation expectations appear to have been contained. With the economy expanding at a solid pace, resource utilization rising, cost pressures increasing, and short-term interest rates still relatively low, the Federal Open Market Committee (FOMC) over the course of 2005 continued the process of removing monetary policy accommodation, raising the Federal funds rate 2 percentage points in eight increments of 25 basis points each. At its meeting on January 31 of this year, the FOMC raised the Federal funds rate another \1/4\ percentage point, bringing its level to 4\1/2\ percent. At that meeting, monetary policymakers also discussed the economic outlook for the next 2 years. The central tendency of the forecasts of Members of the Board of Governors and the presidents of Federal Reserve Banks is for real GDP to increase about 3\1/2\ percent in 2006 and 3 percent to 3\1/2\ percent in 2007. The civilian unemployment rate is expected to finish both 2006 and 2007 at a level between 4\3/4\ percent and 5 percent. Inflation, as measured by the price index for personal consumption expenditures excluding food and energy, is predicted to be about 2 percent this year and 1\3/4\ percent to 2 percent next year. While considerable uncertainty surrounds any economic forecast extending nearly 2 years, I am comfortable with these projections. In the announcement following the January 31 meeting, the Federal Reserve pointed to risks that could add to inflation pressures. Among those risks is the possibility that, to an extent greater than we now anticipate, higher energy prices may pass through into the prices of nonenergy goods and services or have a persistent effect on inflation expectations. Another factor bearing on the inflation outlook is that the economy now appears to be operating at a relatively high level of resource utilization. Gauging the economy's sustainable potential is difficult, and the Federal Reserve will keep a close eye on all the relevant evidence and be flexible in making those judgments. Nevertheless, the risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately--in the absence of countervailing monetary policy action--to further upward pressure on inflation. In these circumstances, the FOMC judged some further firming of monetary policy may be necessary, an assessment with which I concur. Not all of the risks to the economy concern inflation. For example, a number of indicators point to a slowing in the housing market. Some cooling of the housing market is to be expected and would not be inconsistent with continued solid growth of overall economic activity. However, given the substantial gains in house prices and the high levels of home construction activity over the past several years, prices and construction could decelerate more rapidly than currently seems likely. Slower growth in home equity, in turn, might lead households to boost their saving and trim their spending relative to current income by more than is now anticipated. The possibility of significant further increases in energy prices represents an additional risk to the economy; besides affecting inflation, such increases might also hurt consumer confidence and thereby reduce spending on nonenergy goods and services. Although the outlook contains significant uncertainties, it is clear that substantial progress has been made in removing monetary policy accommodation. As a consequence, in coming quarters the FOMC will have to make ongoing, provisional judgments about the risks to both inflation and growth, and monetary policy actions will be increasingly dependent on incoming data. In assessing the prospects for the economy, some appreciation of recent circumstances is essential, so let me now review key developments of 2005 and discuss their implications for the outlook. The household sector was a mainstay of the economic expansion again last year, and household spending is likely to remain an important source of growth in aggregate demand in 2006. The growth in household spending last year was supported by rising employment and moderate increases in wages. Expenditures were buoyed as well by significant gains in household wealth that reflected further increases in home values and in broad equity prices. However, sharply rising bills for gasoline and heating reduced the amount of income available for spending on other consumer goods and services. Residential investment also expanded considerably in 2005, supported by a strong real estate market. However, as I have already noted, some signs of slowing in the housing market have appeared in recent months: Home sales have softened, the inventory of unsold homes has risen, and indicators of homebuilder and homebuyer sentiment have turned down. Anecdotal information suggests that homes typically are on the market somewhat longer than they were a year or so ago, and the frequency of contract offers above asking prices reportedly has diminished. Financial market conditions seem to be consistent with some moderation in housing activity. Interest rates on 30-year, fixed-rate mortgages, which were around 5\3/4\ percent over much of 2005, rose noticeably in the final months of the year to their current level of around 6\1/4\ percent. Rates on adjustable-rate mortgages have climbed more considerably. Still, despite the recent increases, mortgage rates remain relatively low. Low mortgage rates, together with expanding payrolls and incomes and the need to rebuild after the hurricanes, should continue to support the housing market. Thus, at this point, a leveling out or a modest softening of housing activity seems more likely than a sharp contraction, although significant uncertainty attends the outlook for home prices and construction. In any case, the Federal Reserve will continue to monitor this sector closely. Overall, the financial health of households appears reasonably good. Largely reflecting the growth in home mortgages, total household debt continued to expand rapidly in 2005. But the value of household assets also continued to climb strongly, driven by gains in home prices and equity shares. To some extent, sizable increases in household wealth, as well as low interest rates, have contributed in recent years to the low level of personal saving. Saving last year was probably further depressed by the rise in households' energy bills. Over the next few years, saving relative to income is likely to rise somewhat from its recent low level. In the business sector, profits continued to rise last year at a solid pace, boosted in part by continuing advances in productivity. Strong corporate balance sheets combined with expanding sales and favorable conditions in financial markets fostered a solid increase in spending on equipment and software last year. Investment in high-tech equipment rebounded, its increase spurred by further declines in the prices of high-tech goods. Expenditures for communications equipment, which had fallen off earlier this decade, showed particular strength for the year as a whole. In contrast, nonresidential construction activity remained soft. Although the financial condition of the business sector is generally quite strong, several areas of structural weakness are evident, notably in the automobile and airline industries. Despite these problems, however, favorable conditions in the business sector as a whole should encourage continued expansion of capital investment. For the most part, the financial situation of State and local governments has improved noticeably over the past couple of years. Rising personal and business incomes have buoyed tax revenues, affording some scope for increases in State and local government expenditures. At the Federal level, the budget deficit narrowed appreciably in fiscal year 2005. Outlays rose rapidly, but receipts climbed even more sharply as the economy expanded. However, defense expenditures, hurricane relief, and increasing entitlement costs seem likely to worsen the deficit in fiscal year 2006. Outside the United States, economic activity strengthened last year, and at present global growth seems to be on a good track. The economies of our North American neighbors, Canada, and Mexico, appear to be expanding at a solid pace. Especially significant have been signs that Japan could be emerging from its protracted slump and its battle with deflation. In the euro area, expansion has been somewhat modest by global standards, but recent indicators suggest that growth could be strengthening there as well. Economies in emerging Asia generally continue to expand strongly. In particular, growth in China remained vigorous in 2005. Expanding foreign economic activity helped drive a vigorous advance in U.S. exports in 2005, while the growth of real imports slowed. Nonetheless, the nominal U.S. trade deficit increased further last year, exacerbated in part by a jump in the value of imported petroleum products that almost wholly reflected the sharply rising price of crude oil. Surging energy prices also were the dominant factor influencing U.S. inflation last year. For the second year in a row, overall consumer prices, as measured by the chain-type index for personal consumption expenditures, rose about 3 percent. Prices of consumer energy products jumped more than 20 percent, with large increases in prices of natural gas, gasoline, and fuel oil. Food prices, however, rose only modestly. And core consumer prices (that is, excluding food and energy) increased a moderate 1.9 percent. The relatively benign performance of core inflation despite the steep increases in energy prices can be attributed to several factors. Over the past few decades, the U.S. economy has become significantly less energy intensive. Also, rapid advances in productivity as well as increases in nominal wages and salaries that, on balance, have been moderate have restrained unit labor costs in recent years. Another key factor in keeping core inflation low has been confidence on the part of the public and investors in the prospects for price stability. Maintaining expectations of low and stable inflation is an essential element in the Federal Reserve's effort to promote price stability. And, thus far, the news has been good: Survey measures of longer-term inflation expectations have responded only a little to the larger fluctuations in energy prices that we have experienced, and for the most part, they were low and stable last year. Inflation compensation for the period 5 to 10 years ahead, derived from spreads between nominal and inflation-indexed Treasury securities, has remained well-anchored. Restrained inflation expectations have also been an important reason that long-term interest rates have remained relatively low. At roughly 4\1/2\ percent at year-end, yields on ten-year nominal Treasury issues increased only slightly on balance over 2005 even as short-term rates rose 2 percentage points. As previous reports and testimonies from the Federal Reserve indicated, a decomposition of long-term nominal yields into spot and forward rates suggests that it is primarily the far-forward components that account for the low level of long rates. The premiums that investors demand as compensation for the risk of unforeseen changes in real interest rates and inflation appear to have declined significantly over the past decade or so. Given the more stable macroeconomic climate in the United States and in the global economy since the mid-1980's, some decline in risk premiums is not surprising. In addition, though, investors seem to expect real interest rates to remain relatively low. Such a view is consistent with a hypothesis I offered last year--that, in recent years, an excess of desired global saving over the quantity of global investment opportunities that pay historically normal returns has forced down the real interest rate prevailing in global capital markets. Inflation prospects are important, not just because price stability is in itself desirable and part of the Federal Reserve's mandate from the Congress, but also because price stability is essential for strong and stable growth of output and employment. Stable prices promote long-term economic growth by allowing households and firms to make economic decisions and undertake productive activities with fewer concerns about large or unanticipated changes in the price level and their attendant financial consequences. Experience shows that low and stable inflation and inflation expectations are also associated with greater short-term stability in output and employment, perhaps in part because they give the central bank greater latitude to counter transitory disturbances to the economy. Similarly, the attainment of the statutory goal of moderate long-term interest rates requires price stability, because only then are the inflation premiums that investors demand for holding long-term instruments kept to a minimum. In sum, achieving price stability is not only important in itself; but it is also central to attaining the Federal Reserve's other mandated objectives of maximum sustainable employment and moderate long-term interest rates. As always, however, translating the Federal Reserve's general economic objectives into operational decisions about the stance of monetary policy poses many challenges. Over the past few decades, policymakers have learned that no single economic or financial indicator, or even a small set of such indicators, can provide reliable guidance for the setting of monetary policy. Rather, the Federal Reserve, together with all modern central banks, has found that the successful conduct of monetary policy requires painstaking examination of a broad range of economic and financial data, careful consideration of the implications of those data for the likely path of the economy and inflation, and prudent judgment regarding the effects of alternative courses of policy action on prospects for achieving our macroeconomic objectives. In that process, economic models can provide valuable guidance to policymakers, and over the years substantial progress has been made in developing formal models and forecasting techniques. But any model is by necessity a simplification of the real world, and sufficient data are seldom available to measure even the basic relationships with precision. Monetary policymakers must therefore strike a difficult balance--conducting rigorous analysis informed by sound economic theory and empirical methods while keeping an open mind about the many factors, including myriad global influences, at play in a dynamic modern economy like that of the United States. Amid significant uncertainty, we must formulate a view of the most likely course of the economy under a given policy approach while giving due weight to the potential risks and associated costs to the economy should those judgments turn out to be wrong. During the nearly 3 years that I previously spent as a Member of the Board of Governors and of the Federal Open Market Committee, the approach to policy that I have just outlined was standard operating procedure under the highly successful leadership of Chairman Greenspan. As I indicated to the Congress during my confirmation hearing, my intention is to maintain continuity with this and the other practices of the Federal Reserve in the Greenspan era. I believe that, with this approach, the Federal Reserve will continue to contribute to the sound performance of the U.S. economy in the years to come. CHRG-111shrg54789--24 Mr. Barr," We at times benefit from it and at times have costs from it, and on balance, financial innovation and risk taking are central to our system. What we are talking about here is not eliminating risk, certainly not eliminating financial innovation. Quite the contrary. I think those are central concepts. But we have to see that happen on a level playing field with high standards so that people are competing based on price and quality and not consumer confusion. Senator Shelby. The board of the consumer--the composition of the board, the proposal of the Consumer Financial Protection Agency would include the Director of the National Bank Supervisors and four members of the President's choosing. There is no limit on the number of members who are from the same political party. This contrasts, as you well know, with the limits on the composition of both the Securities and Exchange Commission and the Consumer Product Safety Commission. Why did you choose such a politically biased construct at this point knowing that would raise red flags for some? " FOMC20080430meeting--54 52,MR. SHEETS.," Much as Dave just described for the domestic economy, our forecast for economic activity abroad also is little changed from the last Greenbook. Recent data have come in consistent with our view that the slowdown in U.S. activity and the ongoing financial turbulence will leave an unmistakable imprint on economic growth abroad. But the extent of this imprint appears to be somewhat less pronounced than was the case in the high-tech-led recession earlier this decade, particularly for the emerging market economies. Thus we continue to see foreign growth stepping down from last year's 4 percent pace to near 2 percent during the second and third quarters of this year, as foreign activity is constrained by the weakening U.S. economy and headwinds from the ongoing financial turmoil. With these factors projected to abate, we see growth abroad rising back to near its trend rate of around 3� percent in 2009. Suffice it to say, the risks around this forecast remain significant. On the upside, China's surprisingly strong first-quarter GDP growth--which we estimate was nearly 11 percent at an annual rate--highlights the possibility that growth in emerging Asia, and perhaps elsewhere as well, may remain more resilient than we anticipate. On the downside, the softer-than-expected German IFO data last week and the negative tone of the Bank of England's recent credit conditions survey suggest that growth in Europe may slow more than we now project. The exchange value of the dollar, after falling sharply in the month before the March FOMC meeting, has rebounded somewhat during the intermeeting period. Against the major currencies, the dollar is up almost 2� percent, with a particularly sizable gain against the yen. Going forward, we continue to see the broad real dollar depreciating at a 3 percent pace, reflecting downward pressures associated with the large (albeit narrowing) current account deficit. This depreciation is expected to come largely against emerging market currencies (including the Chinese renminbi), which have moved less since the dollar's peak in early 2002. Turning to the U.S. external sector, we now see the arithmetic contribution from net exports to first-quarter U.S. real GDP growth as likely to be around 0.3 percentage point, down a few tenths from the last Greenbook. Recent readings on exports have continued to point to strength, but imports in February bounced back from their December and January weakness more vigorously than we had expected. For 2008 as a whole, we continue to believe that the demand for imports will be significantly restrained by the weak pace of U.S. activity and, to a lesser extent, by the depreciation of the dollar and rising prices for imported commodities. We thus see imports contracting nearly 2 percent this year. In contrast, exports are expected to post 7 percent growth this year, supported by the weaker dollar. The projected contraction of imports, coupled with still-strong export growth, suggests that net exports will contribute nearly 1� percentage points to U.S. GDP growth this year-- the largest positive contribution from net exports to annual growth in more than 25 years. In 2009, import growth is expected to bounce back to around 4 percent as the U.S. economy recovers, and the positive contribution from net exports should accordingly decline to just under � percentage point. Oil prices have continued their apparently relentless march upward, with spot WTI now trading at $115 per barrel. Since your last meeting, the spot price of WTI has increased $6 per barrel, and the far-futures price has moved up almost $5 per barrel. Over the past year, spot oil prices have risen a staggering 80 percent. While the high level of oil prices appears to be taking a bite out of oil demand in the United States and other industrial countries, the demand for oil in the emerging market economies--particularly in China and India--has been supported by the resilience of GDP growth there. In addition, fuel subsidies in some countries (including India) have sheltered consumers from the effects of higher oil prices. In line with these observations, India's state-owned oil company recently released projections indicating that oil demand in the country will increase 8 to 10 percent this year. The supply-side response to the rising demand for oil has been only tepid. Stated bluntly, OPEC remains unwilling--or unable--to increase its supply to the market. Indeed, OPEC has actually cut its production over the past two years. In addition, oil production in the OECD countries has been on a downward trajectory, primarily reflecting the decline in the North Sea fields and in Mexico's giant Cantarell field. Mexico's state-owned oil company recently indicated that, for the sixth consecutive year, additions to its reserves had failed to keep pace with production. The grim outlook for Mexico's oil industry has prompted the government to consider allowing foreign investment in the country's energy sector, a move that would require constitutional reform. Finally, although the potential supply from non-OECD nonOPEC countries is substantial, production continues to be hampered by inadequate infrastructure and by uncertainties about property rights and the stability of tax regimes. In the absence of any better approach, we continue to base our forecast on quotes from futures markets, which see oil prices as likely to remain high--at or above $110 per barrel--through the end of the forecast period. But the confidence bands around this forecast are exceptionally wide given uncertainties surrounding the outlook for oil supply and demand. Nonfuel commodity prices have also been on a wild ride of late. The prices of many of these commodities increased particularly sharply in January and February, before peaking in early March. On balance, our index of nonfuel commodity prices rose at a hefty annual rate of 50 percent during the first quarter. We project a further 13 percent rise in the second quarter, but--again in line with quotes from futures markets--we see these prices flattening out thereafter. The underlying drivers of the sustained run-up in the prices of nonfuel commodities have been broadly similar to those for oil--sharp increases in demand (particularly from emerging-market economies) coupled with typically lagging and often muted supply responses. Notably, however, moves in nonfuel commodity prices since the March FOMC meeting have been quite varied. For example, copper and aluminum prices are up whereas nickel and zinc prices are down. For foods, corn, rice, and soybean prices have risen while wheat prices have declined substantially. The overall strength of commodity prices continues to put upward pressure on inflation in many countries and to complicate life for central banks. Notably, in the euro area, 12-month headline inflation in March rose further, to 3.6 percent, well above the ECB's 2 percent ceiling. In the United Kingdom, inflation pressures stemming from rising utility, gasoline, and food prices are likely to push inflation toward 3 percent during the summer, raising the risk that Mervyn King will be required to write another letter to the Chancellor of the Exchequer explaining why inflation has deviated from the 2 percent target. Concerns about the inflation outlook have limited the willingness of both the ECB and the Bank of England to cut policy rates to address slowing growth. Perhaps even more striking, faced with upward pressures on inflation from rising food and energy prices coupled with still-solid economic growth, central banks in a broad array of emerging market economies tightened policy over the intermeeting period. This group included China, Singapore, India, Brazil, Russia, Poland, Hungary, and South Africa. In addition, some countries have recently responded to social unrest and other strains brought on by higher food prices by restricting exports of foodstuffs, particularly rice, and this has exacerbated upward pressure on the global prices of these commodities. The run-up in commodity prices, coupled with the weaker dollar, has pushed up U.S. core import price inflation of late. Core import prices are now estimated to have increased at a 7� percent annual rate in the first quarter, more than twice the pace of increase in the second half of last year. Prices of material-intensive imports (including industrial supplies and foods) are seen to have surged at a surprisingly rapid pace of 20 percent in the first quarter, on the back of the rapid rise in commodity prices. Prices of imported finished goods (including consumer goods, capital goods, and autos) are estimated to have risen at a comparatively muted rate of 3� percent, but this also was up sharply compared with recent quarters. The acceleration in finished goods prices seems well explained by recent moves in the dollar, however, and does not suggest any notable increase in the extent of exchange rate pass-through. Going forward, we see core import price inflation remaining elevated in the second quarter, at around 6 percent. Thereafter, core import price inflation should abate, given the projected flattening out of commodity prices and the slower pace of dollar depreciation. " FOMC20050322meeting--125 123,MR. GRAMLICH.," Thank you, Mr. Chairman. I think I will be the fourteenth person to explain why the balance of risks is gradually changing. A few months ago, we were still worried about supposed soft spots but at this point the expansion looks pretty solid. Housing and consumption growth remain strong. The feared pothole in business investment never materialized, which strengthens the forecast in two ways. Not only is there no pothole, but now the strength of investment last year can be attributed to underlying forces, not tax incentives, and carried forward into this year. The international economy looks pretty vigorous, especially for emerging-market countries, and actual output expansion is now being forecast even for Japan. The Blue Chip forecasts, which I use as a reflection of conditions more than as forecasts, are now being revised upward. The whole picture looks quite strong, and, if anything, the risks are tilting to the upside. Conditions will be very strong if the personal saving rate doesn’t rise. A recent bank newsletter was entitled “A Whiff of Inflation in the Air.” I actually think it is still possible not to whiff inflation, but there is no denying that the risks are changing. Oil prices have jumped up again both for the spot price and the far futures price. In contrast March 22, 2005 59 of 116 present uptick seems more likely due to international demand conditions, making the higher prices less idiosyncratic and presumably more lasting. Other commodity prices have also jumped. The dollar has fallen already, and there will be continuing fears that it will fall further, with these fears presumably lasting until our international liability ratio stabilizes—a prospect that seems more remote by the day. So far, wages and unit labor costs have been a stabilizing force but wages may become less so as output gaps tighten, and productivity growth rates could at some point stabilize or decline. There is nothing surprising or disappointing in this. If a year ago we had known that output growth would be healthy here and around the world, that output gaps were closing, that oil prices were high, that commodity prices were high, and that the dollar was falling, we all would have been quite worried about inflationary threats. In a way, over this span the anti-inflation news has been reasonably good. Pass-throughs have proved modest, and wages have been rather well behaved. Productivity has hung in there. But there is still an enhanced risk of inflation. In recent meetings, I have held out one factor that could get me to be less hawkish—the prospect of real fiscal tightening. This has become less likely, too. There has been a dispute between those who want to cut spending and extend the tax cuts and those who want to maintain spending. When not dealing with steroids in baseball and feeding tubes in Florida, the Congress seems to be working toward one of their unique compromises: Let’s extend the tax cuts and maintain spending. [Laughter] There just doesn’t seem to be much voice for and hope for real fiscal tightening. Hence, whether one is looking at output growth, inflationary pressures, or fiscal policy, the March 22, 2005 60 of 116 for 25 basis points per meeting and for keeping the “measured pace” rhetoric for a little while longer, but I am also for tightening up our rhetoric in subtle or even occasionally non-subtle ways. There has been some dispute about the normative global impact of our low national saving rate, and I would like to say a word about that. When one aggregates the low personal saving and the large budget deficit, the U.S. national saving rate is at a post-war low. How bad is that? Given what appears to be a saving glut around the world, some argue that it’s actually a good thing our national saving is low. Otherwise, world long-term interest rates would fall to very low levels. It is definitely good for world savers that our own national saving is low. That maintains their return. But I am still more worried about stimulating world investment than about the returns realized by savers. We all know that in this country the number of workers per retiree will fall from 3.3 now to 2 in about 30 years—2 is actually high by world standards. With present trends and with present policy, the same ratio will be a little more than 1 for Canada, France, Germany, Korea, Russia, and the United Kingdom, and actually less than 1 for Italy and Japan. That’s right. Those two countries are on track to have more retirees than workers. Even in most emerging-market countries, the ratio will not be much above 2. Barring the unlikely case where national social security systems are totally fully funded, the younger generations in all of these countries are going to need more capital to pay the retirement and health costs of our generation. Hence, I remain much less worried about the upward pressure that our low national saving puts on world interest rates than the downward pressure it puts on world investment. Yes, in the short run our high budget deficit and low national saving are benefiting world savers. But, no, in the long run, I don’t think they are benefiting the world. Thank you. March 22, 2005 61 of 116" FOMC20060920meeting--177 175,MR. LACKER.," After looking closely at the new data since the last meeting, I do not see a compelling reason to materially alter my assessment of policy. I still think that the fed funds rate should be 5½ percent to bring core inflation down rapidly enough. My preference is based on an assumption that we want to bring core inflation down to 1½. That is how I think things through when I come into these meetings—I have not been told to do otherwise—and, without a firmer policy path, I think that core inflation is likely to decline no more rapidly than the glacial pace of the Greenbook. I acknowledge that there are risks to real growth in the outlook and that raising rates may add to those risks. But the risks strike me as tolerably small partly because my baseline forecast stays a little further away than the Greenbook from your point-of-no-return thresholds, which I think are legitimate concerns. But since you have put that on the table and President Poole has echoed this, let me add to his statement that tolerating a rise in inflation to avoid a point of no return and recession is, I think, a grave error, and I think that the experience of the ’70s is strong evidence of that. Besides that, I think these risks can be significantly lowered to the extent that tighter policy shifts the public’s expectations regarding our future conduct. A lot of comments around the table just now have indicated that the public has substantial uncertainty about whether 1½, 2, or 2½ percent is where we are really interested in bringing inflation to. I am not as concerned about a rise in inflation right now. We have experienced increases in core inflation in response to energy price shocks, and I am concerned about the possible effects on core inflation from the next round of fluctuations in the oil market. The process is repeatable, and just like the inflation dynamics that the Greenbook staff analyzed, the response to energy price shocks is a reduced form, and it embodies what people expect about how we are going to react to those shocks. I think the major danger is that we allow core inflation to persist above 2¼ percent for a substantial time. The longer we allow that, the more likely it is that the public’s expectations will collapse around a high rate of inflation and the harder it will be to bring core inflation down to 1½ percent, if that is what we settle on wanting to do." FOMC20070509meeting--63 61,MS. PIANALTO.," Thank you, Mr. Chairman. The economy from the perspective of the Fourth District isn’t materially different from the way I heard Dave describe national conditions. Manufacturers in the District generally report modest but steady growth. In particular, metals producers and their suppliers report strong orders and production. My business contacts are telling me that capital investment is a bit soft, but it should not at this point pose a serious problem for the overall economy. I’ve had several meetings with homebuilders throughout my District in the past few weeks, and they confirmed some of the information that we see in the national data—sales are still very anemic, and the inventory of unsold homes remains quite high. They also shared some information that is not easy to pull from the national indicators. For example, sales of starter and lower-end homes are particularly slow, in part because lending standards have been significantly tightened. This means that there has been a shift in the composition of homes sold toward the upper end of the price spectrum, causing the reported sales-price data to be a little inflated. The builders I spoke with assure me that price discounts are occurring and that the discounts have been substantial. Likewise, I am told that appraisers are increasingly being asked by lenders to do whatever possible to appraise the properties relative to current market conditions and to discount price information from the historical comparables. My contacts are also saying that the expectation that home prices are going to fall further has been keeping some buyers on the sidelines for now. I also hear that, when possible, residential contractors are shifting resources to nonresidential projects. Some nationally publicly traded home construction companies are completing houses and selling them for a loss in some markets just so that they can exit those markets more quickly. What I take away from my conversations with homebuilders and lenders is that the national data may not yet fully have caught up with the poor conditions in the residential construction sector and, further, those closest to the markets are betting that any semblance of a recovery is still a long way off. This information had an influence on the economic projections that I submitted for today’s meeting. Like the Greenbook, which as a consequence of more weakness in residential construction has shaved an additional 0.5 percentage point off GDP growth in the latter half of this year, I have marked down my expectations for growth in 2007. My projection sees a little more growth relative to what I see in the Greenbook as we move into 2008 and 2009, although I do see slower economic growth as an obvious risk to my outlook. I’m especially concerned about the possibility of some spillover from the housing sector to the business investment outlook. My inflation projection calls for a slightly more optimistic trend in core PCE than what I see in the Greenbook. I had difficulty endorsing a three-year projection that doesn’t assume that our policies are going to be positioned so that we eventually bring core PCE inflation back below 2 percent, if only just below. So my inflation projection represents my interpretation of appropriate monetary policy—namely one that will bring core PCE in under 2 percent. My economic projection is, therefore, based on a federal funds rate path that is very similar to the Greenbook baseline, a constant path over the projection period; but I have assumed a slightly more optimistic price path for oil. Given Karen’s comments this morning, I am a little more comfortable with that assumption. I also have slightly more potential than the Greenbook does. So with these two assumptions, I do have a slightly lower path for inflation than the Greenbook does. Obviously, these assumptions are not made with great conviction, and inflation may continue to track just north of 2 percent. If it does, we do risk conditioning expectations to this level, and that is an outcome that I would not welcome. I had an opportunity just a few weeks ago to spend a day with Paul Volcker, who visited Cleveland. On the subject of inflation, he reminded me that in his experience big inflations start out as a tolerance of modest inflations. Once inflation expectations drag their anchor a little, it’s difficult and costly to get them re-anchored; and this, I think, remains the biggest risk that we face as a Committee. Thank you, Mr. Chairman." FOMC20080805meeting--159 157,MR. KOHN.," Thank you, Mr. Chairman. I support keeping the federal funds rate at 2 percent for now. I think that is consistent with bringing inflation down over time. I agree that we're going to have to tighten at some point. I agree with your analysis, Mr. Chairman--I don't think we have a highly accommodative policy right now. Not only would I cite the interest rates that you cited, but I would cite the behavior of households and businesses, which aren't acting as if they're looking at very low real interest rates by making purchases of durable goods, capital equipment, et cetera. The cost of capital is not perceived to be low right now, and I think it's for the reasons you cited. In my view, over the intermeeting period the inflation risks have narrowed just a bit. The damper on inflation risk comes from the decline in oil and commodity prices, the steadiness of the dollar, and my perception that we can count on a more negative output gap going forward, which will provide some discipline on prices and wages. This is a difficult situation. There are no ideal outcomes when you have this change in relative prices. We will have to live with higher inflation and higher unemployment temporarily. We have to keep our eye on the second-round effects, not just the pass-throughs but the spillovers, and I think so far so good. That's a tenuous situation, I agree, but my read of the incoming information is that we can be a little more patient than we thought we could be six or seven weeks ago. As for the wording of the statement, I could live with President Yellen's rewording, but I think that this language Brian suggested is okay as well. I'm actually not sure how the markets will react to this. Some of the commentary I read over the last couple of weeks thought that we were tilted toward inflation last time because of the way we worded things. I don't think that the market reaction will be large to this, and I agree that the first choice would be not to change market expectations substantially. I think they're aligned pretty well right now, but I think the reactions will be small, and I can live with the alternative B wording. Thank you, Mr. Chairman. " FOMC20060920meeting--129 127,MR. HOENIG.," Mr. Chairman, I’d characterize the Tenth District’s economy as quite healthy right now. As you know, the Tenth District has benefited perhaps disproportionately from the rise in energy prices over the past few years, and this is providing considerable stimulus to the local and state economies in the District. We are also seeing strong manufacturing activity driven by exports of District products. Although the housing markets across the District can be characterized as soft, we have no reports of serious declines in prices anywhere in the region. Retail sales, excluding autos, also are holding up pretty well for us. The other soft spot for us is agriculture, and that is tied pretty much to the drought that we continue to experience. Regarding the national economy, the economic information received since the last meeting confirms a further slowing of economic activity this quarter. Moreover, weakness in housing and auto production suggests that the fourth quarter could be a little bit weaker as well. At the same time, we have recently experienced the sizable and largely unexpected declines in energy prices that we have talked about here, which, if maintained, could provide some stimulus over the balance of the year to offset some of that weaker information. Currently, I expect growth to slow to a range of 2 percent to 2½ percent in the second half of the year and to rebound to above 2½ percent or to 3 percent next year. Generally speaking, I am more optimistic than the Greenbook, especially with regard to housing and consumer spending, and I’m not nearly as pessimistic as the Greenbook on potential output. As to housing, we are in fact, as all have noted, squeezing out of that sector the speculative excesses that developed with the low interest rates of recent years—and doing so is unavoidable if we want to correct the sector. The adjustment process has obviously been painful for some, and it has not yet run its course. However, we perhaps see ourselves getting a little closer to the bottom than we might think right now, and that’s related to the fact that credit remains available at reasonable rates for most homebuyers, as suggested by the recent information on mortgage applications. So, yes, it is painful, and yes, we are going through it; but I don’t think it is necessarily long lasting in terms of the consumer’s position. For the consumer more generally, the situation is obviously mixed. On the one hand, consumption will likely receive less stimulus going forward from the withdrawal of home equity, and with slower house-price appreciation, wealth effects will likely be lower as well. On the other hand, higher labor compensation and lower energy bills should provide support to the consumer in terms of confidence and the ability to spend. Overall, I continue to believe that there are somewhat more downside risks than upside risks to the outlook over the next quarters, but I think we are moving in a fairly consistent way as far as GDP growth goes. Finally, let me provide my perspective on the inflation outlook. My overall views on inflation have not changed materially since the last meeting. I continue to expect core PCE inflation to moderate from about 2.3 percent this year to 2.1 percent next year on the course we have right now. The big negative on inflation, of course, is the higher trajectory for labor costs, which has been mentioned. Although the recent revisions to compensation are perhaps somewhat unsettling, such concerns are partly offset by the recent more-favorable monthly inflation numbers and by the significant fall in the prices of oil, gasoline, and natural gas in recent weeks. Although the recent inflation data have not caused me to alter my inflation outlook, I am in one sense more confident in the forecast of moderation than I was a month ago or so. On balance, as we look at all this, I agree that we still have some upside risks to inflation that we have to remain aware of as we look to the policy discussion ahead. Thank you." FOMC20061025meeting--160 158,MR. KOHN.," Thank you, Mr. Chairman. I support keeping rates unchanged and alternative B. I think that rate, at least for now, seems consistent with growth of the economy just a tad below the growth of its potential and a gradual decline in inflation. Incoming data will tell us if we’re wrong on that, but right now that looks like our best bet to accomplish the objectives I think the Committee ought to be accomplishing. I agree that the pace and the extent of disinflation are great uncertainties here. President Poole has made a valuable contribution here about the loss function relative to the policy path. A failure to reverse the earlier increase in inflation is the main risk to good economic performance that we face. Therefore, we need to see a downward path of inflation. I think our minutes and our speeches have made it pretty clear that that’s what the Committee means by inflation risks remaining. I think the public understands that. President Poole has made a valuable distinction between the loss function and the economic outlook and what that implies for interest rates, but I don’t agree with his conclusion. After all, the Greenbook forecast has essentially a flat federal funds rate and a very, very gradual decline in inflation barely along the path that most Committee members could tolerate. If our loss function is asymmetrical relative to that, it’s more likely that interest rates would have to rise than to fall relative to the Greenbook path. Moreover, many members of the Committee seem to have a stronger path for output, and maybe even inflation going forward, than is embedded in the Greenbook. So the wording about additional firming that may be needed, the asymmetrical wording of a risk assessment, is the appropriate representation of how this Committee is looking at the potential future path of interest rates given both the loss function and the Committee’s outlook for growth and inflation. I do have some comments on the language. In section 2, I like the addition of the forward-looking language and, unlike President Fisher, the use of “moderate.” It seems to me that the word “moderate” is fairly ambiguous, but it does suggest that we don’t expect a great deal of weakness going forward or a great deal of strength. I think that’s about where the Committee is—growth close to, maybe a bit below, the growth of potential, and the word “moderate” conveys the sense that the Committee wasn’t looking for something really weak or something really strong going forward. So I think that was a valuable addition. Like you, President Fisher, I did wonder about the specific reference to the third quarter and how that would play out. Governor Kroszner actually brought this to my attention on Friday. The advantage of the reference to the third quarter is that, by our acknowledging a weak third quarter, the markets might not react as strongly to a print that begins with the number 1 as they would if we didn’t acknowledge that. There are also a couple of disadvantages. The third quarter could come in much closer to 2½ percent. There are a lot of assumptions built into that number. We could be wrong. But even more important, from my perspective, an awful lot of the weakness in the third quarter is in net exports and inventory change. The underlying feel to the third quarter and final demand aren’t really all that different from the second quarter. So emphasizing the weakness in the third quarter in our language may not give a good sense of what we think the underlying situation was. Alternative language might be a more general sentence saying that “economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market.” That more general sentence about “over the course of the year” probably reflects better where the Committee is. I could live with the third-quarter language that’s in there now, but I would have a slight preference for the other one. In section 3, I actually have a slight preference for the wording under alternative A. I’ve always been a little uncomfortable with relating the outlook for inflation to the level of energy prices. The last major increase in energy prices was last spring, and I think they’ve been kind of level since April or May and actually have come down. Some of the commentary after our last announcement pointed out the contradiction in which we have energy prices both pushing up inflation and pulling it down in the future. So my slight preference, again, would be for the wording of alternative A, which says that the high level of resource utilization has the potential to sustain pressures. It doesn’t reference the high level of prices of energy and other commodities. In section 4, the risk assessment, looking at the language that Vincent put on the table yesterday, I think the first sentence of that does a better job of enunciating what the Committee has been thinking about—that the reduction of inflation is what we’re looking at. But I’m hesitant to change the risk assessment language. I think that people do understand what we mean by our risk assessment language now. I am concerned that changing it would provoke a reaction, and I’m not confident that I know what the reaction would be. So my preference, again, is to stick with the current risk assessment language that’s in alternative B. Thank you, Mr. Chairman." FOMC20050630meeting--380 378,MR. OLSON.," Thank you, Mr. Chairman. As Susan indicated, I, too, looked at the mortgage market in anticipation of the theme of our discussions yesterday. But I also had a concern about the extent to which the mortgage market might be creating froth in the market. I interviewed several of the largest mortgage originators. I talked to contacts at banks, nonbanks, and one of the large subprime lenders and asked them to approach the question from the same perspective. That is, I asked them: What are you finding that is new or different in your market? What attracts your eye because it’s new, and where do you see the risks embedded in the nature of the mortgage market today? This does not address the question that President Guynn raised about the risks associated with the activities of contractors or real estate developers, which is a separate and very significant risk. It may get at the question that President Yellen asked as to where the ultimate source of the stupidity is in the market—not whether or not there is stupidity in the market. In conclusion, mortgage terms are indeed becoming more flexible and less restrictive, creating certain defined risk exposures. While each of the risk exposures appears to be both June 29-30, 2005 152 of 234 due to the layering of the exposures. It’s the layering that really causes the risk. And, in part, it means that the most significant body of the risk exposures is in identifiable markets and lenders. There is a lack of consensus as to how the relaxation of credit standards will impact safety and soundness. To date, loan delinquencies have remained modest, both within and outside of the banking industry. However, the undiminished appetite, particularly for the nonconforming mortgage product, has allowed for the flexibility to continue. And there is no slowing in sight, despite all the warnings that we have heard and indications in some markets that there has been a leveling, and even a decline, in some property values. While that environment is clearly likely to produce unrecognized risk somewhere in the financial system, it seems unlikely that that risk will be in any of the portfolio lenders, including the bank lenders, to any significant extent, because of the avaricious nature of the MBS [mortgage­ backed securities] market. The risks, as Susan and others have mentioned, are pretty obvious. The IO loans, now for terms of up to 10 years, may account for 50 percent of total loans in some markets. So there’s a greater risk of negative amortizations. Also becoming more popular is what is known as the alt-A mortgage product, which makes loans based on stated incomes and stated assets, and carries a higher interest rate in exchange for fewer verifications of the income and asset figures provided by the borrower. Let me give you an example of how the layering that causes the risk can work. Let’s take as an example a loan in a high-end market such as California. The mortgage sought by the borrower would exceed the maximum of Fannie or Freddie, automatically making it a nonconforming loan and automatically removing the risk parameters that are embedded in the conforming product. Because it is nonconforming, it opens the opportunity for the Alt-A product, which means that it June 29-30, 2005 153 of 234 associated with that instrument does not seem to be captured in what the secondary market is looking for. So the secondary market will buy it. The originator of the loan is able to meet the competition and rid itself of that risk. That said, there are some identifiable risks that are clearly being managed. According to some lenders, about 20 to 25 markets bear careful watching, and lenders have started to exercise restraint in those markets. Most of the markets were mentioned yesterday, but obviously they include places like Florida and Las Vegas. There is also an ability to look at investor properties and subdivide that category into three groups. One of them is the typical purchaser of a vacation home; Jack Guynn is buying in the Blue Ridge Mountains, for example. Or, as Susan mentioned, another good example is the investor who is concerned about the equity markets and wants to move into residential real estate. So that isolates those in the third group—the most high-risk borrowers. They are the ones who want to get by with the greatest amount of leverage. That is the borrower who is simply looking to take immediate short-term advantage of any increase in value. And that is a buyer those careful mortgage lenders can address with more specificity. A great deal of uncertainty, frankly, surrounds the interest rate risk exposure, because there have been very few adverse interest rate periods in recent years and the industry experience is limited. But the availability and proliferation of FICO scores means that interest-only and high loan-to-value mortgages are given only to those within certain FICO bands, where the lender has the greatest confidence in the borrower’s repayment capability, which is based on the historical experience of that borrower in terms of his or her debt repayment record. To date, foreclosures have been limited and minimal at banks and bank mortgage June 29-30, 2005 154 of 234 secondary market. One lender told me that they are using the secondary market first of all for their conforming products; second, for their nonconforming products; third, for their HELOCs; and fourth, for loans on first delinquency. And for the latter, this lender is selling them at only a 2 or 3 percent reduction to book. So that loan is going off the books, and in some instances, they are even selling the residual in the secondary market. So there are five different channels through which this lender is able to use the secondary market. It sounded to me very similar to what the 1960s New York Yankees were doing with the old Kansas City A’s under Charlie O. Finley—using them to improve asset quality. [Laughter] They were unloading high-risk properties, and doing so without any expectation of compensation from the counterparty. And they were doing it annually. So it’s much the same thing that is happening now. As for the secondary market, why is that market so avaricious? I’d cite a number of reasons. There are many new investors, including the hedge funds, with minimal experience in dealing with market uncertainties. There are many new products; 50 percent of the mortgage-backed products are either alt-A or nonprime. That’s the flow, as we discussed yesterday. There is evidence of a lack of secondary market discretion, including the ability to price for risk; the risk premium simply does not reflect the risk embedded in that product. There have been some indications that the secondary market is starting to tighten its standards, one of which Susan mentioned, which is the new guidelines from Standard and Poor’s. The other is the beginning of some change, particularly in the AAA tranche, where a slight price increase recently was passed on. In summary, the activity in the mortgage market shows no signs of abating. The risk exposures remain, and the risk exposures seem most likely to be in the MBS market. The place to look for the first evidence of weakness would be in the first-loss position, wherever that first-loss June 29-30, 2005 155 of 234 and disseminator of risk or if those in that market will be the last to recognize the risk that’s embedded in what they’re doing and know how to price it. Mr. Chairman, I did not address the statement today because I see no need to adjust our “measured pace” language or to make any other significant adjustment to our statement at this meeting. Thank you." FOMC20080430meeting--190 188,MS. PIANALTO.," Thank you, Mr. Chairman. My concerns about the real economy are similar to those that I had in March. I continue to believe that residential real estate markets could deteriorate even further than what I have in my baseline projection and could exert even greater downward pressure on business activity. Financial markets in my view are still fragile, and larger or more-widespread liquidity pressures could quickly present us with an even weaker set of economic fundamentals. At the same time, I can't easily dismiss the ongoing escalation of energy and commodity prices. Although many of us, as we talked about yesterday, have expected these price pressures to abate for some time, they have not; and as I indicated yesterday, I do believe there is a risk that core inflation will not follow the downward path that I submitted as my projection for this meeting. So like others, I can see a case being made for alternative C. However, I think a modest reduction to our policy rate today as a precaution against further slippage in the real economy is prudent. But I also strongly support the language that indicates we're very close to, if not at, a pausing point in our easing cycle. So I support the policy recommendation and the language in alternative B. Thank you. " FOMC20071031meeting--10 8,MR. STOCKTON.," Thank you, Mr. Chairman. From a forecast perspective, it’s been a pretty wild ride over the intermeeting period, with our outlook for activity shifting sharply at various points in the process in response to large swings in the stock market, the exchange value of the dollar, and the price of crude oil. A couple of weeks ago, with the incoming data stronger, the stock market up substantially, and the dollar down noticeably, we were looking at a forecast that had economic growth moving materially above potential later in the projection period. It appeared that, after taking you for a tour of the sausage factory in my September briefing, I would need to issue a recall of that last batch of sausages even before the arrival of their typically short expiration date. In the event, the stock market retraced most of its earlier increase, and some of the improvement in financial conditions that had occurred immediately following the September meeting was subsequently reversed. As a consequence, our forecast changed relatively little, on net, over the past six weeks. The growth of real activity is higher in the near term, but in 2008 and 2009, the stimulative effects on GDP growth of the lower dollar are offset by the restraint on incomes and spending imposed by the higher path for oil prices. We expect the growth of real GDP to slow from a 2¼ percent pace this year to a 1¾ percent pace in 2008 before edging back up to a 2¼ percent rate in 2009. The period of below-trend growth late this year and next year results in some easing of pressures on resource utilization, and core inflation moves roughly sideways at just under 2 percent over the forecast period. To my mind, recent developments raise three big questions about our forecast. First, does the broad-based strength that we have seen in the data on spending and activity over the intermeeting period suggest that we have overestimated the restraining effects on aggregate demand emanating from the recent financial turbulence? Second, is the staff missing signs of greater restraint on aggregate demand that will weigh more heavily on activity in the period ahead? Finally, with oil prices up sharply, the dollar having depreciated, and resource utilization a touch tighter, why is our forecast for core inflation about unchanged? Let me start with the question about whether the strength in the incoming data casts doubt on our estimates of the restraining effects of financial turbulence. There can be little denying that, almost across the board, the readings on economic activity have been stronger than our expectations in September. In terms of domestic spending, the largest upside surprises have been in consumer spending, and much of the upward revision reflects data on activity after the financial turbulence had already begun. Overall consumer spending was stronger than we had expected in August, and the available information on retail sales and on sales of motor vehicles suggests that real PCE exceeded our expectations for September as well. At this point, we know very little about October. Chain store sales have softened somewhat but only by enough to make us comfortable with the meager monthly gains in spending that we are projecting for the fourth quarter. Our discussions with the automakers suggest that sales this month have remained reasonably steady. All told, third-quarter growth in consumption looks stronger than we had expected, and spending appears to be headed into the fourth quarter with a bit more momentum. In the business sector, stronger purchases of motor vehicles led us to raise our forecast of equipment spending in the third quarter. The other components of E&S came in close to our expectations, though last week’s data on orders and shipments of capital goods, which we received after the Greenbook was completed, were also a bit stronger than we had anticipated. The incoming data on construction put in place are consistent with our projected sharp slowdown in the growth of nonresidential structures after a surge in the second quarter. But even here, the data have outflanked us to the upside, with surprising strength in commercial construction, factory buildings, and telecommunications structures. Taken together, stronger consumption and investment account for only about half of the upward revision that we made to real GDP growth in the third and fourth quarters. The external sector accounts for the other half. In particular, continuing a pattern we have seen during much of this year, the growth of exports once again exceeded our expectations. We estimate that real exports increased at an annual rate of nearly 17 percent in the third quarter, about 3½ percentage points above our September forecast, and we have marked up export growth in the current quarter as well. The greater strength in both foreign and domestic demand led us to revise up the growth of real GDP in the second half of this year about ½ percentage point, with annualized growth rates of 3¼ percent and 1½ percent in the third and fourth quarters, respectively. So, do these fairly broad-based upward surprises in spending and activity suggest that we overreacted in the extent to which we marked down our projection in response to the recent difficulties in financial markets? It certainly seems a legitimate possibility. However, we think it would be premature to make that call. As Bill noted, financial market conditions have improved somewhat over the intermeeting period but remain far from normal. In terms of credit provision, the Senior Loan Officer Opinion Survey revealed a sharp jump in the fraction of banks reporting tighter terms and standards on loans to businesses and households, a development consistent with the restraint on spending that we have built into our forecast. Consumer sentiment remains depressed relative to overall economic conditions, perhaps because of worries about financial developments. For now, although we have slightly trimmed the magnitude of the turmoil effects on aggregate demand, the more important adjustment in this forecast has been to push more of the restraint into next year. At the other end of the spectrum of worry is the second question that I posed earlier: Have we missed some significant signs of potential economic weakness in the developments of the intermeeting period? Financial market participants seem to have reacted to the news of the past six weeks by marking down the expected path for the fed funds rate, whereas our forecast and policy assumptions are nearly unchanged. Is it possible that we are missing signs of an impending downturn in aggregate activity? Of course, the prudent and accurate answer to that question is always “yes.” But if that turns out to be the case, it won’t be for lack of attention. At present, it is difficult to find evidence in high-frequency indicators that the economy is in the process of turning down. Initial claims for unemployment insurance have remained relatively low, motor vehicle sales are reported to have been well maintained at least through mid-October, commodity prices are firm, reports from purchasing managers continue to suggest modest expansion, and few anecdotes outside the housing sector sound as though we’ve moved past a tipping point. If we are missing something important, it seems more likely to me that we could be facing a more-grinding period of subpar economic performance associated with a deeper and more-protracted adjustment in the housing sector. It might seem a bit surprising to point to housing as a major downside risk when this has been one aspect of our forecast that was right on the mark over the intermeeting period; we had expected steep declines in sales and starts, and that is what we got. But I would counsel you not to take too much comfort from that observation. In our forecast, we expect sales and starts of new single- family homes to decline another 8 percent before bottoming out around the turn of the year. The projected configuration of starts and sales is consistent with a dropback in the months’ supply of unsold new homes from an estimated peak of 8½ months early next year to 4½ months by the end of 2009. Residential investment continues to fall through the middle of next year and only edges up thereafter. But it is not difficult to envision a more painful period of adjustment. We know a huge inventory imbalance still exists in the housing sector. If, in response to that imbalance, house prices register steeper declines than the ones we are forecasting, prospective purchasers could experience an even greater fear of buying into a declining market, reinforcing the housing sector’s drag on aggregate activity. Moreover, sharply lower prices could have more-serious implications for the ability of households to refinance existing mortgages and could impair the performance of mortgage markets more broadly. Those strains, as they have in recent months, could spill over into other areas of the financial markets. As we showed in a couple of alternative simulations in the Greenbook, a steeper decline in house prices and construction activity could result in a path for the fed funds rate that does not differ materially from the one that appears to be currently built into market expectations. We remain comfortable with our baseline projection for housing, but it is still easier to see sizable downside risks than sizable upside risks to this aspect of our forecast, and that suggests to me that our modal forecast of GDP still has more weight to the downside than the upside. That said, given the strength over the intermeeting period of the incoming data outside housing, that downward skew is probably less pronounced in this forecast than in the one we presented in September. Turning to the price projection, the question I posed at the outset was why our forecast of core price inflation is largely unchanged given higher oil prices, a lower dollar and tighter resource utilization. With respect to resource utilization, both the GDP gap and the unemployment rate suggest only slightly tighter product and labor markets than in our previous forecast, and given the flatness of our aggregate supply curve, the effect on prices over this period is negligible. As for the lower dollar, we see higher import price inflation in the near term in line with the recent depreciation, but these effects quickly play through. More broadly, the available evidence continues to suggest that exchange rate pass-through to import prices is quite low, which in turn mutes the effects on broader prices. The indirect consequences of higher oil prices are a bit more consequential, and all else being equal, would have added about a tenth to our core price projection in 2008. But not all else was equal. The incoming data on core PCE prices were again slightly more favorable than we had expected. The surprise in this intermeeting period was largely in nonmarket prices. More broadly, the deceleration that we have observed in core PCE prices over the past year has been greater than can be explained by our models, and we have carried a bit larger negative residual forward in this forecast. As a consequence, we expect core PCE price inflation to move sideways at a 1.9 percent pace in 2008 and 2009, unchanged from our previous forecast. Overall price inflation is projected to move down from 3 percent this year to 1.8 percent in 2008 and 1.7 percent in 2009. The deceleration in overall prices reflects some decline, on net, in energy prices over the next two years and a dropback in food price inflation to a rate closer to that of core consumer prices. On the whole, I’d characterize the risks around our inflation forecast as roughly balanced. Nathan will continue our presentation." FOMC20050630meeting--191 189,MR. LACKER.," Yes. I have just a couple of comments and a question. Clearly, there are some perspectives from which housing prices seem to have drifted out of the usual relationship with indicators of fundamentals, and Joshua documented some of them. But it seems to me as if there are a lot of plausible stories one can tell about fundamentals that would explain or rationalize housing prices. Obviously, low interest rates have to top the list. Strong income growth among homeowning populations would be on the list, as would land use restrictions, which were mentioned earlier, and the recent surge in spending on home improvement. I found President Yellen’s suggestions intriguing. I’d like to offer my own, just in the spirit of adding potential explanations here. And it’s really a version of something Governor Kohn observed, which is that housing prices are relative prices. I’ve been struck by the fact that a collection of large metropolitan areas increasingly dominates the national housing figures and that house-price appreciation seems different across various urban regions. It suggests to me that housing values may be affected significantly by—I don’t know exactly how to phrase this—sort of the relative microeconomic value of agglomeration. By that I mean the value of the amenities in a city or the enhanced productivity associated with living in or near where one works. Now, in this age of telecommuting and the Internet, it’s easy to deduce that the value of living in a city has declined. But it seems plausible to me that the value of a thick labor market might be increasingly important for certain skill specialties. And it also seems June 29-30, 2005 63 of 234 urban cores. So I’d be interested if any of our housing data experts have any information relevant to that issue. While I have the floor, I’d like to make just an observation. It seems to me likely that a confluence of several fundamental factors might rationalize the current level of housing prices. So from that point of view, it’s hard for me to see how it would be reasonable to place a great deal of certainty on the notion that housing is significantly overvalued, or that there’s a bubble, or that it’s going to collapse really soon. I think these markets—this is echoing President Poole’s discussion—are too complex. I think our quantitative understanding of them is too limited to warrant second-guessing market forces. And beyond that, the models that we have of bubbles—Glenn wrote it down—are just some statistical noise added to an equation. I don’t think we have any models that give us any reason to hope that we can understand how interest rate changes would affect this little random statistical term added on to these equations. Having said that, housing prices pose a dilemma for us and are going to pose challenges for us soon, I think. Rapid appreciations in asset prices can make monetary policy more difficult. They tend to be associated with tightening labor markets. At the same time, there is a rise in the downside risk. So, even though I’m not very far down Glenn’s decision tree, these are still issues I’m paying attention to. It feels as if it could well occupy our attention here. But I’d be interested in your reaction to this agglomeration story." FOMC20071031meeting--81 79,MR. KROSZNER.," Thank you very much. I very much agree with Dave’s characterization of the Greenbook as a modal forecast, and I think it is an excellent and perfectly reasonable modal forecast. As almost all of us have said, the data are coming in a little stronger. We will have a fair amount of momentum going into the fourth quarter. We will have a significant drag from housing in ’08. The financial markets outside of housing have generally had fairly significant improvement, although a lot of brittleness remains. A very clear example of that is how the markets seemed to flatten out in the past week or so and certain markets backed up a bit, and thus the risk spreads are widening. It is also interesting to note that, when the first earnings reports that were fairly negative were coming out, there was a positive market reaction because it was sort of a relief that they were owning up to the challenges. Now that more information is coming out, some of which is more negative than had been expected, the market’s reactions have been more negative, and some of the risk spreads have been widening. That suggests that a lot of concern is still out there, and a lot of people are waiting for the other shoe to drop. I will note that I am sure that other shoe will have been manufactured in Richmond. [Laughter] Since this was a modal forecast, I want to think about a downside scenario, one on which I put a reasonable amount of probability mass and one that I think we should seriously consider. A number of people have talked about bank balance sheets. Generally, there has been less concern about them than before. One of the big issues that we had focused on earlier was leveraged lending. That seems to be working itself out reasonably well without much incident. There is obviously a lower new flow on, but the new flow does have covenants, et cetera. So that seems to be working out reasonably. ABCP, SIVs, conduits—there is still uncertainty about how much may come onto the balance sheets, although there is a lot more comfort with the extent of the call on the capital that is there, but there is still uncertainty as to how much might be called. You know, the SIVs seem to be working themselves down. They are shrinking through orderly asset sales. But, of course, what are they doing? They are selling the best assets first, so the potential challenges are still left behind. For the banks, the conforming mortgages are easy to get off the balance sheets. There seems to be a debate about whether banks are choosing not to get nonconforming ones off the balance sheet or whether they can’t get them off the balance sheet. Many organizations that have a lot of capital seem to be just originating these wholly on the balance sheet and waiting for better pricing, as we have heard reports from other institutions saying that they are ready, willing, and able to buy at a good price and the supply just isn’t there. Nonetheless, there is still much more carefulness in the underwriting of those loans. Obviously, the jumbo mortgages, the nonconforming mortgages, are more important than they used to be because housing prices have run up so much around the country: $417,000 doesn’t buy you as much house anymore, even in parts of the country that don’t have or traditionally have not had particularly high housing prices. That raises a concern about a squeeze through the mortgage markets. So I see that the consequence of the financial turbulence is primarily highlighting issues in the mortgage markets, as a number of people have said. Also, as I think the Greenbook and Bluebook pointed out, it is not a problem for highly rated or even just moderately well rated corporations to get funding. That is not a challenge right now. It seems mainly to be coming through the housing market. So I see a potential for a slow-burn scenario coming and for the housing market to slowly play itself out because we are going to have continuing negative shocks. More than 400,000 resets are going to be coming every quarter, starting with this quarter, through 2008. As a number of people have noted, we have much higher credit standards than before. Many of the people who were supplying subprime loans no longer exist, and those who are supplying them are supplying them at much, much higher standards. We will be proposing and putting out new rules. The Congress is considering new rules. This is all casting a pall over people who might potentially be supplying credit into some of these markets. The delinquencies and foreclosures are clearly going to continue rising at least for a few quarters, probably—as analysis by some people at the Board suggests—peaking in mid-2008. But there is still a lot of uncertainty with respect to that. So it is going to continue to put more and more challenges in this market. All of these things coming together could put a lot more pressure on housing prices. I think we have been seeing some significant declines in housing construction, but I see a potential for a reasonable likelihood of a much larger negative house-price effect than what the Greenbook has. As a shred of evidence for that, the incredibly illiquid Case-Shiller index that is traded on the Mercantile Exchange, if you look forward, for a number of markets they have a cumulative decline of 20 percent over a couple of years. Now, the number of players may be no more than the number of fingers that I have, but still it is a piece of data suggesting that it could be lower. The anecdotal reports are that real housing prices are much lower than the indexes are indicating. Certainly, in the new market, they are throwing in a lot of extras, add-ons, et cetera, and the inventory may actually be larger because the anecdotal reports are that a lot of people are taking their houses off the market, so they are not formally included in the enormous inventories that are out there but may well be potentially there for supply. So what does this suggest going forward? Well, from a risk-management perspective, we ought to be thinking about buying insurance against this downside scenario. What is the cost of insurance? Inflation and inflation expectations. As most people have mentioned, we have seen some gradual slowing and expectations are still being contained but, as Governor Kohn pointed out, there is a bit of an uptick in the CPI, which is definitely worrisome. But what is the risk? Well, let us think about the upside risk. I go back to 1998, when the FOMC cut 75 basis points. Growth was 4.5 percent in 1998 and 4.7 percent in 1999. As I mentioned last time, we saw very little increase in inflation—actually a decline in core inflation. I looked at the core PCE in addition to the core CPI that I reported last time, and that was effectively flat at 1.4, 1.6 percent in ’98 and ’99 and then 1.6 percent again in 2000. The potential benefit of buying a little insurance now is that, given that a lot of these challenges may be peaking in mid-2008, it may have some effect down the line. It provides perhaps a bit more insurance against some of the negative shocks that we may be hearing about. If those other shoes do drop over the next few months, then we have a lower downside risk for broader financial turbulence. Also, by mid- 2008, if the scenario that I am describing or the other negative scenarios that people have described, aren’t materializing, we can take back some of these moves. Thank you." FOMC20050920meeting--84 82,MS. YELLEN.," Thank you, Mr. Chairman. It goes without saying that the devastation September 20, 2005 51 of 117 economic effects, we’re paying special attention to energy and international trade. So far, at least, the effects on the Twelfth District economy appear to have been muted. Since the end of August, retail gasoline prices are up about 30 cents per gallon on the West Coast, less than elsewhere in the nation. There was some early concern that Gulf Port cargo would be diverted to the West Coast, creating bottlenecks or significantly increasing shipping costs, but these concerns have largely dissipated. Our contacts remain fairly optimistic about the prospects for the regional economy but are very concerned about the future path of energy prices, especially since Hurricane Katrina. Even before the hurricane, they were worried that higher gasoline prices and impending increases in home heating expenses would curb consumer demand. Indeed, PG&E, the public utility for northern California, just announced that rising natural gas prices could drive home heating costs in the area up by as much as 40 percent this winter. Discount retailers in the District expect these increases to put a dent in holiday spending. In addition, higher fuel prices already have trickled into prices for building materials, and contacts expect post-hurricane rebuilding efforts to boost those prices further and lengthen queues on some orders. Turning to the national economy, I share the Greenbook’s assessment of the near-term impact of Hurricane Katrina on economic growth. Pre-Katrina, the outlook was for very strong growth in the second half of 2005. It now seems likely that second-half growth will be substantially reduced due to the disruptions to production in the Gulf region and the negative impact of the run-up in energy prices on consumer spending. Of course, over this time frame September 20, 2005 52 of 117 While the proposed policy statement associated with alternative B acknowledges increased uncertainty about economic performance in the near term, I believe that the uncertainties associated with the medium-term outlook have also risen substantially, and risks now exist that in my view pose a clear and persistent threat. On the upside, rebuilding commitments are escalating by the day. The recovery and bounceback fueled by massive fiscal stimulus could more than make up for the slowdown this winter, propelling the economy on an unsustainable upward trajectory similar to the optimistic scenario laid out in the Greenbook. But downside risks to growth also loom. Rebuilding schedules could easily slip. Moreover, the pace of restarting closed oil and natural gas platforms and rigs in the Gulf of Mexico has leveled off, and the prognosis for restarting the remaining closed facilities as well as refineries and natural gas treatment plants remains in question. If disruptions persist or further shocks to supply occur, the economy could develop more along the lines of the pessimistic scenario in the Greenbook. Moreover, we may not yet have seen the full brunt on spending of the pre-Katrina energy price increases. It’s sobering to note that in the postwar period, the U.S. economy has rarely escaped such severe run-ups in oil prices without suffering a significant downturn. Turning to inflation, I was quite concerned at our August meeting by the elevated rate of core PCE inflation, which was skirting the top of my comfort zone. Since that meeting, I’ve become more confident that core inflation remains well contained. Recent data on core price inflation have been encouraging. Core PCE prices have risen at a 1½ percent rate over the six months through July, right in the middle of my preferred range, and core CPI inflation has also September 20, 2005 53 of 117 index and from the household survey, a series that our research staff has recently started compiling and tracking. These remain remarkably subdued. The elevated rate of growth in compensation per hour from the productivity and cost report over the past year far exceeds the readings provided by these other series and may be more an outlier than a strong signal of tight labor markets and wage pressures. While my comfort level with respect to core inflation has improved since August, the Board’s staff has raised the Greenbook forecast of core PCE price inflation in 2006 by 0.2 of a percentage point to 2.3 percent due to the run-up in energy prices since the August meeting. I must say that I actually found the low-inflation alternative simulation in the Greenbook more compelling. This scenario assumes that inflation expectations remain well anchored, and it shows core inflation falling over the next two years, reaching 1½ percent in 2007. On that point, the relative stability of longer-term break-even inflation rates derived from the TIPS market this year, even as oil prices surged, provides evidence that the public remains confident in the Committee’s commitment to price stability. Of course, the jump in inflation expectations seen in this month’s preliminary Michigan survey was worrisome, but we must be cautious not to read too much into that report since it was taken so soon after Katrina. To assess the likely pass-through of energy into core consumer inflation, our staff has estimated Phillips curve type forecasting models akin to those employed at the Board. An important finding emerges. Changes in real oil prices did have an economically and statistically significant effect on core inflation, but only up to the early 1980s. Importantly for the current situation, they find no evidence of such a relationship in the data since the early ’80s. The September 20, 2005 54 of 117 inflation expectations. During the 1970s, they became unmoored from price stability but now appear to be well anchored, as in the Greenbook’s low inflation scenario. With respect to policy, I support a 25 basis point rate increase rather than a pause today. A pause at this meeting justified by a need to further assess Katrina’s impact would be sensible if we actually expected to know a lot more about the medium-term outlook by November, but that’s unlikely to be the case. A pause could counterproductively mislead market participants about the likely future path of policy or create the misimpression that the Fed is unduly pessimistic about the outlook. So I consider it wiser to stick with our “measured pace” approach for now. I think it’s well justified by the Greenbook forecast, uncertain as it is, and consistent with market expectations. But going forward, we obviously need to be flexible and adjust our views about where we’re ultimately heading on the basis of new data and forecasts." FinancialCrisisInquiry--99 BLANKFEIN: I don’t think we should rely on—I think that was lucky. And I think the amount of attention and time that people—regulators, the industry, legislators—are focused on making sure that the instrumentality and the pipes of clearing derivatives are in place is highly justified, notwithstanding, we didn’t specifically have a derivatives crisis. BORN: Do you think that the failure or near failure of AIG was related to credit swaps? That is, credit-default swaps? And do you think that having clearing would have, in any way, reduced the risks inherent in AIG’s position? BLANKFEIN: I believe that it wouldn’t—it may have helped a bit. I don’t think that was a key thing. AIG was bent on taking a lot of credit risk. They took that credit risk in the derivatives market. They took that business by writing insurance against credit events. They took it by holding securities. It was a failure of risk management of colossal proportion, and there were derivatives in there, but it was really -- those were merely mechanisms of taking credit exposure to get paid for that exposure that they took through multiple kinds of vehicles and could have substituted other vehicles for them. BORN: Do you think—how would having a clearinghouse and having exchange trading of standardized derivatives reduce systemic risk as you say in your testimony? BLANKFEIN: I think that, to the extent that you have a—starting with a clearing house—to the extent that you have a clearing house, the issue we had with an AIG, vis-à-vis margin or fighting over settlements of what mark-to-market should be for the smooth transfer of margin, we would have avoided. We got margin for them, but it was hard to get out of them and it was slow. It lagged what we thought the mark-to-market—in a clearinghouse context, that would be easier to do. So anything that’s liquid enough and could be priced easily to go through a clearinghouse should. FOMC20070321meeting--113 111,MR. KOHN.," Thank you, Mr. Chairman. Like many others, I view the data over the intermeeting period as not fundamentally undermining the basic contours of our expected forecast. We’re still on track for moderate growth and gradually ebbing inflation. The economy has enough underlying strength, bolstered by financial conditions that remain quite supportive of growth, so that the housing correction should not be enough to knock the economy off the moderate growth track. Growth modestly below potential, along with the unwinding of some special factors like rent increases, should allow further declines in inflation. Real-side data reflect the fact that the downshift from above-trend growth for several years to expansion at or a little below trend hasn’t been entirely smooth, and maybe we never should have expected it to be so. Besides the overpricing and overbuilding of housing, businesses apparently built their stocks of inventories and fixed capital in anticipation of continued strong growth, and we’re seeing downshifts in demand for inventories and capital to align them with the slower pace of expected growth. Businesses typically also hoard labor under these circumstances, resulting in weaker productivity growth, and we may just be seeing this adjustment getting under way, judging from the gradual upcreep in initial and continuing claims. The inherently uneven nature of the stock adjustment process and the uncertainty around it help to explain both the overall contours of the recent data and the short-run swings in the data and perceptions of them. A number of factors, most of them mentioned by others, do support expectations of moderate growth ahead. Outside the subprime market, financial conditions remain supportive of growth. Intermediate and long-term rates are low in real as well as in nominal terms. The dollar has fallen. The fallout from the recent turbulence has been very limited. Aside from housing, a good portion of the inventory correction is behind us or is being put behind us. So over time production ought to line up better with sales. Both a rise in the national ISM index and increases in industrial commodity prices, especially in metals, support the notion of a coming recovery in manufacturing, though I admit the increase in metals prices may be a factor of the global economic expansion as well. Continued good growth of jobs to date will support increases in personal income, and as many have remarked, growth in the rest of the world has been pretty strong. I was struck by the upward revision in rest-of-world growth in the Greenbook despite weakness in the United States, the rise in oil prices, and the decline in equity values. So as Karen remarked, domestic demand abroad seems to be strengthening, and I think this bodes well for global external adjustment as well as for U.S. exports. But the information we have received over the intermeeting period not only shifted expected growth down a little but also highlighted some downside risk to activity. In housing, those downside risks center on the implications of the subprime debacle. Will it affect housing demand? Will lending terms tighten beyond the subprime market and the mortgage market? How much will tightening spill over to other lending markets, such as home equity lines of credit, and perhaps affect consumer demand? The possible answers to these questions seem to me to have downside tails that are fatter than the upside tails. Unexpected weakness in investment spending outside housing and auto-related industries is another risk factor. The question is whether this weakness represents just a short-term adjustment to moderate growth or whether businesses themselves see a downside shift in underlying demand that we don’t see. Financial conditions may not remain as supportive of growth, besides the possibility of the dropping of other shoes, such as private equity, as many have mentioned. I see a distinct downside risk to the staff’s assumption of continued increases in equity prices given the likelihood that, if the economy evolves the way the staff anticipates, long-term interest rates will rise and profits will be very disappointing to market analysts. Despite weaker spending, we still face upside risks to the gradual downdrift in inflation. Recent data haven’t been as favorable to deceleration as we would have hoped: Softer investments, slower growth of productivity, and continued strength in labor markets could suggest a slower path of trend productivity growth. If so, we would need to adjust down our expectations for growth, and labor costs would get a boost even at slower growth rates unless increases in nominal wages also downshifted pretty promptly. Good growth in labor demand could suggest a stronger path for demand and less slack than the staff is estimating. Finally, the NAIRU could well be lower than the 5 percent that the staff is estimating, especially in light of the relatively slow updrift in many measures of compensation. But, at 4½ percent, the unemployment rate is low by historical standards, and this suggests to me that the risks from resource utilization remain toward higher inflation. In sum, downside risks to our maximum employment objective have increased, but I do not think they outweigh the continuing upside risk to more-moderate inflation, at least not yet. Thank you, Mr. Chairman." FOMC20080625meeting--146 144,MS. PIANALTO.," Thank you, Mr. Chairman. I support keeping the fed funds rate target at its current level and the language in alternative B. I see some hopeful signs that stress in financial markets has diminished as has the threat of a sharp recession. Despite these recent signs, I expect that the growth momentum in the economy will build only slowly. Moreover, I continue to worry that the residential real estate market could deteriorate even more than I had put in my baseline projection. Nevertheless, I am somewhat more comfortable with the prospects for economic activity than I was in April. At the same time, I can't easily dismiss the recent behavior of energy and some other commodity prices. I found the Bluebook's supplemental analysis on oil prices, inflation expectations, and monetary policy to be very useful in thinking about the dilemma that we face. The fact that oil prices have risen so sharply and have been so persistent highlights the risks surrounding the downward projection that I have for core inflation. Without some evidence of less inflationary pressure I don't believe that the fed funds rate can be kept at its current level for very long. But while I do believe that the next policy action will be a rate hike, the potential for the recovery to sputter makes me cautious about embarking on an upward trajectory for the fed funds rate just yet. I believe that the language in alternative B conveys the right sense of direction for the fed funds rate path, with the right amount of caution. Thank you, Mr. Chairman. " FOMC20050322meeting--128 126,MR. KOHN.," Thank you, Mr. Chairman. Activity has come in somewhat stronger in recent months, and price pressures have been a bit more intense than anticipated at the last FOMC meeting. Evidently, continued good growth in income and high profits are keeping household spending rising briskly and eroding any remaining business caution. The fact that surprises have been concentrated in investment in both business equipment and housing may also suggest that the low long-term rates—the conundrum—have been having an effect. If, as seems likely, those rates have been reduced in part by declining term premiums, as President Yellen was discussing, and not just by an expected lack of vigor in demand here or abroad, their depressed real level would represent a net stimulus to demand most especially for business borrowers who are facing very low risk premiums. In fact, business borrowing has strengthened considerably in the fourth and first quarters. And after an extended period in which cash flows have exceeded business investment, low interest rates and ebbing caution have produced a positive business financing gap in the fourth quarter, which is projected to continue for the first quarter. Moreover, the U.S. economy is not the only one in which growth has picked up; the strengthening of demand seems widespread globally after the disappointments in the second half of last year. And I agree with others who have noted that the sharp upward movement in energy and other commodity prices probably reflects in part this global pickup in demand. The surprise in core PCE prices was only for one month and was small relative to our March 22, 2005 66 of 116 prices, and import prices could be passing through to consumer prices more than anticipated. This, coupled with the rise in near-term inflation expectations, does elevate the risk of second-round effects from such relative price movements. And those relative price adjustments have continued in recent weeks. Still, a number of factors seem to be working to restrain tendencies for inflation to move higher, and we can’t ignore those. Importantly, productivity growth was stronger in the fourth quarter, and, apparently, in the first quarter, than anticipated. Whether that suggests faster structural productivity growth than the staff has built in remains to be seen, but revisions to actual productivity growth will help keep pressures off of labor costs and markups. Partly as a consequence, markups in the nonfarm business sector remain at extraordinarily high levels, giving ample scope for future cost increases to be at least partly absorbed in reduced margins. And wage and compensation growth remain essentially flat, indicating to me that slack in labor markets persists, given the upward pressures on compensation that would otherwise be anticipated from rising headline inflation and the rapid productivity growth of recent years. Bond rates have risen noticeably. To be sure, the upward movement seems mostly to reflect higher inflation expectations, but higher nominal rates could have a noticeable effect on housing markets where buyers seem sensitive to the cash flow implications of their monthly obligations. House price increases should slow quite a bit, in any case, holding back the rise in wealth and boosting incentives to save out of current income. In addition, GDP hasn’t been revised up as much as demand. As the trade deficit continues to surprise on the high side, the staff forecast has net exports turning from a drag on activity to a more neutral influence. But until we see the data confirming that shift, I think the possibility of more demand being drained abroad remains a March 22, 2005 67 of 116 The final and most important force that ultimately will constrain inflation is tightening monetary policy. And the narrowing output gap and the possible emergence of greater inflation pressures do raise questions about how we need to adapt our strategy to keep inflation low and the risks in balance. Two possible responses: One would be to count on extending the gradual path of rate increases to go for longer before slowing or stopping. The other approach would be to increase the incline—prepare to raise rates by 50 basis points soon. For the most part, extending the measured path seems preferable to me. At the same time I think we should make it clear to markets that we are prepared to extend that path, should circumstances call for it, and that we have no firm preconceived notion regarding where our tightening should stop. The gradual approach should enable us to better gauge the ongoing effects of our actions in an uncertain world. It will give us more opportunities to assess the effects of past tightening moves when we know that those effects can vary and will occur with a lag. Hence it will give us more opportunities to calibrate our actions better to the needs of the economy. To date, announcing that we expect to remove accommodation at a measured pace hasn’t materially impeded the markets from responding meaningfully and appropriately to incoming data. Over the last intermeeting period, they extended the anticipated series of gradual rate increases— forward rates two and three years out are up by more than 50 basis points over that period, and this seems completely appropriate to me. The structure of interest rates still seems to be consistent with achieving our objectives. The staff forecast has inflation declining with about the policy tightening that is built into the market. Even if we’re not quite as optimistic on price pressures as the staff, gradual increases in the funds rate in line with market expectations should provide some insurance against rising inflation. March 22, 2005 68 of 116 participants expect that the policy actions they now anticipate will be enough to insulate the longer- term trajectory for prices from near-term increases in inflation. As a consequence, “measured” is still my best guess as to how policy rates will evolve, and that’s what I would continue to indicate to the public. Nonetheless, our expectation of a measured pace of firming has always been conditional. And one essential condition that we have articulated and emphasized in the last sentence of the announcement is that inflation and its expectations remain well behaved. In my view, that would be consistent with the rate of growth of core PCE prices stabilizing at levels close to or not very much above the experience of the last year. If doubts about our willingness to maintain price stability emerge, I can see the potential for a very difficult self- reinforcing feedback loop through declining confidence in policymaking in the United States and accelerated dollar depreciation. Incoming information suggesting that core prices will continue to accelerate, or that the output gap is closing rapidly, or that longer-run inflation expectations are deteriorating, could well call for deviating from the measured pace with a larger firming action. If the signs were serious enough, I think we could, and should, do that as soon as the next meeting, even if the “measured pace” language remains in place. After an expression of concern about inflation pressures, as suggested in alternative B, the market should not be entirely surprised by such an action under those circumstances. Thank you, Mr. Chairman." FOMC20080130meeting--407 405,MR. ROSENGREN.," It is great to see some bank supervision people at this table, and I would just highlight one of the comments that you made about silos. It is interesting that this morning we have been discussing issues of bank balance sheet constraints and how that would occur, and it might be useful to think structurally within our own organization whether there are ways to do a better job of getting people in bank supervision to understand some of the financial stability issues we think about, and then vice versa. Maybe having some bank supervision people come to FOMC meetings might be one way to actually promote some of this. In terms of the things that you were talking about, another issue that I think has been important is that we've been talking about the effect of dropping housing prices. I know a horizontal stress review was done about a year ago, and I'm sure Brian or Jon remembers that the large financial institutions did the stress testing. When they did that stress testing, what was striking was that there were four institutions--I think it was Citigroup, JPMorgan Chase, Wachovia, and Bank of America--in that stress test, and all four concluded that a housing-price reduction of between 10 percent and 20 percent would affect earnings but wouldn't affect capital. Obviously, in retrospect that doesn't seem to have been a good forecast. One, since we do think that stress testing is useful, maybe understanding that and going back to those same four institutions and understanding their stress testing might be a useful exercise to do. Two, if you did that exercise, we'd learn something about how they're thinking about housing prices and the indirect effects that might occur because one of our concerns around the FOMC table is that there may be unintended consequences if housing prices drop more than they have historically. Just as the banks have to think about those kinds of stress tests and what they have already learned from the fact that they didn't pick up some of the indirect effects, our own knowledge would be supplemented if we thought about some of those indirect effects as well. So the horizontal stress testing was interesting in that I think some of those institutions are on the good side and the bad side of your things. The horizontal stress testing isn't what generated the decisions--and I do agree with your conclusion that most of the decisions were made by senior management. Some organizations didn't do subprime mortgages at all. I'm not so sure it was generated from the stress testing as much as a gut feeling by senior bank management that they weren't going to engage in subprime mortgages. I think that's true for a lot of these activities. It's interesting who's at the top of the list and who's at the bottom of the list for a lot of these activities. Ideally, over time, both bank supervision and bank risk management would get to the point that it's not just a gut decision by a person at the top but is a little more systematic and that the riskmanagement process does that. Are you thinking of ways that we could actually encourage that kind of interaction so that it becomes less gut from senior management and more integrated into the risk management? I know that was kind of a long entry. " CHRG-110hhrg44901--72 Mr. Bernanke," Well, as we look back on it, we see that there were just some serious failures in the management of risks. There were many firms that had exposure to the housing market in a variety of ways across the firm, including holding mortgages and other ways. And they didn't fully appreciate that in the contingency that the housing boom would turn around, that house prices would begin to drop; they didn't fully appreciate their exposure to that situation. The regulators bear some responsibility on that. It is our job to make sure that they measure and manage their risks appropriately. We have been working on that for a number of years related to bank supervision initiatives like the Basel Initiative, for example, and so on. But it is clear that we need to redouble our efforts to make sure that the risk management is sound, that the underwriting is sound, and that we don't get ourselves into this kind of situation again. Ms. Pryce. Well, you mentioned Basel. Are there further risks ahead to our system and therefore the overall economy that might arise, and the new capital adequacy standards in Basel? You know, if we are trying to have this happen simultaneously, could that create new risk to the system? Effects of a crisis in any overseas market, could that affect our system in a negative way? Further decline in the dollar. There is a list of many things that could potentially happen. One of the things I would like your comment on is the commercial real estate market. You know, many banks astutely avoided the subprime lending, and they instead expanded their commercial real estate lending. So everywhere we turn we see increased vacancy signs and downward pressure on rents. And do we expect another wave of pressure from that market? And are we planning ahead as a country to address these things as opposed to, you know, being reactionary as it seems that we have had to be of late? " FOMC20051213meeting--76 74,MR. SANTOMERO.," Thank you, Mr. Chairman. There has been little change in Third District economic conditions since our last meeting. The regional economy continues to expand at its potential pace, which is somewhat lower than in other parts of the country. Payroll employment is increasing steadily in our three states, and the tri-state unemployment rate fell to 4.3 percent in October, which is its lowest level since May of 2001. Regional manufacturing activity continues to expand at a moderate pace. The index of general activity in our manufacturing survey eased slightly to 11.5 in November from 17.3 in October. Although there has been some month-to-month volatility in the index this year, it has generally been near the average that was recorded in the 1990s expansion. Retailers report a slightly better sales figure for October and November compared to the same period a year ago. In general, sales of luxury goods and consumer electronics continue to expand more strongly than other lines of merchandise, and discount stores had better results than mid-priced department and specialty stores. While construction continues to be a strong sector in our region, we are beginning to see early signs of moderation in the housing market. These signs do not point to a sharp drop, only a slight softening of demand. As elsewhere, permits have declined and real estate agents reported slower sales in October and November. Some agents also noted that the number of existing homes on the market has risen and that the numbers of offers per house and above-asking-price bids have declined. There was also a slight easing in price appreciation in each of the three states in the third quarter, and this moderation appears to be continuing in the fourth quarter. We continue to see signs of higher prices for industrial goods in our region. There was a sharp increase in the price indices in our manufacturing survey in October. This eased only slightly in December 13, 2005 44 of 100 elevated. The future price indices are high relative to most readings during the expansion, and the results of a special survey question indicate that cost increases are widely anticipated for all inputs next year. These expectations are widespread across firms—and more widespread than during the summer period when we asked the same question. Indeed, while our business contacts expect continued moderate expansion in business activity, rising prices beyond those in energy have become more of a concern for firms in our District. Turning to the national economy, I note that the Greenbook forecast has been revised to show more underlying strength in the third and fourth quarters compared to last time. It’s more consistent with my own view on the national economy. Incoming data over the intermeeting period suggest that the economy retained a good deal of upward momentum. The third-quarter preliminary GDP figures showed broad-based strength in consumption and fixed investment growth, with strong productivity gains. Despite the dislocation from Hurricane Katrina, we have sturdy underlying job growth and a low unemployment rate. Consumer confidence has partially recovered from post-hurricane lows, and consumer spending outside autos continues to advance at a moderate pace. Business spending has also strengthened since the summer, and manufacturing productivity and business investment continue to advance. In my mind, the risks to growth are slightly on the upside, as I read the data as supporting continued underlying strength. The official inflation numbers and readings on inflation expectations have been somewhat reassuring over the intermeeting period. To date, we’ve seen little pass-through, as a number of people have noted, of higher energy prices into core inflation, and we’ve also seen some decline in energy prices. In addition, both near-term and long-term inflation expectations have declined a bit. This news is clearly favorable to the inflation outlook. However, it seems somewhat at odds with December 13, 2005 45 of 100 and have recently found it somewhat easier to raise their own prices in the current environment of quite strong demand. This view has also been supported by our own and other manufacturing surveys. So I remain concerned about inflationary pressures, and I believe that an uptick in inflation is, indeed, a risk. Therefore, a prudent course of action today, in my opinion, is to continue to gradually move rates up. Whether such a move is closing in on the equilibrium real rate from below or whether such a move will put the real funds rate above the equilibrium value or place it in the range of uncertainty around the long-run value is an interesting question. So is how we will explain what we are going to do. But I’ll defer my views on these issues until the second part of our discussion. Suffice it to say I look forward to that. [Laughter]" FOMC20070918meeting--86 84,MS. JOHNSON.," I think there are some inflation risks out there. In general, Mexico, say, or Brazil—some of the countries that target inflation—are operating pretty near their target, maybe even a tiny bit above it. One of the pre-August but sort of persistent problems we have been facing for about six to nine months, maybe even for a year, has been to understand food prices. Why does everybody say that our inflation is up but it is food prices? Sometimes it’s hog disease in China, and sometimes it’s an allusion to biofuel issues or other kinds of one-off things that you might see in some emerging-market countries. But the strength of demand in these economies—and Asia is really operating at a very high level of capacity and at a very strong growth rate—raises the potential for upward pressure on prices in some of these countries. Now, China is obviously an outlier in this regard, right? The numbers are crazy; the numbers aren’t trusted. Again, the government says it is food. But if most of the food is domestically produced and food is approximately one-third of the weight in their CPI, maybe that’s where you ought to look. The most important thing you can do with respect to trying to achieve an inflation objective would be to do something about food prices, either by addressing your supply-side policies or by doing something about the rate of money growth or both. So China is a unique case in this regard. I think people are very skeptical about some of the data. People fear that the inflation problem might be even worse. It has always seemed to me that the obvious solution to China’s problem is to let the exchange rate rise. It would solve many, many ills, including lowering food prices and getting the inflation rate down. I don’t hold out much hope for that. In places where markets are more effective and where monetary policy works in ways that look more like our experience in the service-sector economies, we are probably going to see some monetary tightening continue to be in place. Some of those countries are experiencing a little exchange rate appreciation, and that will help. But I think they are operating with as much inflation as they really want. The industrial countries probably won’t be doing some of the tightening that we had in mind for them and that the markets anticipated, but some of these emerging markets—India, for example—need to continue tightening, and they need to be very alert on their monetary policy. There could be some cases in which their policies aren’t able to do the job or they don’t move quickly enough." FOMC20061212meeting--92 90,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Our forecast hasn’t changed much since the last meeting. We still expect growth to move back to potential in the first half of next year and to stay in the vicinity of potential, which we think is around 3 percent, over the forecast period. We expect inflation, as measured by the core PCE index, to fall to just under 2 percent by the end of ’08. Our view of the outlook differs from the Greenbook in two respects, as it has over the past few cycles. We have a higher estimate of potential growth, with the difference due to higher estimates of labor force growth, and we expect more moderation in inflation than the Greenbook does, principally because we believe there is less inertia, less persistence in inflation in the United States than does the staff. Both these issues, of course, deserve continued analysis and attention by the Committee. These differences in our forecast relative to the Greenbook don’t extend to the policy assumption. Both outlooks are predicated on a likely path of the fed funds rate that’s nearly flat over the next several quarters. This path, of course, is above the one currently reflected in financial markets. Of course, although some disagreement between our view and the market’s view is not unusual, the size of this gap is significant enough to warrant some attention. It’s hard to know, however, what the source of the difference is and, therefore, what the implications are for what we do in terms of policy. The risks to the forecast may have shifted somewhat in the direction of less upside risk to inflation and more downside risk to growth. But to us, the current weakness in the economy still seems principally to stem from the direct effects of the slowdown in housing on construction activity and related parts of the manufacturing sector as well as from the reduction in automobile and auto-related production. As things now stand, the softer-than-expected recent numbers don’t argue, in our view, for a substantial reassessment of the risks in the outlook. Surveys of business sentiment outside the manufacturing sector still seem consistent with reasonable growth going forward. A slowdown of investment in equipment and software doesn’t seem to be particularly troubling to us at this point. Consumer spending seems to be growing at a fairly good pace. Employment growth, of course, is still quite solid, and growth outside the United States still looks pretty good. We think the fundamentals of the expansion going forward still look good, with strong household income growth even after the lagged effects of the recent downward revisions, productivity growth in the range of 2½ percent for the nonfinancial corporate sector, and strong corporate balance sheets in the United States, and prospects for continued expansion outside the United States. Our recent financial market data don’t, in my view, provide a convincing case for a substantial increase in the probability of a much weaker path for growth going forward. Although the yield curve is inverted and long rates continue to drift down, staff research and other indicators suggest that part of that is due to a decline in term premiums, and forward rates seem to be coming down around the world still. This gradual reduction in term premiums and forward real rates globally suggests that what we’re seeing in the long-term interest rates in the United States may not be principally a sign that confidence in the U.S. growth outlook has deteriorated. It’s not clear even 18 months after the conundrum first emerged whether equilibrium rates globally have really moved substantially lower. The Bluebook estimate suggests we’re still within most estimates of equilibrium real rates in the United States. Equity prices and credit spreads are consistent with the view of sustained expansion going forward. All this seems to reinforce the case for the judgment that we have not yet induced overly restrictive financial conditions. We still face considerable uncertainty about the outlook for growth and the familiar sources of downside risk, but to us these still seem to rest mainly with the possibility that a more-acute and protracted fall in housing activity and prices will cause a significant deceleration in housing and household spending and ultimately business spending. The nature of these risks, however, hasn’t changed in our view, and the probability that the risks will materialize may have risen a bit but not much. On balance, this situation should reduce the probability that we’ll have to tighten further, but it doesn’t seem to suggest that today we need to induce a further easing in overall financial conditions. On the inflation front, we confront the familiar mix of underlying inflation still at uncomfortably high levels and considerable uncertainty about whether we’ll see enough moderation soon enough to keep expectations stable at reasonable levels. The remaining inflation risks, in other words, are about whether we get enough moderation. In the absence of a dramatically different outcome for the dollar and energy prices than what’s in the forecast, we don’t see much risk of inflation accelerating from current levels or remaining stuck at current levels. We haven’t had much evidence to justify a significant change in the expected path of inflation or in the risks of that forecast. The news on unit labor costs may be a bit reassuring. Surveys seem to suggest some evidence of diminishing pricing power, which might imply that margins will adjust downward to absorb future rises in labor compensation. The odds of an early return to above-trend growth seem to have receded a bit. Most of the alternative measures of underlying inflation that many of us look at seem to have moderated a bit after the sustained earlier period of acceleration. Inflation expectations derived from TIPS have eased a bit. These pieces of information are somewhat comforting, but they don’t change the fact that our expectation that we’ll achieve the desired moderation in inflation without further tightening of monetary policy remains just that. It is an expectation or a hope; it is not yet reality. Thank you." FOMC20060131meeting--83 81,MR. MOSKOW.," With restraint, Mr. Chairman, most of our contacts this round were positive about current business conditions. However, they were cautious about the prospects for ’06, largely because they didn’t see any obvious drivers for growth. With regard to current conditions, national labor markets appear to be solid. Both of the temporary-help firms headquartered in our District reported that their business was very good. Of course, they mentioned that it was softer in the Midwest, primarily because of the problems of the Big Three automakers and their spillovers and because of suppliers in the regional economy. One mentioned that Michigan was the only state in which he had seen a drop in the demand for business and technical workers. I mentioned last time that things could get worse if the Delphi negotiations result in a strike, and all three parties—Delphi, UAW, and GM—are talking. Delphi has toned down its rhetoric, and the deadline has now been pushed back to February 17. Turning to cost and price pressures, wages and benefits continued to increase at a moderate pace. With regard to other costs, I heard the usual concerns about prices for energy and energy- related inputs in shipping, but the reports about other material costs were mixed. There was one interesting case in which capacity considerations were showing up in higher prices, and that’s the airline industry. United reported that the reduced capacity in the industry has made it easier for them to raise prices, particularly when it comes to passing through fuel costs. And, as you know, they are scheduled to exit bankruptcy shortly. As I mentioned in the past, I’m concerned about the high amount of liquidity circulating in financial markets. For example, one of our directors who heads a major private equity firm noted that such funds were having no trouble attracting investors. He said that the amount of new money invested in private equity firms is expected to expand 50 percent this year, and there is a slightly ominous look to some of the new investors, such as underfunded state pension funds that are “reaching for return,” as he described it. Similarly, early last week we held our semiannual meeting of academics and local business economists, and I heard comments about unusually high liquidity levels from several economists who work for investment firms and commercial banks. And as we all know, risk spreads are quite low by historical standards. So I worry that there’s a lot of money chasing investments out there, and that this may have driven the price of risk down too far. In the national outlook, even with the weak fourth-quarter numbers we continue to expect that economic activity will expand at a solid pace similar to that in the Greenbook. We see growth at or slightly above trend over the next two years and the unemployment rate remaining around 5 percent. Of course, if the fourth-quarter sluggishness spills forward, we would have a more complicated set of issues to deal with, but I agree with the staff and expect that growth will bounce back this quarter. With regard to prices, we think that core PCE inflation will average close to 2 percent over the forecast period. The outside economists at our meeting last week generally agreed with this outlook, although a couple predicted that GDP growth would fall somewhat below 3 percent in 2006. Most of these economists thought that we would raise the fed funds rate to 4¾ to 5 percent and then go on hold. As always, we’re going to have to take a hard look at the data and forecasts before we decide what to do. Inflation could moderate further. We’ve been pleasantly surprised at firms’ ability to absorb cost shocks. If they continue to do so, we could be looking at core PCE inflation rates heading down this spring. In that event, inflation risks would be diminished, and there would be fewer risks in ending the current rate cycle. But there’s a good chance that recent cost increases will pass through, and we’ll experience a repeat of last winter’s uptick in core inflation. Moreover, I can see some plausible outcomes for growth that would pressure resource utilization. And in that event, we’d be looking at a forecast for core inflation that was stuck above 2 percent. I think this would be a problem. With inflation remaining at such rates, we could begin to lose credibility if markets mistakenly inferred that our comfort zone had drifted higher. When we stop raising rates, we ought to be reasonably confident that policy is restrictive enough to bring inflation back toward the center of our comfort zone, which I believe is 1½ percent. And as I read the long-run simulation in the Bluebook, it seemed to say that the funds rate needed to rise a bit over 5 percent by late 2006 to bring core inflation down to 1½ percent within a reasonable period. So for today, we should move forward with an increase of 25 basis points, and we should allow ourselves enough flexibility so that policy can either stop or continue moving, as the situation warrants." CHRG-111shrg54589--67 Mr. Griffin," Chairman Reed, Senator Bunning, Members of the Committee, I am Kenneth Griffin, President and CEO of Citadel Investment Group and I appreciate the opportunity to testify and share our views regarding effective oversight of the OTC derivatives market. The appropriate oversight of the OTC derivatives market is of paramount importance to the safety and soundness of our financial system. The events of recent months have made it abundantly clear that large financial firms are not too big to fail, but rather too interconnected to fail. The idea that extreme measures must be taken to prevent the failure of a single firm, such as Bear Stearns, which had just over $10 billion of shareholders' equity and a few thousand employees, drives home the point that greater regulation of our financial markets is warranted. Derivatives serve an incredibly important role in our financial markets. Current notionals exceed several hundred trillion dollars and reflect the important role of these risk transference contracts. The commercial justifications for this market are well established and well understood. Regretfully, as this market has grown to almost unimaginable scale, the regulatory framework and market structure have not kept pace. Now is the time to put an end to the antiquated practice of bilateral trading. The use of central clearinghouses open to all market participants will end the era of too interconnected to fail. The use of central clearinghouses will bring considerable value to society in the form of far greater price transparency; fairer executions for all users of these instruments, and in particular for less frequent users, such as municipalities, smaller corporations, and local banks; far greater ease of regulatory oversight; and reduced responsibility for any systemic risk regulator. In addition, a central clearinghouse will create a stronger regulatory framework for all users, including regional banks, insurance companies, pension plans, and other pools of investment capital. For example, margin requirements and daily mark-to-markets will apply to all users of the clearinghouse. Capital requirements on the trading of derivatives not cleared through a central clearinghouse should reflect the significant systemic risk they create and should be substantially higher than those in existence today. Citadel has a vested interest in seeing this modernization of our financial markets. We and several of the largest asset managers in the world have united behind the CME group in the development of a neutral, open access, central counterparty clearing solution for credit default swaps. As part of a larger community of investors, we are committed to the improvement of the safety and soundness of our financial markets. The commitment of many of the leading buy-side firms to a central clearinghouse reflects the inherent weaknesses in today's dealer-centric bilateral trading model. For example, customers are often required to post initial margin to their counterparties to initiate a trade. These funds are commingled with the dealer's other assets. Because customer margin is not segregated, customer funds could be lost in a dealer default. In times of stress, customers will rush to close out positions to recover their margin. This can intensify a liquidity crisis, as we saw last fall. And last fall, when customers sought to mitigate credit risk by closing out positions with dealers, the prices at which they could terminate contracts were often extremely unfair. Customers do not have access to high-quality market data in today's paradigm, such as transaction prices. This information is closely held and not broadly available. Customers require transaction data and accurate prices to understand the riskiness of their portfolios. Without this information, the ability of customers to prudently manage their portfolios is substantially limited. The large dealers earn extraordinary profit from the lack of transparency in the marketplace and from the privileged role they play as credit intermediaries in almost all transactions. The current market structure suits their interests and leaves their customers at a significant disadvantage. But the memories of AIG, Bear Stearns, and Lehman Brothers, to name a few, should prompt, in fact, demand, a swift and thoughtful response from our regulators and legislators. Today, the vast majority of credit default and interest rate swap contracts have standardized terms and trade in large daily volumes. Arguments have been advanced about the importance of customized derivatives, which represent a small percentage of total activity. Customized derivatives are important, but they come with significant operational risk, model risk, and financial risk. We should permit the continued use of customized derivatives with appropriately heightened regulatory capital requirements and far clearer risk disclosures to nonfinancial institutions and users. In the end, I strongly believe these arguments are nothing more than a strategy to obfuscate the real issues at hand, principally the need to bring much overdue modernization to our marketplace. This problem has an international dimension. We must work to coordinate our actions with foreign regulators. Otherwise, we face the risk of cross-border capital and regulatory arbitrage. The status quo cannot be allowed to continue. We must work together to drive market structure, reform that fosters orderly and transparent markets, that facilitates the growth and strength of the American economy and protects taxpayers from losses, such as those that we have witnessed in the last year. Thank you for the opportunity to testify today. I would be happy to answer your questions. " FOMC20080805meeting--179 177,MR. KROSZNER.," Thank you. I support no change, alternative B. As I mentioned before, I don't want to put the commodity price decreases and energy price decreases in the bank and say we don't have any problems going forward. But we also can't ignore them, and I think that does take off a bit of the pressure. It also manifests itself in some of the survey numbers and some of the market-based numbers in terms of expectations. So I think it allows a little more time, as someone said earlier, to be patient, to make the determination, given that I still think there are some very real downside risks, as I've mentioned. I think this type of statement will be largely consistent with market expectations, although I do think, and Brian can correct me, that this is one of the first times that we have made a very clear statement such as ""inflation has been high."" I think that's a bit of a change from where we have been. That's a much stronger acknowledgement of the inflation situation, which I think is appropriate to be acknowledging. But I do think that it may send a relatively strong signal to the market, and it makes me feel more comfortable about no change today with the statement because it shows a lot of concern about the level of inflation in actually characterizing it as high. Thank you, Mr. Chairman. " FOMC20080121confcall--13 11,MR. EVANS.," Thank you, Mr. Chairman. I strongly support this recommendation. At our last videoconference, I was in favor of action at that time. The situation has deteriorated since then. I think the macroeconomic outlook supports this type of move. As we look at the data, we are on the edge of a more serious downturn. It is not exactly clear how large that will be, but we ought to be pricing in at least 100 basis points of accommodation against what I think of as sort of a medium-term neutral rate of about 4�, and this is a move that takes us there. I think the growth risks are definitely greater, and the real question after this is what it means for our meeting next week. But I strongly support this. " FOMC20080130meeting--251 249,MR. MISHKIN.," Also an issue that the Chairman raised yesterday was that the housing market is a big component of our downside risk. The market's concerns about future declines in housing prices are causing a very sharp decrease in demand for housing. That could turn around very quickly as well. Even now we should be thinking about these issues, and Governor Kohn's use of the word ""nimble""--I like ""flexibility,"" but I think ""nimble"" is probably a better word--is really I think key here. It is somewhat of a departure from normal--exactly what the Chairman said. This episode is different from past episodes. So we do need to start thinking about this, and the staff will need to think about exactly these issues. " FOMC20050809meeting--163 161,MR. KOHN.," Thank you, Mr. Chairman. As many of you have remarked, underlying demand has shown a surprising degree of vigor over the intermeeting period. Strength in final demand should show through to output as the mini-inventory cycle works itself out. This strength, together with revisions to estimates of the level and rate of growth of potential GDP as a consequence of the NIPA revisions, suggests that the economy is probably a little closer to its long-run sustainable production than we had thought. A smaller output gap, in combination with further increases in oil prices—some portion of which is likely to show through to core prices for a time—in turn suggests that inflation risks are a little higher and raises questions about our policy strategy. In my view, although the risks have shifted a little, they have not shifted enough to throw us off our presumed policy path of measured increases in interest rates, and I would continue to indicate that in our statement. I agree with the staff forecast that the increase in final demand is likely to slow going forward, as we continue to raise rates. The surprise was not in investment, which continues to be August 9, 2005 67 of 110 strong. In part, the unexpected strength reflected auto incentives and is borrowed from spending in the future. The increase in consumption required a further decline in the saving rate from an already low level, a pattern not likely to be sustained absent continued very sharp increases in housing prices. In that regard, at some point rising short-term rates—and recently long-term rates —should take their toll on housing price appreciation. To be sure, to date the indications of cooling housing markets are anecdotal, such as those we heard from President Guynn; they’re not yet data-based. But if, as many assert, the demand for houses is being supported to a considerable extent by ARMs and exotic mortgages tied to short-term rates, the effect of monetary policy tightening should, if anything, be greater than in the past, with the housing wealth channel bearing more of the adjustment. In addition, the further rise in energy prices is likely to shave something off spending, or at least postpone the time when energy prices are no longer holding back growth. And the positive contribution to final sales from net exports in the second quarter appears to be a short- term quirk in either data or behavior. Moderate growth abroad, together with our outsized demand for imports, should once again begin to damp demand on our own productive resources. Moreover, incoming data on prices and compensation continue to indicate, to my mind, that there is some slack remaining, which is working to contain price pressures. Although core PCE data for 2004 and before were revised higher, incoming information about the most recent several months has suggested an appreciable short-term deceleration. The recent price data were, in fact, lower than anticipated. In effect, the data tended to confirm that the higher rates of inflation earlier this year were temporary, probably reflecting the increases in price levels of oil and other imports, and that inflation is not on an upward track. These data have been consistent August 9, 2005 68 of 110 have been contradictory and confounding, but it seems hard to believe that the surprisingly soft numbers for the ECI in Q2 and Q1 were drawn from a labor market under pressure, perhaps giving some more weight to President Poole’s comments on the anecdotal information there. Even the productivity numbers are somewhat ambiguous in their implications for cost and price pressures. Although past productivity growth appears to have been lower, and the staff marked down its estimate of structural productivity growth for 2005 and beyond, actual productivity data for 2005 are running at a higher rate than had previously been anticipated. The estimate for the first half of the year was revised up to 2½ percent, and the current quarter is projected to be substantially higher than that. Market participants seem to think the measured pace of policy tightening will be adequate. They have added to the extent of the tightening but not the pace. And inflation compensation, as President Lacker noted, while edging a little higher over the intermeeting period, remains much lower than it was just a few months ago, despite the further increase in energy prices. Finally, I think the strategy we have followed of tightening at a measured pace and being transparent about our intentions has a number of advantages. In particular, following this strategy—especially compared to one of larger increases or those that weren’t well predicted by the market—reduces the odds of significant overshooting. Gradual changes enable us to get a better handle on their effects on the markets and the economy as they are happening. Their predictability means that they are incorporated into financial conditions more readily and accurately, bringing forward their effects on financial conditions and making observations about August 9, 2005 69 of 110 And I wonder whether this strategy isn’t going to be especially useful given the uncertainty about how our actions could affect housing prices, construction, and consumption. Increasing rates will affect housing markets. Indeed, that’s a necessary condition for constraining inflation pressures. But increased uncertainty about the strength of this channel, given the changing nature of mortgage markets, reinforces the arguments for a gradual approach to policy, if possible. I agree that the incoming data should reinforce and strengthen our intention not to allow inflation and inflation expectations to rise from here. I’m encouraged by the reaction of markets to the news over the intermeeting period in adding 50 basis points to the string of expected gradual increases in the funds rate. This shows that they are not constrained by our language from marking up long-term interest rates, and it strikes me as the right response, at least for now. Thank you, Mr. Chairman." FOMC20071211meeting--156 154,MR. KROSZNER.," Thank you very much. I think we have two fronts on which we have to work—both the macro risks, in particular the housing risks and the liquidity issues, and their interaction, as a lot of people have discussed. So I favor a 25 basis point reduction with the other actions that we will be taking with respect to liquidity—the TAF and the swap. I think it is very important, at least in my thinking, to see them as a package, to try to work on both margins, because many people have raised concerns about the liquidity issues perhaps spilling over into being real economy issues—so liquidity issues turning into capital issues that can turn into credit constriction issues. With respect to the macro risks, most people around the table have said that those are real and that we need to work on those. Then, of course, there is an interaction between the two. Part of the reason for the difficulty of reviving the price discovery process is uncertainty about what is going to happen in some markets, particularly housing markets. So providing a little more insurance there is valuable. But there is also a concern that, even independent of that, there could be liquidity problems that cause difficulties, so working on these two fronts is certainly very valuable. We will, then, have cut the federal funds rate 100 basis points and will have taken some steps, both with the reduction of the difference between the fed funds rate and the discount rate and these new actions, to try to provide more liquidity. With respect to the statement, I think the statement as it is in alternative B is probably the most effective. It is important for us to express the uncertainty with respect to the balance of risks rather than try to describe the balance of risks. I don’t really see what would be added by talking about particular downside risks when we can simply say that there is uncertainty. I agree with Governor Warsh that the markets would interpret this as that there may be more to come and that we will mindful and watching what is going on. Particularly in the context of the new liquidity actions that we will be taking, it is better to say that we are uncertain than to say that we are uncertain with downside risks and then take these other actions. It is more appropriate for us to convey that the combination of actions leaves us uncertain because that, rather than uncertainty with downside risks, may help unlock some of these markets. Thank you, Mr. Chairman." CHRG-111shrg54589--137 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM MARY L. SCHAPIROQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. The primary function of derivatives is to facilitate the efficient transfer of risk exposure among market participants. Trading of risk exposure through derivatives enables parties who have natural risk exposures as part of their business or investment operations to reduce or eliminate that risk by transferring it to somebody who has a natural offsetting risk, or to somebody else who is more willing to bear that risk. Some sources of fundamental business risk are closely related to the prices of assets that are traded in an active cash market, such as stock or foreign currency. Other risks lack robust cash market pricing sources. Derivatives based on these risks, however, can be important tools for managing these risks. As with any derivative product, the key challenge for policy makers will be determining when and whether the value of these products for risk management purposes outweighs potential concerns about the products' underlying market integrity.Q.1.b. If not, what specific, objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. This issue raises important public policy concerns. Products without an active cash or derivatives market may have less robust price discovery. These products, nevertheless, may be useful to hedge or transfer real economic risks and, therefore can play a beneficial role in facilitating risk management and risk transfer activities. Policy makers should consider whether risk management and distribution purposes outweigh concerns with weak or unreliable pricing sources. Traditionally, the SEC has used disclosure to identify valuation risks associated with securities.Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative, and the model is effectively the basis, why should the models not be public?A.2. The best way to improve market understanding and ``value'' determinations for derivatives is to standardize and centrally clear them (to the extent possible) and encourage them to be traded on exchanges. This would provide great transparency. Where standardization or exchange trading is less likely, I believe policy makers should endeavor always to maximize market transparency through reporting or other mechanisms. The argument for making models public when no cash market exists is an interesting way to provide a valuation check, but there are costs to this approach as well. For example, would investors continue to innovate and alter their models if they were public and available to their competitors? Would models become more similar--decreasing market style diversity and increasing the risk that major participants engage in the same trades (increasing volatility and risk)?Q.3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?A.3. Drawing a line, based on trading positions, between hedgers and speculators will necessarily be arbitrary because we cannot determine the intent of a trader from their portfolio holdings. Some market participants will hold derivative positions as part of a well-defined hedge (e.g., they also have large current or anticipated exposure to the prices of securities or debt instruments). Others have no exposure at all and hold a derivatives position strictly to gain exposure, that is to speculate, on price movements. However, drawing a line between the two motives is difficult and may yield unintended consequences. First, there are a number of entities that do not hold large securities or debt holdings, who may, nonetheless have a legitimate risk management purposes: For example, they may want to hedge their ``exposure'' to a major supplier or customer. Second, even if a reasonable line is drawn, there may be significant market consequences: For example, ``speculators'' can often provide liquidity for hedgers--so eliminating speculators can raise the cost of risk management and make hedges less effective. In developing a regulatory framework for OTC derivatives these and other complexities will need to be addressed in a manner that seeks to prevent the potential for market abuses while also creating a system that facilitates legitimate transactions.Q.4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?A.4. Clearly we need to move forward with our regulatory framework, even if other jurisdictions do not follow. However, financial markets today are global markets and coordinating with our international counterparts will be critical. Absent a response coordinated with foreign regulators exercising similar authority, the effectiveness of any regulatory limits would be constrained significantly by the international nature of the derivatives market. Because there is the potential for trading business to move to less regulated markets, we are working with our counterparts internationally to ensure that all derivatives dealers and large participants in OTC derivatives market are subject to prudential regulation and supervision.Q.5. Do over-the-counter or custom derivatives have any favorable accounting or tax treatments versus exchange traded derivatives?A.5. There is no difference in the financial statement accounting principles applied to exchange traded versus other types of derivatives. With respect to the financial accounting treatment, contracts or other arrangements that meet the accounting definition of a derivative are ordinarily recognized and measured at fair value with changes recognized in income each period whether the derivative is exchange traded or customized. However, accounting rules allow companies to achieve hedge accounting and defer recognizing the impact of changes in value of derivatives used for hedging purposes when changes in the value of a derivative match and offset changes in the value of the hedged item to a sufficient degree. It is possible, in some cases, that a customized derivative may be more likely to economically offset changes in the value of the exposure a company is trying to hedge. Thus for certain applications, customized derivatives may be more likely to offset the exposure and thus may be more likely to meet the requirements for hedge accounting. In all cases where a derivative serves as a highly effective hedge, accounting standards clearly permit the entity to reflect the reduction in risk in the measurement of income.Q.6. In addition to the Administration's proposed changes to gain on sale accounting for derivatives, what other changes need to be made to accounting and tax rules to reflect the actual risks and benefits of derivatives?A.6. Even before the credit crisis, financial accounting for derivatives had been identified as deserving additional consideration. In this regard, the Financial Accounting Standards Board (FASB) issued new disclosure requirements in 2008 that provide greater transparency about derivative and hedging activities to investors, including a substantial amount of additional information about credit default swaps. Derivatives accounting also represents a component of the FASB's current project to reconsider the accounting principles for all financial instruments, recently undertaken in concert with the International Accounting Standards Board. This project was added to the FASB's agenda, in part, as a response to issues identified by the SEC and others during the credit crisis. Many have argued that the hedge accounting rules are overly complex and could be improved to make hedge accounting easier to apply and more understandable to investors. While we are supportive of such simplification, we would expect that because of their volatile nature, derivatives will continue to be measured at fair value each period on the balance sheet, and significant disclosures will continue to be needed for investors to understand the exposures, strategies, and risks of companies that utilize them. The tax treatment of different types of derivatives is outside of the SEC's area of expertise and may be better addressed by tax professionals and/or the IRS.Q.7. Should parties to derivative contracts be required to post cash collateral, or is other collateral acceptable? And is there any reason not to require segregation of customer collateral?A.7. Provided that positions are marked to market and collateral calls are made daily, cash collateral is one prudent type of collateral. In certain circumstances, though, highly liquid securities that tend to move in price consistent with the underlying reference asset may be as desirable for collateral as cash. Guidelines for acceptable forms of collateral will need to reflect the risks and circumstances associated with each type of acceptable collateral, including, but not limited to, price volatility and liquidity, and be agreed to by both parties to the transaction. Accordingly, under certain circumstances, noncash collateral may be acceptable. A priority of a regulatory framework for OTC derivatives should be ensuring a process that allows for the prompt return of customer collateral. Properly constructed regulations governing the segregation of customer collateral can provide customer protection while still promoting the operation of efficient OTC derivatives markets.Q.8. Is there any reason standardized derivatives should not be traded on an exchange?A.8. In building a framework for the regulation of OTC derivatives, the goal should be to encourage all standardized derivatives to be traded on exchange or equivalent exchange-like venues that provide full regulatory and market transparency. The regulatory scheme for trading OTC derivatives should be designed to achieve vital public policy objectives for such instruments, including transparency, efficiency, and prevention of fraud and manipulation. The regulatory scheme for standardized derivatives should, however, retain sufficient flexibility to allow market mechanisms to develop that meet varying trading needs for products (such as products that may lack sufficient liquidity to be traded on an exchange), while ensuring all dealers and trading markets (including for nonstandardized products) are subject to a unified regulatory scheme that establishes a framework for fair competition among markets, protects the public interest and is sufficiently transparent to allow for regulatory oversight.Q.9. It seems that credit default swaps could be used to manipulate stock prices. In a simple example, an investor could short a stock, and then purchase credit default swaps on the company. If the swaps are not heavily traded, the purchase would likely drive up the price of the swaps, indicating higher risk of default by the company, and lead to a decline in the stock price. Is there any evidence that such manipulation has taken place? And more generally, what about other types of manipulation using derivatives?A.9. The Commission is very concerned about potential manipulation of the equity markets through the use of credit default swaps or other derivative instruments. Because there is no central reporting or audit trail requirement for OTC derivatives, including securities-related OTC derivatives, there is no organized surveillance by any Federal regulatory agency or self-regulatory organization. This regulatory gap substantially inhibits the Commission's examination and enforcement efforts, and the lack of surveillance creates substantial risk to the markets collaterally affected by swap transactions, such as the market for debt and equity securities related to credit default swaps. The antifraud prohibitions in the Federal securities laws currently apply to all securities-related OTC derivatives, including credit default and other swaps related to securities. The Commission, however, needs better tools to enforce existing prohibitions over all securities-related OTC derivatives, including authority to promulgate reporting and record keeping rules and prophylactic antifraud rules. Currently, if Commission enforcement or examination staff suspects illegal conduct in the derivatives market, staff must engage in the time-consuming process of manually recreating activity in this unregulated market, which is challenging in a market without uniform documentation, transparent pricing, and time-stamped records. Under these circumstances, it is difficult to identify violations and prove the intent required to support charges under the Federal securities laws. Uniform record keeping and reporting would provide the type of information needed to identify suspicious trading patterns and to investigate or examine misconduct. With uniform audit trail and record keeping requirements, Commission staff could, for example, better pinpoint where manipulative credit derivative trading occurs in tandem with other trading strategies, such as short selling.Q.10. Credit default swaps look a lot like insurance when there are unbalanced, opportunistic sellers. However, life and property insurance requires an insurable interest for the buyer and reserves for the seller. Why should we not regulate these swaps like traditional insurance?A.10. Although credit default swaps are frequently described as insurance (buying protection against the risk of default) and may have certain elements similar to traditional insurance, we believe that securities-related credit default swaps are more appropriately considered, and regulated, as securities. The value of the payment in the event of default is determined by reference to a debt security, so that the payment is tied directly to a security. As noted in the CDS example in question #9, securities-related credit default swaps are tied directly to the securities markets and issuers of securities. As a result, manipulative activities in the credit default swap market would affect U.S. issuers in the underlying equity market. Congress recognized the impact of these instruments on the primary markets that are regulated by the SEC when it applied the antifraud and antimanipulation provisions of the securities laws to securities-related OTC derivatives, such as securities-related credit default swaps, in 2000. That authority needs to be extended to provide the SEC the regulatory tools to regulate these products. Regulating securities-related credit default swaps as insurance would actually undermine the protections provided by the Federal securities laws by creating the potential for arbitrage between two different types of regulation for economically related products.Q.11. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than renegotiate the debt?A.11. Some commenters have identified a phenomenon they characterize as the ``empty creditor'' problem. These commenters have noted that credit default swaps, among other products, allow a creditor holding a debt obligation to reduce or eliminate its economic exposure to the debtor while still retaining the rights as a creditor. As a result, creditors who hold significant credit default swap positions may prefer that the debtor enter into bankruptcy because the creditor will receive payments in connection with its CDSs that exceed any benefit the creditor would get if the debtor restructured its debt. The Federal securities laws do not establish any duties of a creditor to a lender or to other creditors. The motivation of a creditor to take any action with respect to its debt holdings in a particular company may be guided by many different economic and investment factors that are unique to such creditor, with credit default swaps being just one such factor. For example, a creditor that also is a significant equity holder may have different motivations in making credit decisions as compared to a creditor that holds only debt. Focusing only on a creditor's actions as influenced by its holding of credit default swaps does not take into account these other motivating factors.Q.12. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?A.12. As the financial crisis illustrates, it certainly appears that some major market participants may have used credit protection as an alternative to engaging in more robust traditional credit research and review regarding their credit exposures--leading to hidden/higher credit risk and the risk that the credit protection provider cannot perform. This tension is real. However, this moral hazard that exists in credit protection exists in a number of contexts in the financial arena. For example, this hazard exists when investors rely on a credit rating or an analyst's research report instead of engaging in their own research. Although inherent, this problem is exacerbated by a number of factors in the credit arena--such as when information is limited to a small number of creditors or unavailable to the public; when traditional credit standards are reduced; or when investors and creditors become less vigilant due to perceptions (or misperceptions) of market safety. In the short term, the financial crisis itself has certainly reduced these risks, but it is important that regulators (as well as investors and other market participants) remain vigilant to help avoid the next crisis. To better ensure that vigilance, we believe more accountability and transparency will do a lot to keep investors informed of the flaws of overreliance on credit protection, credit ratings, or a similar third-party validator before making investment or credit decisions.Q.13. Do net sellers of credit protection carry that exposure on their balance sheet as an asset? If not, why shouldn't they?A.13. Sellers of credit protection typically carry a liability on their balance sheets for the obligation to compensate the guaranteed party if a credit event occurs on the referenced asset. Some types of credit protection are considered insurance contracts under the accounting rules and the resulting obligation is measured based on insurance accounting principles. Other types of credit protection, such as credit default swaps, meet the accounting definition of a derivative and the resulting liability is marked to market each period. Unless an insurer or guarantor controls the referenced asset, accounting rules do not permit or require the referenced assets to be recognized on the guarantor's balance sheet. In other words, simply guaranteeing or insuring the value of an asset does not require a guarantor to record the insured asset on its balance sheet under generally accepted accounting principles. On the other hand, guarantors that control the insured or guaranteed assets will generally be required under new off-balance sheet accounting rules to report on their balance sheets the controlled assets effective for 2010 financial reports.Q.14. In your testimony you mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.14. Synthetic exposure through derivatives can be a good idea, or a bad idea--depending on the circumstances. While they can be used to increase leverage, they can also be used to reduce transaction costs, achieve tax efficiencies, or manage risk. Synthetic exposure through derivatives is a component of many arbitrage strategies that help align prices of related assets across markets. A key question for policy makers, I believe, will be determining how best to utilize the ``good'' aspects of derivatives use (e.g., as a risk management tool for individual institutions); while minimizing the ``bad'' aspects (unclear pricing, hidden leverage, and increased counterparty and systemic risk). It is also important to keep in mind that when synthetic exposure through securities-related derivatives products is used to replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves, the markets for these derivatives directly and powerfully implicate the policy objectives for capital markets that Congress has set forth in the Federal securities laws, including investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. Given the impact on the regulated securities markets--and the arbitrage available to financial engineers seeking to avoid oversight and regulation--it is vital that the securities laws apply to securities-based swaps.Q.15. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn't the economic benefit of that demand--higher value--flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?A.15. This is an interesting question. I believe policy makers should consider carefully whether/how the creation of these synthetics affect demand for the underlying securities. Traditionally, the view is that dealers and other financial intermediaries provide liquidity to the market and help make markets more efficient by reducing the extent to which asset prices are subject to excess volatility that may arise from short-term trading imbalances. The ability of liquidity providers to improve market quality is significantly enhanced when they are able to engage in activities that involve synthetic exposure. Constraints on the ability of intermediaries to provide liquidity increase the propensity for asset prices to deviate significantly from fundamental value. These deviations can lead to a misallocation of capital, and can be harmful to the investors. For example, investors are harmed when they buy an asset at a price that is temporarily inflated due to a demand shock.Q.16. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn't that demand lead to a greater supply and thus more liquidity?A.16. On average, large debt issues tend to be more liquid than small ones because they tend to be held by a greater number of investors and there are more units available for trading. This does not mean, however, that an issuer would have the ability to improve the liquidity of its bond issue by issuing more debt. Market liquidity depends mainly on the ability and willingness of financial intermediaries to take on inventory positions in response to demand shocks.Q.17. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?A.17. The primary justifications I have seen for permitting the purchase of credit protection beyond an entity's ``exposure'' are (1) these participants provide liquidity to those who are themselves hedging; (2) a participant may use credit protection based on one reference asset to hedge risks on other related assets; and (3) investors may wish to take a position expressing a view that the market is underestimating the probability or severity of default.Q.18. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?A.18. The term ``swap'' generally refers to over-the-counter derivative instruments, a category that encompasses a wide range of products, including forward contracts, interest rate swaps, total return swaps, equity swaps, currency swaps, credit default swaps and OTC options, including both traditional and digital (or binary) options. In contrast, futures are a specific kind of standardized, exchange-traded derivative. Swaps may be tailored to address specific risks in ways not available with standardized products such as futures. For example, customized swaps involving foreign currency, interest rates, and hard commodities may play an important risk management role for companies and other end users because standardized contracts, in these circumstances, may not address the needs of a company with respect to the specific risks being hedged.Q.19. One of the arguments for keeping over-the-counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?A.19. Commercial businesses will often individually customize OTC derivatives to meet the company's specific risk management needs. Companies may use OTC derivatives to manage fluctuations in materials prices, equity OTC contracts, commodities, fuel, interest rates and foreign currency. For example, a company that borrows money at a variable interest rate might enter into derivatives contracts to turn the borrowing into fixed-rate debt or as protection against swings in currencies or the price of commodities such as food and oil. The company can customize the contract to mature on a specific date or for a nonstandard notional amount, creating a more effective hedge. The inability to create perfect hedges can introduce basis risk. Basis risk can also occur when the asset being hedged is different from underlying asset of the derivative that is being used to hedge the exposure. Allowing firms to continue to bilaterally negotiate customized OTC derivatives contracts can help mitigate these risks. Standardizing OTC derivatives may increase costs in certain instances and decrease costs in others. Standardized derivatives, particularly those that are cleared through central counterparties, require the posting of cash or cash equivalent collateral. This is a cost not faced by financial firms when they enter into OTC derivatives contracts with other large financial firms. Conversely, standardizing OTC derivatives could result in tightening of the bid-ask spread of the instruments due to fewer individual terms that need to be negotiated between counterparties. This could potentially lower costs faced by purchasers and sellers of those contracts. Standardization could also lead to less effective hedges, but would allow a party to trade out of its position as opposed to negotiating a separate termination agreement. These termination agreements can be extremely expensive for the party seeking to exit customized deals.Q.20. On the second panel, Mr. Whalen suggests that Congress should subject all derivatives to the Commodity Exchange Act, at least as an interim step. Is there any reason we should not do so?A.20. To the extent that derivatives are securities-related, the securities laws should continue to apply. Without application of the securities laws, the derivatives market could be used to manipulate the securities market by circumventing securities laws protection against insider trading and improper short selling, among other things. Secretary Geithner recognized that multiple Federal regulatory agencies should play critical roles in implementing the proposed framework, including the SEC and the CFTC. In my testimony, I recommended that primary responsibility for ``securities-related'' OTC derivatives be retained by the SEC, which is also responsible for oversight of markets affected by this subset of OTC derivatives. Primary responsibility for all other OTC derivatives, including derivatives related to interest rates, foreign exchange, commodities, energy, and metals, could rest with the CFTC.Q.21. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.21. We agree that all derivatives trades should be reported. Information reported should include the identity of the contract traded, the size of the contract, the price, the parties to the contract (and which party was the buyer and which was the seller), and the time of trade. Additional analysis by appropriate regulators may identify other data elements that should be reported. Where a trade is reported depends on where it is traded. If a product is traded on a regulated exchange or an exchange-like facility (such as an alternative trading system), the details of the trade will be captured by the trading system. If a product is traded elsewhere, trades in that product should be reported to another regulated entity, such as a trade repository or self-regulatory organization. Entities to which trades are reported could disseminate information to the public individually. This approach would likely be the easiest to implement in the near term. However, it would mean that trading and reporting data would be fragmented, and it is unclear how easily or well it could be aggregated by private data vendors. Different entities could adopt different standards for trade reporting and dissemination (such as adopting different identification codes for the same derivatives contracts). Significant regulatory efforts could be necessary to promote uniform standards for these various entities to obtain the full benefits of post-trade reporting and transparency. One way to address these potential problems would be for the appropriate regulator to designate a central information processor to collect trade input from various sources and to disseminate trade information publicly in a uniform manner and subject to regulatory standards that ensure that access to the trade data is on terms that are fair and reasonable, and not unreasonably discriminatory. The SEC relies on and regulates such central information processors in the markets for cash equities, securities options, corporate debt securities, and municipal securities. We believe that these trade reporting and dissemination systems work very well and deliver a robust information stream in a timely and cost-efficient manner. As your question notes, some information that is reported may not be appropriate for public dissemination. One such item may be the names of the counterparties. The systems for cash equities, securities options, corporate debt securities, and municipal debt securities that are regulated by the SEC currently do not disseminate such information.Q.22. Is there anything else you would like to say for the record?A.22. I appreciate the opportunity to testify on this important topic and I look forward to working with the Committee to fill the gaps in regulation of OTC derivatives. These efforts are critical to furthering the integrity of the U.S. capital markets. ------ FOMC20080318meeting--102 100,MR. MADIGAN.," 2 Thanks, Mr. Chairman. I will be referring to the revised version of table 1 distributed earlier today in the package labeled ""Material for FOMC Briefing on Monetary Policy Alternatives."" The revised table presents the same basic set of alternatives that was discussed in the Bluebook. However, we have proposed some changes in language that affect the statements for alternatives A and B. I will discuss those changes, shown in blue, shortly. Alternative D, presented in the right-hand column, would leave the federal funds rate unchanged at this meeting at 3 percent. Committee members might be inclined to favor this alternative if they were particularly concerned about prospects for inflation and if they believed that, with due allowance for lags, the monetary and fiscal stimulus in train would likely be sufficient to lead to a resumption of moderate growth over time. The wording of this alternative would acknowledge the downside risks to growth. But as shown in paragraph 3, the statement would indicate that inflation has been elevated, cite several factors that could put additional upward pressure on inflation, and state that the upside risks to inflation have increased. No net assessment of the balance of risks would be included. Under alternative C, the stance of policy would be eased by 25 basis points today. A modest easing of policy might be motivated by judgments that the economic outlook has weakened, but by appreciably less than in the Greenbook, and that the inflation outlook is troubling. Members might see financial strains as concerning but likely to exert less restraint on growth than in the Greenbook forecast. 2 The materials used by Mr. Madigan are appended to this transcript (appendix 2). In these circumstances, the Committee might want to be cautious about policy adjustments that could add impetus to inflation, particularly given the substantial easing of monetary policy to date and the lags in the effects of policy. The language proposed for alternative C would note that the tightening of credit conditions and the deepening of the housing correction are likely to continue to weigh on economic growth. The inflation paragraph for this alternative is the same as that for alternative D. As shown in paragraph 4, the Committee would make an explicit judgment that the downside risks to growth outweigh the upside risks to inflation. Under alternative B, the Committee would reduce the federal funds rate 50 basis points today, to 2� percent. Such an approach could be seen as consistent with the Greenbook forecast. Indeed, under that forecast, the Committee is assumed to ease policy 50 basis points at this meeting and another 75 basis points over the next three months. The motivation for such a trajectory is provided partly by the 1� percentage point downward revision to the Greenbook-consistent measure of short-run r*. The Committee might concur with the staff's assumption regarding the amount of cumulative easing that will eventually prove necessary and find a gradual shift in policy attractive, particularly in view of what seems to be some upward drift of late in inflation expectations. Such a path would also be qualitatively consistent with the optimal control simulations shown in the Bluebook for a 2 percent inflation target, in which the federal funds rate is eventually eased to around 1� percent. As shown in paragraph 2, the statement issued under this alternative would indicate that the outlook had weakened. We have suggested striking the reference to risks as that thought is picked up in the risk assessment. The statement would go on to mention several factors that could weigh on economic growth, and we have suggested adding ""over the next few quarters."" With regard to inflation, the Committee would note that inflation has been elevated. It would also indicate an expectation that inflation will moderate in coming months and cite several factors that could contribute to that moderation but note that uncertainty about the inflation outlook has increased. Notably, the list does not mention ""reasonably well anchored inflation expectations"" or some variant of that phrase, which has been used recently in the minutes and other policy communications. Indeed, the first sentence of the paragraph notes that some indicators of inflation expectations have risen. Partly because inflation compensation includes a premium for inflation risk as well as inflation expectations, we thought that ""indicators"" of inflation expectations might be a better word than ""measures"" and have suggested that substitution. Over the past few days, inflation compensation as read from TIPS has plunged; however, we are skeptical that the decline represents primarily a drop in inflation expectations or inflation risk. Rather, we suspect that it is importantly a result of shifting liquidity premiums, as yields on nominal Treasury securities have fallen sharply partly because of increased demands for safety and liquidity. The final paragraph of alternative B would repeat the risk assessment issued after the January meeting. It would again indicate that downside risks remain and emphasize that the Committee will act in a timely manner to address those risks. Finally, under alternative A the Committee would lower the funds rate 75 basis points today. Given the extent of policy easing assumed in the staff forecast, this alternative could easily be consistent with an outlook along the lines of the Greenbook. This policy approach could also be motivated by concern about the possible implications for the economic outlook of the worsening in financial market conditions in the five days since the staff forecast was finalized or by a riskmanagement approach that gave particular weight to the downside risks around the outlook. The language proposed for the rationale section, paragraphs 2 and 3, of alternative A is identical to that proposed for alternative B. As with alternative B, the risk assessment paragraph says that policy actions should promote moderate growth over time and mitigate downside risks, but this version also alludes to the measures that the Federal Reserve has implemented to promote market liquidity. This language could also be used in alternative B. Rather than providing an assessment of the balance of risks, as we did in the Bluebook version, here in alterative A we have suggested simply indicating that downside risks to growth remain. Given the high degree of uncertainty, you might again prefer not to make an overall risk assessment. This paragraph differs from the corresponding part of the January statement also by indicating that the Committee will act in a timely manner as needed to promote sustainable economic growth and price stability. Thus, while the Committee eases 75 basis points, this language of alternative A would signal some increase in the Committee's concern about inflation in several ways: by indicating that inflation has been elevated; by noting that some indicators of inflation expectations have risen; and by incorporating a traditional formulation of the dual objectives, including price stability, in the final sentence. As Bill noted this morning, market participants appear to place substantial odds on a 100 basis point policy move at this meeting. Thus, implementation of any of these alternatives would involve at least somewhat less easing than expected. Given what would appear to be very fragile market conditions and highly skittish investor sentiment, you might see somewhat greater risks than usual in diverging from market expectations, and obviously the risks would be larger the greater the gap between anticipation and your actions. At the same time, you might see good reasons for some divergence. First and most obviously, you might see a smaller move as appropriately calibrated given your outlook and sense of the risks. Also, some indicators do seem to suggest that inflation expectations have become a bit less firmly moored. Even if you see gradual dollar depreciation as likely to be appropriate given the weakness of the U.S. economy and quite possibly a necessary factor in fostering an improved current account balance over time, you may be concerned about the downward lurch in the dollar over recent days and the potential for disorderly conditions to develop. You may judge that a policy decision today to implement somewhat less easing than markets expect and a statement that implies somewhat greater concern about inflation could be helpful in leaning against inflation expectations and any sense in markets that you are indifferent to downward pressure on the dollar. Alternative A would likely prompt some increase in shorter-term interest rates; but given that the risk assessment would point to continued downside risks, market participants would infer that further easing is a likely prospect, and the effects on other financial asset prices and financial conditions more generally could be reasonably limited. The 50 basis point easing of alternative B, in contrast, would suggest to market participants that you are inclined to be considerably more cautious in easing policy further, even with the downside risk assessment, and short- and intermediate-term interest rates could ratchet considerably higher, equity prices decline, and credit conditions tighten--responses that presumably would be amplified, perhaps nonlinearly, under alternatives C and D. " FOMC20050322meeting--109 107,MR. POOLE.," Thank you, Mr. Chairman. One of my business contacts, my Wal-Mart contact, started our conversation by saying that the situation is rather strange—his word. Spending coming out of the Christmas season has been higher than anticipated—with same-store sales about 4 percent higher on a year-over-year basis—and they’re not sure where this strength is coming from. They are anticipating about that same strength, or maybe even a bit more, going forward. He noted that their inflation situation is not a concern. Their prices overall are flat; food prices are up a little and prices of nonfood items are down a little. The labor market is very stable; Wal-Mart is having no problem at all hiring associates at their stores. My UPS contact noted an expansion of their capital spending. He said that business from retail mail order firms is very strong. He indicated that his company has some labor concerns. They March 22, 2005 48 of 116 doing contingency planning for it. They do not believe that the rest of the industry has the capacity to fill in, should UPS be shut down. My FedEx contact noted also an increase in capital spending, up 15 percent for this fiscal year over last fiscal year. He indicated that about two-thirds of that is for expansion of capacity and about one-third for productivity enhancements. Also, he said that they had no concern regarding labor availability. Fuel prices, obviously, are a concern for them. My contact in the trucking industry had contrary information. He said that demand is softer than anticipated and that there has been a switch from prebookings for truck shipping services to last-minute bookings. He also noted that the driver shortage is getting worse and worse. A contact in a major software company said that sales had come in a little soft relative to their expectations but attributed it to Intel coming up short on inventory—I think particularly on notebook computers. Apparently Intel was surprised by demand that was higher than anticipated. Also, I might mention that a contact in the banking industry noted that C&I [commercial and industrial] loans year-over-year are now positive and accelerating and that there appears to be a lot of momentum. Let me turn now to some comments about the economy in general. We have in place a very broad-based and robust recovery. Business fixed investment is taking hold and taking the lead. I think it’s highly likely, of course, that employment and income will grow, which will provide support for consumption, as the Greenbook emphasizes. So even if we had a welcome increase in the saving rate, we’d probably see continued strength in consumption. The Greenbook contains—and we continue to hear elsewhere—a lot of comments on energy prices. In my view, it’s very important that we think of energy prices as being demand-driven. This March 22, 2005 49 of 116 appropriate to think about what the world would look like if energy prices had not increased and how much gets taken off growth. But I’m not sure that that’s quite the right way to look at this, because the situation is being driven fundamentally by demand. It’s not that output is being constrained by energy; it’s that vigorous output growth is driving up energy prices. As for labor compensation, productivity gains are holding down growth in unit labor costs. That’s a source of great stability. Let me make a general point about this expansion that really took hold roughly six quarters ago. Relative to U.S. business cycle history, this expansion has been one of the most orderly and best predicted. The forecast errors are astonishingly small—much lower than the usual standard errors that we see—and I think that has a lot to do with the very well-balanced and orderly nature of the expansion. This expansion is about as surprise-free as we ever see. I think our policy goal should be to maintain the orderly nature of the expansion as far as we can, and, of course, that includes as an essential element maintaining the stable inflation environment. I think the staff forecasts for both real GDP and inflation make a lot of sense. As point forecasts, they’re as good as one can find. I think the risks around the GDP forecast are probably pretty symmetrical, but I do not believe that the risks around the inflation forecast are symmetrical. I view the inflation forecast more as a median of the distribution than a mean. I think the distribution is skewed to the right—that there’s a substantially higher probability that we could have a ½-point upside surprise than a ½-point downside surprise on the inflation outcome. That’s all I’ll say at this time. Thank you." FinancialCrisisReport--262 Subprime loans, Alt A mortgages that required little or no documentation, and home equity loans all posed a greater risk of default than traditional 30-year, fixed rate mortgages. By 2006, the combined market share of these higher risk home loans totaled nearly 50% of all mortgage originations. 1014 At the same time housing prices and high risk loans were increasing, the National Association of Realtors’ housing affordability index showed that, by 2006, housing had become less affordable than at any point in the previous 20 years, as presented in the graph below. 1015 The “affordability index” measures how easy it is for a typical family to afford a typical mortgage. Higher numbers mean that homes are more affordable, while lower numbers mean that homes are generally less affordable. By the end of 2006, the concentration of higher risk loans for less affordable homes had set the stage for an unprecedented number of credit rating downgrades on mortgage related securities. 1013 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 8. 1014 Id. 1015 11/7/2007 “Would a Housing Crash Cause a Recession?” report prepared by the Congressional Research Service, at 3-4. (2) Mass Downgrades FOMC20061025meeting--85 83,MR. KOHN.," Thank you, Mr. Chairman. The Committee’s focus has been on encouraging a gradual abatement of core inflation, and I think the limited evidence we’ve gotten since the last meeting is consistent with this outcome. The price data themselves show some signs of deceleration of core inflation on a three-month basis from the very high levels of last spring and summer, though the rates are still elevated. A further decline in energy prices should help to keep inflation expectations down and will take a little pressure off business costs and core inflation even if pass-throughs are fairly small. As expected, the rent-of-shelter component has been increasing less rapidly, supporting the projection that, in a soft housing market with overhangs of unsold housing units, this component will not be boosting measured inflation rates very much. Inflation expectations as derived from financial market quotes remain at the lower levels reached earlier this fall. As the Bluebook notes, the exact level of these expectations is really impossible to tease out of the data; and although they may be a bit higher than we would like, they do look lower than the recent twelve-month inflation rates and, at these levels, should exert some downward gravitational pull on realized inflation. The economy appears to be running modestly below the rate of growth of its potential, and this should relieve pressure on labor and product markets. How far the economy is running below potential in an underlying sense is uncertain. I suspect it is not as weak as the estimated third-quarter GDP number but is somewhat softer than the labor market indicators, which show no slackening in the pace of demand or decline in resource utilization. I base this conclusion in part on the data and projections of final domestic and total demand, which the Greenbook has averaging in the neighborhood of 2 percent in the second half of the year. Industrial production was weak in August and September, pulled down by the ongoing inventory corrections in housing and autos, and this reinforced my sense that, at least for a time, the economy is growing a bit below the rate of growth of its potential. Going forward, I think a projection of economic growth gradually recovering next year as the drag from housing abates is reasonable, with growth supported by favorable financial conditions and lower energy prices. How quickly it returns to potential is an open question. Though other forms of spending have proven resilient to date, I agree with the staff analysis that some spillovers on consumption and investment from the weakness in housing and in housing wealth are likely to restrain growth at least a little next year. I also see that the spending risk is still pointed somewhat to the downside, although less so than at the last meeting. To be sure, the recent signs are somewhat reassuring that the housing market isn’t weakening faster than expected. Still, in the staff forecast the housing market is left with a relatively high level of inventory at the end of 2008, and prices are still elevated relative to rents, suggesting the possibility of greater declines in activity and prices. In addition, equity prices are vulnerable to disappointing earnings as labor costs rise even gradually. The economy is most likely to grow a little below its potential for a while and inflation to trend gradually lower. All in all, this is a pretty good outcome following the earlier oil price shock and rise in core inflation and housing market correction. With demand outside of housing as resilient as it has been and inflation as high as it has persisted, the extent and trajectory of the expected inflation trend is uncertain and should remain our focus. A failure of inflation to reverse the uptick of earlier this year before it becomes embedded in higher inflation expectations continues to be the main risk to good, sustained economic performance over time. Thank you, Mr. Chairman." CHRG-111hhrg48674--352 Mr. Bernanke," Well, I do think that there are big liquidity premiums and risk premiums in the market, and that eventually, in all likelihood, those premiums will at least become more normal, which would--otherwise everything else being equal, would tend to improve asset prices. With that being said, I think one of the big issues right now is that markets are very uncertain about where the economy is going. They have a sense of what is likely to happen, but they fear a small probability, a very bad outcome, and that makes them very reluctant to take on risk. To the extent the government has more capacity to bear risk and more capacity to hold assets for a longer period, there is some benefit for the government to take assets via the asset purchase facility or some similar mechanism. Ms. Bean. You also, in response to a question from Congressman Miller earlier, talked about Secretary Geithner's proposal and how he certainly wants to move what we are now calling legacy assets instead of illiquid assets off the book of many of our financial institutions so that we can better also then evaluate how solvent many of these institutions are. I just want to clarify whether I understood your comments in response to that; that you felt the good news about that is while some institutions will be proven nonviable, and that there may be some fallout, it should attract more capital than sitting on the sidelines waiting to have better confidence in reentering the market. " FOMC20060629meeting--87 85,MS. PIANALTO.," Thank you, Mr. Chairman. Much like the Greenbook, the reports that I hear from my directors and business contacts are consistent with an economy that is expanding, but at a slower pace than earlier this year. Activity related to residential real estate has softened, and I continue to hear from my business contacts that they are concerned that consumer spending will retrench in response to the softer housing market and higher energy prices. But I do not get much indication that this concern is having a substantial effect on their business plans. Capital spending plans in particular seem little changed from the beginning of this year. As for inflation, rising costs are widely reported by my business contacts, but most of these pressures are still related to energy and material prices. I continue to hear that productivity-adjusted wage pressures remain in check. Among producers of intermediate goods, the number of firms that report the ability to pass through costs seems to be increasing, but as of now, I am not hearing a lot in the way of substantial price increases at the retail level. Despite what I am hearing from my business contacts, the data tell a different story, and they have affected my thinking since our last meeting. The core inflation numbers have been drifting up, whether calculated by excluding food and energy or by the trimmed mean and median CPI measures that we monitor in Cleveland. Since December the majority of items in the CPI weighted by their expenditure shares have risen at annual rates in excess of 3 percent. It is still possible, of course, that the pattern of these price increases that have been showing up lately is just an outsized but transitory pass-through of energy and commodity prices or the realignment of rents to the exceptional residential housing market that we have seen in the past few years. But this explanation is becoming increasingly difficult for me to defend. At our May meeting I expressed concerns that risks were weighted against both our objectives, and the Greenbook baseline now reflects those concerns: weaker economic growth and higher inflation. At this time, I do not see any signs that the real economy is going to be weaker than projected in the Greenbook baseline, but unfortunately I do not expect an inflation outlook that is much better than the Greenbook baseline either. That is my report, Mr. Chairman. Thank you." FOMC20080430meeting--110 108,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. In terms of markets, Fed credibility, and negative surprises on the data relative to our forecasts, I think this has been the best intermeeting period in a long time. The markets reflect increased confidence that policy will be effective in mitigating the risks both of a systemic financial crisis and of a very deep, protracted recession. We have seen a substantial upward movement in the expected path of the fed funds rate and in real forward rates, significant diminution in the negative skewness in fed funds rate expectations, and a significant move down in a range of different measures of credit risk premiums, and markets have been pretty robust despite bad news over the past few weeks or so. Medium- and long-term expectations in TIPS have moved down, and we have had a very important and substantial additional wave of inflow of equity into the financial system. Our forecast, though, is roughly the same as it was in March, and it is broadly similar to the path outlined in the Greenbook. We expect economic activity to follow a path somewhere between the last downturn--a relatively mild downturn--and that of 1990. We expect underlying inflation to moderate somewhat over the forecast period to something below 2 percent. We see the risks to the growth forecast still skewed to the downside, though somewhat less so than in March, and we see the risks to the inflation outlook as broadly balanced. Uncertainty around both paths, though, is unusually high. I want to make four points. First, on economic growth, again, I still think we face substantial risk in this adverse self-reinforcing interaction among falling house prices, slower spending, and financial headwinds. Even with the very substantial adjustment in housing construction that has already occurred and even if demand for housing stays stable at these levels, we still have several quarters ahead of us before the decline in housing prices starts to moderate. A further falloff in aggregate demand during this period would raise the prospect of a much larger peak-to-trough decline in housing prices, with higher risk of larger collateral damage to confidence, spending, credit supply, et cetera. Weakness, as the Chairman has reminded us several times over the past few years, tends to cumulate and spread in these conditions, and weakness may only just be beginning outside of housing. The saving rate here may have to rise substantially further. The world is behind us in this cycle, and it is likely to slow further, diminishing potential help from net exports going forward. Second, financial conditions are, I think, still very fragile. The financial system as a whole still looks as though it is short of the capital necessary to support growth in lending to creditworthy households and borrowers. Parts of the system still need to bring leverage down significantly. Liquidity conditions in some markets are still impaired; securitization markets are still essentially shut. I think the markets now reflect too much confidence in our willingness and ability to prevent large and small financial failures. We are going to disappoint them on the small ones, which may increase the probability they attach to the large. At least I hope we disappoint them on the small ones. Third, I think the inflation outlook, as many of you have said, still has this very uncomfortable feel to it--very high headline inflation, very high readings on the Michigan survey, and the dollar occasionally showing the spiral of feeding energy and commodity prices and vice versa. I sat next to Paul Volcker when he gave his speech in New York the other day, and he said that the world today feels as it did in the 1970s. I was alive in the 1970s, but only just. [Laughter] But I think it is better than that. It has to be better than that. Core has come in below expectations. David is not going to explain all of that away by these temporary, reversible factors. You have all acknowledged that there is somewhat of an improvement in inflation expectations at medium-term horizon. It is very important that you have not seen any material pressure in broad measures of labor compensation. Profit margins are coming down, but they are still unusually high. The path of output relative to potential, both here and around the rest of the world, is going to significantly diminish pressure on resource utilization going forward even if you have other forces that push up demand for energy and food secularly. I think it is worth remembering that we had a very, very large sustained relative price shock in the years preceding this downturn, with very little pass-through to core inflation. In fact, in many ways, core inflation moderated over that period with output to potential much tighter. Fourth, on monetary policy, it seems to me that we are very close to a level that should put us in a good position to navigate these conflicting pressures ahead. What matters for the outlook is the relationship between the real fed funds rate and our estimates of equilibrium. Although we can't measure the latter with any precision, those estimates of equilibrium have to be substantially lower than normal because of what is happening in financial markets. The Greenbook and Bluebook presentations suggest that the real fed funds rate now is about at equilibrium. You can look at it through a number of prisms and see some accommodation--see the real fed funds rate somewhat below equilibrium now. We won't know the answer until this is long over. I think that we are probably now within the zone where we are providing some insurance against the risk of a very bad macroeconomic financial outcome without creating too much risk of an inflation spiral. We should try for an outcome tomorrow in our action and in our statement that is pretty close to market neutral. One final point about the future. What strikes me as most implausible in our forecast in New York, and I think in the average of our submissions, is the speed with which we expect to return to growth rates that are close to estimates of long-term potential. A more prudent assumption might be for a more protracted period of below-trend growth for a bunch of familiar reasons. I don't know if that is the most likely outcome, but it is a plausible and realistic outcome. I don't think we should be directing policy at trying to induce an unrealistically quick return to what might be considered more-normal growth rates over time. Thank you. " FOMC20080310confcall--3 1,MR. DUDLEY.," Thank you, Mr. Chairman. Financial conditions have worsened considerably in recent days. Credit spreads have widened, equity prices have declined, and market functioning has deteriorated sharply. Although there are many factors that can be cited to explain what we are seeing--including the acute weakness in the U.S. housing sector, a deteriorating macroeconomic outlook, and the loss of faith in credit ratings and structured-finance products--we may have entered a new, dangerous phase of the crisis. Major financial intermediaries are pulling back more sharply and along more margins than previously--shrinking their collateral lending books and raising the haircuts they assess against repo collateral. For a time, this adjustment was occurring in a relatively orderly way, but we appear to have passed that point about ten days ago. The failure of Peloton--a major hedge fund--and the well-publicized problems of Thornburg Mortgage and Carlyle Capital Corporation in meeting margin calls have triggered a dangerous dynamic. That dynamic goes something like this: Asset price declines--say, triggered by deterioration in the outlook--lead to margin calls. Some highly leveraged firms are unable to meet these calls. Dealers respond by liquidating collateral. This puts downward pressure on asset prices and increases price volatility. Dealers raise haircuts further to compensate for the heightened volatility and the reduced liquidity in the market. This, in turn, puts more pressure on other leveraged investors. A vicious circle ensues of higher haircuts, fire sales, lower prices, higher volatility, and still lower prices, and financial intermediaries start to break as a liquidity crisis potentially leads to insolvency when assets are sold at fire sale prices. This dynamic poses significant risks. First, it impairs the monetary policy transmission mechanism. We have seen that in recent weeks in the sharp widening between mortgage rates on an option-adjusted basis and Treasury bond rates. Second, as hinted at above, there is a systemic issue. If the vicious circle were to continue unabated, the liquidity issues could become solvency issues, and major financial intermediaries could conceivably fail. I don't want to be alarmist, but even today we saw double-digit stock price declines for Fannie Mae and Freddie Mac. There were rumors today that Bear Stearns was having funding difficulties: At one point today, its stock was down 14 percent before recovering a bit. Third, the problems in one financial market disturb others. We have seen the problems move from subprime to alt-A mortgages to jumbo prime mortgages and now even agency mortgage-backed securities. Commercial-mortgage-backed security spreads and corporate credit spreads have also widened, and we have seen considerable distortions in the municipal market. The deterioration in market function can be seen in a number of ways. First, term funding spreads have widened back out. For example, the one-month LIBOR�OIS spread today is 56 basis points, up from its low point in 2008 of 16 basis points, which was reached in January. Second, haircuts for residential MBS have increased sharply, and if anything, the rate of deterioration in terms of haircuts has accelerated markedly in the last week. Third, bid-asked spreads for transactions on many types of financial instruments have widened, indicating a growing liquidity problem in the market. To address these issues, the Federal Reserve has responded by increasing the size of the TAF program and by implementing a large, term, single-tranche RP program. Together, these two programs will likely cumulate to total outstandings of about $200 billion. In addition, as the Chairman mentioned, the ECB and the SNB today have submitted requests to increase their foreign exchange swap draws and restart their term funding auctions. But there are limits to what these programs can do. The TAF provides liquidity only to depository institutions--this liquidity is not necessarily passed on readily to primary dealers and to other financial institutions. Although term RPs do provide some assistance to primary dealers, these operations are limited to the highest quality collateral--Treasuries, agencies, and agency mortgage-backed securities. Moreover, as both programs are scaled up, there is a large impact on reserves that must be offset by Treasury redemptions, sales, or reverse repurchase operations. Frankly, there are limits to our ability to adjust our portfolio quickly without our actions becoming a source of disruption to financial markets. For this reason, the staff has proposed a new facility, the term securities lending facility, or TSLF. A memo from the New York Fed staff and a term sheet were circulated to the FOMC earlier today, and these documents discuss in some detail this proposal. Let me give a summary of what I see as the most important points. In brief, this facility would expand the Federal Reserve's securities lending program for primary dealers by lending securities secured for a term of 28 days, rather than overnight, by a pledge of other securities--Treasuries, agencies, agency mortgagebacked securities, or AAA-rated private-label mortgage-backed securities. The last category is not currently eligible for open market operations (OMO). Currently, our securities lending program is overnight and exchanges only Treasuries for Treasuries. The purpose of this facility is to help alleviate the rapidly escalating pressures evident in term collateral funding markets. So how would this facility help to accomplish this? By providing the ability to swap illiquid mortgage-backed collateral for Treasury securities, the program would reduce the uncertainty among dealers about their ability to finance such collateral. The expanded supply of Treasuries obtained in the collateral swaps would improve the ability of primary dealers to finance the positions on their balance sheets. This should, in turn, increase the willingness of dealers to make markets across a range of securities. Better market-making, in turn, should lead to greater liquidity for these securities. This, then, should reduce price volatility and obviate the need for dealers to assess higher haircuts against such securities. The liquidity option provided by the TSLF should reduce liquidity risk more generally. The program should help slow, or even reverse, the dynamic process of reduced liquidity, greater price volatility, higher haircuts, margin calls, and forced liquidation. Why does the staff recommend that the scope of collateral be broader than OMOeligible collateral? The staff believes that a program based only on OMO collateral could help improve liquidity in those markets. An improvement in liquidity in these core markets could help other related markets. Despite this, the staff recommends that the TSLF go one step further and also accept AAA-rated private-label residentialmortgage-backed securities in this program. The staff believes that it is important to take this additional step because the level of dysfunction in the non-agency mortgagebacked securities market is pronounced, this market is large, and steps to improve market function in this asset class are likely to have positive consequences for the availability and the cost of mortgage finance. In other words, improvement in this area would make monetary policy more effective and would likely generate significant macroeconomic benefits. To limit the credit risk exposure of the Federal Reserve, the facility for nonOMO-eligible collateral would be limited to AAA-rated residential-mortgage-backed securities assets not on review for downgrade. In addition, the securities would be repriced daily, and appropriate haircuts would be applied against such securities. Why not go further? Although the SOMA lending facility could be extended to include other asset classes such as commercial-mortgage-backed securities, corporates, and municipals, the staff recommends against such a broader extension for two reasons. First, these markets are not under the same degree of duress as the residential-mortgage-backed securities market. Second, adding additional asset classes would increase the operational complexity and risk of the program--for example, by requiring additional auction cycles. What are the risks of such a program? We think there are several risks that are particularly noteworthy. First, we cannot be sure that the program will have its intended impact. Experience with the TAF suggests that it will, but there is no guarantee of this. Second, the TSLF could increase moral hazard. If the program is successful in preventing losses that would have arisen from an inability to obtain funding, the TSLF would be a form of insurance that could conceivably induce broker�dealers to run smaller liquidity cushions during normal times. Third, Federal Reserve credit risk would increase as the SOMA portfolio accepted lower-quality collateral from primary dealers. On the first point--Will it work?--the TSLF would be quite large, perhaps cumulating to $200 billion, the same size as the TAF and the term RP program combined. We can make it even bigger if we desire. So we think we have the muscle here to have an impact on term funding markets. On the second point--the moral hazard issue--the staff believes that the TSLF will increase moral hazard somewhat. Ideally, this type of program would also be accompanied by prudential regulation to ensure that primary dealers hold adequate liquidity buffers across the typical business cycle. On the third point--the issue of credit risk to the Federal Reserve--we conclude that there will inevitably be some increase in credit risk. But this risk should be controllable. We know our counterparties, we are not accepting securities that are on watch for downgrades, and the non-agency MBS securities will be AAArated. Moreover, we plan to limit the exposure to the more robust AAA-rated MBS by not accepting private-label MBS with CDO-type structures and characteristics. And if securities are put on watch, we can demand substitution. Fully cognizant of these risks and others--which are outlined in more detail in the memorandum circulated to the FOMC earlier today--we conclude that the benefits are likely to significantly exceed the costs of the program. The staff believes it is important to take those steps necessary to restore the monetary policy transmission mechanism to working order and to short-circuit the vicious dynamic now evident in financial markets. Debby Perelmuter will now describe the TSLF program in more detail, focusing on how it will operate in practice, now that I've outlined the theory. Debby. " FinancialCrisisReport--268 The evidence shows that analysts within Moody’s and S&P were aware of the increasing risks in the mortgage market in the years leading up to the financial crisis, including higher risk mortgage products, increasingly lax lending standards, poor quality loans, unsustainable housing prices, and increasing mortgage fraud. Yet for years, neither credit rating agency heeded warnings – even their own – about the need to adjust their processes to accurately reflect the increasing credit risk. Moody’s and S&P began issuing public warnings about problems in the mortgage market as early as 2003, yet continued to issue inflated ratings for RMBS and CDO securities before abruptly reversing course in July 2007. Moody’s CEO testified before the House Committee on Oversight and Government Reform, for example, that Moody’s had been warning the market continuously since 2003, about the deterioration in lending standards and inflated housing prices. “Beginning in July 2003, we published warnings about the increased risks we saw and took action to adjust our assumptions for the portions of the residential mortgage backed securities (“RMBS”) market that we were asked to rate.” 1036 Both S&P and Moody’s published a number of articles indicating the potential for deterioration in RMBS performance. 1037 For example, in September 2005, S&P published a report entitled, “Who Will Be Left Holding the Bag?” The report contained this strong warning: “It’s a question that comes to mind whenever one price increase after another – say, for ridiculously expensive homes – leaves each succeeding buyer out on the end of a longer 1036 Prepared statement of Raymond W. McDaniel, Moody’s Chairman and Chief Executive Officer, “Credit Rating Agencies and the Financial Crisis,” before the U.S. House of Representatives Committee on Oversight and Government Reform, Cong.Hrg. 110-155 (10/22/2008), at 1 (hereinafter “10/22/2008 McDaniel prepared statement”). 1037 See, e.g., 6/24/2010 supplemental response from S&P to the Subcommittee, Hearing Exhibit 4/23-108 (4/20/2005 Subprime Lenders: Basking in the Glow of A Still-Benign Economy, but Clouds Forming on the Horizon” S&P; 9/13/2005 “Simulated Housing Market Decline Reveals Defaults Only in Lowest-Rated U.S. RMBS Transactions,” S&P; and 1/19/2006 “U.S. RMBS Market Still Robust, But Risks Are Increasing and Growth Drivers Are Softening” S&P). “Housing Market Downturn in Full Swing,” Moody’s Economy.com (10/4/2006); 1/18/2007 “Special Report: Early Defaults Rise in Mortgage Securitization,” Moody’s ; and 9/21/2007 “Special Report: Moody’s Subprime Mortgage Servicer Survey on Loan Modifications,” Moody’s. See 10/22/2008 McDaniel prepared statement at 13-14. In addition, in March 2007 Moody’s warned of the possible effect that downgrades of subprime mortgage backed securities might have on its structured finance CDOs. See 3/2007 “The Impact of Subprime Residential Mortgage-Backed Securities on Moody’s-Rated Structured Finance CDOs: A Preliminary Review,” Moody’s. and longer limb: When the limb finally breaks, who’s going to get hurt? In the red-hot U.S. housing market, that’s no longer a theoretical riddle. Investors are starting to ask which real estate vehicles carry the most risk – and if mortgage defaults surge, who will end up suffering the most.” 1038 FOMC20080430meeting--207 205,CHAIRMAN BERNANKE.," Thank you all. The discussion was very good as usual, and let me just assure you that I listened very, very carefully. So I'm certainly hearing what you're saying, and I understand the concerns that people have expressed. I play Jekyll and Hyde quite a bit and argue with myself in the shower and other places. [Laughter] Let me first say that I think we ought to at least modestly congratulate ourselves that we have made some progress. Our policy actions, including both rate cuts and the liquidity measures, have seemed to have had some benefit. I think the fear has moderated. The markets have improved somewhat. As I said yesterday, I am cautious about this. There's a good chance that we will see further problems and further relapses, but we have made progress in reducing some of the uncertainties in the current environment. I also think that there's a lot of agreement around the table--and I certainly agree--that we have reached the point where further aggressive rate-cutting is not going to be productive and that we should now be signaling a willingness to sit, watch, and listen for a time, for two reasons. First, risks are now more balanced. That is, there is more attention to inflation risks and dollar risks, and although our output risks remain quite significant, the balance is closer than it has been for some time. Second, given that we have done a lot in a short time and moved aggressively and that we're seeing fiscal actions coming in and perhaps other policy effects as well--lagged effects of our own actions-- it seems to be a reasonable time for us to pause, to watch carefully, and to presume that we're not going to move unless conditions strongly warrant it. So I think that, at least in that broad respect, there's a lot of agreement around the table. The two alternatives that have been discussed by most people are B, which is to move 25 basis points today but to send a fairly strong signal of a preference to pause after this meeting, and C, which is not to move but to keep some elements of the downside risk alive in our risk assessment. Like a number of people, I think both are plausible. Both have appeal. Alternative C, in particular, has the appeal of pushing back against some critics on the inflation side who have criticized us for not being sufficiently attentive to the dollar, to commodity prices, and so on. As I said yesterday, I think that inflation is an important problem. It's a tremendous complication, given what is happening now in the other parts of the economy. In no way do I disagree with the points made by many participants that inflation is a critical issue for us and that we have to pay very close attention to it. As I said yesterday, I do think that some of the criticism that we are getting is just simply misinformed. I don't think there's any plausible interest rate policy that we can follow that would eliminate the bulk of the changes in commodity prices that we're seeing. I think they are due mostly to global supply-and-demand conditions. A small piece of evidence for that is that yesterday the ECB was mentioned favorably as having the appropriate inflation attitudes compared with our attitudes. I would just note that headline inflation in the euro zone is about the same as it is here, despite their stronger currency, because they are being driven by the same global commodity prices that we are. I would also say that, although the inflation situation is a very important concern, I don't see any particular deterioration in the near term. Since the last meeting, oil prices have gone up, which is very high profile, but gold, for example, has dropped about 12 or 13 percent. Other precious metals are down. Some other commodities are down. The dollar is stronger. TIPS breakevens have moved in the right direction. Wages, as we saw this morning, are stable, and I would urge you to compare wage behavior over the past five years with wage behavior during the 1970s. Wage growth then was not only high but also very unstable and responsive to short-term movements in headline inflation. So I think the canary is still getting decent breath here. [Laughter] I want us to be careful not to overpromise. We cannot do anything about the relative price of gasoline, and I don't think that we're on the edge of an abyss of the 1970s type. I do think it's an important issue, and I do think that there is benefit to pushing against the perceptions. In this business, perceptions have an element of reality to them, and we understand that. That's an important part of central banking, and I fully appreciate that point. So again, I see a lot of merit in the alternative C approach. As I think you can conjecture, I'm going to recommend alternative B--25 basis points but with a stronger indication of a pause. Let me discuss why in the end I come down on that side. First is the substance, the fundamentals. I don't think that 25 basis points is irrelevant. For example, one-month LIBOR is up about 35 basis points since our last meeting. These short-run financing costs do matter, particularly in a situation of financial fragility. So it is not just an issue, as President Evans mentioned, of long-term interest rate expectations. Overnight and short-term financing costs do matter for the financial markets, and a lower rate will help the markets to heal. It will affect other rates. To take an obvious example, it affects the adjustable rate that mortgages move to in the economy. So I think there's a case to be made on the substance. I will not add much to the discussion about how we define ""accommodative."" But one way to do it, I guess, is to look at the Greenbook's very thorough analysis, which rather than using rules of thumb attempts to look at a broad forecast conditional on what the staff can ascertain about the financial drags that we're seeing. Their analysis suggests that something around where we are or a little lower is consistent with slow economic growth but also price stability within a relatively short time. That is one way of trying to calibrate. Obviously, there are other ways as well. The second point I'd make, besides just the substance, is the consistency with our own projections. Virtually everybody around the table still thinks that the downside risks to growth are significant, and we've mentioned the same factors--financial conditions, housing, and a few other things. Those remain very serious downside risks. I don't think anybody thinks they are under control at this point. Yes, we also see an increased number of people with upside risks to inflation. But again, in terms of the numbers we'll publish, I think the downside risks are still held by more people than the inflation assessment. That, by the way, suggests why we can't really do what President Plosser suggests--hold and move to the alternative B, paragraph 4, language. Not to move and to say that the risks are balanced would, I think, be clearly inconsistent with the risk assessments that are in the projections. The other issues have to do with communications. We are at an important transition point in our communication strategy. One of the risks that we took when we made the very rapid cuts in interest rates earlier this year was the problem of coming to this exact point, when we would have to communicate to the markets that we were done, that we were going to flatten out, and that we were going to a mode of waiting. It was always difficult to figure out how that was going to work in a smooth way. Whether through luck or design, market expectations have set up perfectly. I mean, basically they're now assuming a flat path going forward, with some increase later; and that appears to be consistent, as Vice Chairman Geithner noted, in the last few days with significant dollar appreciation, declines in commodity prices, and declines in inflation expectations--all the things that we want to see. It appears that we're in a position that had seemed really problematic some time ago, so we are now able to make the transition in a way that will be relatively clear and, I hope, not too disruptive. Now, I want to come back to the issue of disappointing markets. I agree with President Fisher and many others that disappointing markets can be a good thing. It is certainly not always a bad thing, by any means. I think the issue is a little more subtle than that. The issue here is the clarity of what we're trying to say and the way our message is going to be read. Let me make two points about that. If we were to do alternative C, I think there would be essentially two issues. One is that, although we would not be moving, which would be a surprise, we would also not be declaring a pause because of downside risk, which would be another surprise. We'd have a surprise both in the action and in the statement. The risk there is that we confuse the markets about what our intentions are and what would cause us to respond. For example, the Greenbook's projections of Friday's employment numbers are somewhat more pessimistic than those being held in the market. If we took action C today and Friday's numbers were consistent with the Greenbook forecast and with our own projections but worse, significantly worse, than the market expectation, would statement C then lead to the building in of additional ease? I think there would be a lot of confusion there--a lot of uncertainty about what exactly we are saying about when we'd be willing to respond. The other communication issue that I have with alternative C--and this, again, is something President Fisher said yesterday--is that if we don't move and we put C out there, the stock market could go up because it might be read as saying that the Fed has increased confidence, is seeing things looking better, and is feeling stronger about the economy. I'm not sure that really is the assessment we have, and if we then have bad data on the labor markets and the financial markets weaken somewhat, will we be seen as having made a wrong call, as being blindsided by circumstances? This is more discussion than it's worth, but what I'm trying to convey is that it's not just a question of disappointing or not disappointing markets. It's a question of whether or not we're sending a clear message. I think alternative B, while it's consistent with our risk assessments, is also a pretty strong statement. Let me, just for what it is worth, assure you now that data that come in within the general, broad ranges of what we're expecting, even though they will be weak, should not cause us to ease further, given this statement. I believe that this statement will provide us with plenty of cover. No matter what the markets expect, we have said that we have come to a point at which we need to take a pause, we need to see what's happening, and we are going to be watchful and waiting. With respect to the language, I just want to point out how much the language in alternative B has moved from March. It really is a very significant change. First of all, we are acknowledging explicitly how much we have already done--the substantial easing of monetary policy to date plus the measures to foster market liquidity--and expressing a general confidence implicit in that first sentence that we have done a lot; that it is likely to help; and therefore, that we should wait and see what happens. Second, we removed any reference to downside risk to growth, which has been in there for a long time. That's a very strong statement. That says a lot about our inclinations going further. Third, we've added the phrase ""continue to monitor,"" which to me suggests very much a watchful waiting rather than an active approach to developments in the economy. Finally, we have made it clear that we are going to be data dependent and, in particular, though we have done a lot, we are expecting continued weakness, and we'll act as needed. But we have taken out the ""timely manner,"" so the presumption that we'll be responding in a very rapid and aggressive way, I think, has been moderated. I think of alternative B as being a compromise in the sense that it takes a step that is consistent with the fundamentals in terms of the underlying tightness of the financial system and the risks that most of us see to economic growth as well as inflation. At the same time, I think it is a rather strong step in expressing a shift in our strategy--that we are moving from the phase of rapid declines and aggressiveness to a phase of waiting and observing how this economy is going to evolve. Again, with full respect to everyone's comments, I understand. Unlike Governor Mishkin, I wasn't sitting on the fence; I thought that was a little uncomfortable. But I understand the concerns and the arguments. The communication issues did concern me, and largely on that basis, I would advocate B today. Are there any comments? If not, could you please take a roll call? " FOMC20050322meeting--111 109,MR. STERN.," Thank you, Mr. Chairman. The broad-based expansion in our District March 22, 2005 50 of 116 growing rapidly. Demand for construction equipment reportedly is very strong. Backlogs are building in that sector, and there are long lead times. There is an emerging scarcity of some skilled labor. The mining and energy sectors, not surprisingly, are strong. Housing construction activity remains robust, although sales have slowed a bit year-over-year. The concerns expressed by business leaders are the usual suspects: medical insurance costs, rising raw material prices— including energy, of course—and rising transportation costs. Turning to broader issues, based on the tenor of the incoming information on the economy and on my earlier forecast, the national economy continues to look quite good to me. It’s still early in the game, of course, but 4 percent real growth this year looks like a reasonable forecast. It would not be a stretch but simply a continuation of what we’ve experienced in the previous two years. As far as inflation is concerned, I do not expect a material acceleration in core measures of inflation this year. Nevertheless, I do see signs that there is some buildup in price pressures. Therefore, it seems to me that the risks we are confronting are in the process of shifting, mostly because the risks of a subpar or disappointing performance of the real economy have diminished but also because the inflation pressures have perhaps ticked up a notch. I think the policy implication of this is that we can continue for now with the program that we have been on of ¼-point increases in the funds rate. But I do think we need to modify the language in the announcement to reflect changing circumstances and to preserve internal consistency." CHRG-111hhrg52406--56 Mr. Bachus," What are some of the most destructive high-risk practices or products that you see? Ms. Warren. Well, actually, I found it interesting that you listed those as separate entities. The real point, in my view, is when customers cannot follow what you are doing, I regard it as extremely destructive, as high-risk, when you dump 30 pages on a customer and you call that a credit card contract and when only after the customer has used the credit card, discovers terms in it when those terms are charged against the customer. I think that is extremely destructive. I think it is destructive to show up at a mortgage closing and be handed literally hundreds of pages with stickers saying, sign here, sign here, sign here, and the advice, ``you cannot read it.'' I think that is destructive. I think it is destructive when there are changes over time--when you are quoted one price on a mortgage, but when you show up after you have already sold your house and after you have already gotten all the furniture in the moving truck and are told that the interest rates will be different or that there are prepayment penalties. I think those are very destructive practices. " CHRG-111hhrg74855--5 Mr. Shimkus," Thank you and I want to thank my friend, Fred Upton. I have got to go over to the Capitol floor meeting on the Illinois Gitmo so that is where I am headed from here. Thousands of companies use derivatives to manage risk. There are winners and losers in the market. One aspect of this bill is transparency and our focus on does this bill achieve this at the cost of the marketplace. With this bill that the Ways and Means and Ag have both passed, are we making it more difficult for these companies to manage risk? I have talked with many and this will cost them more and prices will go up. Will the CFTC and FERC both have jurisdiction? Will it be shared? One has in some instances, one in others. Does this bill make this clear or is this burdensome with the CFTC and the FERC or companies dealing in derivatives? Are any of these completely capable of this request and can they afford new cost placed upon them? This is an important hearing, Mr. Chairman. We need to fix the agencies. We don't need to create new ones and we will be focusing on that. I yield back my time. I thank Fred for the yielding. " FOMC20050503meeting--73 71,MR. MOSKOW.," Thank you, Mr. Chairman. In our calls this round, we tried to get a sense of the depth and the breadth of the current soft patch and how much of it might be associated with May 3, 2005 26 of 116 District. While the manufacturing sector is still quite robust, there are some hints of slowing orders and the Big Three auto manufacturers are still hurting. Our retail contacts note that business is a bit softer, but they don’t seem alarmed. Retailers say that higher gasoline prices are affecting sales. Middle-income consumers are switching from specialty stores to discounters, and lower-income consumers are cutting back more noticeably. Gasoline prices are depressing the demand for large SUVs, as David mentioned. I’d add that orders for recreational vehicles are down significantly as well. But air travel continues to be strong despite higher fares. Business spending continues to be solid. The heavy equipment market is the strongest in years. One manufacturer in this sector said that he was increasing capital expenditures 40 percent this year to alleviate production bottlenecks in existing facilities, though not to build new plants. In contrast, a large diversified manufacturer has started to see some softening in orders in the last few weeks, although business overall remains good. On the price front, the big story continues to be energy. There is now a more pervasive sense that higher energy prices are here to stay. We’re hearing this from the auto industry, from retailers, and from firms in the energy sector. Nonetheless, a major oil company told us that they remain cautious in their investment planning. Despite significantly higher spot prices and elevated long-term futures, they’re still using an assumption of $20 a barrel when evaluating new production projects. So it seems that oil prices will have to remain elevated for a longer period of time before the industry becomes willing to expand supply through aggressive long-term investments. In addition to energy, we’re still hearing about cost pressures elsewhere, notably for construction materials, rubber, and plastics. Some of these pressures may be creeping into May 3, 2005 27 of 116 percent decline in material costs, but their actual costs ended up 3 percent higher, and this year they’re budgeting for another 3 percent increase. Looking downstream, many manufacturers have been able to pass through cost increases, and, in a few particularly strong sectors, firms have even been able to increase margins. With regard to labor costs, a major retailer reported that for the first time in two years they had to offer higher starting salaries for sales associates. However, our contacts at temporary help firms see wages increasing at the same rate or perhaps a little more slowly than earlier in the year. And union contracts have been restrained. Union wages are flat or coming down, more contracts include lower pay for new hires, and health care costs continue to be shifted to workers. Turning to the national outlook, our best assessment is that price pressures remain a concern and that the current soft patch is not the beginning of a major slowdown in the economy. With regard to growth, most of the fundamentals remain strong. Monetary accommodation and the underlying trend in productivity continue to support solid growth. The claims data suggest a firmer labor market than we saw in March, and I don’t get the sense from my contacts that consumers or businesses are retrenching in a significant fashion. Accordingly, growth should pick up at a pace above potential in the second half of the year. With regard to prices, we expect that higher costs will continue to pass through to the consumer level, boosting core inflation to around 2 percent this year. But we expect core inflation to stabilize or edge off a touch in 2006, mainly because we don’t think there are broad-based resource constraints. Still, these assessments are uncertain. We’re not really sure which shocks are most responsible for the soft spot and what their ultimate impact might be on the output gap. If factors such as increased caution or reduced policy stimulus are the main culprits, then there may be a May 3, 2005 28 of 116 appropriate to remove policy accommodation very gradually, say, along the path that’s embedded in futures prices right now. But we need to do more than that if the weakness largely reflects a reduction in potential output due to higher energy prices. Otherwise we would be accommodating an adverse supply shock and would risk unhinging inflationary pressures. So far, long-term expectations appear to be fairly well anchored, although some measures have crept up slightly in recent months. If we have a few more months of bad price data, we’ll need a more aggressive policy response to avoid a pickup in long-term inflationary expectations. For today’s meeting, I think we should continue on our current pace of rate adjustments. However, the statement should avoid giving the impression that the recent softness in economic activity diminishes the underlying inflation risk." FinancialCrisisInquiry--10 Having to fair value our assets on a daily basis and see the results of that marking in our P&L forced us to cut risk regardless of market or individual views, estimates or expectations. Throughout 2007 we were committed to reducing certain of our risk exposures, even though we sold at prices many in the market, including at times ourselves, thought were irrational or temporary. After the fact, it was easy to be convinced that the signs were visible and compelling. In hindsight, events not only looked predictable, but sometimes looked like they were obvious or known. The truth is that no one knows what is going to happen. And that recognition defined our approach to risk management. We believe key attributes of our strategy, culture and processes were validated during the extraordinary events and macro-economic uncertainty of the past year. But they have also prompted change within our firm. Over the last 18 months our balance sheet has been reduced by a quarter, while our capital has increased by over a half. Our Basel I and tier one capital ratio has increased to 14.5 percent through earnings generation and the number of capital offerings. Our pool of liquidity was relatively high at the onset of the crisis, but we carry a great deal more cash on our balance sheet than ever before to deal with contingencies. While we believe our firm has produced a strong relationship between compensation and performance, we have announced additional reforms in this area. At our shareholders meeting last year we outlined specific compensation principles. Consistent with those principles, in December, we announced that the firm’s entire management committee will receive 100 percent of their discretionary compensation in the form of shares at risk, which cannot be sold for five years. In addition, we announced that the five-year holding period on shares at risk includes an enhanced recapture provision that will permit the firm to recapture the shares in cases where the employee engaged in materially improper risk analysis or failed sufficiently to raise concerns about risk. CHRG-111hhrg51698--436 Mr. Masters," Sure. In the bill, in terms of defining what position limits should be, there is a sort of principle that was really developed by Franklin Roosevelt in the first Commodity Exchange Act, and that was there is something called ``excessive speculation.'' There is not just manipulation, there is excessive speculation. And that only applies to commodities futures markets, it doesn't apply to other markets. The reason it applies to commodities futures markets is because these markets used to be dominated by physical hedgers, and they are there for them to price risk. That is why we have commodity futures markets. We have a different regulator. We have a different way of looking at the markets, because these are commodities. They are not interest rates. Nobody goes home and eats a bowl of interest rates. " FinancialCrisisInquiry--408 CHAIRMAN ANGELIDES: Thank you, Mr. Vice Chairman. I was going to hold all my questions until the end, but I want to ask one now so I don’t forget. And that is, one thing you seem to be saying is, in a world of rapid innovation, rapid change, expansion of new industries, there’s an argument, at least for the core financial sector, to have perhaps even greater stability as opposed to, for example, all the entities out there who can take greater risk without consequence to the taxpayers. January 13, 2010 But you seem to be saying that the price of greater innovation, greater volatility in the larger economic world may be having a stronger core. Am I hearing you correctly? FOMC20071031meeting--11 9,MR. SHEETS.," Although the foreign economies appear to have grown at a moderate pace during the third quarter as a whole, indicators for September and October suggest that the recent financial turmoil may yet leave an imprint on activity in some countries. Perhaps the most striking evidence on this score has been the ECB’s survey of euro-area bank lending. In the third quarter, this survey showed the sharpest shift toward tightening in its five-year history, along with evidence of more- stringent credit standards for business and housing loans. In addition, we have seen downward moves in surveys and measures of sentiment in the euro area, particularly in Germany, although these indicators have generally remained in expansionary territory. In the United Kingdom, the growth of mortgage lending continued on a downward path in September, and a recent Bank of England survey suggests a tightening of corporate credit conditions. All in all, we see this (admittedly fragmentary) evidence as broadly consistent with our assumption in the September Greenbook that fallout from the financial turmoil is likely to exert some drag on growth over the next several quarters in the euro area, the United Kingdom, and Canada. This assessment, however, is marked by significant upside and downside risks—as it is still too soon to gauge these effects with much confidence. As in our previous forecast, we do not see the turmoil weighing directly on activity in Japan or the emerging-market economies. More generally, the contours of our forecast remain similar to those in September. Recent data have confirmed our expectation that average economic growth abroad declined to about 3½ percent in the third quarter, cooling from the very rapid rate in the first half of the year. We see growth edging down further in the current quarter, to just over 3 percent, and remaining at about that pace in 2008 and 2009. After the Greenbook went to bed, we received Chinese GDP data, which according to our seasonally adjusted quarterly estimate grew at an annual rate of just over 8 percent in the third quarter—a little slower than we had expected and down from the 14 percent rate in the first half of the year. This deceleration appears to have been led by a slowing in investment and a smaller contribution from the external sector. Going forward, economic growth in China should remain below its previous double-digit pace, as the Chinese authorities take further action to cool the country’s booming real estate market and the rapid growth of bank lending. In addition to uncertainty about the eventual effects of the financial turmoil on real activity, other risks to our generally favorable foreign outlook are worth noting. First on this list is the possibility of a softer-than-expected performance from the U.S. economy. Although there is talk in some quarters about so-called decoupling—that is, that the foreign economies may now be less linked to developments in the United States than has been the case in the past—the jury is still out on this point. Although domestic demand does appear to have firmed in some foreign countries in recent years, a marked slowing in U.S. growth would affect the rest of the world through trade channels (particularly Canada, Mexico, and emerging Asia) and, as highlighted by the recent turmoil, probably through financial channels as well. As a second risk, house-price valuations in many advanced economies appear elevated. Given that, a correction in housing markets abroad—with potentially sizable accompanying wealth effects—strikes us as an important downside risk for some countries. Third, although we see average foreign inflation remaining well behaved, at near 2½ percent over the next two years, inflation risks cannot be dismissed. After several years of exceptionally strong economic growth, the foreign economies on average are now operating near potential, and resource constraints may be more binding than we currently envision. In addition, food prices have moved up in many countries, and the prices of oil and other commodities are at high levels. Indeed, recent developments in oil markets seem to pose intensified risks. The spot price of WTI is trading today at nearly $92 a barrel, up $5 since the Greenbook went to bed. Since your last meeting, the spot WTI price has climbed $13 per barrel, while the far-futures price has increased about $10 per barrel. It suffices to say that underlying supply-demand conditions in the oil market are exceptionally tight. Over the past several years, as the global economy has expanded briskly, oil production has increased only sluggishly—reflecting both OPEC supply restraint and diminishing production from OECD countries. Against this backdrop, the price of oil has been driven up further in recent weeks by reports of decreasing inventories (at a time of year when such stocks are typically on the rise) and by intensified concerns about the stability of Middle East oil production, triggered by tensions between Turkey and Iraq and by concerns about U.S. relations with Iran. We see OPEC’s plans to expand production 500,000 barrels per day beginning on November 1, even if fully implemented, as unlikely to go very far in defusing the tightness in the market. Futures markets call for WTI prices to remain elevated, in the neighborhood of $80 per barrel, through 2015. I conclude with some upbeat news on U.S. external performance. Exports continue to surprise on the upside, having shown exceptional strength in the July and August trade data, as exports of aircraft, autos, and agricultural products have all expanded briskly. Consequently, as Dave mentioned, real exports of goods and services are now thought to have surged at a pace of 17 percent in the third quarter, up 3½ percentage points from the last forecast. We estimate that real imports in the third quarter grew at a comparatively modest rate. Taken together, these data suggest that net exports made an arithmetic contribution of 1¼ percentage points to U.S. real GDP growth in the third quarter. Going forward, we see export growth moderating to just under 8 percent in the current quarter and proceeding at a solid 6½ percent average rate through the next two years. Relative to our September forecast, the path of export growth is up nearly 2 percentage points in the fourth quarter and by lesser—but still sizable—amounts in 2008 and 2009. This higher projection reflects stimulus from recent declines in the dollar, which have exceeded our previous projections. The broad dollar index has dropped more than 3 percent since your last meeting. But in addition to support from the weaker dollar, we now see greater underlying strength in exports than we had previously thought. Our projected path for imports, in contrast, is little changed from the last Greenbook. Import growth is slated to bounce up in the current quarter, largely because of a seasonal rebound in oil imports. Thereafter, the projected strengthening of U.S. growth and a deceleration in core import prices should provide increasing support to imports. All told, we see the external sector making a neutral contribution to U.S. real GDP growth in the fourth quarter, contributing 0.4 percentage point to economic growth next year, and returning to neutrality in 2009 as imports accelerate. Thus, to the extent that our forecast materializes, large negative contributions from net exports might very well be a thing of the past. Brian will now continue our presentation." FOMC20071031meeting--103 101,MR. MADIGAN.,"4 Thank you, Mr. Chairman. I will be referring to the package labeled “Material for FOMC Briefing on Monetary Policy Alternatives.” That package includes two versions of table 1: The first is the version that was discussed in the Bluebook, and the second is a revised version dated October 31. The revised table presents basically the same policy alternatives as the Bluebook version but with some changes in the rationale and risk assessment sections. To review, alternatives B and C contemplate leaving the stance of policy unchanged today, but they differ importantly in their assessments of risk: Alternative C characterizes the downside risks to growth as roughly offsetting the upside risks to inflation, whereas alternative B indicates that the downside risks to growth are the Committee’s greater policy concern. Alternative A, in contrast, eases the stance of monetary policy 25 basis points and indicates that the Committee assesses the risks to growth and inflation as roughly in balance. In discussing these alternatives, I will basically be working from right to left across the two versions of the table. As Dave Stockton discussed yesterday in response to a question from Vice Chairman Geithner, the Greenbook projection is a modal forecast. Without consideration of risks, the Greenbook analysis would seem to support the Committee’s selection of alternative C. In that forecast, which is conditioned on the federal funds rate remaining at 4¾ percent, economic growth slows in the near term, and below-trend growth over the next few quarters closes the small positive output gap that the staff sees as currently prevailing. Maintaining the present stance of monetary policy leads to a gradual strengthening of the expansion over 2008 and 2009 and by enough to leave the economy producing at its capacity. Core inflation stays under 2 percent, while total inflation runs a bit lower, reflecting declining energy prices. Judging by your projections, most of you would find such a trajectory for inflation satisfactory, at least for the next couple of years if not over the longer term. Your projection submissions, however, as well as your comments yesterday, suggest that many of you see less vigor in aggregate demand than the Greenbook does as well as appreciable downside risks—an outlook that might argue against alternative C. The Greenbook provided several alternative simulations involving greater weakness in housing and larger fallout from financial stress that illustrate some prominent risks to spending; they suggested that the path of the federal funds rate might need to run ¾ percentage point or more below baseline should such weakness in aggregate demand eventuate. The choice of alternative B could be consistent with a modal expectation along the lines of the Greenbook coupled with appreciable concerns about downside risks and a judgment that you need to await additional information before deciding whether to ease policy further. As noted in alternative B, section 2, of either version, the statement would in effect explain the decision to stand pat, first, by recognizing that economic growth last quarter was solid and perhaps conveying the implicit suggestion that the economy was likely to continue to expand at an acceptable pace, even if growth were to slow temporarily; second, by noting that strains in financial markets have eased somewhat on balance; and third, by indicating that the domestic 4 The materials used by Mr. Madigan are appended to this transcript (appendix 4). economy apart from housing has proven resilient and that the global economy remains strong. At the same time, the statement would indicate that the Committee is concerned about downside risks to growth, explicitly citing the potential effect of tightening credit conditions. Regarding inflation, the language would be identical to that used in September. The statement would conclude by indicating that, on balance, the Committee saw the downside risks to growth as the greater policy concern. As Bill Dudley noted, the market was all but certain as of yesterday that you will ease policy today 25 basis points. Today, in response to the economic data released earlier, intermediate and longer-term interest rates have risen somewhat; however, futures quotes still suggest that investors now see high odds that you will ease policy today. Thus, the announcement of an unchanged stance of policy would come as a considerable surprise to markets. To be sure, the assessment under alternative B that the downside risks are the greater policy concern and its implication that further easing might well be forthcoming before long would soften the blow. But a selloff in bond and equity markets would no doubt ensue. Moreover, financial asset prices could remain volatile for a time, as investors attempted to recalibrate their expectations of the probable path of monetary policy going forward. Concern about such market reactions clearly would not persuade you to ease policy at this meeting if you judged that an unchanged stance of policy would likely be more consistent with maximum employment and stable prices, and hitching monetary policy to market expectations would make for extremely poor economic outcomes. But especially in circumstances of persisting financial strains, concern about unnecessarily adding to those strains might incline you a bit more toward easing, as in alternative A, if you were already strongly leaning that way today based on your view of economic and financial fundamentals. As I noted yesterday, your economic projections suggest that most of you believe that the stance of policy should be eased within the next six to twelve months, and many of you indicated that some easing was appropriate imminently. You may see several reasons for preferring to move earlier rather than later. In particular, you may think that a timely reduction in interest rates could be valuable now in buoying household, business, and investor confidence. Yesterday the Chairman noted the possibility of a vicious cycle involving a deteriorating macroeconomic outlook and tightening credit conditions. By bolstering confidence in the outlook, easing policy as expected could help reduce concerns about deteriorating economic fundamentals and declining asset values. Beyond reducing the risks of nonlinear responses, easing policy as expected by market participants would support growth of aggregate demand over time through the usual channels. Of course, you may also be worried about a possible increase in inflation. Such concerns may reflect a variety of factors—the further sharp increase in oil prices of recent weeks, the depreciation of the dollar, accelerating unit labor costs, and perhaps the relatively high level of resource utilization. But given the recent good inflation performance, you may feel that downside risks to growth are the more immediate danger and believe that further easing today to address those risks is warranted. You may also believe that, should the easing eventually appear to have been unnecessary, you could act as quickly to remove stimulus as you did to put it in place. If you were inclined toward easing policy another 25 basis points at this meeting, you would need to confront the question of the appropriate statement language. In both versions of alternative A, the first two sentences of section 2 are similar to those proposed for alternative B. But rather than emphasizing remaining downside risks, the statement would then repeat most of the “help forestall” language used in September. The language proposed for the inflation paragraph in both versions is identical to the corresponding paragraph suggested for alternative B; again, the language shown in the October 31 version suggests a bit more concern about inflation risks than the September language. Finally, both versions of alternative A would characterize the upside risks to inflation as roughly balancing the downside risks to growth. This indication might well lead market participants to reduce the nearly two-thirds odds that they currently place on another quarter-point easing in December and might trim the extent of the overall easing of policy anticipated over the next year or so. Thus, implementation of alternative A also could prompt some further backup in market interest rates. In closing, let me remind the Committee that the September trial run highlighted the potential for inconsistencies between the results of the projections survey and the Committee’s statement. Your latest forecast submissions indicated that, while a minority of you sees the risks to inflation as skewed to the upside, a slight majority perceives the risks to total inflation as broadly balanced, and a more-sizable majority judges that the risks to core inflation are in balance. These results could be seen as incongruent with the draft statements for some of the alternatives. For example, alternative A references upside risks to inflation. Several considerations might explain this apparent inconsistency. For example, your responses on skews in the projections survey may capture only the subjective probabilities that you attach to various outcomes, while you may see the statement language as capturing not only the odds but also the economic costs associated with those outcomes. Or perhaps the upside risks to inflation referenced in the statement should be interpreted as reflecting the views of all members not just of the majority who saw inflation risks as balanced, thus encompassing the views of those in the minority who see upside inflation risks. Finally, I am worried about the possibility that some of you may have provided your numerical projections under the assumption of appropriate monetary policy but may not have applied that assumption as well to your individual risk assessments. In your upcoming remarks, you may wish to address whether there is any tension between your own views of the distribution of risks and the risk assessments in the draft statements. Thank you." CHRG-110hhrg34673--251 The Chairman," The gentlewoman from Wisconsin. Ms. Moore of Wisconsin. Well, thank you very much, Mr. Chairman, and thank you very much, Mr. Chairman, for your patience here today. Thank you, Mr. Chairman. I did have an opportunity to review your testimony before the committee, and I do want to thank you. I have a reached some conclusions, which I guess I want to sort of vet with you. As others have mentioned, you mention several times in your testimony that consumer spending continues to be the mainstay in the current economic expansion, and you also seem to indicate that the resilience of this consumer spending is important towards sustaining our economic growth. You also indicate that increase in people's compensation accounts for this, and that our higher labor productivity and perhaps a narrowing of corporate profits might offset the higher labor productivity and that narrowing--I am sorry--profit margins of companies might prevent higher prices from occurring, and people might experience a real higher compensation. A couple of questions come to mind when I review this testimony. First of all, I guess I want to ask you if you account for this stronger gain in personal income as many of us do, foresee that it is all aggregated kind of at the top, that this increase in consumer spending is a very narrow number of consumers, and that imposes some kind of risk unless we spread the purchasing and consumer spending power a little bit broader. And secondly, leading into that sort of executive compensation, if we were to--again, if we are depending--if our economy is depending on consumer spending, wouldn't it be better if we sort of spread the wealth a little bit and, in keeping with your testimony, resist raising prices by narrowing corporate prices, profits? " CHRG-109shrg24852--19 Chairman Greenspan," Thank you, Mr. Chairman. I have excerpted only part of that rather extended statement. Mr. Chairman and Members of the Committee, I am pleased to be here to present the Federal Reserve's Monetary Policy Report to the Congress. In recent weeks, employment has remained on an upward trend, retail spending has posted appreciable gains, inventory levels have been modest, and business investment appears to have firmed. At the same time, low long-term interest rates have continued to provide a lift to housing activity. Although both overall and core consumer price inflation have eased of late, the prices of oil and natural gas have moved up again on balance since May and are likely to place some upward pressure on consumer prices, at least over the near term. Should the prices of crude oil and natural gas flatten out after their recent run-up--the forecast currently embedded in futures markets, incidentally--the prospects for aggregate demand appear favorable, and upward pressures on inflation would be reduced. Thus, our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation. This generally favorable outlook, however, is attended by some significant uncertainties that warrant careful scrutiny. With regard to the outlook for inflation, future price performance will be influenced importantly by the trend in unit labor costs, or its equivalent, the ratio of hourly labor compensation to output per hour. Over most of the past several years, the behavior of unit labor costs has been quite subdued. But those costs have turned up of late, and whether the favorable trends of the past few years will be maintained is unclear. Hourly labor compensation as measured from the national income and product accounts increased sharply near the end of 2004. However, that measure appears to have been boosted significantly by temporary factors. Over the past 2 years, growth in output per hour seems to have moved off the peak that it reached in 2003. However, the cause, extent, and duration of that slowdown are not yet clear. Energy prices represent a second major uncertainty in the economic outlook. A further rise could materially cut into private spending and thus damp the rate of economic expansion. More favorably, the current and prospective expansion of U.S. capability to import liquefied natural gas will help ease long-term natural gas stringencies and perhaps bring natural gas prices in the United States down to world levels. The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates. The yield on 10-year Treasury notes, currently near 4\1/4\ percent, is about 50 basis points below its level of late spring 2004. Two distinct but overlapping developments appear to be at work: A longer-term trend decline in bond yields and an acceleration of that trend of late. Some, but not all, of the decade-long trend decline in bond yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real term premium that seems due to a moderation of the business cycle over the past few decades. In addition to these factors, the trend reduction worldwide in long-term rates surely reflects an excess of intended saving over intended investment. What is unclear is whether the excess is due to a glut of savings or a shortfall of investment. Because intended capital investment is to some extent driven by forces independent of those governing intended saving, the gap between intended saving and investment can be quite wide and variable. It is real interest rates that bring actual capital investment worldwide and its means of financing, global savings, into equality. As best we can judge, both high levels of intended saving and low levels of intended investment have combined to lower real long-term interest rates over the past decade. Since the mid-1990's, a significant increase in the share of world gross domestic product produced by economies with persistently above average saving--predominantly the emerging economies of Asia--has put upward pressure on world saving. These pressures have been supplemented by shifts in income toward the oil-exporting countries, which more recently have built surpluses because of steep increases in oil prices. Softness in intended investment is also evidence. Although corporate capital investment in the major industrial countries rose in recent years, it apparently failed to match increases in corporate cashflow. Whether the excess of global intended saving over intended investment has been caused by weak investment or excessive saving--that is, weak consumption--or, more likely, a combination of both does not much affect the intermediate-term outlook for world GDP or, for that matter, U.S. monetary policy. What have mattered in recent years are the sign and the size of the gap of intentions and the implications for interest rates, not whether the gap results from a saving glut or an investment shortfall. That said, saving and investment propensities do matter over the longer-run. Higher levels of investment relative to consumption build up the capital stock and thus add to the productive potential of an economy. The economic forces driving the global saving-investment balance have been unfolding over the course of the past decade, so the steepness of the recent decline in long-term dollar yields and the associated distant forward rates suggests that something more may have been at work over the past year. Inflation premiums in forward rates 10 years ahead have apparently continued to decline, but real yields have also fallen markedly over the past year. Risk takers apparently have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. These actions have been accompanied by significant declines in measures of expected volatility and equity in credit markets. History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress. Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks. And, certainly, the exceptionally low interest rates on 10-year Treasury notes and hence on home mortgages have been a major factor in the recent surge of homebuilding, home turnover, and particularly in the steep climb in home prices. Whether home prices on average for the Nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor. The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Historically, it has been rising real long-term interest rates that have restrained the pace of residential building and have suppressed existing home sales. The trend of mortgage rates, or long-term interest rates more generally, is likely to be influenced importantly by the worldwide evolution of intended saving and intended investment. We are the Federal Reserve will be closely monitoring the path of this global development few, if any, have previously experienced. We collectively confront many risks beyond those I have just mentioned. As was tragically evidenced again by the bombings in London earlier this month--and, I might add, some questions about what is going on in London today--terrorism and geopolitical risk have become enduring features of the global landscape. Another prominent concern is the growing evidence of anti-globalization sentiment and protectionist initiatives, which, if implemented, would significantly threaten the flexibility and resilience of many economies. This situation is especially troubling for the United States, where openness and flexibility have allowed us to absorb a succession of large shocks in recent years with only minimal economic disruption. That flexibility is, in large measure, a testament to the industry and resourcefulness of our workers and businesses. But our success in this dimension has also been aided importantly by more than two and a half decades of bipartisan effort aimed at reducing unnecessary regulation and promoting the openness of our market economy. Going forward, policymakers will need to be vigilant to preserve this flexibility, which has contributed so constructively to our economic performance in recent years. In conclusion, Mr. Chairman, despite the challenges I have highlighted and the many I have not, the U.S. economy has remained on a firm footing, and inflation continues to be well contained. Moreover, the prospects are favorable for a continuation of those trends. Accordingly, the Federal Open Market Committee in its June meeting reaffirmed that it ``. . . believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.'' Thank you very much. I look forward to your questions. " FOMC20070321meeting--111 109,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Our view of the outlook has changed since our last meeting, but more in the balance of risks and the sources of uncertainty than in our actual forecast for growth. But just to go through the changes quickly, we’ve reduced our forecast for growth in ’07 a bit, to something less than 3 percent, and we see more downside risks to that forecast. We’ve moved up the expected path of core PCE inflation just a bit in light of recent numbers, but we have maintained essentially the same view as before—that inflation will moderate to around 2 percent by the end of this year and a bit below that in ’08. We see the risk to this forecast still to the upside. We face greater uncertainty about the near-term outlook than we have over the past few meetings. Looking to the medium term, although we haven’t yet reduced our estimate of potential growth, we’re a bit more concerned than we’ve been about the strength of underlying structural productivity growth going forward. We have also changed our view of the appropriate path of policy a bit, introducing a gentle move down now in the fed funds rate beginning around the middle of the year. So this puts us a bit below the assumed path in the Greenbook, but we assume a slower, smaller reduction in the nominal fed funds rate than the market does today. Our forecast is quite close to that of the staff’s in the Greenbook, and the basic story is similar. Our differences are the same as they have been for some time—we have slightly more growth and slightly lower inflation. That reflects things we talked about before, different views about information dynamics and about potential growth. Our view of the output gap and its evolution, however, is similar. I have just a few points on some issues. On the growth front, the recent numbers suggest both a deeper adjustment in housing and a broader weakness in the economy than we anticipated, notably in capital goods orders. The effect of these developments on our forecast is not that large, however. Their significance is more in the risk to the outlook and the uncertainty, the puzzle that the investment weakness presents for the medium term. On housing and consumption, the probability of the dark scenario is still small, but it is higher than it has been and deserves some attention. The dark scenario is the risk that the reduction in credit to the household sector amplifies the decline in housing demand, which leads to a greater adjustment in prices, with a risk of a more- pronounced, prolonged decline in growth and spending. Monetary policy should not be directed at trying to put a floor on housing demand or on prices, only at limiting the risk that the weakness accumulates substantially or spreads to overall demand. Regarding capital spending, we just don’t have a good explanation for why—with margins that are still pretty good, reasonable earnings growth, solid growth in aggregate demand here and globally, relatively low interest rates, and reasonable levels of business confidence—spending has continued to come in well below our expectations. This series of disappointments, of course, has been going on for some time; it’s not just about the latest numbers for durable goods orders. Perhaps this situation will prove transitory, but it justifies a bit more caution to the outlook. Of these two risks—in housing and in investment—I’d say the latter matters more and is potentially more consequential. But both of these effects are offset, in our basic view, by the expected strength in personal income growth going forward, by what are still fairly favorable overall financial conditions, and by fairly robust external demand. Regarding productivity, productivity growth per quarter at an annualized rate has, over the past ten quarters, come in significantly below 2 percent, kind of close to the estimates of the trend rate for the period between ’73 and ’95. Some of the analysts who spend a lot of time thinking about this are starting to lose conviction that trend growth is still in the neighborhood of 2½ percent for the nonfarm business sector. We’re still viewing the recent weakness as transitory or cyclical, but the risk that trend growth is below our estimate is, I think, increasing. On inflation, despite the higher recent numbers, not much has really changed in our view. We still expect core PCE to move to below 2 percent over the forecast period, and we still see the risk as not getting quite that moderation. The sources of the recent negative surprises in the core data, which seem concentrated in medical services, probably don’t say much about monetary policy or broader inflation dynamics, and inflation expectations remain stable at reasonable levels. So our view of the growth outlook has changed a bit, but our view of the inflation outlook hasn’t changed much based on these numbers. On the markets, as many people have said and as Bill discussed at the beginning, I don’t see much that’s been troubling thus far. Although correlations across asset markets have risen, overall liquidity seems fine. There’s been very limited contagion from mortgages into other credit markets. Debt issuance seems to be continuing. People are able to raise money to finance corporate restructuring investment. There is very little concern, I think, about substantial losses, on the basis of what’s happened to date, in the core of the financial system and very limited evidence of stress among the various funds. But it’s still early in some ways, and the fundamental outlook for growth is a bit weaker and more uncertain. Risk premiums, credit spreads, and volatility still look potentially vulnerable to a more substantial reversal. The weakness in the subprime market will take some time to work through the full range of securities issued against pools of collateral that include mortgages. The complexity in valuing structured mortgage products, the difficulty in designing hedges that actually work against exposure to that risk, and uncertainty about the shape of the adverse tail and that part of the credit spectrum are all conditions that apply to a range of other structured credit markets and credit products. In the debate about the implications of this prolonged yield-curve inversion, we have tended to side with those who have found comfort in the contrary signal you see in lower levels of risk premiums and credit spreads. Yet it’s possible that the forces that may have been holding down forward rates are also holding down credit spreads and holding up the value of other assets and, therefore, may be masking weakness in the economy rather than masking strength. On balance, although the outlook still looks fundamentally positive, we see a more complicated and less benign set of risks to the outlook, more downside risks to growth, and some continued concern that we won’t get enough moderation in inflation. To us, this outlook justifies a stance of policy with a path for the fed funds rate somewhat above what is now priced into the markets. This doesn’t mean, in our view, that we need to signal that nominal rates going forward are more likely to rise than to fall from current levels; it means only that we should convey the sense that our view of the most likely evolution of policy still implies a higher path than is now priced into the markets. We can afford to be patient before adjusting policy, as Sandy said, but we need to have as much flexibility as possible going forward. This suggests that we acknowledge that the overall balance of risks has shifted a bit toward neutral, toward a flat stance of policy, but not all the way there. A delicate task for us is to do this without inducing a reaction in the market that pulls forward significantly more easing than has already occurred." FOMC20080310confcall--75 73,MR. FISHER.," Well, Mr. Chairman, extraordinary circumstances require extraordinary responses. I am very worried about this vicious cycle or, as Governor Kohn put it, vicious spiral of liquidity constriction. I have a lot of questions about the program, and I have, like President Plosser, a sort of end game concern, but I would vote in favor of this program. I think it is something we have to take a risk with. I would like very much for us to think through collectively or under your leadership, again, how we can use this to strengthen our franchise and at least influence this odd regulatory structure we have, which I think is insufficient. I have the same concerns that President Rosengren has, which I expressed about having counterparties over which we don't have great influence, even though we have communication with other regulators. I also think it would be worthwhile, once we have set up this thing and are moving forward, to have some kind of decision tree on all the risk parameters that were outlined in the memo. If we inappropriately affect the pricing of financing credit or if the scale is too small or all the other risks that we're concerned about occur, what do we do under those circumstances? Where do we go next? What are the cutoff points? This is a fine piece of work that took an awful lot to put together, but it would be helpful at least to me and I think it would be helpful to the Committee if we knew where these different branches would go under different circumstances and what our responses are likely to be so that we can be prepared to go forward. Having said that, I support the program with the different concerns that I have, and I would vote for it. Thank you, Mr. Chairman. " CHRG-111shrg54589--100 Mr. Pickel," All right. I would say that in the derivatives space--and this has been around for 25 years--a lot of the developments were on market risk--interest rates, currencies, equities, commodities, where you are managing a market risk. Credit risk is a new, a relatively new derivative, and I would say that we are still understanding some of the implications of that. And I think that Professor Hu's work has been very interesting in that regard. I would say that, regarding that empty creditor issue, the fact is that every time somebody is going to into the market and buying protection, which is he suggested somebody is doing, they are sending signals to that company: Your business plan is not working; your business plan is not working. The yellow light is getting brighter and brighter and brighter. And so when it comes to the end and somebody says, ``Time is up; I am not going to continue to lend to you,'' I think that is a natural evolution of this market, but let us certainly understand that. I would also just mention that credit default swap spreads are becoming embedded in various ways. They are being used for pricing loans. It was done with the rollback of Scotland extension of credit by the U.K. Government, and just today in the Wall Street Journal, it was mentioned that S&P has developed an additional means of providing information on credit exposure to the marketplace that incorporates a credit default swap spread. So we see continuing evolution here, and I think it ought to be encouraged, but, understood, certainly. " CHRG-111hhrg51591--39 Mr. Hunter," Just a couple of points about what you said, Mr. Chairman. The Federal Government has rather failed in recent years of taking--moving into insurance, and certainly have not made it self-sustaining. The flood program by now, that I ran, should have been self-sustaining. But it isn't, in part because the maps are antiquated, in part because there is still unwise construction that should have been stopped from occurring. That needs to be done, and the mitigation has to work, and the prices have to really meet the risk. And it can, but it has to be enforced. And it isn't. TRIA, for example, is somewhat modeled after the old riot reinsurance program, except the only difference is the riot reinsurance program charged premiums. TRIA doesn't. The Federal Government refused to charge premiums when it took on the risk. Now, that is a decision Congress made, and the Administration. Whether that was right or not, the problem is you can't--a premium of zero is never going to break even. And so that--I wouldn't be so pessimistic. You can fix these things. It takes some will, though, because there is always pressure to go the other direction. And then finally, on too-big-to-fail, it is not just too-big-to-fail. I think those are pretty easy to look at and find. But even within markets, consider title insurance. Two-thirds of the market is in two companies. Are they too-big-to-fail within the title insurance context? That is why I think you have to--the systemic risk regulator has to look at everything. " CHRG-111shrg57322--607 Mr. Viniar," It didn't say we shouldn't, and it didn't say we should take no risk. But it said that we should reduce risk. Senator Levin. Now, on October 4, 2007, Exhibit 46,\1\ you wrote the SEC. Page 3, at the bottom. You say that ``[I]t is important to note that we are active traders of mortgage securities and loans and, as with any of the financial instruments we trade, at any point in time, we may choose to take a directional view of the market and will express that view through the use of mortgage securities, loans, and derivatives.''--We may choose to take a directional view of the market.--``Therefore although we did have a long balance sheet exposure''--long balance sheet exposure--``to sub-prime securities in the past three years, albeit small exposure, our net risk position was variously either long or short depending on our changing view of the market.'' You had a changing view of the market.--------------------------------------------------------------------------- \1\ See Exhibit No. 46, which appears in the Appendix on page 361.--------------------------------------------------------------------------- ``For example,'' now this is the example of choosing to take a directional view of the market, ``during most of 2007, we maintained a net short sub-prime position and therefore stood to benefit from declining prices in the mortgage market.'' Was that true when you said it? " CHRG-111shrg51395--95 Chairman Dodd," I agree. Senator Warner. And I appreciate your asking that question. I want to follow up, before I get to my quick question, on Senator Shelby's comments along the notion of the institutions that have posed this systemic risk, the ``too big to fail'' excuse, and Damon's comments about perhaps not publishing those that are systemic risks, but this problem we are in the middle of the crisis now of too big to fail. And I would be curious perhaps in a written question to the Members--I know Senator Shelby has, I think, provocatively raised a number of times the issue of, well, how much more on Citi and should we go ahead and let it go through some kind of process? And the quick response normally being, well, no, that is too big to fail. Well, I would love to hear from the panel, perhaps in written testimony, if you were to see the transition, dramatic transition--and I know we are sometimes afraid of the terminology, whether it is ``receivership'' or ``nationalization,'' some other way to get it out of the current ditch that it is in--you know, how you would take one of these institutions that fall into this ``too big to fail'' category that appears to have real solvency issues and get it through a transition? And I perhaps would work with the Senator on submitting that type of written question. So we have seen, you know, the big take-aways on how we regulate and where we put this prudential or systemic risk oversight. We have seen the question of how we deal with the current challenging institution. I want to come with my question, and I know our time is about up, but I will start with Mr. Pickel, but would love to hear others' comments on this, and that is, maybe come at this from the other end. Even if we get the risk right, with the great people that Mr. Turner has advocated, where and how should we look at the products? I would argue that intellectually I understand the value of derivatives and the better pricing of risk. I candidly would love somebody to say, How much societal value have we gained from this additional pricing of this risk when we have seen all of the downside that the whole system is now absorbing because, to use your terms, you know, actions by AIG and others of misunderstanding of the products and not taking appropriate hedging? I guess I have got a series of questions. How do we prevent the current products or future products from being abused? Should we have standards whereby if an AIG, a future AIG, either misunderstood or went beyond protocols, that that would set off more than an alarm bell and would require some kind of warning? Is it simply enough to say we are going to move toward some level of a clearinghouse? Is clearing alone enough security? As some of the European regulators have talked about for those products and contracts that do not go through a clearinghouse, should there be needs of additional capital requirements? You know, I am all for innovation, but in some cases I think under the guise of financial innovation and financial engineering, we have ended up with a lot of customers, including customers that Mr. Doe represents in terms of some of the muni market, getting in way over their head. And I just fear on a going-forward basis that regulation and transparency alone may not solve the problem. So rather than coming at it at the macro level on regulation or on the specific issues that I think Senator Shelby has wonderfully raised about how do we unwind one of the ``too big to fail'' institutions, I would like to look at it from the bottom up on the products line, starting with Mr. Pickel and then anybody else can comment. " FOMC20081029meeting--207 205,MS. YELLEN.," Thank you, Mr. Chairman. In the run-up to Halloween, we have had a witch's brew of news. Sorry. [Laughter] The downward trajectory of economic data has been hair-raising--with employment, consumer sentiment, spending and orders for capital goods, and homebuilding all contracting--and conditions in financial and credit markets have taken a ghastly turn for the worse. It is becoming abundantly clear that we are in the midst of a serious global meltdown. Like the Board staff, I have slashed my forecast for economic activity and now foresee a recession with four straight quarters of negative growth starting last quarter. I wish that I could claim that I place a lot of confidence in the sobering forecast, but I am sorry to say I can't. In fact, I think we will be lucky if the adverse feedback loop that is under way doesn't wrench us into a much more pronounced and more protracted downturn. The outlook for inflation has shifted markedly, too, with the days of heightened upside inflation risks behind us. In fact, I am concerned that beyond next year we run the risk of inflation falling below the level consistent with price stability. Even before the extraordinary deterioration in financial market conditions over the past few weeks, there were numerous signs that the economy had weakened dramatically. I won't recite the litany of disappointing data but instead try to touch upon some high, or I guess I should say low, notes based on what my contacts tell me. They are consistent with President Fisher's observations. Consumer purchases of durable goods, especially motor vehicles, have been particularly hard hit by the one�two punch of tight credit and reeling consumer confidence. The mood on showroom floors is downright grim. One auto dealer in my District reports that he is now experiencing the worst period in his thirty-plus years in the business. A home appliance retailer adds that he has never seen more uncertainty and gloom from both the retailers and the vendors. This sentiment is echoed by a large retailer who says simply, ""The holiday shopping season is going to stink."" Businesses are under siege from weak demand, high costs of borrowing, curtailed credit availability, and pervasive uncertainty about how long such conditions will last. Our contacts report that bank lines of credit are more difficult to negotiate. Many have become more cautious in managing liquidity and in committing to capital spending projects that can be deferred. They are even cutting back trade credit to customers. Even firms that are currently in good shape report that they are hunkering down, cutting back on all but essential spending, and preparing for the worst. Our venture capital and private equity contacts tell us that they are instructing their portfolio companies to cut costs, put expansion plans on hold, and draw down existing credit lines. The market for commercial mortgage-backed securities has all but dried up, and lenders have also become less willing to extend funding. With financing unavailable, I am hearing talk about substantial cutbacks on new projects and planned improvements on existing buildings, as well as the potential for distress sales of properties whose owners will be unable to roll over debt as it matures. The deterioration in overall financial conditions since the September FOMC meeting is truly shocking. Even with today's 900-point increase in the Dow, broad indexes are still down about 20 percent, and the latest data suggest house prices in a freefall. Baa corporate bonds are up about 200 basis points since our last meeting, low-grade corporate bonds are up a staggering 700 basis points, and to top it all, the dollar has appreciated nearly 10 percent against the currencies of our trading partners. The sharp deterioration in financial and credit conditions will weigh heavily on economic activity for some time. In addition, prospects for the one remaining cylinder in the engine of growth--namely, net exports--are bleak owing to the slowdown in global demand and the appreciation of the dollar. We now expect real GDP to decline at an annual rate of 1� percent in the second half of this year and to register two more negative quarters in the first half of next year. That forecast is predicated on cutting the funds rate to � percent by January, as assumed in the Greenbook, and also is premised on another fiscal package. An absolutely critical pre-condition for the economy to recover next year is for the financial system to get back on its feet. In that regard, I have been greatly heartened by the important actions that the Treasury, the FDIC, the Fed, foreign governments, and other central banks have taken in recent weeks to improve liquidity and inject capital into the financial systems. But we are fighting an uphill battle against falling home prices, an economy in recession, and collapsing confidence. It is not clear whether these steps will reopen credit flows to households and businesses, especially those with less than sterling credit. Under the Greenbook forecast we will see further large declines in housing prices over the next two years. Banks and other financial institutions will likely suffer larger losses than many had anticipated, and that will mute the impact of recent capital injections. The interaction of higher unemployment and rising delinquencies raises the potential for even greater losses by banks and other financial institutions and for an intensification of the adverse feedback loop we have worried about and are now experiencing. Such a sequence of events plausibly could lead to outcomes described in the ""more financial fallout"" alternative scenario in the Greenbook. There are considerable downside risks to the near-term outlook as well. As I mentioned, the most recent economic data have consistently surprised on the downside, and I see a real risk that the data may continue to come in weaker in the near term than the Greenbook has assumed. For example, a dynamic factor model that my staff regularly uses is much more pessimistic in the near term than is the Greenbook. This model aggregates the information contained in more than 140 data series. Based on the most recent economic and financial data available, this model predicts that real GDP will fall 2� percent in the fourth quarter. The model's pessimism reflects the combination of the recent weak data releases for the month of September, followed by the abysmal data that we have available so far for October, including financial market prices, regional business surveys, and consumer sentiment. Turning to inflation, the most recent data have been encouraging. Looking forward, the sharp decline in commodity prices, especially oil prices, will bring headline inflation down relatively quickly. More fundamentally, the considerable slack in labor and product markets will put downward pressure on the underlying rate of inflation over the next few years. A number of my contacts already report that their businesses are working on lower margins in the more challenging economic environment. I expect headline PCE price inflation to decline to about 1� percent in 2009 and core PCE price inflation to be 1� percent next year. I expect both inflation rates to edge down to 1� percent in 2010. Given the sizable downside risk to the forecast for growth, the risks to the inflation forecast are likewise weighted to the downside. In conclusion, I think the present situation obviously calls for an easing of policy, as I assumed in my forecast. Given the seriousness of the situation, I believe that we should put as much stimulus into the system as we can as soon as we can. " FOMC20071211meeting--117 115,MR. MISHKIN.," Thank you, Mr. Chairman. You are all aware that I have a very optimistic personality; and at the last FOMC meeting, I actually had that kind of optimism. I felt that the economy was evolving in a quite reasonable way and, in fact, was responding to our policy changes in a way that I felt was very appropriate in order to minimize the cost of the financial destruction that we’re experiencing. In particular, with the credit markets stabilized, we were in a situation in which our policy moves had reduced a lot of the macroeconomic risk that was out there in terms of credit spreads. Clearly we were still left with the opaqueness spreads or valuation risks that would require price discovery to resolve. It looked as though that was going to progress very slowly and over time we’d get out of the situation we were in and the economy would go through a solid rebalancing, moving away from some sectors that had too much going on—that is, housing—to sectors which we needed to expand—for example, the tradable sector—to deal with some of the global imbalances that we had. So I was actually feeling very positive. I felt that things were going exactly the way that I had hoped. Of course, things don’t always work out that way, and we started to see shortly after the October meeting a substantial deterioration in credit markets. My view is that the deterioration that we’re seeing is appropriately reflected in the substantial revision to the forecast. I’m very comfortable with the way the staff has revised the forecast downward. It’s obviously something that is an art because you have to do it in terms of add factors, but you do want to inform it by science, and I think they have appropriately done so in terms of thinking about what we’ve learned from past experiences that may tell us about how credit disruptions of this type will actually lead to lower spending in many categories. But I want to talk about why my sunny disposition is much less sunny right now and why I’m actually very, very worried—not to say depressed, but at least a little more that way than usual. It is because I think that the kind of negative scenarios that are pointed out in the Greenbook are very real possibilities. In particular, there are two scenarios that they go into separately—the housing correction scenario and the credit crunch scenario. I think that there’s a very strong possibility those would come together because, if housing prices go down more, that creates a much more serious problem in terms of valuation risk, and a serious problem in valuation risk will mean a further credit market disruption, which then can lead to more macroeconomic risk because it leads to this downward spiral. The real economy gets worse. That means that there is more uncertainty. Credit spreads get worse, and you get a very bad scenario happening. That could lead to the credit crunch scenario. Similarly, a credit crunch scenario, I think, would have a very negative effect on the real economy, which would mean that housing prices would go down, which would then make it much more likely that we have the greater housing correction scenario. So that’s the first part of my depression. The second issue is that the Greenbook does not go into the issue of what effect that might have overseas. There has been a lot of discussion in the media about decoupling the U.S. economy from foreign economies, and when it’s just trade that’s going on, I think that is usually completely reasonable. But when it’s financial, then there is very good reason to think of recoupling because a financial disruption in the United States is very likely to spread to financial disruption abroad. We, of course, have already seen that. It’s remarkable that what happened in the subprime sector has in some sectors affected European banks maybe even more than American banks. So the possibility that problems develop in the United States and lead to problems in Europe and other advanced countries and then those problems actually spill over back into the United States again means that there’s a third scenario that could be all tied together. When you look at all of this, I get very nervous. The bottom line is that my modal forecast is certainly down, very much along the lines of what the staff has suggested. But I think there is a significant probability that things will go south. You don’t like to use the R word, but the probability of recession is, I think, nearing 50 percent, and that really worries me very much. I also think that there’s even a possibility that a recession could be reasonably severe, though not a disaster. Luckily all of this has happened with an economy that was pretty strong and with banks having good balance sheets; otherwise it could really be a potential disaster. I don’t see that, but I do see that there is substantial risk that the economy could have a severely negative hit to it that would be very, very problematic. Now, when I look at the issue of inflation, I have a different view from many of the people at this table. I feel strongly that the one thing a central bank can never afford to do is to lose its nominal anchor. If we do that, it’s a disaster. With that viewpoint, I should say that, if shocks occurred such that recession was going to occur and the only way we could stop a recession from occurring was to inflate the economy, we couldn’t allow that to happen. We actually have to preserve the nominal anchor because, in the long run, the pursuit of price stability is what makes good monetary policy and has been a key reason for the remarkable success of monetary policy by the central bankers throughout the world in recent years that I think nobody would have predicted. But when I look at what’s going on in terms of inflation right now, I really do not see the substantial upside risk that a lot of people are talking about. For me the key driver of inflation is, as you know, inflation expectations. The question is whether inflation expectations are grounded, and I think the answer is “yes.” In fact, we’ve had a situation in which higher energy prices have not led to any upward movement in expected inflation as far as I can tell. Neither has the dollar declined—that actually happened when the economy was doing much better. Now we’re facing a situation in which we have some substantial negative shocks to the economy, and those substantial negative shocks actually, if anything, put some downside risk in terms of inflation. I don’t see that inflation will move much from 2 percent. One thing that has happened recently is that we have not seen some of the favorable inflation numbers. President Plosser talked about the fact that we’ve seen less favorable inflation numbers, but that’s because we had temporary factors that were going to make inflation look overly good and drive it below 2 percent. The staff strongly indicated to us in the Greenbook and in past Greenbooks that those temporary factors were not going to persist. They got that one right, but there’s no information from the fact that those temporary factors are no longer present that says that inflation pressures have actually heated up. Indeed, what we see is that inflation seems to be moving around 2 percent. That’s where I think inflation expectations are grounded, and I see no tendency at all for things to get much worse in that regard. I’m not saying that couldn’t change, and so I think we have to be very vigilant. But in the current environment, where I see a very negative potential path of the economy, the idea that inflation is our primary concern right now is not where I am. With that let me end." FOMC20080625meeting--167 165,CHAIRMAN BERNANKE.," Thank you very much. In April, we signaled that, following our aggressive rate actions and our other efforts to support financial markets, it was going to be a time to pause and to assess the effects of our actions. That was not that long ago, and I think it is appropriate to continue our watchful waiting for just a bit longer. I talked yesterday about the balance of tail risks as opposed to the balance of risks. I think that, although the tail risks on the growth and financial side have moderated somewhat, they are still quite substantial. I agree with the Vice Chairman on that point. They arise from two separate but related sources. The first is that, notwithstanding the stronger-than-expected performance in the second quarter, I think there is an excellent chance that we will still see a recessionary dynamic with the associated strong movements in employment and production. Second--again as the Vice Chairman mentioned--I do not agree that systemic risk has gone away. I think it is in abeyance. There is perhaps, if anything, excessive confidence in the ability of the Fed to prevent a crisis situation from metastasizing. Even if we don't have a failure of a major firm, we still have the possibility of a significant adverse feedback loop as credit conditions worsen and banks come under additional pressure. So if I could try to think about this--I don't want to say ""mathematically""--a lot of our discussion has implicitly suggested that there has been a linear model, which is that we are just trying to balance on the scales this risk against that risk. Again, if you are worried about preventing bad outcomes, you have to worry more about nonlinear or discontinuous changes. I think that, at this point, we still have significant risk of a nonlinear, discontinuous change in the financial markets or in the real economy. Tail risks have risen for inflation. There is no question about it. I take what has been said around the table extremely seriously, and I am quite anxious about it, I have to concede. If I were making a comparison of tail risks to tail risks, I still think that the inflation tail risks have not yet reached the level of the concerns I have about the financial crisis. In particular, some important indicators--such as wages, inflation expectations, and core inflation--have not yet signaled a major shift. That being said, I do think we need to acknowledge the relative change in those risks, and we need to begin to prepare the market for the normalization that is going to have to come. Both President Fisher and President Stern talked about the rhetorical aspects of our policy and the effects on policy expectations, and I think we are all in agreement that words mean nothing unless they are eventually backed up by actions. On the other hand, actions may be better if they are preceded by words, if you will. We do need to begin to prepare the markets and to communicate clearly so that people will know what's coming and that the system will be better able to deal with that. If I thought for sure that we were going to begin renormalizing very soon, I would propose doing it today. Why wait? But I think enough uncertainty and enough risks are on both sides that there is some benefit from waiting just a bit longer to see, first, how the financial markets evolve and, second, whether we continue this stronger-than-expected growth pattern or whether we begin to see a more recessionary-type of pattern. In particular, between now and the next meeting, we have two employment reports, a lot of other relevant information, and a lot of insight from the financial markets. At the same time, on the inflation side, we will see how commodity prices evolve, whether we have any kind of relief from what we saw in the last intermeeting period, how the dollar behaves, and how inflation expectations behave. All those things will give us a better sense of where we are and how we should proceed. So I think we should try to be nimble. We should try to respond to the information as it comes in. We should be focused particularly on tail risks. I think we should begin to move, or should maintain, market expectations toward tightening. President Fisher, I think I have to note for the record that I don't think we should let political considerations affect our decisions in any way, and I am not concerned about that. I think we are all prepared to do what is necessary. I don't know what we are going to do in the next meeting or the meeting after that. But my expectation now is that, as others have mentioned, we will begin normalizing interest rates relatively soon, and we should, if possible, begin to prepare the markets for that. For today, as I have indicated, I recommend no change in the federal funds rate target and alternative B for the statement. I think alternative B captures the facts pretty well on the whole. I won't go into it, but I think the inflation paragraph is a little more hawkish. It drops the discussion of a leveling-out of commodity prices. It doesn't refer to core inflation, which we have taken before as sort of a reassuring element. I'm disappointed that President Fisher is going to vote against his own language in alternative B, paragraph 4, which we have adopted and which I think is a very good expression of the risks. " CHRG-111hhrg63105--149 Mr. Duffy," Chairman Boswell, Ranking Member Moran, and Members of the Subcommittee, thank you for inviting us to testify regarding the implementation of Dodd-Frank's provisions relating to position limits. I am going to focus on the requirements of Dodd-Frank and then briefly discuss this theory that speculators are distorting futures markets. Dodd-Frank requires the Commission to make a finding that position limits are necessary to diminish, eliminate, or prevent burdensome excessive speculation before imposing such limits. The CFTC is not permitted to act on the basis of assumptions or political demands. Core principle 5, section 5 of the CEA also demonstrates that position limits are not required in every case since it permits exchanges to adopt accountability levels as an alternative to rigid position limits. Dodd-Frank also requires that CFTC wait to impose limits on futures exchanges until it can simultaneously impose limits on economically equivalent swaps. The purpose of this provision is to prevent a flight of trading from regulated exchanges with no limits to unregulated markets with limits. Given these requirements, it is clear that the CFTC lacks sufficient data to impose limits on swaps and therefore may not act against futures. The Commodity Exchange Act allows limits to be imposed only on excessive speculation, not speculation generally. This is a clear recognition that futures markets cannot operate without the participation of speculators. Arbitrary position limits distort markets, increase cost to hedgers, and increase cost to consumers. Position limits are unnecessary unless burdensome excessive speculation is present or is likely. Academic literature and all the studies produced by the CFTC's economists demonstrate that position limits in futures trading are not the means to deal with real supply-demand issues. It is my firm belief that efforts to focus on position limits rather than the underlying issues are certain to divert attention from the real problems and do more harm than good. Worse yet, position limits in derivatives markets that preclude investors from seeking economic exposure to particular asset classes drive those investors to speculate in physical commodities. This, in turn, has a significant and often detrimental impact on the flow of commodities in commercial channels. We have already seen the beginnings of such distortions in the metals and energy markets in anticipation of the imposition of limits on derivatives. This is not a development that any of us should favor but one that is an unfortunate result of position limits based on bad economics. CME Group is not opposed to position limits and other similar measures if used correctly. For example, we employ limits on most of our physically delivered contracts. However, we use limits and accountability levels, as permitted by the Core Principles, to mitigate potential congestion during delivery periods and to help us respond in advance to any effort to manipulate our markets. CME Group believes that the core purpose that should govern Federal and exchange-set position limits, to the extent such limits are necessary and appropriate, should be to reduce the threat of price manipulation and other disruptions to the integrity of prices. Such activity destroys public confidence in the integrity of our markets and harms the acknowledged public interest in legitimate price discovery. CME Group appreciates the opportunity to offer the foregoing comments regarding the implementation of Dodd-Frank provisions for position limits on certain contracts involving exempt and agricultural commodities. We hope that the views expressed today are helpful, and we look forward to answering any questions the Committee will have. [The prepared statement of Mr. Duffy follows:]Prepared Statement of Terrance A. Duffy, Executive Chairman, CME Group Inc., Chicago, IL I am Terrence A. Duffy, executive Chairman of CME Group Inc. Thank you, Chairman Boswell, and Ranking Member Moran for inviting us to testify today. You asked us to discuss the implementation of provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act relating to position limits. CME Group is the world's largest and most diverse derivatives marketplace. We are the parent of four separate regulated exchanges, including Chicago Mercantile Exchange Inc. (``CME''), the Board of Trade of the City of Chicago, Inc. (``CBOT''), the New York Mercantile Exchange, Inc. (``NYMEX'') and the Commodity Exchange, Inc. (``COMEX'') (collectively, the ``CME Group Exchanges''). The CME Group Exchanges offer the widest range of benchmark products available across all major asset classes, including futures and options on futures based on interest rates, equity indexes, foreign exchange, energy, metals, agricultural commodities, and alternative investment products. CME Clearing, a division of CME, is one of the largest central counterparty clearing services in the world, which provides clearing and settlement services for exchange-traded contracts, as well as for over-the-counter derivatives contracts through CME ClearPort'. Using the CME ClearPort' service, eligible participants can execute an OTC swap transaction, which is transformed into a futures or options contract that is subject to the full range of Commodity Futures Trading Commission (the ``Commission'' or ``CFTC'') and exchange-based regulation and reporting. The CME ClearPort' service mitigates counterparty credit risks, provides transparency to OTC transactions and enables the use of the exchange's market surveillance monitoring tools. The CME Group Exchanges serve the hedging, risk management and trading needs of our global customer base by facilitating transactions through the CME Globex' electronic trading platform, our open outcry trading facilities in New York and Chicago, as well as through privately negotiated CME ClearPort' transactions. The theory that speculators in futures markets cause unwarranted price volatility and excessively high and/or low prices is not new; Congress has dealt with that notion since the late 1800s. The Commodity Exchange Act (``CEA''), however, does not limit speculation, but only ``excessive speculation.'' This is an implicit recognition that futures markets cannot operate without the participation of speculators. The so-called ``speculators,'' such as index funds and swap dealers, who are the focus of recent intense criticism, are not engaged in traditional speculative activity, i.e., trying to beat the market. Rather, swap dealers use futures markets to facilitate the hedging of more complex and specific risks accepted in connection with swap transactions with commercial customers and others. Denying or limiting their access to the futures markets will simply impede hedging activity by commercial market participants. Index funds aggregate the buying and selling decisions of many thousands of investors, most of whom are doing what they have been taught for decades to do: diversifying their investment portfolios and hedging inflation risks to their investment returns in order to maximize their retirement savings and their individual wealth. Position limits are not a costless palliative. Position limits, when improperly calibrated and administered, can easily distort markets, increase the costs to hedgers and effectively increase costs to consumers. Unfortunately, many demands for speculative limitations assume that severe limits on speculation will bring prices to some favored level. On the contrary, position limits on futures contracts will not and do not control cash market prices. There is a complete disconnect between the implied promise to drive prices down or up, whichever the most vocal constituency desires, and the ability of position limits to deliver on that promise.Introduction We disagree with those who contend, in contravention of the clear academic evidence and of the clear intent of Congress, as expressed in Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203, July 21,2010) (``DFA'' or ``Dodd-Frank''), that speculative positions must be limited in order to eliminate price volatility and/or high prices or low prices for essential commodities. Some of the proponents for limits are well intentioned, but have no credible evidence to support their claims. Some contend for example that strict limits on silver futures will allow the price of silver to go up to levels that they think is appropriate. Other proponents of strict position limits contend that limits on oil positions will cause the price of gasoline to fall to levels that are ``better'' for the economy or their constituents. The Wall Street Journal reported on December 8, 2010, that: ``[T]he latest data also show an increase in speculation doesn't necessarily bring with it an increase in prices. Natural gas, for example, is down 21% this year despite a surge in speculative bets. In opposite circumstances with sugar, prices rallied despite a withdrawal of speculative bets.'' The Wall Street Journal--Investors Pile Into Commodities, Carolyn Cui and Susan Pulliam. All of the serious academic literature, including all of the studies produced by the CFTC's economists demonstrate that position limits in futures trading are not the means to deal with real supply and demand issues that are prevalent in markets for many physical commodities. It is my firm belief that efforts to focus on position limits rather than the underlying economic issues are certain to divert attention from the real supply and demand dynamics and do more harm than good. Worse yet, position limits in derivative markets that preclude investors from seeking economic exposure to particular asset classes drives those investors to speculate in physical commodities, which has a significant and often detrimental impact on the flow of commodities in commercial channels. We have already seen the beginnings of such distortions in metals and energy markets in anticipation of the imposition of limits on derivatives. This is not a development that anyone should favor, but one that is the logical result of even the threat of position limits based on bad economics. CME group is not opposed to position limits and other similar measures in all circumstances; we employ limits in most of our physically delivered contracts. However, we use limits and accountability levels, as contemplated by the Congressionally-approved Core Principles for Designated Contract Markets, to mitigate potential congestion during delivery periods and to help us identify and respond in advance to any threat to manipulate our markets. CME Group believes that the core purpose that should govern Federal and exchange-set position limits, to the extent such limits are necessary and appropriate, should be to reduce the threat of price manipulation and other disruptions to the integrity of prices. Such activity destroys public confidence in the integrity of our markets and harms the acknowledged public interest in legitimate price discovery. CME Group is therefore vigilant in seeking to deter and prevent price manipulation or other illegitimate distortions of market prices. Speculation, however, is not manipulation, nor is it an abusive practice. As CME Group observed in its response to the Commission's January 2010 energy position limits proposal, speculation is essential to the orderly functioning of futures markets--it provides market liquidity which promotes more effective commodity price discovery and allows for the efficient transfer of price risk. See CME Group Comments, 10-002 Comment CL-02714, at 2 (Apr. 26, 2010) (``CME Comments''). The Commission's responsibility and challenge is not to restrict speculation per se, but to act when necessary to prevent ``excessive speculation'' from burdening interstate commerce through what the Commodity Exchange Act (``CEA'') calls ``unreasonable'' and ``unwarranted'' fluctuations in the price of a commodity. To this end, Congress has granted to the Commission the authority to impose speculative position limits under Section 4a of the CEA, as amended by DFA. CME Group understands the extensive demands being made on the Commission's limited resources. However, the Commission must gather critical data regarding swap markets and individual traders' swap positions. Without a thorough understanding of such data, the Commission runs the risk of inappropriately setting position limits. CME Group appreciates the great challenge this presents to the Commission.I. Statutorily Required Basis for Imposing Position Limits Section 4a(a)(1) provides in pertinent part: ``For the purpose of diminishing, eliminating, or preventing such burden [of unwarranted or unreasonable price fluctuations resulting from excessive speculation], the Commission shall . . . fix such limits on the amount of trading which may be done or positions which may be held . . . as the Commission finds are necessary to diminish, eliminate, or prevent such burden.'' (emphasis added) By its terms, DFA requires the Commission to make a finding that position limits ``are necessary to diminish, eliminate, or prevent'' burdensome excessive speculation before imposing such limits. Dan Berkovitz, CFTC General Counsel, confirmed that Section 4a(a)(1) sets forth a conditional mandate during the CFTC's July 2009 hearings on energy position limits. In response to Chairman Gensler's question, ``What does the word `shall' mean in 4a?,'' Berkovitz replied, ``If the Commission finds that position limits are necessary to prevent, diminish, or eliminate such burdens, then there is a directive that it shall establish position limits.'' Transcript of July 28, 2009 CFTC Hearing on Energy Position Limits at 35-36 (emphasis added). The above quoted language from Section 4a(a)(1) was not deleted or in any way altered by DFA. New CEA subsection (a)(2) (``Establishment of Limitations'') even reaffirms that any position limits must be established ``[i]n accordance with the standards set forth in paragraph 1 of this subsection,'' which include the requisite ``necessary'' finding. Core Principle 5, Section 5(d)(2)(5) of the CEA as amended by DFA, also recognizes that ``accountability levels'' are an alternative to rigid position limits: (5) Position limitations or accountability.-- (A) In general.--To reduce the potential threat of market manipulation or congestion (especially during trading in the delivery month), the board of trade shall adopt for each contract of the board of trade, as is necessary and appropriate, position limitations or position accountability for speculators. (emphasis supplied) Moreover, the Commission must publish the statutorily required finding and the information in support thereof in any notice of proposed rulemaking to comply with the Administrative Procedure Act (``APA''). The APA requires that the notice of a proposed rule include ``sufficient detail on its content and basis in law and evidence to allow for meaningful and informed comment.'' See, e.g., Am. Med. Ass'n v. Reno, 57 F.3d 1129, 1132 (D.C. Cir. 1995). Absent a finding with supporting evidence that position limits are ``necessary,'' this APA requirement cannot be met because the public will not know the Commission's specific reasoning for the essential finding that triggers its proposed rulemaking. DFA indicates that such limits would be ``unnecessary'' where burdensome excessive speculation does not exist or is unlikely to occur in the future. CME Group's comment letter on the Commission's energy position limits proposal discussed at length the absence of any credible empirical evidence of the existence of burdensome excessive speculation or its likely future occurrence. See CME Comments at 17-24. The weight of empirically sound analysis and research demonstrates that movements in commodity prices are attributable to fundamental market conditions rather than speculative trading. CFTC studies, for example, have found that supply and demand factors were largely responsible for the 2008 rise in oil prices and that, far from harming the market, speculators serve as an important source of liquidity for other participants. See, e.g., CFTC Interagency Task Force on Commodity Markets, Interim Report on Crude Oil at 3-4 (July 22, 2008); Michael Haigh et al., Market Growth, Trader Participation and Pricing in Energy Futures Markets (Feb. 7, 2007), available at http://web.uvic.ca/econ/research/seminars/robe.pdf. Like CFTC staff, the Government Accountability Office (``GAO'') has not identified a causal relationship between speculation in the futures market and changes in commodity prices. See GAO, GAO-09-285R, Issues Involving the Use of the Futures Markets to Invest in Commodity Indexes at 5 (Jan. 30, 2009). The conclusions of these governmental studies and reports are consistent with those of academic and private sector economists. See, e.g., Paul Krugman, The Oil Nonbubble, N.Y. Times, May 12, 2008, http://www.nytimes.com/2008/05/12/opinion/12krugman.html (``[T]he rise in oil prices isn't the result of runaway speculation; it's the result of . . . the growing difficulty of finding oil and the rapid growth of emerging economies like China.''). To the extent there are any legitimate concerns with the potential for excessive speculation to cause unwarranted or unreasonable price fluctuations, CME Group believes that futures exchanges effectively address such concerns through their existing market surveillance programs. CME Group provided a detailed account of the futures exchanges' capabilities in its April 26, 2010 comments filed with the CFTC. See CME Comments at 8-12. Briefly stated, the exchanges independently have the ability to establish position limits as warranted by the characteristics of their traded contracts, and to employ position accountability provisions as appropriate given particular market constructs and market conditions. This flexible regulation is a much more appropriate and effective means of addressing potentially manipulative or disruptive positions than are blunt position limits that fail to account for variability in specific contract months, market conditions, and market participation. Insofar as the existing exchange programs are and have been proven to be effective, CME Group believes the Commission would lack the statutory basis for establishing new Federal position limits on certain contracts involving exempt and agricultural commodities.II. Mechanics of Imposing Position Limits Assuming the Commission is able to find that position limits ``are necessary to diminish, eliminate, or prevent'' burdensome excessive speculation, CME Group offers the following views on how to impose those limits:A. The Imposition of Limits Should be Deferred Until the Commission Can Properly Determine and Ensure Compliance with Appropriate Limits Dodd-Frank sets forth several seemingly inconsistent timing requirements for the exercise of the Commission's position limit authority. New CEA 4a(a)(2)(B) directs the Commission to impose limits for certain contracts, within 180 days for exempt commodities and within 270 days for agricultural commodities, respectively, of Dodd-Frank's enactment. Meanwhile, new CEA 4a(5)(A) requires that limits for swaps that are economically equivalent to futures and options be established simultaneously with the limits under Section 4a(a)(2)(B). The statute, however, also vests the Commission with discretion to establish limits ``as appropriate,'' thereby indicating that the Commission is not bound by the aforementioned dates. CME Group believes that DFA requires the Commission to defer imposing limits until doing so would be ``appropriate''--that is, when it has the data needed to accurately set and enforce those limits and when it is in a position to impose limits simultaneously on futures (and options on futures) and swaps.B. Position Limits Should Be Set with Due Regard for Legislative Objectives and Considerations Under Dodd-Frank, the Commission is required to take into account several factors when setting position limits. New CEA 4a(a)(3) provides that, to the maximum extent practicable, the Commission should use its discretion to establish limits to: (i) diminish, eliminate, or prevent ``excessive speculation''; (ii) deter and prevent market manipulation, squeezes, and corners; (iii) ensure sufficient market liquidity for bona fide hedgers; and (iv) ensure that the price discovery function of the underlying market is not disrupted. Additionally, new CEA 4a(a)(2)(C) states that the Commission must act to avoid shifting the price discovery function to FBOTs in establishing limits. In mandating these considerations, Congress recognized that limiting trading positions has the potential to reduce liquidity and adversely affect the hedging and price discovery functions of U.S. commodity markets. The Commission is obliged to give due weight to each consideration in setting any position limits and may not focus solely on imposing limits to diminish, eliminate, or prevent ``excessive speculation.''C. The Commission's Exemptive Authority Should Be Interpreted Broadly To Accommodate All Non-Speculative Positions New CEA 4a(a)(7) gives the Commission authority to exempt from any position limit rule, with or without conditions, ``any person or class of persons, any swap or class of swaps, any contract of sale for future delivery or class of such contracts, any option or class of options, or any transaction or class of transactions.'' Under this provision, the Commission's statutory power to exempt any person or class of person from position limits is greater than it has ever been before. CME Group believes that DFA authorizes the Commission to use its broad new exemption authority under 4a(a)(7) to grant exemptions to market participants who use futures, options, or swaps when economically appropriate to the reduction of the risks they face in their enterprises. Although it is impossible to enumerate the breadth of exemptions that should be permitted in order to ensure that entities are able to effectively manage exposure that is highly correlated to fluctuations in the price of exempt and agricultural commodities, an application for exemption should be judged on its merits in terms of the specific risks to be hedged, the relevant price relationships, the proposed position sizes, and the operational procedures for establishing and lifting the hedge. If the Commission were to narrowly construe its 4a(a)(7) exemptive authority to exclude non-speculative trading activity, then market participants could be forced to either actually speculate on those price risks (i.e., not establish any positions to mitigate the risk), and potentially increase costs to consumers, or hedge their risks through transactions that lie outside the CFTC's position limit authority. Either strategy would undermine the Commission's mission to promote liquidity and protect the price discovery function of its regulated markets. The Commission should thus broadly interpret its exemptive powers and grant exemptions to market participants who are not seeking to establish positions in the futures market for speculative purposes but rather to serve their legitimate commercial and financial hedging needs.III. Conclusion CME Group appreciates the opportunity to offer the foregoing comments respecting the implementation of DFA's provisions respecting position limits on certain contracts involving exempt and agricultural commodities. We hope that the views expressed herein prove to be helpful and we are available to answer any questions the Committee may have. " FOMC20050630meeting--12 10,MR. WILLIAMS.," I’ll be referring to the exhibits beginning on page 26. In my presentation today, I’ll lay out a few scenarios that illustrate the potential macroeconomic fallout resulting from a significant decline in house prices, and I will examine policy responses that minimize it. I’ll start by describing the possible size of the current problem—assuming there is one. As pointed out in Dick Peach’s presentation, there are serious difficulties in accurately measuring both actual and “fundamental” house prices. But, for the purposes of my presentation, I will take as a working hypothesis that house prices are high relative to fundamentals—or, in terms of the decision tree that Glenn just laid out, I assume that the answer to his question 1 is “Yes, the asset price appears misaligned.” As Josh Gallin indicated, it would take up to a 20 percent decline in house prices to bring the price-to-rent ratio back in line with fundamentals. With housing wealth standing at around $18 trillion today, such a drop in house prices would extinguish $3.6 trillion of household wealth. That’s equal to about 30 percent of GDP. Based on a marginal propensity to consume from housing wealth of 3½ cents on the dollar, this decline in wealth would entail a nearly 1½ percentage point increase in the personal saving rate. And, according to estimates from the FRB/US model, it implies a 40 basis point reduction in the long-run neutral real funds rate. June 29-30, 2005 18 of 234 at that time were arguably some 50 to 70 percent overvalued. Correction of prices to fundamentals at that time would have implied a reduction in household wealth of $6.7 trillion, equal to about 70 percent of contemporaneous GDP. In the event, stock market wealth fell by $4.6 trillion between March 2000 and March 2001, and at its lowest point was down $8.5 trillion. There is considerable uncertainty regarding the magnitude of the effects of changes in stock market and housing wealth on household spending; nonetheless, it seems clear the magnitude of the current potential problem is much smaller than, and perhaps only half as large as, that of the stock market bubble. Of course, if house prices continue to soar—and in the San Francisco Bay Area, at least, they show no signs of slowing—the magnitude of the housing overvaluation problem will rise as well. A cautionary note worth emphasizing is that the monetary policy cushion available today, as measured by the prevailing federal funds rate, is noticeably smaller than it was in early 2000 at the peak of the stock market. The first question that comes to mind is: What should monetary policy do, if anything, about the apparent overvaluation in house prices? The answer to that depends crucially on the answer to Glenn’s second question: “Do bubble fluctuations result in large macroeconomic consequences that monetary policy cannot readily offset?” Therefore, I now explore the effects of a bubble collapse and the ability of policy to respond effectively to them. I consider three scenarios in which a housing bubble deflates relatively quickly. I use the FRB/US model to quantify these effects. Note that for the materials posted last Wednesday, I based my simulations on the April Greenbook projection. I have since updated the simulations, and the ones that I will be showing today are based on the extended June Greenbook projection. In each scenario, I assume that house prices fall by 20 percent relative to the baseline over the next 2½ years. June 29-30, 2005 19 of 234 gap, and with the long-run natural rate of interest that appears in the rule varying in accord with sustained changes in housing wealth and bond premiums. The second page of my exhibit shows the results from model simulations of a 20 percent decline in house prices, where only the standard channels included in the FRB/US model are in play. For comparison, I have also plotted the baseline paths, based on the June extended Greenbook projection but modified under the assumption that monetary policy is set optimally in the way I just described. Because a decline in house prices primarily influences demand, not supply, it does not pose a difficult tradeoff between policy goals. In addition, according to the model, the macroeconomic effects play out gradually and are moderate in magnitude, giving policy time to respond. The optimal policy calls for a path for the funds rate that averages about 3¼ percent during 2007 and 2008—about 40 basis points below the baseline path. Under this policy, the unemployment and inflation rates are nearly the same as in the baseline. The very small rise in inflation reflects the effects of the depreciation of the dollar resulting from the reduction in domestic interest rates. The modified Taylor rule is able to mimic the outcomes under the optimal policy reasonably well, indicating that policy need not fully anticipate future house- price declines to be effective, but can simply respond to events as they unfold. Note that if the house-price decline were larger (or the marginal propensity to consume out of housing wealth bigger), then the policy implication would simply be to cut rates by proportionally more. In summary, assuming that the FRB/US model does a good job of capturing the macroeconomic implications of declining house prices, such an event does not pose a particularly difficult challenge for monetary policy. One lingering concern, however, is that the model may be missing other important avenues by which large movements in house prices affect the economy. I now consider a scenario that entertains that possibility. June 29-30, 2005 20 of 234 The Taylor rule, however, is not as successful. It fails to anticipate the spillover effects and responds too timidly once they occur. Still, it contains the rise in unemployment to only about ½ percentage point above baseline and moves inflation slightly more rapidly toward the assumed inflation objective. I should note that, given the uncertainty regarding the size and timing of such spillovers, the ideal outcome in the optimal policy simulation exaggerates the real-world ability of monetary policy to offset the effects of such shocks. As I noted before, the thought experiment behind these first two sets of simulations is that house prices fall in a kind of vacuum, without any relationship to other events. Some commentators have argued that the current high level of house prices is the outcome of a history of very low interest rates and past house-price appreciation that has given rise to irrationally optimistic expectations of future appreciation. Indeed, a simple estimated equation relating the current price-to-rent ratio to the user cost of housing and past house-price appreciation does a reasonably good job of explaining much of the run-up in house prices over the past several years. If this explanation holds water, a potential risk to housing prices and the outlook in general lies in the path of longer-term interest rates—which have been surprisingly low, given prevailing economic conditions—and the usual behavior of term premiums. Bond yields could return to more normal levels and in so doing contribute to a downward trajectory in house prices. I explore such a possibility in the final scenario, which builds on Scenario 2, and is the subject of the next page of my exhibit. I now add the assumption that the term premiums on long-term bonds rise by 75 basis points, relative to baseline, over the second half of this year and remain at these levels. This aspect of the scenario is similar to an alternative scenario reported in the June Greenbook. This shock to bond premiums by itself reduces the long-term equilibrium real funds rate by about 70 basis points. Optimal policy calls for the funds rate to fall below 1 percent by the middle of next year and for the funds rate to remain below 3 percent through 2008. The optimal policy is just able to contain the rise in unemployment without confronting the zero bound. The Taylor rule, on the other hand, responds too gradually to events, and, as a result, the unemployment rate reaches 6 percent in early 2007. This scenario presents a difficult challenge for monetary policy, especially in light of the looming zero lower bound on interest rates under the optimal policy. More generally, it highlights that the risks posed by a house-price decline are magnified if they occur in tandem with other events that damp economic activity. June 29-30, 2005 21 of 234 other factors, upon which such a policy necessarily would rely, is imperfectly understood and may have changed over time. Moreover, as seen in the earlier presentations, there remains considerable uncertainty over the degree of overvaluation. Thus, the successful use of monetary policy to reduce the magnitude of a misalignment of house prices would be a daunting task, even assuming that such a goal were deemed desirable. This concludes our prepared remarks." CHRG-110shrg50369--144 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKEQ.1. Increases in the GSE/FHA Conforming Loan Limits: The stimulus bill recently passed by Congress includes an increase in the conforming loan limit amount for mortgages that the Government Sponsored Entities (GSEs) and the Federal Housing Administration can guarantee. Do you believe that increasing these loan amounts adds to the systemic risks associated with the GSEs' operations? While these increases are only temporary, some have raised the idea of permanently increasing the amounts. Are there additional risks associated with a permanent increase?A.1. Temporarily raising the conforming loan limit allows the GSEs to securitize an expanded range of mortgage loans and likely would increase liquidity in the secondary market for loans covered by the expansion. The GSEs should be strongly encouraged to rapidly use this authority, even if it requires that they raise substantial amounts of capital. Over a longer horizon, it is important to realize that raising the conforming loan limits extends the implicit government-backing of the GSEs into a larger portion of the mortgage market. While the jumbo mortgage market has experienced substantial liquidity problems during the past year, this market historically has operated efficiently and functioned well without GSE involvement. Moreover, prime quality homeowners who use jumbo mortgages are, in general, the highest income and wealthiest members of our society. Extending the reach of the GSEs to these borrowers would do little to expand homeownership or to extend mortgage credit to those that cannot obtain mortgages otherwise. Thus, raising the conforming loan limit involves the larger question of how far to extend government guarantees, either explicit or implicit, to resolve short-term liquidity problems in secondary asset markets. Temporary expansions of the safety net, such as those undertaken by the Federal Reserve, can boost short-term liquidity without distorting private market credit analysis. In contrast, permanent expansions of the safety net, such as raising the conforming loan limit permanently, may well cause greater problems in the long-run. There are many reasons for the recent breakdown in private market credit analysis, but it is not clear to me that the best approach to rectify the current situation is simply to substitute implicit government guarantees for much needed private market discipline. If private markets are unable to provide a secondary market for some assets, we should first endeavor to understand why this is the case rather than immediately turn to a broader expansion of GSE guarantees. Any permanent expansion of GSE guarantees must, be accompanied by comprehensive GSE reform to mitigate further systemic risks. In particular, capital standards for the GSEs must be significantly toughened and clear and credible receivership procedures for the GSEs should be established. Moreover, the role and function of the GSE portfolios should be clearly articulated by Congress. As has been evident in recent months, this portfolio is managed mainly to meet needs of GSE shareholders and not to fulfill public policy objectives.Q.2. International Liquidity Coordination: Chairman Bernanke, as of the minutes of the last Federal Open Market Committee meeting, the Federal Reserve reaffirmed their commitment to working with foreign central banks to coordinate international monetary policy. Please describe for us the details of the Federal Reserve's agreements with foreign central banks, such as the European Central Bank and the Bank of England for exchanging assets into dollars. Why have these agreements been made and are financial institutions using these tools?A.2. The Federal Open Market Committee (FOMC) established swap lines with the European Central Bank (ECB)and Swiss National Bank (SNB) in conjunction with the establishment of the Term Auction Facility (TAF) on December 12, 2007. These swap agreements were requested by the ECB and SNB and allowed them to draw a maximum of $20 billion and $4 billion respectively, for a period of up to 6 months. Under the agreements, both central banks are allowed to purchase U.S. dollars with their foreign currencies based on the prevailing spot exchange rate, and they pay interest on the foreign currency received by the Federal Reserve. Given the strong financial position of the ECB and SNB, the swap lies involve virtually no credit risk to the Federal Reserve. The Federal Reserve has also maintained longstanding swap facilities with the Bank of Mexico and the Bank of Canada as part of the North American Framework Agreement. Those facilities amount to $2 billion with the Bank of Canada and $3 billion with the Bank of Mexico. The agreements with the ECB and SNB were established to allow dollar funding problems faced by European and Swiss banks to be addressed directly by their respective home central banks. In the absence of such agreements, European and Swiss banks were believed to be more likely to seek dollar funding in U.S. markets, potentially increasing volatility and adding to term funding pressures in U.S. markets. By providing dollars to the ECB and SNB to use in their efforts to address term dollar funding problems abroad, the FOMC believed that it would assist U.S. credit markets. Both the ECB and SNB have used their swap agreements. The first use of these swap lines was on Monday, December 17, when the ECB drew upon $10 billion and the SNB drew upon $4 billion for a 28-day period. The two central banks used the funds to auction dollar funding to their eligible depository institutions; the ECB offered funds to its eligible depository institutions at the 4.65 percent rate set in the Federal Reserve's TAF auction, and the SNB auctioned $4 billion at a weighted average rate of 4.79 percent. The ECB drew upon a further $10 billion on Thursday, December 20, in conjunction with the second TAF auction held by the Federal Reserve. At the expiration of its first use of its swap line, the ECB renewed its draws in conjunction with the January 14 and January 28 TAF auctions, offering $10 billion in 28-day dollar funds both times at a rate equal to the rate set in the TAF auction. The SNB also renewed its draw of $4 billion on its swap line to participate in the January 14 auction of dollar funds. On March 11, the FOMC announced that it would increase its temporary swap line to the ECB from $20 billion to $30 billion and its line to the SNB from $4 billion to $6 billion, extending the swap lines through September 30, 2008. Both central banks have signaled that they would draw upon the lines to offer 28-day dollar funding in auctions to be held on March 25.Q.3. Sovereign Wealth Funds and Systemic Risk: Chairman Bernanke, recently we have seen an influx of capital into our domestic financial institutions from foreign governments, specifically sovereign wealth funds. Previous foreign direct investments have usually been in smaller quantities and from private investors, rather than governments. These investments may be under the threshold of control for each sale, but collectively could represent a large proportion of U.S. financial services firms. Is there a danger of systemic risk from one or more Sovereign Wealth Funds holding noncontrolling stakes many financial firms?A.3. The recent prominent equity investments by sovereign wealth funds in large U.S. financial institutions permanently increased the capital of these firms, enhancing their soundness and the soundness of the U.S. financial system. These investments also support the ability of the financial institutions to provide credit to businesses and consumers. It is difficult to envision circumstances under which non-controlling equity stakes in financial institutions, could increase systemic risk in a financial system. Sovereign wealth funds have been relatively stable investors. The funds generally are neither highly leveraged nor exposed to liquidity risk arising from investor withdrawals or redemptions. Sovereign wealth funds often use professional private fund managers who are tasked with seeking higher returns and greater diversification--relative to official reserves--for a portion of a country's foreign exchange assets. Because sovereign wealth funds are government owned, there has been concern, however, that these funds have the potential to be motivated by political reasons To the extent these funds make only smaller, noncontrolling investments, the ability of a sovereign wealth fund to have an effect on the operation, strategic direction or policies of a banking organization are minimal. If two or more companies with noncontrolling investments in a U.S. bank or bank holding company were to agree to act together in an attempt to influence the operations of a U.S. bank or bank holding company, the Federal Reserve has the authority to combine the companies' shareholdings and treat the group as one company (an ``association'') for purposes of the Bank Holding Company Act (BHC Act). If the combined shareholding were significant enough, the association could be treated as a bank holding company subject to the requirements of the BHC Act. To date, the Board has not found that sovereign wealth funds from different countries have in fact acted together to control a U.S. financial institution. Another important safeguard applies to the U.S. banking organization itself. U.S. banking organizations themselves are subject to the supervisory and regulatory requirements of U.S. banking law. For example, federal banking agencies are required under the Federal Deposit Insurance Act to establish certain safety and soundness standards by regulation or guideline for all U.S. insured depository institutions. These standards are designed to identify potential safety and soundness concerns and ensure that action is taken to address those concerns before they pose a risk to the Deposit Insurance Fund. Thus, the Federal banking agencies may monitor and require action by the U.S. banking organization to maintain its financial health regardless of the owner of the banking organization.Q.4. Is there a Bernanke ``Put''? Chairman Bernanke, some economists speculate that market participants became willing to take greater risks because monetary policy under Chairman Greenspan protected investments by cutting interest rates in response to economic shocks. This phenomenon came to be called the Greenspan ``put''--referring to the financial instrument that guarantees its owner a certain return if prices fall below a specified level. Now critics are wondering if there is also a Bernanke put, given the recent significant drop in rates. How do you respond to these observations? How do you balance responding to slower economic growth while at the same time allowing the market to follow a normal business cycle? Do you have any concerns that the 225 basis point drop in interest rates since last August creates moral hazard for market participants?A.4. In conducting monetary policy, the Federal Reserve is guided by its statutory mandate to promote maximum employment and stable prices over time. I do not believe that monetary policy actions aimed at these goals are a significant source of moral hazard. To be sure, in carrying out its mandate, the Federal Reserve takes account of a broad range of factors that influence the outlook for economic growth and inflation, importantly including financial asset prices, such as the prices of equity shares and houses. Financial asset prices are important for the economic outlook partly because they affect household wealth and thus consumer spending on goods and services and therefore ultimately influence output, employment, and inflationary pressures. Depending on overall circumstances, declines in asset prices may adversely affect the outlook for aggregate demand, and consequently the stance of monetary policy may need to be eased in order to cushion the effect on aggregate demand. It is important to recognize that such a response of monetary policy is not designed to support financial asset prices themselves but to foster overall economic growth and to mitigate the risks of particularly adverse economic outcomes. It is also worth noting that past Federal Reserve efforts to buoy economic growth in the face of declining asset prices have not insulated from substantial losses investors who made poor investment choices. This point is evidenced by the very large losses suffered by investors in the tech sector early this decade despite considerable monetary policy easing, and by the losses experienced by investors in many subprime-related mortgage products more recently even as the stance of monetary policy was eased.Q.5. Term Auction Facility: Chairman Bernanke, the Federal Reserve created a new Term Auction Facility to help ensure that American banks have adequate liquidity. What has been the response to the auctions thus far and for how long will they continue? What type of collateral are banks posting in these auctions? What happens if that collateral, particularly AAA-rated mortgage backed securities, is downgraded?A.5. The demand for TAF credit from depository institutions has been ample. All eight auctions conducted to date have been oversubscribed, with resulting interest rates in each case above the minimum bid rate. The Federal Reserve will continue to conduct TAF auctions for at least the next 6 months unless evolving market conditions clearly indicate that such auctions are no longer necessary. TAF borrowing is collateralized by the same pool of assets as pledged against other types of discount window loans. For all types of discount window loans, Federal Reserve Banks will consider accepting as collateral any assets that meet regulatory standards for sound asset quality. Commonly pledged assets include residential and commercial real estate loans, consumer loans, business loans, and a variety of securities. The standards applied to each type of collateral are available on the Federal Reserve discount window Web site at www.frbdiscountwindow.erg. Collateral that is downgraded below Federal Reserve eligibility standards is given no value and must be withdrawn. The likelihood that the downgrade of a portion of a depository institution's collateral will affect a TAF loan is reduced by the requirement that, at the time of bidding, the sum of the aggregate bid amount submitted by a depository institution and the principal amount of TAF advances that the same depository institution may have outstanding cannot exceed 50 percent of the collateral value of the assets pledged by the depository institution.Q.6. Value of the Dollar: As you know, the U.S. dollar declined against most major currencies over the past year. The dollar has lost 10.4 percent again the Euro and 5.7 percent versus the yen in 2007. What does it mean for our economy if foreign countries turn away from holding the dollar as their reserve currency or even if they diversify, which has already begun? Are there dangers that we will be more constrained in the actions we are able to take domestically, including selling Treasury securities, to finance our deficit?A.6. The dollar's status as a reserve currency reflects investor confidence in the sophistication and liquidity of U.S. financial markets and the relative stability of our macroeconomic environment. To date, there is little evidence of a shift in foreign official holdings away from dollar denominated assets. U.S. data show further growth in foreign official holdings of U.S. assets. Data reported to the IMF also show continued growth in dollar assets in foreign official reserves. While the IMF data show a decline in the dollar share of reported reserves, this decline is entirely attributable to the depreciation of the dollar, which has raised the dollar value of the other currencies held in the reserve portfolios. In response to a private survey conducted by the Royal Bank of Scotland, several reserve managers indicated they planned to increase the weight of non-dollar assets in future investments, but there was again no evidence of a general shift out of the dollar on the part of these respondents. In principle, a shift in foreign appetite away from U.S. securities toward foreign securities might be expected to lower the value of the dollar and to raise U.S. interest rates; however, these effects are difficult to measure and appear to be modest. Furthermore, while it is true that foreign official institutions hold a significant fraction of U.S. Treasury securities outstanding, it is important to note that these holdings represent less than 5 percent of the total debt outstanding in U.S. credit markets. As such, U.S. credit markets could likely absorb a shift in foreign official allocations away from dollar assets without undue difficulty. In the event that such a shift were to occur and put undesired upward pressure on U.S. interest rates, the Federal Reserve has the capacity to increase available credit to maintain a level of short-term interest rates consistent with our domestic economic goals. Any effect of reduced foreign demand on the term premium between short-term and long-term interest rates could affect the cost of long-term borrowing by the Federal Government; however, this impact is likely to be relatively small and is unlikely to materially constrain the U.S. government's ability to finance its deficit.Q.7. Slow Growth and Rising Inflation: Mr. Chairman, there is some evidence of contradictory forces at play in the economy right now. In the middle of the present economic downturn, commodity and food prices have increased. What do you judge to be the threat of slow growth continuing, with inflation remaining above the Federal Reserve's comfort level?A.7. The FOMC, in the statement released at the conclusion of its most recent meeting on March 18, noted that the outlook for economic activity has weakened further in recent weeks and that downside risks to growth remain. At the same time, inflation has been elevated, uncertainty about the inflation outlook has increased The actions taken by the Federal Reserve since last August, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, the Federal Reserve remains attentive to the risks to the outlook for activity and inflation, and it will act in a timely manner as needed to promote sustainable economic growth and price stability.Q.8. Capital: The ongoing turmoil in our financial markets vividly demonstrates the wisdom of prudent capital requirements for our financial institutions. If our financial institutions hold sufficient capital, they are much more likely to weather the inevitable economic storms that occur as part of the business cycle. Because a healthy banking system is one of the best defenses against a severe economic downturn, one of the most important responsibilities of our financial regulators is ensuring that financial institutions are adequately capitalized. Chairman Bernanke, what is your assessment of the current capital levels in our banking system? As part of your answer, would you explain the steps your agency has taken over the past year to make sure that our banks are adequately capitalized?A.8. As you how a bank is deemed to be well capitalized under Prompt Corrective Action rules if it has a tier 1 risk-based capital ratio of 6 percent or greater, a total risk-based capital ratio of 10 percent or greater, a leverage ratio of 5 percent or greater and is not subject to any written directive issued by the Federal Reserve Board. As can be seen in the summary table below, the majority of U.S. commercial banks have substantial buffers over the well capitalized requirements (as of year-end 2007), which should prove helpful during these difficult times. However, capital ratios in banking organizations can erode rapidly during downturns, depending on the rate of increase and amounts of write-downs and additions to the allowance for losses and the extent to which these cannot be offset by the retention of earnings or raising of new capital. Summary Average Data for Insured Commercial Banks------------------------------------------------------------------------ Ratios Avg. 1997-2007 2006 2007------------------------------------------------------------------------Equity Capital/Assets............... 9.2 10.2 10.2Leverage............................ 7.8 8.1 7.9Tier 1 Ratio (Risk-Based)........... 9.7 9.8 9.4Total Ratio (Risk-Based)............ 12.4 12.4 12.2% Deemed Well Capitalized........... 98.3 99.3 98.9------------------------------------------------------------------------Source: Summary Profile Report, Dec. 2007, BS&R, Federal Reserve Board of Governors. The Federal Reserve Board, together with the other banking agencies, is currently reviewing several elements of its regulatory capital requirements to ensure that banking organizations have sufficient capital levels to weather losses during difficult times and to ensure a high standard in the quality of capital (i.e., its ability to absorb losses effectively) being issued by these organizations. In addition, our ongoing supervisory activities include monitoring banking organizations' asset quality, market exposures, quality of earnings, capital management plans, effectiveness and adequacy of provisioning, and valuation policies, all of which directly impact the banking organizations' capital standing. In December 2007, the Federal Reserve Board, together with the other banking agencies, approved final rules implementing the Basel II advanced risk-based capital rules--for large, internationally active banking organizations--that more closely align regulatory capital requirements with actual risks and should further strengthen banking organizations' risk-management practices. The improvements in risk management under Basel II will be valuable in promoting the resiliency of the banking and financial systems. Under the Basel II rules, banking organizations must have rigorous processes for assessing their overall capital adequacy in relation to their total risk profile and publicly disclose information about their risk profile and capital adequacy. We will continue to assess the Federal Reserve Board's capital rules to ensure that banking organizations' capital requirements remain prudent.Q.9. Role of Credit Rating Agencies for Capital Requirements: Many financial institutions and pension funds are only permitted to hold assets with an ``investment grade'' rating. Chairman Bernanke, what steps is the Fed taking to ensure that banks monitor the quality of assets on their balance sheets and that financial institutions are not outsourcing their due diligence requirements to credit rating agencies?A.9. Many investors and financial firms relied too heavily on ratings assigned by credit rating agencies in their risk management activities, particularly with regard to structured credit instruments. The Federal Reserve has long stressed to bankers the importance of proper due diligence and independent analysis in making credit risk assessments. A recent analysis of several global financial institutions by supervisors from the United Kingdom, Germany, France, and the United States--including staff from the Federal Reserve--demonstrated that principle in the current environment. Those institutions that had developed robust internal processes for assessing risks of complex subprime-related instruments were able to more quickly identify declines in value and the heightened risks of these instruments. Accordingly, these institutions were less vulnerable to the underestimates of risk made by the credit rating agencies on these instruments, less likely to underestimate the volatility of these instruments, and better able to analyze the effects of changing market conditions on their credit and liquidity risk profiles. \1\--------------------------------------------------------------------------- \1\ Senior Supervisors' Group, ``Observations on Risk Management Practices During the Recent Market Turbulence,'' March 6, 2008.--------------------------------------------------------------------------- We are reminding institutions that they should conduct independent, thorough, and timely credit risk assessments for all exposures, not just those in the loan book. Their processes for producing credit risk assessments should be subject to periodic internal reviews--through financial analysis, benchmarking and other means--to ensure that these assessments are objective, accurate and timely. Supervisors are also redoubling efforts to ensure that institutions do not rely inappropriately on external ratings. We continue to emphasize that for any cases in which U.S. banks rely on third-party assessments of credit risk, these institutions should conduct their own assessments to ensure that they are sound and timely and that the level and nature of the due diligence should be commensurate to the complexity of the risk. In addition, the Federal Reserve and the other members of the President's Working Group on Financial Markets (PWG) have recommended a review of existing regulations and supervisory policies that establish minimum external ratings requirements to ensure they appropriately take account of the characteristics of securitized and other structured finance instruments. The PWG also has endorsed plans by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions to reconsider capital requirements for complex structured securities and off-balance-sheet instruments that are keyed to ratings provided by credit rating agencies. The PWG further has recommended changes in the oversight of credit rating agencies and their required disclosures to improve the comparability and reliability of their ratings, and expressed support for recent initiatives by the credit rating agencies to improve their internal controls and ratings for structured finance instruments. \2\--------------------------------------------------------------------------- \2\ The President's Working group on Financial Markets, ``Policy Statement on Financial Market Developments,'' March 12, 2008.Q.10. HOEPA Rulemaking: During this period of correction in the housing market, I believe it is incredibly important that we do not overreact and restrict access to credit to individuals who need it the most. In December of last year, the Federal Reserve produced a proposed rule under its Homeownership Equity Protection Act (HOEPA) authority. That rule is currently out for notice and comment. Mr. Bernanke, can you comment for the record on some of the steps that the Fed took to ensure that an appropriate balance was struck between eliminating many of the mortgage market excesses that created many of the problems we face today while ensuring that borrowers have adequate access to credit?A.10. Our goal in proposing new regulations under the authority of the Home Ownership and Equity Protection Act (HOEPA) was to produce clear and comprehensive rules to protect consumers from unfair practices while maintaining the viability of a market for responsible mortgage lending. To help us achieve this goal, we gathered substantial input from the public, including though five public hearings we held on the home mortgage market in 2006 and 2007. We also focused the proposed protections where the risks are greatest by applying stricter regulations to higher-priced mortgage loans, which we have defined broadly so as to cover substantially all of the subprime market. As an example of the Board's approach, the rules would prohibit a lender from engaging in a pattern or practice of making higher-priced loans that the borrower cannot reasonably be expected to repay from income or from assets other than the house. The proposal is broadly worded to capture different ways that risk can be layered even as the practices that increase risk may change. It would not set numerical underwriting requirements, such as a specific ratio of debt to income, but would provide some specific guidance for lenders to follow when assessing a consumer's repayment ability. For instance, creditors who exhibited a pattern or practice of not considering consumers' ability to repay a loan at the fully-indexed rate would be presumed to have violated the rule. Another proposed rule would require lenders to verify the income or assets they rely on to make credit decisions for higher-priced loans. Creditors would be able to rely on standard documents to verify income and assets, such as W-2 forms and tax returns. However, to ensure access to credit for consumers, such as the self-employed, who may not easily be able to provide traditional documentation, the rule would allow creditors to rely on any third-party documents that provide reasonably reliable evidence of income and assets. For example, creditors could rely on a series of check cashing receipts to verify a consumer's income. We believe these proposed rules will help protect mortgage borrowers from unfair and deceptive practices. At the same time, we did not want to create rules that were so open-ended or costly to administer that responsible lenders would exit the subprime market. So, our proposal is designed to protect consumers without shutting off access to responsible credit.Q.11. Housing Market: Chairman Bernanke, the current downturn in the housing market is not the first that we've seen, and is unlikely to be the last. What has been the average length of time from peak to trough in previous housing market downturns? How does the current downturn compare to previous ones?A.11. Although there are considerable differences across episodes and measures of housing market activity, the trough usually occurs between 2 and 3 years after the peak. Thus far, the current downturn in residential investment has lasted eight quarters, similar to the average of previous downturns. As measured by single-family housing starts, the decline in activity so far in this cycle has been greater than average, although not quite as large as the contraction that occurred in the late 1970s and early 1980s.Q.12. Home Prices and Inflation: Chairman Bernanke, a commonly watched measure of inflation is the core-CPI. Housing constitutes almost a third of core-CPI. To what extent has the recent decline in housing prices moderated recent increases in the core-CPI? What would be the trend in core-CPI if house prices were excluded?A.12. The CPI for owner-occupied housing is not directly affected by changes in housing prices. The Bureau of Labor Statistics (BLS) uses a rental equivalence approach to measure changes in the price of housing services from owner-occupied units. This approach defies the implicit rent of an owner-occupied unit as the money that would be received were it to be rented out (that is, the opportunity cost of owning, as opposed to renting, the unit). As a result, the BLS uses observations on tenants' rents (after making adjustments for landlord-provided utilities) to construct the CPI for owner-occupied housing. It is reasonable to expect that tenants' rents should be related over time to the affordability of owner-occupied housing, which would depend in part on home prices. The BLS does not publish an index for the core CPI excluding owners' equivalent rent. However, one can gain some insight with regard to its limited contribution to core CPI inflation of late from the fact that the CPI index for all items less food and energy rose 2.3 percent over the 12 months ending in February 2008, while the index for owners' equivalent rent of primary residence increased 2.6 percent.Q.13. Housing Wealth: Chairman Bernanke, the recent decline in home prices in many parts of the country followed several years of extraordinary home price appreciation. What has been the overall impact of the housing bubble, and its burst, on household wealth? Is a family that purchased a home in 2002 or 2003 still better off? Of those families who purchased homes earlier this decade, and have seen substantial overall appreciation, how have their spending patterns been affected by the declining market?A.13. Nationwide, according to the Office of Federal Housing Enterprise Oversight (OFHEO) purchase-only house price index, house prices peaked in mid-2007 and have since fallen about 3 percent; according to the more volatile S&P/Case-Shiller house price index, house prices peaked in mid-2006 and have since fallen about 10 percent. Both indexes show major regional disparities, with house prices peaking earlier, and falling more, in California, Nevada, some New England states, and Michigan and Ohio. Indeed, according to OFHEO's measure, home prices in Michigan have fallen, on net, since 2001. In all other states, families that purchased their homes in 2003 or earlier continue to have seen a net appreciation in their home's value. According to the Federal Reserve's flow of funds accounts, housing wealth peaked at $20.3 trillion in 2007:Q3 before falling about $170 billion in 2007:Q4. Estimates by academic economists of the direct effect of housing wealth on consumption vary widely, from as little as 2 cents on the dollar to as high as 7 cents on the dollar. These effects tend to be spread out over roughly a 3-year period, so that current spending is still being supported to some extent by earlier house price gains, and the effects of the current declines will only be fully felt over the next couple of years. In addition to directly affecting spending by reducing family wealth, falling house prices may affect a family's spending indirectly through credit market channels. Borrowing against home equity is often the lowest-cost form of finance available to a household; falling house prices can decrease the collateral value of a home, forcing borrowers to turn to costlier forms of finance, such as credit cards. These indirect effects, which are extremely difficult to quantify, probably are a factor that has increased the size of some of the larger published estimates of the effect of falling house prices on consumer spending.Q.14. Covered Bonds: Chairman Bernanke, recently FDIC Chairman Bair indicated that covered bonds were a ``front burner issue'' at the FDIC as they continued to look for ways to improve liquidity in the mortgage market. I understand that Europe has a mature, $2 trillion covered bond market. Do you think there could be a benefit to fostering such a market in the United States? What distinctions do you see between the European market and the status of the U.S. market?A.14. As long as banks and their counterparties are safe and sound, efforts to provide more financing opportunities to banks and bank holding companies, particularly under current market conditions, should be taken seriously. Such actions may make it more likely that the financial markets will be able to provide the necessary credit to sustain and enhance economic activity. In general, the European markets appear to be useful additions to their financial markets, successfully providing liquidity and credit for some assets under most market conditions. Covered bonds have been available in Europe for many years, and such programs differ greatly across countries. Much could be learned by studying the merits of each country's program and applying these lessons to creating a unique program in the United States. Creating a covered bond market in the United States, however, may be difficult without Congressional discussion and legislation. Covered bonds raise many issues related to the safety net provided to banks in the United States, including issues related to the bank deposit insurance fund. The legal structure provided for covered bonds in European countries resolves many of these issues. With regard to creating a covered bond market in the United States, all parties should seek to distill the best practices from the European markets and work towards the establishment of a robust and well-designed covered bond market that includes safeguards to ensure that the safety net provided banks would not be measurably extended further." CHRG-111shrg54589--149 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM ROBERT G. PICKELQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. In general, derivatives markets tend to be more liquid than underlying cash markets. For example, bank loans and many bonds issues tend to be fairly illiquid. There is no good reason to prohibit credit default swaps on such securities because the underlying instruments do not trade in a liquid market. Such a prohibition would only serve to reduce bank lending capacity and the ability and willingness of investors to purchase bonds, which would not be desirable while the economy is in the midst of a credit crunch. Privately negotiated derivatives are built on the fundamental principle of freedom of contract. Two parties can construct a mutually beneficial agreement to address their risk management needs, which may or may not be related to the existence of a cash market. We question whether the creation of such an agreement should be subject to conditions specified by law or regulation, especially since regulators can use powers they already have to limit trading in products that are judged to threaten systemic stability.Q.1.b. If not, what specific objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. We do not believe it would be productive to attempt to legislate or regulate the types of risks traded in derivatives markets. All derivatives reference risks arising from normal economic activity are borne by market participants. Most securities, even the most basic types of securities such as bonds, embody a bundle of risks. The benefit of derivatives is that they permit the unbundling and pricing of specific risks. For example, an investor holding a corporate bond bears both interest rate risk and credit risk. Those individual risks can separately be traded, and valued, using interest rate derivatives and credit default swaps. By allowing investors to unbundle and trade individual risks, derivatives make it possible for investors to tailor the risks they bear. Likewise, hedgers in commercial markets can reduce financial risk while concentrating on managing the business risk associated with their enterprises. The need to manage specific risks can change as economic conditions change. Any a priori restriction on the types of risks that can be referenced by derivatives could easily hamper effective risk management.Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative and the model is effectively the basis, why should the models not be public?A.2. As a general matter, prices are determined through trading and not by financial models. Financial models attempt to explain the factors determining values of financial instruments. Many such models lend insight into the factors that influence prices of financial instruments, which is why some traders use financial models to inform their trading decisions. But most existing models cannot predict asset prices accurately enough to be used exclusively for price setting, which is why many more traders do not rely on financial models. In addition to informing trading decisions, models are used for risk management purposes and to value illiquid positions for which market prices are not readily available. Many dealers currently publish newsletters that analyze factors determining the behavior of credit default swap valuation along with insights into how they model the behavior of credit default swap spreads. Moreover, existing regulations require regulated financial intermediaries to disclose to regulators in detail the methods they use to value financial instruments and to measure risk and the controls placed on such processes. This is as it should be. But there has been no demonstrated advantage, yet there would be great expense, associated with a legal mandate requiring every institution to publish the details of their own proprietary models and to explain in detail how they apply those models in practice. We are not suggesting that greater forms of transparency are not desirable. For example, ISDA has recently released the ISDA CDS Standard pricing (originally developed by JPMorgan) as part of an effort to facilitate the central clearing of standardized credit default swap contracts. The ISDA standard CDS model does not determine CDS prices. It merely provides a standardized method for calculating changes in up-front payments for standardized credit default swaps based on changes in credit default swap spreads. Credit default swap spreads are still determined through trading, however, which is the principal method of price discovery in all markets. The ISDA model is freely available to all market participants on a Web site maintained by Markit at www.cdsmodel.com. As a final point, we are not aware of any derivatives market for which there is no cash basis. We are aware that some commentators have leveled this criticism at the credit default swaps market, but we believe the criticism is misplaced. The cash basis for credit default swaps is the difference between the credit default swap spread and observed risk premium paid by bond issuers and borrowers in the loan market. Several good books analyzing and explaining the behavior of the credit default swap basis have been published in recent years. These books are publicly available to all interested parties.Q.3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?A.3. The dichotomy between ``legitimate'' hedges and ``purely speculative bets'' is a false one because a functioning market requires a seller for every buyer. A person who buys a bond and does not hedge the risk of the bond, for example, could be characterized under an exceedingly narrow definition as engaging in a ``purely speculative bet.'' Few would adopt such a characterization, however, because it would imply that buying bonds without hedging is not legitimate. Similarly, a person who wants to hedge the risk of a bond by buying CDS protection requires that another person be willing to sell protection, which could itself be characterized as a purely speculative bet. Requiring that all hedges be offset by other hedges would result in a ``by appointment only'' market that matches hedges, which would be impossible in the case of credit risk because it is unlikely that a seller of protection would meet the definition of a hedger. Put simply, what is a seller of protection hedging? Further, requiring an insurable interest for purchasers of credit protection, which is meant to apply to insurance products and not to financial derivatives, would effectively make risk transfer impossible. Suppose, for example, that a bondholder buys CDS protection from a bank; the bank that sells protection will normally want to hedge the credit risk it takes on from the bondholder by buying protection. But if only bond owners can buy protection, the bank will not be able to hedge its risk. In the presence of such restrictions, few firms will be willing to act as protection sellers. Finally, requiring delivery of the reference asset, which was the standard means of settlement prior to 2005, would be counterproductive and harmful to bond market liquidity in light of the large number of index CDS transactions found in today's market.Q.4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?A.4. Derivatives markets are fluid and global. Any increased regulation must take into account that certain trades will not be done or will be done elsewhere. A recent article shows that the concern about business moving overseas is real: According to Euractiv.com, the European Commission's proposed rules for derivative dealers, which appear to be more flexible than those discussed in the U.S., might be intended to ``court'' U.S. dealers faced with a choice of where to conduct business. More broadly, companies need the risk management tools that only derivatives can supply and will respond to arbitrary restrictions on their ability to enter into risk-shifting contracts by seeking out venues where they can enter into such agreements. For example, an American company with foreign subsidiaries routinely needs to enter into a variety of contracts with local parties as part of the conduct of business, and these business dealings will produce risks that they will wish to hedge. The assumption that a U.S. company could always find a market in derivatives for any type of risk in the United States is unfounded. Derivatives contracts are not universal. Interest rate derivatives referencing foreign interest rates, for example, are typically actively traded in the home country of the currency. The demand for such contracts inside the United States might be so limited that a U.S. market for such contracts does not exist. Thus, restricting a U.S. company to trade only U.S.-regulated derivatives will have the effect of prohibiting the hedging of interest rate risks borne by overseas subsidiaries. At the very least, such a prohibition would effectively make it impossible for U.S. banks to offer through overseas subsidiaries a full complement of financial services to U.S. firms operating outside the U.S., which would thereby hamper the competitiveness of any U.S. company with overseas operations.Q.5. Do over-the-counter or custom derivatives have any favorable accounting or tax treatments versus exchange-traded derivatives?A.5. Over-the-counter derivatives may enjoy favorable accounting treatment when they are used to hedge an existing risk. U.S. GAAP hedge accounting guidelines are extremely rigid. Unless a company can demonstrate that a hedge employing a derivative instrument is a nearly perfect hedge, it is required to report the mark-to-market gains and losses from the hedge instrument as a profit or loss, even if it does not report changes in the value of the underlying exposure. By their nature, standardized derivatives contracts almost never qualify as a perfect hedge. Thus, if a company hedges the interest rate risk using interest rate futures it must report any gains or losses on the hedging position in its income statement. But if the underlying instrument is held in the investment portfolio, changes in the market value of the instrument do not affect reported income. Such a regime creates artificial volatility in reported earnings. Similarly, a multinational company that wishes to use standardized foreign exchange futures to hedge against changes in exchange rates might find that the exercise exacerbates the volatility of its reported income. Thus, requiring all companies to use only standardized derivatives may have the unintended effect of making reported income more volatile than it really is. The ultimate result would be to discourage legitimate hedging activity, placing U.S. companies at a competitive disadvantage. Over-the-counter derivatives do not necessarily enjoy favorable tax treatment relative to exchange-traded derivatives. To the extent that the tax treatment may differ, it is because gains and losses on exchange-traded derivatives are recorded daily. Whether this difference benefits the user depends on the nature of the transaction and the ultimate change in the value of the contract, which may be positive or negative. As a general rule, it all depends on the type of transaction, the terms of the contract, and what happens to market prices and rates over the term of the contract.Q.6. In addition to the Administration's proposed changes to gain on sale accounting for derivatives, what other changes need to be made to accounting and tax rules to reflect the actual risks and benefits of derivatives?A.6. ISDA is actively engaged with tax authorities and accounting standard setters on rules governing derivatives. The FASB has an active agenda, and we would encourage policy makers to engage them in consideration of their views. ISDA is concerned about preserving the ability of commercial end users to customize derivatives in order to meet their particular risk management needs. Without the ability to precisely hedge risks in accordance with FASB 133 through customized OTC derivatives, companies would experience increased volatility, reduced liquidity, and higher financing costs.Q.7. Is there any reason standardized derivatives should not be traded on an exchange?A.7. Standardization is a necessary but not sufficient condition for trading on an exchange: Standardized derivatives can be traded on an exchange only when a product has sufficient volume and liquidity to support reliable price discovery for the product. If sufficient volume and liquidity do not exist, it would be preferable to trade the products over-the-counter, that is, execute trades privately, and then manage the risk in other ways, such as through a clearinghouse. Policy discussions frequently confound exchange trading--which means that all trades must be negotiated and executed through a central venue--with clearing--which means that trades must be booked with a central counterparty that serves as the counterparty to all cleared transactions. Exchange trading is possible without clearing, although most exchanges involve clearing as well; and clearing is compatible with both exchange trading and over-the-counter trading. Exchanges and clearinghouses both make use of standardization, but for different reasons. Exchange trading involves extensive standardization because it makes a product easier to trade, which leads to higher liquidity. But as a product becomes more standardized, it may attract a narrower range of traders, leading to lower liquidity. As a result of these conflicting effects, only products that inherently appeal to a large number of traders are likely to succeed on an exchange; more specialized products generally lack liquidity and consequently do not trade successfully on an exchange. Clearinghouses also rely on standardization: not to facilitate trading but to facilitate valuation for the purposes of margin setting. Although cleared products need to be substantially standardized, they need not be as liquid as exchange-traded instruments. What matters is that the clearinghouse can calculate contract values and required margin in a timely manner and can unwind a position in the event of clearing member default.Q.8. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than renegotiate the debt?A.8. It is debatable whether such an incentive exists at all. It is more likely that bankruptcy and credit default swap protection are independent of each other. Claims that bought credit default swap protection somehow ``caused'' a bankruptcy filing appear to be based on misunderstanding of how credit default swaps work. One misunderstanding is that buyers of credit default swap protection can profit only if the reference entity actually goes bankrupt. But if the credit quality of a borrower deteriorates, a protection buyer need not wait for bankruptcy, but can instead take its profit by closing out the contract that presumably has appreciated in value. It is even possible that the protection buyer might prefer that the reference entity continue as a going concern instead of fail. Consider an investor that believes that credit default swaps are underpriced relative to the underlying bond. The investor can buy the bond and buy credit protection, thereby locking in a profit. If the reference entity fails, the investor will be compensated and can then seek recovery on the bond. But if the reference entity survives, the investor can continue to collect the difference between the bond's interest and the fee paid for the credit protection. Another misunderstanding is that it is possible to game the bankruptcy system by buying protection on distressed firms and then somehow ``forcing'' the firms into bankruptcy. This misunderstanding appears to be based on the assumption that the cost of protection is independent of the likelihood of a credit event so one can buy protection on distressed firms at a low cost. But the price paid for credit default swap protection is in fact related directly to the expected loss on the reference credit. Indeed, protection on a distressed credit--one widely expected to declare bankruptcy--requires that the protection buyer pay a substantial amount up-front. And if the reference entity does not declare bankruptcy, the protection buyer will in fact incur a substantial loss. A final misunderstanding is that, because a protection buyer is ``made whole'' after a reference entity fails, a protection buyer that cash settles their CDS position and remains in possession of the underlying bond has no incentive to maximize the recovery on the underlying bond. It is not clear why this should be the case: A bond holder that has been compensated and fails to pursue further recovery is in effect ``leaving money on the table,'' which does not seem in the bond holder's interest. The way the credit default swap market works, after settlement of a credit event, someone ends up holding the underlying bond, and that party has an interest in maximizing recovery.Q.9. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?A.9. The presumption that creditors lack incentives to perform strong credit research belies an understanding of how hedging works. As a general matter, it is necessary to take on risk in order to earn a profit. Because hedging involves giving up risk, it also generally means giving up the potential profit from taking risk, usually by paying the cost of the hedge. Further, routinely entering into hedged transactions is seldom profitable unless one has knowledge superior to that of the rest of the market, which is unlikely to be the case on a systematic basis. Hedging loans with credit default swaps affects profitability as follows. A bank hopes to profit by making a loan; its profit is based on the difference between the bank's cost of funding and the interest charged the borrower. Before making the loan, the bank should perform strong credit research in order to avoid losses from default. But if the bank decides to hedge against losses on the loan by buying credit protection, the bank will have to pay a periodic fee for protection, which will offset some or all of the profit from the loan. A bank that routinely lends and then buys protection on the loans will almost certainly run a loss-making business; the bank has incentive to hedge only if the borrower's condition deteriorates unexpectedly. So the bank can either choose not to hedge and possibly profit, or to hedge but give up the opportunity to profit, but generally cannot both hedge and profit simultaneously.Q.10. Do net sellers of credit protection carry that exposure on their balance sheet as an asset? If not, why shouldn't they?A.10. Because the value of a credit default swap is zero at inception and the parties to the contract do not exchange a consideration at the time the contract is initiated, as typically happens when an asset is purchased or sold, the potential exposure is not recorded on the balance sheet at the time the contract is first settled. Under long-standing accounting conventions, there is no way to record a contract as an asset or liability when no consideration is paid or received and the contract has a zero value. For analogous reasons, banks do not report on their balance sheets the notional amount of loan commitments, stand-by letters of credit and unused amounts on revolving credit lines, which all create a similar type of credit exposure as a credit default swap. This is why such commitments are classified as ``off-balance sheet.'' This is not to say that financial companies are not required to report the amount of their potential credit exposure arising from credit default swaps, however. First, companies must report the mark-to-market value of their derivatives exposures as either a ``derivatives receivable'' or a ``derivatives payable'' when the value of the contract changes. To illustrate, if a bank sells protection on company XYZ and the credit spreads on that company subsequently widen, then the protection seller must record the mark-to-market loss on the contract as a derivatives liability. Similarly, the protection seller's counterparty will record the mark-to-market gain as a derivatives receivable. Second, financial companies are required to report as a supplementary item the notional amount of any financial guarantees they have assumed. Thus, the financial reports of banks and other financial companies contain tables detailing the amount of ``financial guarantees'' the entity has written, including protection sold using credit default swaps, exposures created through written options, and the amount of other financial guarantees that include loan commitments, revolving credit lines and stand-by letters of credit. AIG, for example, did report to investors, credit-rating agencies, and to regulators in its public financial statements that it wrote protection on $125 billion of securities in its 2002 10k. The table below, which draws on data reported in subsequent annual reports, documents the growth in AIG's exposure to $527 billion by year-end 2007, the year when AIG first began reporting losses related to its credit default swap portfolio. ------------------------------------------------------------------------ Amount ($ in Date Reported (at December 31) billions)------------------------------------------------------------------------2002................................................ 125.72003................................................ 203.02004................................................ 290.32005................................................ 387.22006................................................ 483.62007................................................ 527.0------------------------------------------------------------------------ Moreover, AIG's financial reports discuss explicitly the risk the company faced of margin calls stemming from its credit default swap exposure. In short, investors, credit-rating agencies and regulators all had ample prior knowledge of AIG's credit derivatives related potential risk exposure. Like AIG's management, however, all involved parties failed to appreciate the impact a collapsing housing market would have on that exposure. Opaque financial reporting was not the reason why AIG was permitted to amass such a large risk exposure using credit default swaps.Q.11. In her testimony Chairman Schapiro mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.11. ``Synthetic exposure'' refers to the ability to take on a risk by means of derivatives or a combination of derivatives and cash instruments. Synthetic exposure is not necessarily equivalent to leverage. For example, many investors use equity swaps to gain synthetic exposure to foreign equities. They do not do this to leverage their exposure. Purchasing foreign equities can be very expensive. In many countries, it can only be done from within the country and ownership is limited to residents. A U.S. investor can enter into an equity swap to gain equivalent economic, or ``synthetic,'' exposure to foreign equities, thereby gaining diversification while holding cash in the form of Treasury bills or other liquid investments. More generally, equity swaps can be used to gain exposure to baskets of equities while avoiding the brokerage fees and other transactions costs associated with buying and selling the cash instruments. Another form of synthetic exposure is exemplified by selling credit default swap protection on asset backed securities. The motivation for doing so is to attain access to investments that are limited in supply, but does not necessarily constitute leverage. This form of synthetic exposure will be discussed in the next question.Q.12. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn't the economic benefit of that demand--higher value--flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?A.12. Financial assets such as bonds represent a bundle of risks. For a bond, that bundle of risks comprises credit risk, interest rate risk, funding risk, and possibly foreign exchange risk. Derivatives facilitate the unbundling of the different types of risks embodied by securities such as bonds. Because derivatives are not funding transactions, the act of selling protection on a reference entity is not equivalent to buying a bond issued by that entity and does not drain away the benefit of access to credit from the bond issuer. Finance is not a zero-sum game. The benefit that one party derives from being able to trade an unbundled risk does not necessarily diminish the benefit of access to credit by borrowers. In the case of synthetic exposure such as credit default swaps on securitized products, it is doubtful that synthetic exposure occurs at the expense of the ``creators or owners'' of the underlying assets. If access to synthetic exposure is restricted, investors will not necessarily continue to bid up the price of the underlying asset but will likely turn to other, lower priced investments instead. And in many cases, creators or owners of assets will benefit from the existence of synthetic exposure. For instance, a bond issuer may benefit from such activity because it indirectly promotes the liquidity of its bonds, thereby lowering funding costs. Also, after an investor takes on synthetic exposure on an asset by selling protection to a dealer, the dealer will in many cases buy the underlying asset to hedge its own position. The economic benefit in these cases will flow to the owners.Q.13. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn't that demand lead to a greater supply and thus more liquidity?A.13. Financial assets are not homogeneous--that is, infinitely interchangeable with each other--nor are they completely elastic in supply. Instead, assets are heterogeneous and can generally be issued only in limited amounts. Particularly in the case of fixed income (bond) markets, many individual issues tend to be illiquid. There is therefore demand for access to certain assets that have attractive properties but cannot easily be increased in supply. Restricting access to synthetic exposure would make it more difficult for investors to benefit from exposure to these assets. As noted earlier, financial assets embody a bundle of different risks. Derivatives facilitate the unbundling of risks so that they can be managed individually. Thus, a bond incorporates both interest rate risk and credit risk. What derivatives cannot do is to confer the benefit of funding to the contract's counterparties. Therefore, the act of selling credit protection does not divert the benefit of receiving credit from the borrower. To the contrary, the availability to creditors of a means of hedging and trading the borrower's credit risk in more liquid markets should facilitate the availability of credit, thereby benefiting the bond issuer. In general, market liquidity tends to reduce borrowing costs, which is why interest rates paid by bond issuers tend to be lower than interest rates on loans.Q.14. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?A.14. For every buyer of protection, there is a seller of protection. Prior to default, the terms of a credit default swap is determined by market sentiment regarding a firm's prospects, but has no causal influence that we are aware of on the underlying bond's price. After default, recent experience has shown that the vast majority of the offsetting bought and sold protection net down to a comparatively small proportion of the market. Harrah's, for example, has $17 billion of outstanding debt compared with $30 billion of outstanding CDS protection. But according to the Depository Trust Clearing Corporation, this $30 billion of CDS protection nets down to $1.86 billion, which is far less than the amount of outstanding debt. Given the ISDA Credit Event Auction Mechanism, most protection buyers need not deliver the underlying asset, so there is little if any liquidity pressure on the underlying asset.Q.15. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?A.15. A swap is a bundle of forward contracts with different maturity dates. In the early days of trading in interest rate futures, the exchanges listed contracts with maturities extending only 2 years into the future. Swaps and other OTC derivatives originally were created in part to address the needs of market participants who wished to hedge longer-dated exposures. While market participants currently have a broader choice of standardized contracts, they typically turn to OTC markets for longer-dated contracts and, more generally, when available standardized products do not meet their needs. Only highly standardized contracts can be traded on exchanges because contract standardization facilitates liquidity by limiting trading to just a few contracts. The Eurodollar futures contract, for example, specifies a $1 million notional principal. These contracts are listed for quarterly expiration (in March, June, September, and December) on the second London business day preceding the third Wednesday of the expiration month. Such standardized contracts are well suited for speculation on changes in the general level of interest rates, but are ill-suited to hedge the unique risk exposures borne by most market participants. In the parlance of derivatives markets, using exchange traded derivatives requires hedgers to take on significant basis risk, the risk that changes in the value of the exposure being hedged and changes in the value of the hedging instrument might not fully offset each other. For example, a company may have floating-rate bonds outstanding for which the interest rate resets on the 15th of February, May, August, and November. As noted above, however, the only available interest rate contracts mature in the third week of March, June, September, and December. In such circumstances, the company would find it impossible to hedge perfectly its interest exposure. Each interest payment would be unhedged for over a month of the quarter. Instead of taking on the basis risk, the company could enter into an OTC interest rate swap, thereby effectively passing on the basis risk to an OTC derivatives dealer. OTC dealers have a natural advantage in managing such risks because they trade continuously with a large number of counterparties and have the skilled personnel and order flow necessary to manage interest rate risk arising from mismatched contracts and exposures. For these reasons, futures markets tend to be professional markets while the OTC markets serve the needs of customers such as corporates and smaller, less-sophisticated banks. There is no easy way around this obstacle. The range of listed contracts cannot be extended to include all contracts because most individual contracts arising from commercial trade are so unique as to be inherently illiquid. Simply listing a contract on an exchange does not guarantee liquidity, and may actually reduce the liquidity of existing contracts. Every derivatives exchange has had experience listing new contracts that subsequently had to be withdrawn because the contract never acquired sufficient interest to become viable. If a contract is illiquid, it cannot be marked to market reliably and the exchange clearinghouse cannot manage the associated risk as effectively as with a liquid instrument. Thus, a blanket requirement that all derivatives be exchange traded would have the practical effect of prohibiting most contracts for deferred delivery, including such straightforward transactions as the purchase or sale of fuel oil or wheat at a negotiated price for delivery at a chosen future date. Mandating that all risk management solutions be standard does not reflect the hedging needs driven by the unique risks that businesses encounter.Q.16. One of the arguments for keeping over-the-counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?A.16. As noted in the above response to Question 15, standardized contracts list standard delivery dates, maturities and deliverable grades that do not necessarily correspond to the delivery dates and types of exposures market participants need to hedge. Bank loans, for example, are illiquid by their very nature. A creditor bank might wish to reduce its exposure to a particular borrower so as to expand its lending capacity. But if the company in question is relatively small, exchanges will not find it worthwhile to list standardized credit default swaps against that company's loans. At the same time, there might be some investors interested in diversifying their portfolios by taking on an exposure to bank debt. They can do this by buying a portion of the loan, but because bank loans are illiquid trading loans is much more expensive than entering into an over-the-counter credit default swap. More than any other group, restricting trading to standardized derivatives would hurt small businesses. In the area of equity derivatives, investors often use equity swaps to gain exposure to foreign equities because the direct purchase of foreign equities can be very expensive--and in some cases impossible--for an institution without foreign offices (and foreign broking licenses). Thus, restricting trading to standardized contracts traded only in the United States would make it much more difficult and much more costly for U.S. investors to diversify into foreign stocks. The problem would be even more severe in commodity markets. Airlines wishing to hedge jet fuel costs, for example, are often forced to use heating oil futures because the market for jet fuel derivatives is relatively illiquid. Substituting heating oil futures for jet fuel forwards or jet fuel swaps exposes the airline to basis risk. As noted earlier, managing basis risk is a difficult task that typically requires the expertise of professional traders. Simply banning trading in OTC instruments does not guarantee that a liquid market in jet fuel futures would emerge. Moreover, futures markets are typically only liquid for short-term contracts, so that companies such as airlines would find themselves without a way to secure long-term, fixed-price delivery contracts. By offering to provide such custom-tailored contracts, banks supply risk management services to their corporate customers more effectively and at a lower cost than those organizations could do if they had to hire the staff necessary to manage those risks themselves. Managing risks using standardized contracts would require companies to replicate the types of trading and risk management systems typically found only in commodity dealers and banks, and at a very steep cost. More generally, the ability to enter freely into a variety of long-term contracts facilitates the conduct of business. No one can anticipate in advance the terms of all the long-term contracts U.S. companies will find necessary to conduct business, which makes it impossible to list standardized contracts that will address all the needs of all businesses.Q.17. Who is a natural seller of credit protection?A.17. A ``natural'' seller of protection is any entity seeking to profit from being exposed to credit risk of a company, region or industry. Examples of natural sellers include: Institutional investors, pension funds, and insurers, which also invest in corporate bonds. Banks seeking to diversify their sources of income in order to reduce credit concentration. Hedge funds and other investors seeking to profit from perceived overpricing of credit. A seller of credit protection is in an analogous position to a bond holder who has hedged the interest rate risk and, in some cases, exchange rate risk bundled in the bond. The advantage to doing so using credit default swaps instead of buying the bond is that transactions costs typically are smaller and credit default swaps tend to be more liquid than the underlying debt. Credit default swaps may also be available for maturities that would be otherwise unavailable to investors.Q.18. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.18. Trades across all derivative asset classes will be reported to various trade information repositories. A repository is accessible in full detail to anyone who regulates the entities who have provided such information to allow the regulator to properly access the risk inherent in the transactions. Aggregated data on open positions and trading volumes will be available to the public. We would direct your attention to http://www.newyorkfed.org/newsevents/news/markets/2009/ma090602.html, which contains a link to the most recent industry letter outlining its commitments to the Federal Reserve Bank of New York, which included commitments regarding trade reporting.Q.19. What is insufficient about the clearinghouse proposed by the dealers and New York Fed?A.19. Please review the ``Report to the Supervisors of the Major OTC Derivatives Dealers on the Proposals on Centralized CDS Clearing Solutions for the Segregation and Portability of Customer CDS Positions and Related Margin'' for a detailed analyses of the relevant clearinghouses. The report can be accessed at http://www.isda.org/credit/docs/Full-Report.pdf. The report highlights some legislative changes that would be desirable to facilitate buy-side access to clearing.Q.20. How do we prevent a clearinghouse or exchange from being too big to fail? And should they have access to Fed borrowing?A.20. These questions are matters of pubic policy that are appropriately decided by legislative and regulatory bodies and not by ISDA or other industry groups. Nonetheless, we respectfully suggest that the possibility of failure is an important element of the market process and that protecting firms from failure can have the paradoxical effect of making individual firms safer while making the financial system less safe. Congress might consider the precedent of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), which placed limitations on the ability of regulators to rescue failing banks, subject to a systemic risk exception. Such limitations put the industry on notice that they will have to bear the consequences of unsound practices. But in order for such a policy to be effective, the limitations must be credible; in other words, the industry must know that regulators will not routinely invoke a systemic risk exception when faced with an actual failure. If such a credible policy cannot be achieved, it is difficult to envision circumstances in which the government would not find it necessary to rescue a large central clearinghouse if it ever experienced financial distress. Access to Fed borrowing by the clearinghouse might be necessary to cope with temporary liquidity crises but should not be used as a bailout tool. In order to address the moral hazard issue, policy makers could require that any lending by the Fed could be repaid out of guarantee funds as well as loss sharing arrangements among surviving firms so the losses would ultimately be borne by the industry. The result would be greater incentives for clearinghouse participants to monitor the risks associated with the clearinghouse.Q.21. What price discovery information do credit default swaps provide, when the market is functioning properly, that cannot be found somewhere else?A.21. Credit default swaps have made credit pricing more transparent by means of their price discovery function. First, credit default swaps on diversified credit indexes such as CDX in North America and iTraxx in Europe provide virtually the only price discovery information on credit markets overall, similar to the price discovery information for U.S. equity markets provided by the ability to enter into contracts on such indexes as the S&P 500 and Dow Jones indexes. Second, both single-name credit default swaps and corporate bond markets provide price discovery for individual corporate debt issues, and the two are linked by means of asset swap pricing. Credit default swaps are arguably more liquid than the underlying bond issues, however, and are therefore likely to provide more informative credit pricing than the underlying cash markets. Finally, the uneven liquidity of corporate bonds is a primary reason not only for widespread reliance on credit default swaps for price discovery, but for early warning about impending credit problems as well. While it is true that corporate bond credit spreads also provide early warning, most corporate bonds tend to trade infrequently so the information dispersal is generally less timely than with credit default swaps.Q.22. Selling credit default swaps is often said to be the same as being long in bonds. However, when buying bonds, you have to provide real capital up front and there is a limit to the lending. So it sounds like selling swaps may be a bet in the same direction as buying bonds, but is essentially a highly leveraged bet. Is that the case, and if so, should it be treated that way for accounting purposes?A.22. First, it should be noted that while it is true that an investor who holds a bond bears the same credit risk as the seller of credit default swap protection, the protection seller does not bear the same bundle of risks as a lender or bond investor. In addition to credit risk, a bond investor faces interest rate risk, possibly foreign exchange risk (in the case of a bond denominated in a foreign currency), funding risk (it is worth remembering that many bond investors such as banks and insurance companies are leveraged: they must borrow the funds they use to buy bonds), and liquidity risk (bonds tend to be much less liquid than derivatives referencing those bonds). Therefore, there is no compelling conceptual reason to apply the same accounting treatment to credit default swaps and bonds based on an equivalence of risks. Moreover, as discussed in response to Question 10 above, it is simply infeasible to apply the same accounting treatment to off-balance-sheet instruments such as credit default swaps as to transactions involving cash securities. Companies can and do report their off-balance-sheet exposures; existing bank regulatory capital requirements already limit the effective leverage that can be created using derivatives. To the extent that existing regulations have not always been applied effectively in the past, or to the extent that they have not been applied uniformly to financial companies in all industries, this is an issue best addressed through more uniform and effective regulation and supervision and more effective risk management. Mandating changes to accounting standards is not a solution. Existing accounting standards were originally devised as expense tracking systems and are not a substitute for capital requirements. Therefore, mandating changes to accounting standards in contravention of conventions established by existing professional rulemaking bodies would likely prove an ineffective method of improving risk management practices.Q.23. Why should we have two regulators of derivatives, with two interpretations of the laws and regulations? Doesn't that just lead to regulation shopping and avoidance?A.23. Regulation of the derivatives markets is a part of the broader public policy debate over the financial regulatory reform. Federal regulation of securities, commodities, exchanges, and derivatives has developed over time and reflects the evolution of the capital markets. In its white paper released last month, the Administration supports the harmonization of futures and securities regulation, proposing the CFTC and the SEC make recommendations to Congress for changes to statutes and regulations that would harmonize regulation of futures and securities. The SEC and CFTC are expected to complete a report to Congress on this issue by the end of September. As Congress considers these recommendations, we submit that inconsistency between regulatory requirements and enforcement of those requirements, for generally equivalent instruments or activities leads to costly uncertainties. Reporting requirements, filing requirements, and approval standards should be harmonized as much as possible. Harmonized standards are necessary to enhance the quality of regulation by the primary Federal regulators and any systemic risk regulator. Finally, the derivatives markets are global and require cooperation among the international markets' regulators. Coordination among regulators at the Federal Government level is critical to successful coordination on the international level. Toward this end, any regulatory reform restructuring that will be passed by Congress should include provisions to preempt State initiatives on the regulation of derivatives instruments, users, and markets.Q.24. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.24. Please see the response to Question 11.Q.25. What is good about the Administration proposal?A.25. The Administration's proposal is an important step toward much-needed reform of financial industry regulation. ISDA and the industry welcome the Administration's recognition of industry measures to safeguard smooth functioning of our markets and its support of the customized OTC derivatives as tools needed by companies to meet their specific needs. ISDA supports appropriate regulation of financial and other institutions that have such a large presence in the financial system that their failure could cause systemic concerns. For nearly 4 years, the industry has been engaged in a dialogue with the Federal Reserve that has resulted in ISDA and the industry committing to strengthening the resilience and robustness of the OTC derivatives markets through the implementation of changes to risk management, processing and transparency that will significantly transform the risk profile of these important financial markets. Specifically, the industry has undertaken to increase standardization of trading terms, improve the trade settlement process, bring more clarity to the settlement of defaults, move toward central counterparty clearing where appropriate, enhance transparency, and enhance openness in the industry's governance structure. All of these initiatives are consistent with the Administration's proposals. We would direct your attention to http://www.newyorkfed.org/newsevents/news/markets/2009/ma090602.html, which contains a link to the most recent industry letter outlining its commitments to the Federal Reserve Bank of New York.Q.26. Is the Administration proposal enough?A.26. Please see answer to 25 above.Q.27. Mr. Whalen suggests that Congress should subject all derivatives to the Commodity Exchange Act, at least as an interim step. Is there any reason we should not do it?A.27. Here is an extract from Mr. Whalen's testimony: ``Congress should subject all OTC contracts to The Commodity Exchange Act (CEA) and instruct the CFTC to begin the systematic review and rule making process to either conform OTC markets to minimum standards of disclosure, collateral and transparency, or require that the contracts be migrated onto organized, bilateral exchanges.'' ISDA disagrees with Mr. Whalen's suggestion, which would turn the clock back almost two decades by reintroducing substantial legal and regulatory uncertainty into derivatives activity and to financial markets in general. The problem is that the CEA is unclear about which financial instruments are and are not futures as defined in the CEA, so extensive discretion is left to the Commodity Futures Trading Commission (CFTC) to decide. The extreme possibility is that an over-the-counter derivatives will be found to be an off-exchange futures contract and therefore illegal. Although the CFTC has the authority to carve out exceptions to the exchange trading requirement, the exceptions themselves are subject to uncertainty because they can be subsequently narrowed and possibly even revoked. The result is that parties seeking to manage their risk with OTC derivatives are forced to do so under the cloud that their transaction could at a later date be declared null and void, which can have potentially disastrous consequences for the firms involved. We submit instead that the Commodity Futures Modernization Act appropriately cleared up much of the legal and regulatory uncertainty surrounding the CEA while leaving CFTC with sufficient authority to address fraud and market manipulation concerns. Returning to an earlier era of legal uncertainty would unnecessarily increase the risks faced by market participants. Further, forcing useful but relatively less liquid products onto exchanges might in many cases doom such products to failure because they cannot generate sufficient volume to support continuous trading.Q.28. Is there anything else you would like to say for the record?A.28. ISDA and the OTC derivatives industry are committed to engaging with Congress to build upon the substantial improvements that have been made in our business since 2005. We will continue to support efforts of Congress, the regulators and the Administration to determine the most effective prudential regulation of this important industry. Changes to the OTC derivatives industry should be informed by an understanding of how the OTC derivatives market functions as well as a recognition that OTC derivatives play an important role in the U.S. economy. OTC derivatives offer significant value to the customers who use them, to the dealers who provide them, and to the financial system in general by enabling the transfer of risk between counterparties. Ultimately, it is important to maintain the continued availability and affordability of these important tools. ------ CHRG-111shrg51303--58 Mr. Dinallo," It is completely severed now. So the concept of continued systemic risk from securities lending, to the extent anyone thought there was--and I would not agree that there was--it is a completely severed situation, because in order to sell the operating companies to various buyers to pay off the loan that you authorized them to give, you had to untangle the operating companies from the securities lending pool, and that required the Fed to buy $20 billion at face value of the securities. Those may actually perform well. They may not. But they were bought at the market price so we could unwind securities lending pool so we could sell the operating companies that have huge value. Senator Shelby. Thank you. " fcic_final_report_full--194 Stephen Ashley, the chairman of the board, introduced Fannie’s new chief risk officer, Enrico Dallavecchia, he declared that the new CRO would not stand in the way of risk taking: “We have to think differently and creatively about risk, about compliance, and about controls. Historically these have not been strong suits of Fannie Mae. . . . Today’s thinking requires that these areas become active partners with the business units and be viewed as tools that enable us to develop product and address market needs. Enrico Dallavecchia was not brought on-board to be a business dampener.”  In , Fannie acquired  billion of loans; of those (including some overlap),  billion, or about , had combined loan-to-value ratios above ;  were interest-only; and  did not have full documentation.  Fannie also purchased  billion of subprime and  billion of Alt-A non-GSE mortgage-backed securities.  The total amount of riskier loans represented larger multiples of capital than before. At least initially, while house prices were still increasing, the strategic plan to in- crease risk and market share appeared to be successful. Fannie reported net income of  billion in  and then  billion in . In those two years, CEO Mudd’s compensation totaled . million and Levin, who was interim CFO and then chief business officer, received . million.  In , Freddie Mac also continued to increase risk, “expand[ing] the purchase and guarantee of higher-risk mortgages . . . to increase market share, meet mission goals, stay competitive, and be responsive to sellers’ needs.”  It lowered its under- writing standards, increasing the use of credit policy waivers and exceptions. Newer alternative products, offered to a broader range of customers than ever before, ac- counted for about  of that year’s purchases. Freddie Mac’s plan also seemed to be successful. The company increased risk and market share while maintaining the same net income for  and ,  billion.  CEO Richard Syron’s compensation totaled . million for  and  combined,  while Chief Operating Officer Eugene McQuade received . million.  Again, OFHEO was aware of these developments. Its March  report noted that Fannie’s new initiative to purchase higher-risk products included a plan to cap- ture  of the subprime market by . And OFHEO reported that credit risk in- creased “slightly” because of growth in subprime and other nontraditional products. But overall asset quality in its single-family business was found to be “strong,” and the board members were “qualified and active.” And, of course, Fannie was “adequately capitalized.”  Similarly, OFHEO told Freddie in  that it had weaknesses that raised some possibility of failure, but that overall, Freddie’s strength and financial capacity made failure unlikely.  Freddie did remain a “significant supervisory concern,”  and OFHEO noted the significant shift toward higher-risk mortgages.  But again, as in previous years, the regulator concluded that Freddie had “adequate capital,” and its asset quality and credit risk management were “strong.”  The GSEs charged a fee for guaranteeing payments on GSE mortgage–backed secu- rities, and OFHEO was silent about Fannie’s practice of charging less to guarantee secu- rities than their models indicated was appropriate. Mark Winer, the head of Fannie’s Business, Analysis and Decisions Group since May  and the person responsible for modeling pricing fees, raised concerns that Fannie Mae was not charging fees for Alt-A mortgages that adequately compensated for the risk. Winer recalled that Levin was crit- ical of his models, asking, “Can you show me why you think you’re right and everyone else is wrong?”  Undercharging for the guarantee fees was intended to increase market share, according to Todd Hempstead, the senior vice president at Fannie in charge of the western region.  Mudd acknowledged the difference between the model fee and the fee actually charged and also told the FCIC that the scarcity of historical data for many loans caused the model fee to be unreliable.  CHRG-111shrg50815--121 PLUNKETT Q.1. Without access to traditional credit, where do you believe that individuals would turn to finance their consumer needs? A.1. As I mentioned in my testimony before the Committee, it is important to note that the lack of regulation can also lead to detrimental market conditions that ultimately limit access to credit for those with less-than-perfect credit histories. Credit card issuers have recently reduced the amount of credit they offer to both existing and new cardholders, for reasons that have virtually nothing to do with pending regulation of the market. Issuers losses have been increasing sharply, in part because of unsustainable lending practices. (Please see my written testimony for more information.) Had Congress stepped in earlier to require issuers to exercise more responsible lending, they might not be cutting back on available credit as sharply right now. Regarding access to affordable credit for individuals with an impaired or limited credit history, CFA has urged mainstream financial institutions to offer responsible small loan products to their depositors. We applaud FDIC Chairman Sheila Bair's leadership in proposing guidelines for responsible small loans and her call for military banks to develop products that meet the test of the Military Lending Act predatory lending protections. Banks and credit unions should extend their line of credit overdraft protection to more account holders. The FDIC has a pilot project with 31 participating banks making loans under the FDIC guidelines for responsible small-dollar lending. Offering affordable credit products is not the only strategy needed to help households more effectively deal with a financial shortfall. Borrower surveys reveal that many households are not using high-cost credit because of a single financial emergency, but instead have expenses that regularly exceed their income. For these households who may not be able to financially handle additional debt burdens at any interest rate, non-credit strategies may be more appropriate. These may include budget and financial counseling; getting help from friends, family, or an employer; negotiating with a creditor; setting up different bill payment dates that better align with the person's pay cycle; and putting off a purchase for a few days. Toward this end, it is very important that banks and credit unions encourage make emergency savings easy and attractive for their low- and moderate-income customers. Emergency savings are essential to keep low-income consumers out of the clutches of high-cost lenders. CFA's analysis based on Federal Reserve Board and other survey data found that families earning $25,000 per year with no emergency savings were eight times as likely to use payday loans as families in the same income bracket who had more than $500 in emergency savings. We urge banks and credit unions to make emergency savings easy and attractive for their customers. Q.2. Do you agree that prudential regulation and consumer protection should both be rigorously pursued together by regulators? A.2. Absolutely. Credit card issuers must do a better job of ensuring that borrowers truly have the ability to repay the loans they are offered. As I mention in my testimony, card issuers and card holders would not be in as much financial trouble right now if issuers had done a better job of assessing ability to repay. This is why CFA has supported legislation that would require issuers to more carefully assess the repayment capacity of young borrowers and potential cardholders of all ages. Q.3. Do any of the witnesses have concerns that moving away from risk-based pricing could result in the subsidization of credit to wealthy yet riskier borrowers, by poorer but lower-risk borrowers? A.3. Under the Federal Reserve rules, card issuers will certainly have to be more careful about who they extend credit to and how much credit they offer. Given the current levels of indebtedness of many card holders--and the financial problems this indebtedness has caused these borrowers and card issuers--it is hard to argue that this is a bad thing. However, the Federal Reserve rules still preserve the ability of card issuers to price for risk in many circumstances, if they wish. They can set the initial rate a cardholder is offered based on perceived financial risk, reprice on a cardholder's existing balance if the borrower is late in paying a bill by more than 30 days, and change the borrower's prospective interest rate for virtually any reason, including a minor drop in the borrower's credit score or a problem the borrower has in paying off another debt. In addition, issuers can manage credit risk in more responsible ways by reducing borrowers' credit lines and limiting new offers of credit. Q.4. Do you believe that borrowers' rates and fees should be determined based on their own actions and not on those of others? A.4. It is certainly reasonable to base offers of credit on legitimate assessments of borrowers' credit worthiness. As I mention in my testimony, however, many of the pricing methods that card issuers have used to arbitrarily increase borrowers' interest rates and fees do not appear to be based on true credit risk, but rather on the judgment of issuers that they can get away with charging what the market will bear. Q.5. Do you think that credit card offerings from the past, which had high APR's and annual fees for all customers were more consumer friendly than recent offerings that use other tools to determine fees and interest rates. A.5. As I mention in my response above, the Federal Reserve rules leave plenty of room for card issuers to price according to borrower's risk, so I do not think it is likely that we will see a return to the uniform, undifferentiated pricing policies of the past." FOMC20080130meeting--292 290,MR. STERN.," Thank you, Mr. Chairman. We had a fairly extended discussion yesterday about concerns about the condition of various financial markets and some financial institutions and their implications for the economic outlook, and I certainly share those. In this environment, I favor alternative B--a 50 basis point reduction in the federal funds rate target. My own forecast is below the Greenbook forecast for this year and next, and so my guess is that we're going to wind up moving further before we're done. But that said, I don't have enough confidence in my forecast to advocate that we do more right now. As far as language of alternative B is concerned, I am certainly happy in general with what we have as written, and I share President Hoenig's view, although perhaps for a different reason, that the less we say about inflation right now, the better. The reason is that, in some sense, we haven't adequately expressed to at least some market participants that we understand where the risks lie right now. In trying to remind people that we are not inflation nutters but are serious about maintaining price stability, we've kind of garbled our message, in my opinion, and I think people in the marketplace know this central bank is committed to price stability. I don't think we have to remind them with every statement. Thank you. " FOMC20070628meeting--107 105,MR. MOSKOW.," Thank you, Mr. Chairman. Conditions in the Seventh District have changed little since my last report. Overall activity in the District is lagging the nation, mainly because of the continued difficulties of what we now call the Detroit Three, formerly known as the Big Three, [laughter] and their suppliers. But other sectors of our region are doing better—notably, a number of manufacturers outside autos—and consumer spending is moving forward at a moderate rate. Looking at the outlook for the national economy, the Greenbook baseline forecast has growth recovering to potential and core inflation stabilizing at 2 percent. Our outlook is not much different. We see growth returning close to potential. Assuming that monetary policy maintains its slightly restrictive stance, we think inflation will edge a shade below 2 percent by 2009. That would be a good outcome, and I sure hope we get it. The biggest news since the May FOMC meeting is the adjustment in financial conditions. The change in fed funds futures brings market expectations into better alignment with what I think will be the appropriate path for monetary policy. I’m not sure, however, how much restraint we can expect from the increase in long-term interest rates. As the Chairman heard from our directors last week, the effects can be muted by ample liquidity in the financial markets. One of our directors, who heads a large private equity firm, says that he does not see much of a change in the lending environment. Financing for even high-risk projects continues to be readily available at quite favorable rates and terms. Notably, such loans are being made with few covenants and no automatic default triggers. Of course, the housing market remains a risk. Like the Greenbook, we continue to expect large declines in residential investment through the end of this year, and I remain concerned that builders may need to cut back even more to reduce the high inventory of unsold homes. Our Detroit Branch director, who is CFO of Pulte Homes, noted that two-thirds of their sales usually occur between the Super Bowl and Memorial Day. Sales this year in that period were sluggish and relatively unresponsive to price discounting. Accordingly, he is not looking for a turnaround in housing markets before ’08. Another director, the head of U.S. Gypsum, agreed that it would be ’08 before we could expect a pickup in housing. With regard to consumer spending more generally, some contacts noted the impact of higher gasoline prices. A developer of malls and shopping centers downgraded his expectations for the rest of 2007, but he is not overly pessimistic and is expecting retail sales in the second half to remain near their first-half pace. Both GM and Ford believe that the higher gasoline prices are holding down the overall level of motor vehicle sales in addition to moving the mix of sales away from SUVs and toward cars. At this point, they believe that higher interest rates are having only a marginal effect on demand. Both are predicting that total light vehicle sales will be about 16.5 million units in 2007. That is the same as the pace predicted by the participants in our annual outlook symposium that we held in Detroit earlier this month. But the rest of the manufacturing is doing better than autos. Producers of heavy machinery and agricultural equipment continue to report strong demand. The Chicago purchasing managers’ report, which is confidential until its release this Friday, was 60.2 in June; that reading is down only a bit from its very high one of 61.7 in May. Some of this strength reflects strong growth abroad, which is fueling the demand for U.S. products, as we talked about during the chart show. Indeed, I think that there may be some upside risks to the GDP forecast from faster-than-expected export growth. Labor markets continue to be strong, and we heard the usual stories about selected labor shortages and associated increases in wages. One exception is the soft demand for temporary workers, but this could be normal for a mature business cycle. Turning to prices, our contacts seem to be a bit more pessimistic about the prospects for inflation. We heard concerns that higher energy prices would boost transportation costs and that the demand for food stuffs from abroad and the booming domestic ethanol market are pushing up food prices. In contrast to the anecdotes, the incoming data on core inflation were better than expected. Our indicator models revised down a tenth or two from the last round; they now have core PCE inflation being about 2 percent this year and next and then edging down to 1.8 or 1.9 in 2009. Without any meaningful resource slack, this improvement would require a comparable adjustment in inflation expectations, which may be difficult given a prolonged period of core inflation at or above 2 percent. So I continue to think that the predominant risk remains that inflation will not moderate as expected." FOMC20070807meeting--107 105,CHAIRMAN BERNANKE.," Thank you for the useful discussion. As usual, I am going to very briefly summarize what I heard. I will be happy to take any comments on that. Then I just want to make a few short points. Again, most of the key points have been made. Most participants expect growth to remain moderate over the forecast period. Despite lower household wealth resulting from weaker house and stock prices, consumption is likely to continue to grow as labor markets remain strong, real incomes increase, and gasoline prices moderate. Business investment should also grow moderately, although lower productivity and higher volatility could be drags on investment. Commercial real estate, in particular, may be slackening, but it retains good fundamentals. The global economy is strong. Industrial production is expanding at a reasonable pace. However, downside risks to growth were noted and perhaps received somewhat greater emphasis than at past meetings. Most notably, housing appears to have weakened further, with sales of new and existing homes declining and inventories of unsold homes remaining high. Homebuilders are experiencing financial strains, and there is downward pressure on home prices. Spillover on consumption spending is not yet evident but is a possible risk. In this regard, developments in credit markets received considerable attention. On the positive side, the repricing of risk and the reevaluation of underwriting standards seem appropriate. Liquidity still exists, credit is still being extended, and markets may work out their problems on their own. A lower dollar and lower long-term Treasury rates also tend to offset financial tightening. However, higher risk premiums, tougher underwriting, and greater uncertainty may constrain housing and investment spending, leading to broader macroeconomic effects. In more-pessimistic scenarios, dislocations in credit markets may last awhile and have a more substantial effect on credit availability and costs for businesses as well as for homebuyers. The possibility of contagion or severe financial instability also exists. Many participants took note of the NIPA revisions and their implications for productivity growth, consumer saving, and unit labor costs. Meeting participants tend to put potential growth at higher rates than the Greenbook. Views on inflation are similar to those in previous meetings. Recent readings are viewed as reasonably favorable. However, risks to inflation remain, including the possible reversal of transitory factors, tight labor markets, the high price of commodities, and higher unit labor costs resulting from lower productivity growth. In all, the risks to inflation remain to the upside. That is my summary of what I heard. I’m sure a lot more could be said. Any comments? If not, let me just make a few additional comments. There have been two very important developments since the last meeting. The first was the downward revision to the NIPA growth numbers. It’s not obvious yet, of course, how much of that reflects a permanent decline in productivity and how much is transitory. But certainly the best guess is that some of it is more long term in nature. I think the main point I’d like to make is that the implications of this downward revision for inflation and monetary policy, except perhaps in the very short run, are not obvious. The question is, What is the effect of the lower productivity growth on aggregate demand? We have examples of both types of phenomena. In the late ’90s, the pickup in productivity growth stimulated a very strong boom working through the stock market, consumption, and investment, so it led to an overheating economy, whereas in the earlier part of this decade, productivity growth picked up again but with weak aggregate demand. We had a jobless recovery associated with that. So it remains to be seen exactly how aggregate demand will respond to these developments. I do think that perhaps that in the very short run, given wage behavior and unit labor costs, if I had to choose, I would say that there is a slight bias toward higher inflation and tighter money. In the longer run, you would expect to see lower long-term rates because of slower growth. The second issue that has been widely discussed around the table is the financial market. It is an interesting question why what looks like $100 billion or so of credit losses in the subprime market has been reflected in multiple trillions of dollars of losses in paper wealth. So it’s an interesting question about what is going on there. I think there are three reasons that the financial markets have moved in the direction they have. First, there has been a widespread repricing of risk. That is, obviously, a healthy development, particularly if there is no overshoot, which is a possibility. But all else being equal, it is restrictive in terms of aggregate demand, and it makes our policy tighter than it otherwise would be. The second reason for the changes in markets is that there has been a loss of confidence in the ability of investors to evaluate credit quality, particularly in structured products. There is an information fog, as I have heard it described. This is very much associated with the loss of confidence in the credit-rating agencies. I think one of the implications of this is that some of the innovations we have seen in financial markets are going to get rolled back. We are going to see more lending taken out of originate-to- distribute vehicles and put back onto portfolio balance sheets. So the question is how much effect this adjustment process will have on the availability of credit. The third reason that I think the markets have reacted as much as they have is concern about the macroeconomic implications of what is happening. In particular, there is a fear that subprime losses, repricing, and the tightening of underwriting standards will have adverse effects on the housing market and will feed through to consumption, and we will get into a vicious cycle. That certainly is reflected in the expectations of policy. I am not going to go through all the things that are going on now in the markets. You have had very good reviews of that. Obviously, the markets right now are not functioning normally. Some conduits of credit are simply closed or frozen. A number of companies are having difficulties with short-term finance, and so, per President Fisher’s comment, we are watching those things very carefully. We are prepared to use the tools that we have to address a short-term financial crisis, should one occur. In the longer term, of course, our policy should be directed not toward protecting financial investors but, rather, toward our macroeconomic objectives. That is very important. Then the question is what the long-run implications of the financial market adjustment will be for the economy. I think the odds are that the market will stabilize. Most credits are pretty strong except for parts of the mortgage market. But even so there will be notably tighter credit, tighter standards, probably some loss of confidence in markets, and higher risk premiums that will on net be restrictive. This restrictive effect could come in various magnitudes. It could be moderate, or it could be more severe, and we are just going to have to monitor how it adjusts over time. Again, there is a bit of a risk—and tail risk has been mentioned not only in a financial sense but also in the macro sense—that, if credit is severely restricted so that we get feedback from lower house prices, for example, into the financial markets, that situation would be difficult to deal with. Those are the two major issues that people have talked about. Just very briefly on the overall assessment—on the output side, economic growth looks a little softer to me, mostly because of housing. There are also some slightly worrying developments in terms of automobile demand, which suggest some weakening in consumer spending. But there are some strong elements as well. Also the labor market has marginally softened. The unemployment rate is about 25 basis points above its recent low; so there has been some movement, and I still expect to see some reduction in construction employment. So I think there is a bit more softness and there are a few more downside risks to output than at our last meeting. Like others, I think the recent inflation data are moderately encouraging. I continue to see risks. If you’re not satiated with risks, I’ll add one more, which is that if the housing market really weakens and people go back to renting, we could get the same phenomenon that we saw last year, by which rents are driven up and we get an effect working through shelter costs. So I agree with those who still view the risk to inflation as being tilted to the upside. If there are no comments or questions, let me turn now to Brian to discuss the policy action." fcic_final_report_full--432 Commission focused thousands of staff hours on investigation, and not nearly enough on analyzing these critical economic questions. The investigations were in many cases productive and informative, but there should have been more balance be- tween investigation and analysis. Conclusions: • The credit bubble was an essential cause of the financial crisis. • Global capital flows lowered the price of capital in the United States and much of Europe. • Over time, investors lowered the return they required for risky investments. Their preferences may have changed, they may have adopted an irrational bub- ble mentality, or they may have mistakenly assumed that the world had become safer. This inflated prices for risky assets. • U.S. monetary policy may have contributed to the credit bubble but did not cause it. THE HOUSING BUBBLE The housing bubble had two components: the actual homes and the mortgages that financed them. We look briefly at each component and its possible causes. There was a housing bubble in the United States—the price of U.S. housing in- creased by more than could be explained by market developments. This included both a national housing bubble and more concentrated regional bubbles in four “Sand States”: California, Nevada, Arizona, and Florida. Conventional wisdom is that a bubble is hard to spot while you’re in one, and painfully obvious after it has burst. Even after the U.S. housing bubble burst, there is no consensus on what caused it. While we still don’t know the relative importance of the possible causes of the housing bubble, we can at least identify some of the most important hypotheses: • Population growth. Arizona, Florida, Nevada, and parts of California all expe- rienced population growth that far exceeded the national average. More people fueled more demand for houses. • Land use restrictions. In some areas, local zoning rules and other land use re- strictions, as well as natural barriers to building, made it hard to build new houses to meet increased demand resulting from population growth. When supply is constrained and demand increases, prices go up. • Over-optimism. Even absent market fundamentals driving up prices, shared expectations of future price increases can generate booms. This is the classic explanation of a bubble. • Easy financing. Nontraditional (and higher risk) mortgages made it easier for potential homebuyers to borrow enough to buy more expensive homes. This doesn’t mean they could afford those homes or future mortgage payments in the long run, but only that someone was willing to provide the initial loan. Mortgage originators often had insufficient incentive to encourage borrowers to get sustainable mortgages. FOMC20070628meeting--37 35,MR. LEAHY.," As you know from the Greenbook, recent news on foreign economic activity has been generally upbeat, supporting our view that growth abroad will continue at a solid pace. The top panel of exhibit 10 shows our weighted average of total foreign GDP growth and our outlook. If our forecast is borne out, foreign growth will soften slightly over the forecast period, to about 3½ percent, which is also our current best guess of the rate of foreign potential growth. As you can see from the chart, rates of growth of 3½ percent (the thin horizontal line) or better are not unprecedented, but a stretch of five consecutive years, like that from 2004 to 2008, would be unusual. The chart also shows foreign growth maintaining most of the momentum it developed over the past couple of years even as U.S. growth has taken a more substantial step down. This is also a bit unusual. However, as shown in the middle left panel, foreign domestic demand gained strength throughout the current expansion, leaving foreign economies less dependent on demand from the United States. Foreign investment spending, in particular, has been picking up. As shown to the right, fixed investment spending as a share of GDP has moved up a couple of percentage points since 2003. With foreign activity expanding slightly faster than potential, it is not surprising that we are seeing signs in some foreign economies that labor market slack is dwindling. The unemployment rate in Japan, shown in the bottom left panel, is at a nine-year low; in Canada, the rate is at a thirty-year low; and the euro-area rate is also at a multiyear low. Tight labor market conditions are less apparent in emerging- market economies, although we are hearing stories of labor shortages in certain sectors in China, where growth has been extremely rapid. What is more apparent is that in markets for oil and other primary commodities, shown in the bottom right panel, demand has outstripped available supply, driving prices higher. Supply capacity is expanding, however, and we are projecting, consistent with futures markets, that commodity prices will flatten out by the end of the forecast period. Before they do, our forecast calls for oil prices to rise a bit further over the remainder of 2007 and 2008. Food commodity prices are projected to move slightly higher on average as well, in part as energy-related demand for grains remains strong. If this forecast is realized, oil and energy prices should impart in coming quarters noticeable but only moderate upward pressure on headline consumer price inflation abroad. In part this is because the projected increase in oil prices is relatively modest, at least compared with what we’ve seen in recent years. In addition, the direct effect of oil prices on consumer prices in many cases is damped by tax structures or more-active government intervention in energy markets. The top panels of exhibit 11, which examine the pass-through of crude oil prices to gasoline prices, provide some evidence of how such pass-through varies across countries. These panels present local-currency prices of unleaded gasoline and imported crude oil over the past couple of years or so, plotted on a ratio scale so that vertical distances correspond to percent changes in prices. Looking across the panels, you can see that the price of imported crude oil in local currency—the black line at the bottom of each panel—moves similarly across countries. In contrast, the prices that consumers pay at the pump—the red lines—are less volatile in the foreign economies shown than in the United States and have moved up more slowly. In part, this reflects some differing movements in refinery and distribution margins, which are represented by the gap between imported crude oil prices and retail gasoline prices excluding taxes (the blue lines). This is most noticeable for Japan, where margins are proportionally higher and more of the increase in crude oil prices was absorbed than in the United States and the other countries. In addition, higher gasoline taxes abroad have inserted a greater wedge between the pre-tax price and the retail price of gasoline—the difference between the blue and the red lines. Accordingly, increased crude oil prices have pushed up retail gasoline prices proportionally less abroad than in the United States. The middle left panel presents some calculations of the rates at which the changes in crude oil prices were passed through to the retail gasoline prices between September 2004 and March of this year, the most recent observation I have for these countries. During this period, rates of pass-through were lower abroad, particularly for Japan and Germany, the countries with relatively high taxes. The smaller pass- through of oil prices to retail gasoline prices abroad has also shown through to broader measures of consumer energy prices. As shown to the right, consumer energy prices in Canada, Germany, and Japan have increased less than those in the United States over the past four years. An extra factor holding down energy price inflation in Canada over this period was the substantial appreciation of the Canadian dollar, which made imported energy relatively cheaper. Overall, this suggests that the effects of past increases in global energy prices on headline inflation, as well as on consumer sentiment and inflation expectations, were likely smaller abroad than in the United States. In many emerging market economies, gasoline and other retail energy prices are controlled or subsidized, so that energy-related fluctuations in consumer prices, if they occur at all, tend to be gradual. For this group of economies, what has left a bigger imprint on headline consumer price inflation in recent months is the global rise in food prices. The black line in the bottom left panel shows that food price inflation in Mexico has been heavily influenced in recent years by enormous, weather-induced swings in domestic tomato price inflation, shown in red (of course). [Laughter] This year, however, food price inflation has not followed tomato price inflation down. Rather, it has been sustained in part by a sharp acceleration in prices of tortillas and other corn products, shown by the green line, which are responding to the fuel-related surge in the global price of corn. Food price inflation in China, shown to the right in black, has also been boosted by higher grain prices, as higher feed costs, along with an outbreak of swine flu, have driven up meat and poultry prices. Prices for corn and other grains are forecast to level out by the end of 2008, after they have increased enough to align supply and demand growth. A risk, of course, is that further rapid expansion of demand might continue to outstrip that of supply, making food price inflation more persistent and more likely to spur inflation in other sectors. The Bank of Mexico cited such a risk following its policy tightening in April, and China’s authorities have raised concerns that food prices may exert upward pressure on wages. Evidence for emerging market economies that inflation pressures might already be spreading outside the food and energy sectors is limited so far, however. The top left panel of exhibit 12 shows core inflation rates in four of our largest emerging market trading partners. China’s core rate (in blue), which excludes only food, shows no sign of wider inflation pressures. In Brazil, inflation has declined substantially over the past few years, despite a slight uptick recently. Core inflation in Korea has been trending upward, but it is still low. Mexico’s core inflation rate has edged up toward 4 percent, a rate that concerns Mexican authorities, but this upward trend may merely reflect the fact that core inflation in Mexico does not exclude processed food such as corn tortillas. The advanced foreign economies appear to be exhibiting more broadly based inflation pressures. As shown on the right, in Canada, the euro area, and the United Kingdom, core inflation has been on a rising trend since the middle of 2006 or earlier. In response, the central banks in all three economies, as well as the Bank of Japan, are expected to tighten policy in the near term. Core inflation is still in generally acceptable ranges, however, except perhaps for the Bank of Japan, for which it might be too low, and market sentiment does not indicate concern that inflation pressures are going to rise substantially. As you can see from the middle left panel, ten-year government bond yields in the major markets have all risen since the beginning of the year. Except for Japan, most of the increases in nominal yields (the first column) can be attributed to higher real yields, shown in the second, which is consistent with stronger prospects for growth. The table to the right shows that survey measures of inflation expectations for the year 2007 rose moderately for Canada between December and June and a bit less for the United Kingdom, whereas the measures fell off some for the euro area and Japan. Longer-run inflation expectations as of the most recent survey date in April were still locked in at rates consistent with inflation targets in Canada, the euro area, and the United Kingdom. Our outlook for headline inflation abroad, shown in the bottom panels, reflects a diminishing inflationary impulse from oil and other primary commodity prices as they flatten out over the forecast period. It also incorporates the view that some further monetary policy tightening will be needed to restrain domestic demand and guide inflation in each economy toward its price stability objective by the end of the forecast period. Your last two international exhibits focus on the extent to which external adjustment is under way. A little more than a year ago, in May, was the last time we forecast that the U.S. current account deficit in 2007 would exceed $1 trillion. Since then, as shown in the top left panel of exhibit 13, our outlook for the current account has improved substantially, so much so that currently we don’t see the deficit reaching $1 trillion within our forecast period. As shown to the right, much of the improvement has come through an improved outlook for the trade balance. What surprised us? Two likely suspects fail to provide the answer. Given the recent strength of foreign growth, one might have thought that a year ago we were perhaps too pessimistic on foreign activity and consequently undershot on U.S. export performance. However, as shown in the middle left panel, our outlook today for foreign economic activity is very similar to what we had in mind a year ago. Similarly, the decline over the past year in the broad real dollar, shown to the right, which has helped curb the deterioration in the trade balance, has turned out to be not much different from our forecast a year ago. Part of the answer, it turns out, is that, even though the assumptions we fed our model for exports have not proved much off the mark, our model forecast for core exports, shown at the bottom left, failed to catch the unusually strong growth of exports in 2006. We attribute this miss to the composition of foreign demand rather than its overall magnitude. As shown in the table to the right, the largest contributors to growth of U.S. core exports in 2006 were in the categories of capital goods (line 2) and industrial supplies (line 3). With capital goods making up a large fraction of core exports, the rise in foreign investment as a share of GDP (mentioned earlier) likely provided a boost to core exports above that indicated by our aggregate measure of foreign GDP. Similarly, the global commodity boom likely favored U.S. exports of industrial supplies. Additional factors behind the improved outlook for the U.S. current account are described in exhibit 14. One is the lower path of U.S. real GDP, shown in the top left panel, which prompted real imports of core goods, shown to the right, to expand along a shallower trajectory than we had predicted last year. A third factor, illustrated in the middle left panel, is that we did not forecast the dip in the price of oil in the second half of 2006, which reduced the value of oil imports substantially. These three factors explain the bulk of the upward adjustment in our forecast for the trade balance in 2007. In addition, the improved outlook for the current account reflects an upward revision to net investment income, shown in the middle right. This adjustment results from a number of factors, including new data on U.S. holdings of direct investment abroad, new procedures for determining interest payments to foreign holders of U.S. Treasuries, and a change in the methodology used to record interest flows on cross-border holdings of other fixed-income securities. As a result of these surprises, the external accounts have clearly improved. Going forward, we expect the current account deficit to resume widening nonetheless as interest payments on the net external debt mount. But the combination of solid, demand- driven foreign growth and weaker U.S. growth has led the external accounts to make a more positive contribution to U.S. GDP growth in the near term, as shown in the table. In our current forecast, shown in the rightmost column, we project that the arithmetic contribution of real net exports to GDP growth should be roughly neutral starting in the second half of this year, as strong foreign growth helps sustain real export gains that match those of real imports." FinancialCrisisInquiry--58 BLANKFEIN: Well, a lot of this has to do with our own internal risk committee functions. We, obviously, describe our risk committee, but this is an ongoing organic process. HOLTZ-EAKIN: OK. Mr. Dimon? DIMON: I say, if you do everything right in business, you are going to make mistakes. And you really have to look at the continuum of how many, how big. Even if you were right, you’ll make some. Hopefully, they’ll be smaller and won’t be threatening to our your institution or anybody else. And the process is very rigorous. You know, if you look at— we have risk. We have a separate pricing group. It’s internal audit, external audit, and it’s reviewed by the OCC and the Fed. I think when you have a chance to look at those things; you’ll be pretty impressed with the diligence behind some of that process. And as a company, we always did some stress testing because history tells you that things go bad in the markets and you have to be prepared. That should never be a surprise, and you don’t know exactly what’s going to go bad or exactly what direction it’s going to come from. When you look at a business—this partially answers the question that the senator was asking, too—we look at a whole balanced scorecard. So it’s not—you know, if you are not financially successful, you fail. So it is, obviously, a sine qua non of doing business, but it is not the most important thing. So if you were running a business for us, we’d say, are you building a great company for the future? Will you be proud of it? Is it sustainable? Are you building better systems, better processes, better people, better training? So we look at the whole thing. It is never driven by one metric, and I think you can get—make mistakes doing that. CHRG-111shrg52619--187 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM SHEILA C. BAIRQ.1.a. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. Chair Bair's written testimony for today's hearing put it very well: `` . . . the success of any effort at reform will ultimately rely on the willingness of regulators to use their authorities more effectively and aggressively.'' My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue?A.1.a. It is unclear whether a change in the U.S. regulatory structure would have made a difference in mitigating the outcomes of this crisis. Countries that rely on a single financial regulatory body are experiencing the same financial stress the U.S. is facing now. Therefore, it is not certain that a single powerful federal regulator would have acted aggressively to restrain risk taking during the years leading up to the crisis. For this reason, the reform of the regulatory structure also should include the creation of a systemic risk council (SRC) to address issues that pose risks to the broader financial system. The SRC would be responsible for identifying institutions, practices, and markets that create potential systemic risks, implementing actions to address those risks, ensuring effective information flow, completing analyses and making recommendations on potential systemic risks, setting capital and other standards and ensuring that the key supervisors with responsibility for direct supervision apply those standards. The macro-prudential oversight of system-wide risks requires the integration of insights from a number of different regulatory perspectives--banks, securities firms, holding companies, and perhaps others. Only through these differing perspectives can there be a holistic view of developing risks to our system. In the long run it is important to develop a ``fail-safe'' system where the failure of any one large institution will not cause the financial system to break down-that is, a system where firms are not systemically large and are not too-big-to fail. In order to move in this direction, we need to create incentives that limit the size and complexity of institutions whose failure would otherwise pose a systemic risk. Finally, a key element to address systemic risk is the establishment of a legal mechanism for quick and orderly resolution of these institutions similar to what we use for FDIC insured banks. The purpose of the resolution authority should not be to prop up a failed entity indefinitely or to insure all liabilities, but to permit a timely and orderly resolution and the absorption of assets by the private sector as quickly as possible. Done correctly, the effect of the resolution authority will be to increase market discipline and protect taxpayers.Q.1.b. Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.1.b. History shows that banking supervisors are reluctant to impose wholesale restrictions on bank behavior when banks are making substantial profits. Regulatory reactions to safety and soundness risks are often delayed until actual bank losses emerge from the practices at issue. While financial theory suggests that above average profits are a signal that banks have been taking above average risk, bankers often argue otherwise and regulators are all too often reluctant to prohibit profitable activities, especially if the activities are widespread in the banking system and do not have a history of generating losses. Supervision and regulation must become more proactive and supervisors must develop the capacity to intervene before significant losses are realized. In order to encourage proactive supervision, Congress could require semi-annual hearings in which the various regulatory agencies are required to: (1) report on the condition of their supervised institutions; (2) comment on the sustainability of the most profitable business lines of their regulated entities; (3) outline emerging issues that may engender safety and soundness concerns within the next three years; (4) discuss specific weaknesses or gaps in regulatory authorities that are a source of regulatory concern and, when appropriate, propose legislation to attenuate safety and soundness issues. This requirement for semi-annual testimony on the state of regulated financial institutions is similar in concept to the Humphrey-Hawkins testimony requirement on Federal Reserve Board monetary policy.Q.2.a. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms?A.2.a. During good times and bad, regulators must strike a balance between encouraging prudent innovation and strong bank supervision. Without stifling innovation, we need to ensure that banks engage in new activities in a safe-and-sound manner and originate responsible loans using prudent underwriting standards and loan terms that borrowers can reasonably understand and have the capacity to repay. Going forward, the regulatory agencies should be more aggressive in good economic times to contain risk at institutions with high levels of credit concentrations, particularly in novel or untested loan products. Increased examination oversight of institutions exhibiting higher-risk characteristics is needed in an expanding economy, and regulators should have the staff expertise and resources to vigilantly conduct their work.Q.2.b. Is this an issue that can be addressed through regulatory restructure efforts?A.2.b. Reforming the existing regulatory structure will not directly solve the supervision of risk concentration issues going forward, but may play a role in focusing supervisory attention on areas of emerging risk. For example, a more focused regulatory approach that integrates the supervision of traditional banking operations with capital markets business lines supervised by a nonbanking regulatory agency will help to address risk across the entire banking company.Q.3.a. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking?A.3.a. Since 2007, the failure of community banking institutions was caused in large part by deterioration in the real estate market which led to credit losses and a rapid decline in capital positions. The causes of such failures are consistent with our receivership experience in past crises, and some level of failures is not totally unexpected with the downturn in the economic cycle. We believe the regulatory environment in the U.S. and the implementation of federal financial stability programs has actually prevented more failures from occurring and will assist weakened banks in ultimately recovering from current conditions. Nevertheless, the bank regulatory agencies should have been more aggressive earlier in this decade in dealing with institutions with outsized real estate loan concentrations and exposures to certain financial products. For the larger institutions that failed, unprecedented changes in market liquidity had a significant negative effect on their ability to fund day-to-day operations as the securitization and inter-bank lending markets froze. The rapidity of these liquidity related failures was without precedent and will require a more robust regulatory focus on large bank liquidity going forward.Q.3.b. While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk?A.3.b. Although hedge funds are not regulated by the FDIC, they can comprise large asset pools, are in many cases highly leveraged, and are not subject to registration or reporting requirements. The opacity of these entities can fuel market concern and uncertainty about their activities. In times of stress these entities are subject to heightened redemption requests, requiring them to sell assets into distressed markets and compounding downward pressure on asset values.Q.3.c. Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.3.c. As stated above, the bank regulatory agencies should have been more aggressive earlier in this decade in dealing with institutions with outsized real estate loan concentrations and exposures to certain financial products. Although the federal banking agencies identified concentrations of risk and a relaxation of underwriting standards through the supervisory process, we could have been more aggressive in our regulatory response to limiting banks' risk exposures.Q.4.a. From your perspective, how dangerous is the ``too big to fail'' doctrine and how might it be addressed? Is it correct that deposit limits have been in place to avoid monopolies and limit risk concentration for banks?A.4.a. While there is no formal ``too big to fail'' (TBTF) doctrine, some financial institutions have proven to be too large to be resolved within our traditional resolution framework. Many argued that creating very large financial institutions that could take advantage of modem risk management techniques and product and geographic diversification would generate high enough returns to assure the solvency of the firm, even in the face of large losses. The events of the past year have convincingly proven that this assumption was incorrect and is why the FDIC has recommended the establishment of resolution authority to handle the failure of large financial firms. There are three key elements to addressing the problem of systemic risk and too big to fail. First, financial firms that pose systemic risks should be subject to regulatory and economic incentives that require these institutions to hold larger capital and liquidity buffers to mirror the heightened risk they pose to the financial system. In addition, restrictions on leverage and the imposition of risk-based assessments on institutions and their activities would act as disincentives to the types of growth and complexity that raise systemic concerns. The second important element in addressing too big to fail is an enhanced structure for the supervision of systemically important institutions. This structure should include both the direct supervision of systemically significant financial firms and the oversight of developing risks that may pose risks to the overall U.S. financial system. Centralizing the responsibility for supervising these institutions in a single systemic risk regulator would bring clarity and accountability to the efforts needed to identify and mitigate the buildup of risk at individual institutions. In addition, a systemic risk council could be created to address issues that pose risks to the broader financial system by identifying cross-cutting practices, and products that create potential systemic risks. The third element to address systemic risk is the establishment of a legal mechanism for quick and orderly resolution of these institutions similar to what we use for FDIC insured banks. The purpose of the resolution authority should not be to prop up a failed entity indefinitely or to insure all liabilities, but to permit a timely and orderly resolution and the absorption of assets by the private sector as quickly as possible. Done correctly, the effect of the resolution authority will be to increase market discipline and protect taxpayers. With regard to statutory limits on deposits, there is a 10 percent nationwide cap on domestic deposits imposed in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. While this regulatory limitation has been somewhat effective in preventing concentration in the U.S. system, the Riegle-Neal constraints have some significant limitations. First, these limits only apply to interstate bank mergers. Also, deposits in savings and loan institutions generally are not counted against legal limits. In addition, the law restricts only domestic deposit concentration and is silent on asset concentration, risk concentration or product concentration. The four largest banking organizations have slightly less than 35 percent of the domestic deposit market, but have over 45 percent of total industry assets. As we have seen, even with these deposit limits, banking organizations have become so large and interconnected that the failure of even one can threaten the financial system.Q.4.b. Might it be the case that for financial institutions that fund themselves less by deposits and more by capital markets activities that they should be subject to concentration limits in certain activities? Would this potentially address the problem of too big to fail?A.4.b. A key element in addressing TBTF would be legislative and regulatory initiatives that are designed to force firms to internalize the costs of government safety-net benefits and other potential costs to society. Firms should face additional capital charges based on both size and complexity, higher deposit insurance related premiums or systemic risk surcharges, and be subject to tighter Prompt Corrective Action (PCA) limits under U.S. laws. In addition, we need to end investors' perception that TBTF continues to exist. This can only be accomplished by convincing the institutions (their management, their shareholders, and their creditors) that they are at risk of loss should the institution become insolvent. Although limiting concentrations of risky activities might lower the risk of insolvency, it would not change the presumption that a government bailout would be forthcoming to protect creditors from losses in a bankruptcy proceeding. An urgent priority in addressing the TBTF problem is the establishment of a special resolution regime for nonbank financial institutions and for financial and bank holding companies--with powers similar to those given to the FDIC for resolving insured depository institutions. The FDIC's authority to act as receiver and to set up a bridge bank to maintain key functions and sell assets as market conditions allow offers a good model for such a regime. A temporary bridge bank allows the government time to prevent a disorderly collapse by preserving systemically critical functions. It also enables losses to be imposed on market players who should appropriately bear the risk.Q.5. It appears that there were major problems with these risk management systems, as I heard in GAO testimony at my subcommittee hearing on March 18, 2009, so what gave the Fed the impression that the models were ready enough to be the primary measure for bank capital?A.5. Throughout the development and implementation of Basel II, large U.S. commercial and investment banks touted their sophisticated systems for measuring and managing risks, and urged regulators to align regulatory capital requirements with banks' own risk measurements. The FDIC consistently expressed concerns that the U.S. and international regulatory communities collectively were putting too much reliance on financial institutions' representations about the quality of their risk measurement and management systems.Q.6. Moreover, how can the regulators know what ``adequately capitalized'' means if regulators rely on models that we now know had material problems?A.6. The FDIC has had long-standing concerns with Basel II's reliance on model-based capital standards. If Basel II had been implemented prior to the recent financial crisis, we believe capital requirements at large institutions would have been far lower going into the crisis and our financial system would have been worse off as a result. Regulators are working internationally to address some weaknesses in the Basel II capital standards and the Basel Committee has announced its intention to develop a supplementary capital requirement to complement the risk based requirements.Q.7. Can you tell us what main changes need to be made in the Basel II framework so that it effectively calculates risk? Should it be used in conjunction with a leverage ratio of some kind?A.7. The Basel II framework provides a far too pro-cyclical capital approach. It is now clear that the risk mitigation benefits of modeling, diversification and risk management were overestimated when Basel II was designed to set minimum regulatory capital requirements for large, complex financial institutions. Capital must be a solid buffer against unexpected losses, while modeling by its very nature tends to reflect expectations of losses looking back over relatively recent experience. The risk-based approach to capital adequacy in the Basel II framework should be supplemented with an international leverage ratio. Regulators should judge the capital adequacy of banks by applying a leverage ratio that takes into account off-balance-sheet assets and conduits as if these risks were on-balance-sheet. Institutions should be required to hold more capital through the cycle and we should require better quality capital. Risk-based capital requirements should not fall so dramatically during economic expansions only to increase rapidly during a downturn. The Basel Committee is working on both of these concepts as well as undertaking a number of initiatives to improve the quality and level of capital. That being said, however, the Committee and the U.S. banking agencies do not intend to increase capital requirements in the midst of the current crisis. The plan is to develop proposals and implement these when the time is right, so that the banking system will have a capital base that is more robust in future times of stress. ------ FOMC20070816confcall--3 1,MR. DUDLEY.," Thank you. As you noted, market turbulence has continued to spread and intensify. The strains that have emerged in the prime nonconforming home mortgage market and in the asset-backed commercial paper market have proved to be self-reinforcing. As investors have backed away from asset-backed commercial paper, this has led to a forced sale of mortgage collateral, and that has put downward pressure on the prices of private-label whole mortgages and of mortgage-backed securities. The downward pressure on prices of mortgage loans and mortgage-backed securities, in turn, has resulted in increased haircuts by prime brokers and lenders. This has provoked a rapid, forced deleveraging among many mortgage investors. This process has unfolded rapidly and has overwhelmed the ability of depository institutions to take up the slack, even though at current prices many of these assets appear to be at attractive valuations. The absence of strong offsetting demand by depository institutions not faced with these same constraints appears to have been influenced by factors that threaten to put pressure on these institutions’ balance sheets. These include leveraged loan commitments associated with private equity deals and the assets from busted commercial paper programs that might end up on their balance sheets. Over the past few days, we have seen a significant increase in market dysfunction. First, although the aggressive provision of reserves by the Desk last Friday successfully pushed the federal funds rate back down after it had climbed above its 5¼ percent target, term rates remain elevated. For example, the one-month term federal funds rate is currently quoted at 5.40 percent, even though fed funds rate futures imply an average rate over the next month of less than 5 percent. This is consistent with a significant rise in risk premiums. Second, over the past two days, we have seen a sharp decline in Treasury bill rates. Although a diminished supply may be a partial explanation, flight- to-quality concerns appear to account for most of the sharp move down in yields. Some investors have reported that dealers are very reluctant to sell Treasury bills. Third, other measures show that risk aversion has increased. For example, interest rate swap spreads have widened significantly, and the spread between on-the-run and off-the-run Treasuries has increased. Fourth, equity prices around the world have moved lower. The S&P 500 index is now down roughly 10 percent from its peak. Fifth, the so-called carry trade in currencies is unwinding with a vengeance. The yen has appreciated sharply against the dollar, even as the dollar has strengthened against many other currencies, such as the euro. The yen-dollar rate has fallen below 114. Sixth, market volatility has spiked. The VIX measure of implied volatility for the stock market has climbed above 30, well above the peak it reached in late February and early March. Implied volatility in fixed income in currency markets has also moved up sharply. The market turbulence and the rise in risk aversion have created several areas of vulnerability. First, there is the risk that money market mutual funds could suffer losses on certain asset-backed commercial paper programs that have weak backstops. This could conceivably cause some funds to “break the buck.” In the worst case, this could even result in a run from these funds by investors. Second, worries about the exposure of the financial guarantors to the mortgage market could cause problems to spread from this area to areas that have up to now been more sheltered from stress, such as the municipal securities market. The intense market turbulence has caused investors to become more worried about the downside risk to the economy. As a result, investors now anticipate significant monetary policy easing in the weeks and months ahead, much more than even a week ago. For example, September federal funds futures currently imply a 4.92 percent federal funds rate for the month, 33 basis points below the current 5¼ percent target, and the Eurodollar futures strip through mid-2008 is consistent with roughly 100 basis points of easing over this period. Thank you. I’m happy to take any questions." FOMC20060328meeting--134 132,MR. LACKER.," Thank you, Mr. Chairman. While we had some softer readings on our District’s economic performance early in the year, recent measures have been noticeably stronger. Our survey results from March have come in since the Beige Book, and they show continued strength in service-sector revenue growth, along with a sharp rebound in shipments, new orders, and employment for the manufacturing sector. The retail sector, in contrast, has been weaker in February and March. Some of the weakness is in furniture and may reflect cooling housing markets. However, other retailers suggest that they are still experiencing givebacks following the extraordinary sales growth they saw in January, and many remain optimistic about sales prospects going forward. Several District businesses we talked to plan to increase investment in the months ahead. Their plans include not only computers and technology but also factory machinery. Labor markets in our District seem to be getting tighter. In January, Districtwide unemployment stood at 4.1 percent, and we hear scattered reports of shortages of skilled workers, as you mentioned earlier, along with some complaints that worker shortages are constraining production. I had heard occasional references to worker shortages in past months, going back into last year, but this chatter has picked up noticeably in recent weeks. Not only have the number of reports increased somewhat, but some now come from outside the traditionally strong urban areas. We’re hearing it now in the manufacturing-dependent Carolinas, for example. Price growth measures moderated in our March survey results. District businesses report that input price increases slowed, but they continued to express concerns about future cost pressures. Our respondents also reported slower growth in their output prices, and this was broadly based across all sectors we survey. In addition, expected price increases for the next six months generally lessened. Our regional economic indicators on production, employment, and price pressures seem broadly consistent with the national picture. The data point to a strong rebound in GDP growth this quarter, perhaps stronger than had been anticipated by the Greenbook and private forecasters. While household residential investment is slowing, business investment and spending appear to be strong, suggesting that firms are adding to capacity in anticipation of healthy demand growth. The prospects for income growth, driven by continued employment gains and respectable growth in compensation, give me some confidence that overall consumer spending should hold up well, even as housing market activity moderates. Inflation has come in a bit lower than expected, and I’m increasingly comfortable with the idea that we’ve gotten beyond the risks to inflation presented by the shock associated with last year’s hurricanes and run-up in energy prices. Core PCE inflation averaged 2.3 percent from August through November but has averaged 1.8 percent from November through January. Although market-based measures of longer-run inflation expectations rose briefly last fall, they soon subsided and have remained steady since. So while I’m not entirely sanguine about the inflation outlook, I think the immediate risk of pass-through has probably passed us by. Looking back over this episode, and how we and many others feared that things might have unfolded, I think it illustrates the challenges we face in trying to understand inflation dynamics. As energy prices rose sharply last fall after the hurricanes, the fear was that a sustained increase in core inflation and inflation expectations would work its way through the economy in the first half of 2006. This bulge now appears to have been small and short-lived. A common approach to forecasting the effect of energy-price shocks on core inflation is to rely on relationships estimated over historical periods that include seemingly similar episodes. Such an exercise implicitly treats the empirical relationship between energy prices and core inflation as structural, as in models in which wages or prices are set in a backward-looking fashion. But as President Yellen and others have emphasized, this relationship is not stable in the historical data. It has largely disappeared since the late 1980s. This underscores the pitfalls of forecasting inflation based on a backward-looking approach that relies on pass-through correlations or, for that matter, Phillips curve correlations between measures of slack and inflation. In contrast, to the extent that price-setting is forward looking, these correlations must embed expectations regarding our policy behavior and so will not generally be stable across changing policy regimes. This perspective suggests that the limited magnitude of the pass-through from last fall’s energy-price shocks was influenced by the public’s confidence that we would focus on preventing broader inflationary spillovers. In other words, we may have gotten less pass-through than we feared because we were more credible than we realized, and the public’s behavior was more forward looking than we thought. Again, this is not to say that I’m complacent about inflation. The initial response to last fall’s shocks embodied expectations of a lower path for the funds rate and a greater rise in inflation. Fortunately, the combination of communication by FOMC participants and the Committee’s steady actions appears to have brought these expectations back in line. I bring all of this up because in the months ahead we are likely to see tighter resource utilization if the Greenbook is correct, and we will be concerned about the extent to which that would put upward pressure on inflation and inflation expectations. So the question of the extent to which inflation dynamics are backward looking or forward looking is going to be front and center for us." CHRG-111hhrg52261--98 Mr. Robinson," Congresswoman, perhaps there is a parallel in the financial services--noninsurance financial service area you that might consider. I mentioned earlier about underwriting, or identifying the risk, underwriting it and pricing it properly. And you do the best job you can, whether it be a house on a beach or a subprime mortgage or whatever. And then, when the hurricane comes or the collapse happens, management meetings happen that say, We are not going to do that again. And then we have to recast our expectations, and that usually results in underwriting tightening up, which could mean change in credit score or unwillingness to put out lines of credit. Also, a bad result could result in an organization being overleveraged. We have too much out there and so we have to pull back. Ms. Fallin. Thank you, Madam Chairwoman. " FOMC20080310confcall--67 65,MR. KOHN.," Thank you, Mr. Chairman. I thought I would begin, if it is okay with you, Mr. Chairman, with talking a bit about what I heard in Basel this weekend. I just got back this afternoon from Basel. I think it is fair to say that Bill's description of what is going on in U.S. financial markets is going on much more broadly. Liquidity has dried up in London and other European markets in particular, but elsewhere as well. There is really no price discovery. There is aggressive deleveraging and a flight to safety and soundness. Spreads have widened everywhere. It is true that the EURIBOR�OIS spreads haven't widened very much in the one-month and three-month areas, unless something happened today. But the people from the ECB in Europe reported that they had widened beyond three months, suggesting that people expect this crisis to go on for quite a while. Even in European government bond markets, spreads have widened among different governments that are part of the ECB for the first time since the ECB was founded, reflecting probably liquidity rather than differences in perceived credit risk. Prices were perceived in European markets as well as in U.S. markets to be well out of alignment with any plausible path for economies. That is, the risk spreads were way out of whack with anything that might possibly happen to the economy. There was no price discovery. The prices that were out there were just being driven by fear. Liquidity and solvency were becoming intertwined. The dysfunction in the securities markets and the banking sector were intertwined, and there was just a very vicious spiral going on in many financial markets. ""Dysfunctional"" was the word that a lot of people used to describe their home markets. Even in the emerging market economies, which so far had been relatively ""decoupled""--in the current vogue phrase-- from the industrial economies, there at least the financial markets were becoming coupled to our markets. One emerging market economist-- this is in my CGFS, my global financial system group--reported that locally owned banks in his market were refusing to advance funds through their New York affiliates and their London affiliates to U.S. and European banks. I think I will pause there for the irony to sink in for a second. Those economies that had multinational banks operating in them said that the multinational banks with headquarters in Europe or the United States were definitely selling assets in emerging market economies, not only their portfolios in order to raise funds and hoard liquidity but also subsidiaries were being shopped around in order to conserve their capital. It was broadly viewed that way by everybody, and my global financial system group probably has 35 countries--I don't know the exact number, but every industrialized country and a half a dozen emerging-market economies are represented. When I summarized the meeting just as I did for you and I asked if anyone disagreed with that summary, no hands went up. In that context, the G-10 governors were very concerned about what was going on and about the turn that financial markets had taken over the last couple of months, but especially over the past week. Any number of them said that they had been getting calls on Thursday and Friday from lots of market participants reporting the same type of dynamic that I was just describing to you and being very, very worried. In that context, they suggested--it didn't require any urging by me, I can assure you--that a coordinated announcement such as was undertaken in December would be an appropriate step to take. In addition to the swap actions, the United Kingdom and Canada are planning special auctions in their term funding markets much as they did in December, a similar combination. That will be announced tomorrow in conjunction with our stuff. Let me go on to the TSLF and the swap lines. I support these steps, but I agree with the thrust of the questions. This is not an easy decision. It hasn't been easy for me in any regard. I think in many respects this is a logical next step. We are broadening the collateral. We're expanding securities lending. We're lengthening terms. We're being more aggressive in the term funding markets. We're holding auctions. This is an extension of what we've been doing all along in response to this crisis, and this is just the next step. Other central banks have been doing exactly the same thing, reaching out to counterparties, taking more collateral, and doing more at longer maturities. As you pointed out, Mr. Chairman, one very critical difference between us and the other central banks is that they are dealing with universal banks, so they don't have this division between investment banks and commercial banks in the United Kingdom and Switzerland and in Europe. When they do an open market operation, it's with the investment banks as well as the commercial banks because they are one and the same thing. I think this facility is aimed at the critical piece of the market, the mortgage markets. This is where the problems are most acute and from where they are radiating out into the rest of the market, where the liquidity, price, and solvency interactions are most intense in this downward spiral that Bill described. As Bill and Debby noted, this swap, which can be expanded rapidly, is a very efficient way to try to address this problem, and we don't present the Desk with the issues of absorbing the reserves. But I also acknowledge, as many of you pointed out, that we are crossing a line because of the combination of the collateral and counterparty. It is not so much the asset class--that's not the line we're crossing because we already crossed that line at the discount window. We've taken many classes of assets at the discount window for a long time. The line we're crossing is the combination of the collateral and the counterparty. That's why this has to be a combination of sections 14 and 13 of the act. We are setting a precedent of a sort. I mean, I think we can step back when markets improve, but it is a precedent. There are moral hazards. There are risks. There are reputational risks. I agree with all of those things, and as Chairman Bernanke can tell you, I was resistant to this idea when it was raised a little while ago. But I have changed my mind, and I have changed my mind for a variety of reasons. The first and most important of them is the downward spiral that we're in. I had changed my mind before I went to Europe, but certainly hearing the people in Europe describe the same thing happening on a global basis just reinforced it. That is the most important thing that has happened. We are in dysfunctional markets, and we have to try what we can to help them along. I think there are sensible steps here to limit the costs. The degree that the safety net is being extended is small, but the perception that it is being extended is there. I think we've limited it as best we can. If I thought that price discovery was occurring in these markets, I would be hesitant to do anything that might interfere with it. But there isn't any real price discovery happening. So I don't think this is a case that, if we could only get out of the way, the markets would find their prices, and then the prices would be low enough, and people would step in, and price and liquidity would be restored. That's not what's happening. The markets just aren't operating. There are no guarantees that this will work. We're not addressing the solvency issues that are to a certain extent at the heart of this. But I do think liquidity and solvency are interacting in a particularly difficult and vicious way right now. To the extent that we have even a chance of breaking that spiral by intervening on the liquidity side--which is what the central banks are here for--and can help at least stabilize the situation, it may encourage the dealers to make markets if they know that we're behind there in terms of the AAA mortgage-backed securities tranche as well as the agencies and the agency mortgage-backed securities. I think it is well worth taking the chance in the current situation. One of the members of the CGFS said toward the end of our meeting on Saturday that ""sometimes it's time to think the unthinkable,"" and I think that time is here for us right now, Mr. Chairman. Thank you. " CHRG-111hhrg49968--149 Mr. Bernanke," Certainly. And I think, not just for the benefit of the Chinese, but for the benefit of the United States and for our own people, we need to explain how we are going to restore fiscal sustainability and avoid inflation. On that latter issue, let me just begin by saying that the Federal Open Market Committee of the Federal Reserve is strongly committed to price stability. We will ensure price stability. Price stability means neither deflation nor inflation. And in the near term, our concern for a time at least was that the recession would be so severe that we would see deflation, and we have taken strong actions to try and avoid that. And I think the fear of deflation has receded somewhat, and that is a positive development. Now, for the time being, we still need to maintain a strong, supportive position in order to help this economy begin its recovery. But as that begins, at some point we are going to need to begin to withdraw the policy of accommodation so that we can avoid any inflation down the road. Basically, the exit strategy is that when the time comes, we need to begin to raise interest rates. That is the usual way that the Federal Reserve tightens policy as the economy begins to recover. And the question is, will we be able to raise interest rates given the size of our balance sheet? My answer is yes. First of all, as I mentioned earlier, many of our programs are short term and can be wound down. That will reduce the size of our balance sheet. Secondly, and very importantly, our ability to pay interest on reserves means that we can raise interest rates by raising the interest rate we pay on the reserves because banks will not be willing to lend in the Federal funds market at rates below what they can earn by just holding their cash at the Fed. We can raise interest rates and then we can tighten policy. Beyond that, we have additional tools. For example, we can do reverse repurchase agreements which will allow us to fund our balance sheet outside the banking system and therefore doesn't have the same effects on the money supply or interest rates. And if worse came to worse, we could sell some of our assets, but that is not a big part of the plan certainly in the near term. There are still other possibilities that we are looking at and that perhaps we can discuss with Congress at some point. But we are certainly, as we look forward and decide what further actions we want to take, we want to be sure that we will be able to remove accommodation at an appropriate time and an appropriate speed to be sure that we don't have an inflation risk down the road. It is not going to be an easy call, but we will have to balance the risk on both sides, not going too soon and stunting the recession, not going too late and having a bit of inflation, but we will get price stability after we get out of this recession. " FOMC20060131meeting--114 112,MR. FERGUSON.," Thank you, Mr. Chairman. The Greenbook baseline presents a relatively positive scenario. But as the 90 percent confidence interval given in the Greenbook clearly indicates, there is considerable uncertainty around this baseline. In a theoretical world of certainty equivalence, that range of uncertainty would not matter. But as you’ve taught us many times, in the world of practical policymaking, how that uncertainty is resolved will matter importantly for policy judgments. As a mere cadet, if you will, sitting next to the monetary policy Yoda, [laughter] I will attempt to look at some of these uncertainties and to understand how they may unfold in their implications for policy. Yoda, of course, is a complimentary word in my household. [Laughter] One particularly salient aspect of uncertainty relates to the way that inflation expectations are influenced by energy prices. As we’ve seen recently, despite spiking oil prices in December, near- term inflation expectations remained stable or edged even somewhat lower, reversing the run-up that we saw in the fall. As the presentation this morning showed, preliminary January Michigan survey results for median inflation expectations for the coming year ticked down, and median five- and ten-year inflation expectations also moved lower. Rate spreads from TIPS also indicated remarkably contained inflation expectations despite oil price shocks. This stability is both remarkable and quite important, because, in my view at least, the optimal course of monetary policy at this juncture depends critically on the fragility or stability of inflation expectations in the presence of the oil price shock. I judge that, for now at least, this important element of uncertainty supports a continued execution of the strategy we are following to date, with no need to fear that we’re falling behind the curve, even as energy prices have spiked again. Of course, with the slight rise in the near-term inflation outlook and, in fact, slight deterioration in near-term inflation itself, prudence will require close monitoring of these variables as we go forward. But thus far, I judge that the announced strategy is consistent with maintaining our credibility. Second, as we discussed earlier, there is great uncertainty about why long-term rates are low and what the shape and level of the yield curve may imply for us. As we saw in yesterday’s Board briefing, forward nominal rates fairly far out in time have moved down over the past year, both here and abroad, and are low today by historical standards. As we know, long-term rates are low today partly because inflation expectations are low. If this were the whole story, short-term rates would not need to depart from the historical terms or norms in real terms. But while this is part of the story, it isn’t the whole story. As we’ve already discussed, if the shape of the yield curve and low rates both indicated that market participants expected some further economic weakness, then the proper response would be to run a looser-than-average monetary policy. But I agree, and I think most of us agree, with the staff assessment that the low real long- term interest rate and a flat yield curve are not precursors to a global softening and an expected drop in rates but rather are due to an unusually low term premium. In my judgment, part of the reason for that low term premium is an increased assessment on the part of global investors that the future looks like an environment involving less risk than usual. This was borne out I think in Dino’s pie charts earlier on and also in the global equity markets. I’d also say, based on various conversations I’ve had with central bankers in January on the various committees that I attend and others I attend with the Chairman, there is a general sense in the world of policy that this low-risk assessment is approximately right. However, I continue to think that these lower rates reflect some forces that are holding back investment demand globally. And, for the United States, I think they also reflect a drag from the external sector. However, with corporate balance sheets in good shape and global growth firming, I don’t expect a sudden reassessment of risk and a rise in the term premium to result from these sources. I do have some concern that we may see a snapback in term premiums from another source that we’ve touched on a bit already, and that’s the third and final uncertainty I wish to look at, which is the housing sector. Here I’d say that President Santomero’s comments in some sense preceded and introduced mine. I don’t doubt that the housing market is slowing somewhat, but I do wonder about the impact of a slowing of house prices and wealth extraction on household saving and consumption. Here I pick up where Dave left off, which is that the models take a historical norm. Let’s say we’re at about the 3 percent that Dave indicated. I think there’s possibly a greater risk, for reasons that Dave has already indicated, that we may find a much stronger impact on the global economy, certainly on the U.S. economy, based on a slowing of housing prices. And here, though I recognize their economies are different, I am still somewhat troubled by the experience in the United Kingdom, Australia, and the Netherlands, all of which had an unexpectedly large impact, from a GDP standpoint, from a relatively slow flattening of house prices. I recognize that these other economies are different from ours, but I’d also say that we’ve seen even in our own economy some nonlinearities that have emerged—for example, as asset prices moved down relatively rapidly—that might have surprised us in the past. So what’s the implication of all of these uncertainties? I’d like to put three things on the table for this meeting. First, I continue to believe, as I think the Greenbook or the Bluebook does, that the equilibrium real rate has, in fact, moved down somewhat on average, to lower than it was, let’s say, over the past ten years, with the exception of the recessionary periods of 2001 and 2002. Second, I firmly believe, as do many of you, that we are well within the range of neutrality at this stage. And, third, since I would say there’s a great deal of uncertainty here, I want to make sure that what we say, both in word and in deed, reflects a great deal of flexibility. I heard Vice Chairman Geithner suggest that we want to put out some words that say it’s probable that we’ll move at the next meeting. I suggest that we be a little more nuanced and put out some words that suggest it’s at least possible that we move at the next meeting. Having said all of that, obviously, I, along with everyone else, think that what happens going forward will be extraordinarily data-dependent. All the more reason for us to keep, if you will, our powder dry and our options open. Thank you very much, Mr. Chairman." FinancialCrisisReport--545 In addition to marketing its CDOs at inflated prices compared to its internal valuations, the Mortgage Department told some clients that the mortgage market was strengthening. On May 14, 2007, for example, Edwin Chin, a trader on the Mortgage Department’s ABS Desk, sent this upbeat commentary to both Goldman traders and clients: “Incredible as it may seem, the subprime mortgage slump is already [a] distant memory for some. It’s been two months since the ABX market plunged amid worries about a housing meltdown, and already investors (and some dealers) are beginning to get ‘complacent’ again. Blame it on the CDO bids, but with subprime production projected down 40-60% from last year’s level, appetite for spread products triumphs any risk concern in the marketplace right now. ABX Index is trading higher as dealers short cover their single name positions after a month of range-bound trading. Flows continue to weigh toward better seller of protection – longs outpace shorts by 3 to 1 as CDO demand has been robust the last two weeks. While warehouse activities might be slow, many CDOs are still looking to finish up their ramp post-closing.” 2407 Daniel Sparks responded to Edwin Chin’s commentary by asking senior ABS traders, David Lehman, Mike Swenson, and Joshua Birnbaum: “Is this a head fake or does this make you bullish on all spread product?” Mr. Lehman responded: “[G]iven the sizable short interest in ABS/subprime mkt it does not surprise me that short covering is pushing spds [spreads] tighter. Not sure I would enter new longs here.” Mr. Swenson responded: “I would characterize this as a great opportunity to be constructive on the market.” 2408 2406 See 7/12/2007 “Goldman W arehouse SP CDO positions and hedges_7-12-07, ” GS MBS-E-001866482; See also Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. In an interview with the Subcommittee, David Lehman explained that the bid/offer spread (the difference between the price at which a security is offered for sale [ “offer price ”] and the price at which a bank would buy the same security [ “bid price ”]) was the reason for the difference between Goldman ’s internal valuation of the price of the AA rated securities and price at which it sold them to Bank Hapoalim. However, in many instances during this period, it appeared as if Goldman ’s internal valuation price had no relationship to the bid and offer prices quoted to clients. For example, at the end of June 2007, Goldman provided Timberwolf investor M oneygram with an offer price of $86 for Timberwolf A2 securities and bid price of $83, indicating a bid/offer spread of 3 points. Meanwhile, Goldman had an internal valuation of $75 for the same securities, far different from $83 and $86 quoted to M oneygram. See Moneygram valuation, 7/5/2007 email from Goldman Sachs Operations, “MoneyGram Marks from GS as of 06/29/07,” GS MBS-E-022023387; Goldman internal evaluations see “W arehouse SP CDO positions and hedges_6-29-07,” GS MBS-E-010809241. See also 6/6/2007 email from Sheara Fredman, GS MBS-E-010795808 and attachment GS MBS-E-010795809. Goldman ’s pricing in such situations seemed consistent with the strategy articulated earlier by Mr. Sparks, the head of the Mortgage Department, that Goldman should write down the value of the assets, “but market [the CDO securities] at much higher levels,” because he was concerned that Goldman was “overly negative and ahead of the market, and that [Goldman] could end up leaving some money on the table.” 5/14/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-019642797. 2407 2408 5/14/2007 email from Edwin Chin, GS MBS-E-012553986. Mr. Birnbaum responded directly to Mr. Swenson: “what a beautiful quote.” Id. FOMC20080430meeting--125 123,MR. ENGLISH.," 3 I will be referring to the revised version of table 1, which is included in the package labeled ""Material for the FOMC Briefing on Monetary Policy Alternatives."" The revised table presents the same range of options regarding the target federal funds rate as the version discussed in the Bluebook, but we have proposed some changes to the statement language for alternatives B and C. New language introduced in the draft distributed on Monday is shown in blue, with language reintroduced from the March 18 statement shown in black and underlined. An additional adjustment made since Monday is shown in purple. [Laughter] We have about used up the color palette in Word. I will discuss these changes as I go along. Your policy decision at this meeting would seem to depend on three judgments: Where do you think you are; where do you want to be; and what path do you want to follow to get there? The staff's assessment of where you are--at least in terms of the stance of monetary policy--is summarized in the r* chart that was included in the Bluebook. That chart showed that the current real federal funds rate is about 50 basis points above the Greenbook-consistent measure of r*, suggesting that the rapid easing of policy this year has left the real funds rate fairly close to the level required to bring the economy back to its potential over the medium term. The low level of the 3 The materials used by Mr. English are appended to this transcript (appendix 3). equilibrium funds rate reflects the staff's judgment that the housing correction and financial market stresses--with their associated effects on consumer and business confidence--have been sufficient to shift the economy into a recession regime in which spending by both households and businesses is likely to be weak. As for where you want to be, the Greenbook projection assumes that the real funds rate is moved down to its equilibrium level--that is, the federal funds rate is trimmed 50 basis points further--and then remains unchanged over the rest of the projection period. Finally, as for the path you want to follow to get there, the staff projection assumes that you move the federal funds rate to the staff's estimate of the rate's equilibrium level relatively quickly by trimming the fed funds target 25 basis points at this meeting and another 25 basis points at the June meeting. However, there is no overshoot below the equilibrium level in order to provide insurance against a further unexpected slide in spending. If you agree with the staff that about 50 basis points of additional easing is needed to bring the real federal funds rate into alignment with its equilibrium level and you are at least moderately confident of that assessment, then you might be inclined to ease policy by 50 basis points at this meeting and issue a statement suggesting fairly balanced risks to the outlook, as in alternative A. A relatively large adjustment to policy at this meeting would be particularly attractive if the Committee wanted a somewhat faster recovery in output or was concerned about downside risks to growth and wished to move the funds rate back to its equilibrium value quickly in order to help head them off. Members might also select a larger rate cut if they were willing to live with somewhat higher inflation over time, as in the optimal control simulation in the Bluebook with an inflation goal of 2 percent. The rationale language proposed for alternative A sticks fairly closely to the language used in March, making modest adjustments that are intended to avoid leaving the impression that the weakness in economic activity or the concerns about inflation had worsened appreciably over the intermeeting period. The assessment-ofrisk language would continue to indicate that the easier stance of policy should ""foster moderate growth over time and . . . mitigate the risks to economic activity,"" but it would move toward balance by dropping the explicit reference to downside risks. As in March, it would end by promising timely action to ""promote sustainable economic growth and price stability."" Investors would be surprised by the adoption of alternative A. Market participants generally expect a 25 basis point rate cut at this meeting and put very low odds on a 50 basis point cut. However, the effect of the relatively large easing would be damped somewhat by the shift to a more balanced risk assessment. The result would likely be lower short- and intermediate-term interest rates, a rise in equity prices, and a softening of the dollar. If the Committee viewed the target federal funds rate as probably close to the level that would appropriately balance the risks to its dual objectives but saw considerable uncertainty regarding that level, then it might be inclined to reduce the funds rate another 25 basis points at this meeting and suggest a more gradual pace of policy easing, or even a pause, after this meeting, as in alternative B. Policy has been eased very rapidly, and it is difficult at this point to assess the extent to which that easing has been transmitted to households and firms and so to spending. That assessment is complicated by the ongoing turbulence in financial markets as well as the usual difficulty in extracting signals from noisy data on economic activity. Against this backdrop, the Committee may be inclined to take a relatively small policy step at this meeting and then move to a more incremental policy approach under which policy will be guided by incoming information on economic and financial developments. Moreover, with some measures of long-term inflation expectations having moved higher in recent months, members may be concerned that a larger policy move at this meeting would encourage the view that the Committee is more willing to tolerate inflation than had been thought. By taking a smaller policy step at this meeting and suggesting reduced odds of additional near-term policy action, the Committee could limit the extent to which investors extrapolate the recent large policy moves and so build into asset prices more easing than is warranted. Such a brake on expectations may be seen as particularly useful since the incoming data on employment and economic activity are likely to be pretty soft in the near term, and the data releases could well spur expectations of further rate cuts even though the Committee anticipated the weakness when setting policy. Communication on this point will presumably be enhanced by the release of the ""Summary of Economic Projections"" in three weeks, which should clarify the Committee's views on the appropriate path for policy and the expected trajectory for economic growth over coming quarters. In the Bluebook, the rationale portion of the statement associated with alternative B was identical to that under alternative A. However, in the revised version of table 1, the first sentence on inflation has been changed to acknowledge the recent improvement in readings on core inflation but point to the continued run-up in energy and other commodity prices. Rather than simply noting the Committee's judgment that a further easing move is appropriate, as in alternative A, the assessment-of-risk paragraph begins by stating that ""[t]he substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity."" The explicit, time-dependent pause that was suggested in the Bluebook formulation for this alternative has been replaced by wording that is intended to suggest that policy will be more data-dependent, with the final sentence now reading, ""The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability."" The addition of the phrase on monitoring developments coupled with the deletion of the indication in the March statement that the Committee will act ""in a timely manner"" will likely be read by investors as suggesting a slowing in the pace of easing and possibly a pause after this meeting if the economy develops as the Committee anticipates. Investors appear to expect that the Committee will trim the federal funds rate 25 basis points at this meeting and then leave the federal funds target at 2 percent for some time. The 25 basis point policy easing and the associated statement under alternative B would seem to be about in line with these expectations, implying little response in financial markets. If the Committee thinks that the substantial easing of policy already put in place, along with the coming fiscal stimulus, is likely to foster outcomes that appropriately balance its inflation and growth objectives, then it may want to stay its hand at this meeting and issue a statement suggesting that policy is likely to change gradually going forward and could even be on hold for a time, as in alternative C. The Committee may expect the ongoing weakness in spending to be relatively mild and brief. The real federal funds rate is already very low, and the incoming data may not be seen as sufficiently weak to confirm the staff's view that the economy has shifted to a recessionary footing and therefore that spending is likely to come in weaker than one would otherwise expect. With financial markets most recently improving, on balance, and investors apparently less concerned about tail events, the Committee may see smaller downside risks to the outlook for growth. At the same time, members may think that the inflation outlook remains worrisome. Prices of oil and some other commodities touched new highs over the intermeeting period, and members may anticipate that firms will be able to pass a larger share of the increase in these costs through to their customers than the staff anticipates. Longer-term inflation expectations may have increased in recent months, and the Committee might be concerned that failing to push back, at least modestly, against that rise could allow for a more significant increase in expectations that could be very costly to reverse. Moreover, some members may worry that additional policy easing could trigger declines in the foreign exchange value of the dollar and increases in commodity prices that would give a further boost to inflationary pressures. Taken together, these arguments might suggest that, if a further easing step were taken at this meeting, it might have to be reversed fairly soon--an outcome that some members may wish to avoid. The discussion of economic activity in the statement under alternative C is identical to that under the other two alternatives. The inflation paragraph is similar to that under alternative A, but it does not list the reasons for the anticipated moderation in inflation. The exclusion of this list is intended to suggest less confidence in the judgment that inflation will moderate as expected. Some members may also be uncomfortable repeating the reference to ""a projected leveling-out of energy and other commodity prices"" when those prices have surprised to the upside yet again. The assessment-of-risk portion of the statement starts by pointing to downside risks, but then proceeds as in alternative B. The reference to downside risks might counter to some degree the suggestion of a possible pause in the easing process, but the lack of policy action combined with this statement language would presumably limit expectations for easing at coming meetings. Market participants put only about one-quarter odds on unchanged policy at this meeting, and so the combination of unchanged policy and a statement suggesting that the Committee could remain on hold for a time would surprise investors, even with the retention of downside risks to growth. Short- and intermediate-term rates would rise, stock prices would likely fall, and the dollar could rally. Effects on longer-term rates, and also on inflation compensation, would depend on whether investors interpreted the statement as indicating that the Committee desired a lower level of inflation than had been thought. The unexpectedly firm policy decision could boost pressures in short-term funding markets, either immediately, as a result of higher funding costs for leveraged firms and a weaker outlook for the real economy, or over time, in the event that economic data came in weaker than anticipated and the FOMC was seen as less likely to ease policy in response. That concludes my prepared remarks. " FOMC20050630meeting--81 79,MR. POOLE.," Essentially, it’s the same problem that arises with wage and price controls. Having that as a policy instrument that is sometimes used and sometimes not used completely changes the pricing mechanism in a market economy. I think that problem applies in spades to stock prices, equity prices, and bond prices. With house prices I think the problem is a little different, but I believe the same basic principle applies." FOMC20071211meeting--128 126,MS. YELLEN.," Thank you, Mr. Chairman. With respect to policy, I also favor alternative A, a 50 basis point rate cut. Let me explain my reasoning. Otherwise I certainly agree with what President Rosengren said. First, I think the equilibrium real rate of interest is low relative to its long-run average. The range of medium-run measures of r* reported in the Bluebook is between 1.8 and 2.3 percent, and this range includes the Greenbook-consistent measure and the staff’s Kalman filter model estimate of 2.1 percent. Market perceptions of future real interest rates are also very low, with yields on five-year Treasury inflation-indexed bonds now below 1¼ percent. I think the headwinds from financial market turmoil and the more general reassessment of risks that is taking place in global markets are good reasons why the equilibrium real rate may be low in the current situation. We do have historical precedence for this. For example, Kalman filter estimates of r* fell noticeably during the credit crunch of the early 1990s. Given the current state of the economy with inflation near a level consistent with price stability and resource utilization near its equilibrium level, policy should be close to neutral, which implies a nominal funds rate of 4 to 4¼ percent. The forecast and risk assessment must also enter the analysis. With an assumed 25 basis point cut at this meeting, the Greenbook foresees the economy barely skirting a recession, so any more bad news could put us over the edge; and the possibility of getting bad news—in particular, a significant credit crunch—seems far from remote. To my mind, the risk to the forecast and the risk of a vicious cycle, in which deteriorating financial conditions and a weakening economy and house prices feed on each other, argue for adopting a risk-management strategy that, at the very minimum, moves our policy stance to the low end of neutral—namely, a cut of 50 basis points—and I think it argues for doing so now rather than taking a “wait and see” approach and lowering it only grudgingly. This may not be enough to avoid a recession—we may soon need outright accommodation—but it would at least help cushion the blow and lessen the risk of a prolonged downturn. I should also say that my recommendation assumes that the implementation of the TAF, even if it succeeds in improving liquidity in the money market, will not appreciably alleviate macroeconomic conditions. Regardless of the policy actions taken at this meeting, I think we need to be very careful in these unsettled conditions about how we communicate our assessment of risks and likely future policy actions. We should maintain maximum flexibility so that our future actions can, in Governor Kohn’s well-chosen words, be nimble. If the Committee chooses to cut the funds rate 50 points, I would favor the assessment of risks from section 4, alternative B, in table 1. This appropriately leaves open what the future policy will be and stresses that it depends on developments. If the Committee goes with the 25 basis point cut, then I would support using the assessment of risks from section 4, alternative C, which states clearly that the predominant concern is the downside risk to growth. Otherwise I fear that market participants may mark up their expected path for policy over the next year, leading to further erosion in financial conditions. Finally, I would suggest that, given the long period of time between today and the next FOMC meeting, we be open to the possibility of a special intermeeting videoconference to assess economic and financial developments, and this meeting could also benefit from an assessment of the effects of the TAF once it’s in place." CHRG-111shrg52966--58 Mr. Polakoff," Senator, I would say that there is an element of truth to that statement in the report, but it probably does not capture the entire universe. What we do and we do very well is put boots on the ground. We have examiners that go onsite from one large institution to another large institution. And while there may be a stable--and there is a stable examiner in charge, we send specialists from institution to institution, which allows a horizontal review, which allows an assessment of best practices. So whether it is modeling, whether it is pricing, whether it is risk factors, we do not silo the examination approach. And that is very helpful in addressing these kind of issues. That is number one. Number two, we look to the outside parties, so whether it is the external auditors, whether it is the external accountants, we work with them on models, because they also bring a similar expertise of looking horizontally across a number of institutions for best practices in a number of areas. And then, number three, like Erik said, we look at the corporate governance of the institution itself; how is it structured, how robust is the risk management committee, how robust is the audit committee as part of the board, how are the reporting lines handled. Each of those three areas, I think, allows us to very independently assess and judge whether it is the risk models or other factors. Senator Reed. Having listened to that, it is, I think, very insightful, and it seems to be a great approach. It just does not seem to have worked in the case of some of the institutions that you regulated. What would you point--that was not the approach that was being used in 2004, 2005, and 2006? Or it was an approach, but something else undermined it? " FOMC20080805meeting--31 29,MR. WILCOX.," Thank you, Mr. Chairman. In putting together the economic outlook for the current Greenbook, we confronted three main changes in circumstances relative to the situation as it stood in June. First, the labor market looked distinctly weaker than we had anticipated. In the employment report that was released in early July, payroll employment declined by more in June than we had been expecting, and the unemployment rate held at 5� percent rather than dropping back as we had anticipated, following the increase of 0.5 percentage point in the previous month. The fraction of the labor force working part time for economic reasons had moved up sharply, and claims for unemployment insurance were trending up. The second major change in circumstance that we confronted was a secondquarter increase in real GDP that apparently continued to outpace our expectations. In last Wednesday's Greenbook, we projected growth at an annual rate of 2.7 percent in the second quarter, 1 percentage point stronger than in the June Greenbook. At that pace, GDP growth would have slightly exceeded our estimate of the rate of growth of potential output. The third major change was a financial sector that looked more hostile to economic activity, on balance, than at the time of the last meeting despite the improvement during the second half of the intermeeting period that Bill Dudley has just described. When we put the Greenbook to bed, the stock market was about 7 percent lower than we had expected as of June, a variety of spreads remained wide or had widened further since the previous Greenbook, and concerns had been heightened about some key institutions. In addition, the latest reading from the Senior Loan Officer Opinion Survey pointed to a remarkably widespread continued tightening of terms and standards for both households and businesses. These three factors--a weaker labor market, apparently stronger aggregate demand, and a more hostile financial environment--did not easily fit together. To resolve the situation, we began by ruling in favor of the profile presented by the labor market and heavily discounting the greater vigor being signaled by the spending indicators. In our judgment, the story being told by the labor market seemed by far the more credible one, what with housing prices continuing to decline at a rapid pace, consumer sentiment dropping into sub-basement levels, energy prices remaining high even after their recent partial reversal, loan officers reporting a pervasive tightening of credit terms and standards, and other measures of financial stress flashing at least amber. Moreover, while quarter-to-quarter discrepancies between GDP and IP are commonplace, the nearly 4 percent drop in manufacturing IP during the second quarter fueled our skepticism that the economy was on a fundamentally sound footing. As you know, for several Greenbooks our GDP projection has been substantially weaker than it would have been if we had kept in line with the advice from our forecasting models. We were motivated to impose this judgmental weakness partly in recognition of the possibility that we might be entering a recession, and recessions are times when spending tends to fall short of the level that would be indicated by the fundamentals. We also were motivated by the restraint that we think financial markets are imposing on real activity and which our models are ill-equipped to capture. In the current projection, we had to modify these assumptions in light of the changed circumstances. In effect, we interpreted the greater-than-expected strength of real GDP during the second quarter as reflecting an error of timing with respect to the judgmental weakness that we had built into the forecast but not a misjudgment about the overall magnitude of that weakness. Implementing that interpretation involved three steps. First, we responded to the unexpected strength in first-half GDP growth by shifting some judgmental weakness into the second half. Second, we deepened the overall amount of restraint that we imposed in light of the less favorable financial climate. Third, we stretched out the period of financial recuperation: Whereas previously we had financial market conditions essentially returning to normal by the middle of next year, in this projection we have the period of recuperation extending into 2010. These adjustments left our projection for real GDP growth 0.1 percentage point lower over the second half of this year and 0.2 lower next year, despite the offsets from lower oil prices and a slightly greater dose of fiscal stimulus, reflecting the introduction of extended unemployment insurance benefits. For the most part, the avalanche of information that we received since putting out the Greenbook last Wednesday has corroborated our projection. This year's revision of the national income and product accounts threw us no real curve balls. (Sorry for the baseball analogy.) [Laughter] The growth of real GDP was revised down by an average of 0.2 percentage point per year. The revisions to the PCE price indexes, both core and total, were very slight. While the BEA has given us some homework to do between now and the September meeting in folding these data into our thinking, any adjustments that we might be prompted to make, including to the supply side of our forecast, are likely to be slight. On the face of it, the advance estimate of real GDP growth in the second quarter of this year seemed to hold a bigger surprise. The BEA's estimate, at 1.9 percent, came in � percentage point below our estimate in the Greenbook. However, as best as we can tell--based on still-incomplete information--the miss was attributable to lower estimates by the BEA of farm inventory investment and of value added in the trading of used motor vehicles. Our preliminary reading is that neither of these errors carries any signal for the forward momentum of the economy moving into the second half of the year. Friday's employment report was likewise mercifully well behaved-- at least in the narrow sense of conforming to our expectation. Private payroll employment declined an estimated 76,000 in July; together with small downward revisions to May and June, that left the level of employment in July very close to our forecast. In addition, the unemployment rate came in only a few basis points higher than we had expected. The only real news since Greenbook publication came from the motor vehicle manufacturers. On Friday, they reported that sales of light vehicles in July were at an annual pace of 12.5 million units, much weaker than our already weak forecast of 13.3 million units. Moreover, they knocked their assembly schedules for the third quarter down from 9.4 million units to 8.9 million units. Taking their schedules on board would slice another � percentage point from our estimate of GDP growth in the third quarter. The manufacturers have already announced increases in incentives, but it remains to be seen how vigorously consumers will respond in the current environment and how great the financial wherewithal of the manufacturers will prove to be to sustain such moves. In any event, the drop in sales and production is certainly large enough to give renewed urgency to the question as to whether a broader retrenchment in spending might be in train. Turning to the inflation side of the projection, our forecast for core PCE prices over the remainder of this year is nearly unchanged from the June Greenbook. We still have core inflation stepping up from a little more than 2 percent during the first half of this year to a little more than 2� percent in the second half, as the surge in prices for imports, energy, and other commodities passes through to retail prices and as some components that saw unusually low readings earlier in the year accelerate to a more normal rate of increase. Next year, with the pressures from import, energy, and commodity prices diminishing and with slack in resource utilization becoming a little greater, we have core inflation dropping back to 2� percent. The projection for next year is also the same as in the June Greenbook, as the influences from lower energy prices and slightly greater economic slack are roughly offset by the passthrough of higher import prices. The more dramatic changes in our inflation outlook came in the noncore pieces. Not surprisingly, the plunge in oil prices since the June meeting caused us to whack our forecast for retail energy price inflation over the second half of this year. For next year, however, we marked up PCE energy price inflation a little, partly because natural gas futures prices have a more positive tilt than they did before and partly because gasoline margins will still have some recovering to do. At the same time, we have become more pessimistic about the outlook for food price inflation. The CPI for food in June came in at 0.8 percent, much higher than our forecast of 0.3 percent. Because we have mostly been surprised to the upside thus far this year, we decided to move closer to our food price model, which has been calling for larger increases than we were previously willing to write down. The net result, as you saw in the Greenbook, is an outlook with faster food price inflation despite the fact that futures curves for both livestock and crops have moved down since the last meeting. All told, we now have headline PCE inflation running at an average annual pace of 3� percent over the second half of this year, nearly 1 percentage point slower than in the June Greenbook. For next year, we have marked up total PCE inflation by a few tenths in light of our reassessment of the food price situation and the slightly greater rise in energy prices that we now see next year. With regard to the risks in the outlook, my sense is that the downside risks to economic activity have increased since the time of the June Greenbook. That view is informed by two main factors: First, while we have factored the more unsettled nature of the financial environment into our baseline outlook, the situation seems more fragile than before, and the implications for real activity of a sharp deterioration in financial conditions could be quite large. The first alternative scenario that we presented in the Greenbook--entitled ""severe financial stress""--updates our periodic attempt to assemble an integrated macroeconomic and financial scenario. Second, the deterioration in the motor vehicles sector now, to my eye, more convincingly takes on the profile of what we usually see in the course of a typical recession. During the intermeeting period, we will be on high alert for evidence suggesting that the weakness in vehicle sales is a harbinger of a broader shortfall in consumer spending. As for inflation, the upside risks have, in my view, diminished somewhat. Again, two factors inform this assessment. First, the downtick in the long-term inflation expectations measured in the Reuters/Michigan survey is somewhat reassuring. Second, the drop in oil prices is a welcome relief from the steady drumbeat of bad news from that sector and suggests a somewhat diminished probability that persistently high topline inflation will be reflected in a more serious erosion of household expectations, with all the adverse implications for monetary policy that would entail. To be sure, even with those favorable developments, upside risks remain. We illustrated one such risk in the scenario entitled ""inflationary spiral,"" in which we posited an initial shock to inflation expectations of 50 basis points followed by an adverse feedback loop that causes actual and expected inflation to chase each other up nearly 1 percentage point above baseline. Monetary policy eventually brings the process under control but only over a lengthy period of time, partly because the rule that we use in the simulations has policy responding to actual but not to expected inflation. Steve Kamin will now continue our presentation. " FOMC20080625meeting--166 164,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. I just want to say at the beginning that I think the way you framed your remarks yesterday had perfect pitch and balance, and it is really important that we not get ahead of ourselves in taking too much comfort from the fact that the first half was not as bad as we thought and think that the risks on the growth front are definitively behind us. The improvement in financial markets that many of you spoke of is not as significant as we think or hope; we have had a lot of false dawns over this period. A lot of what you see as improvement is the simple result of the existence of our facilities in the implied sense that people infer from our actions that we are going to protect people from a level of distress that we probably have no desire, will, or ability to actually do. It is sort of like waking up in the hospital and having them say, ""You are not dead yet, but we are not sure you're going to live."" It is not as good an improvement, and there has been a material erosion over the past four weeks. It is very unlikely that you will have a substantial improvement in overall confidence in markets, a durable improvement in market functioning, and a substantial reduction in those spreads until there is more clarity about the likely path of the economy going forward, house prices in particular, and therefore the cash flows associated with the huge amount of credit that was extended over the past five years. Again, it is going to be very hard for us to have a better feel for the balance of risks on growth front and the financial sector until we think we see signs ahead of some significant deceleration in the rate of decline of housing prices, if not some actual bottom. On the basis of everything we know, that is still several quarters ahead. Maybe it is going to surprise us on the upside and maybe we are going to see a big improvement in housing demand, but I think that the sense of a bottom looks to be several quarters ahead of us still. I would say that the risks are still acute. Sure, the markets are a little more confident that we are going to successfully avoid a systemic financial crisis, but I wouldn't take too much comfort from that. I think it is also plausible that oil will be at $150 or $200 over the next six months or so. There is some material probability that the set of challenges on that front is going to get worse. So all that is just in favor of a fair amount of care and caution now, given the scale of the uncertainty out there and how fat the tail risks are on both sides of our mandate going forward. I like, and fully support, the language in alternative B. I would not--as you might sense from my comments--take out the word ""considerable"" from the characterization of stress. I am pretty comfortable with the framework laid out here, and, more important, Mr. Chairman, with the broad balance and strategy that you outlined yesterday. " FOMC20060920meeting--131 129,MS. PIANALTO.," Thank you, Mr. Chairman. Since our last meeting, I made a special effort to talk with my directors and business contacts about two topics—developments in housing markets and inflation. My District has been growing at a slower pace than most other parts of the country; consequently, housing prices in the District never appreciated as much as those in the hot markets in the country. Nonetheless, a major Realtor in our region told me that houses in his market, which includes the northern half of Ohio and the western half of Pennsylvania, are taking longer to sell and that the average price of houses sold from January to August is down about 2 percent compared with the same period last year. His view is that nationally the housing market still has a way to go before conditions stabilize. Nevertheless, right now he sees only a limited possibility that the adjustment process will cause serious harm to the U.S. economy. Apparently people are not leaving much to chance. I heard a report yesterday morning that sales at religious stores for statues of St. Joseph have been soaring. [Laughter] It seems as though people who are trying to sell their homes are buying statues of St. Joseph because he’s the patron saint of real estate, and they’re burying him next to the “For Sale” sign. Unfortunately, there is no patron saint for central bankers. [Laughter] Some forecasters, like the Greenbook, are expecting strength in the commercial construction sector to offset much of the weakness in residential building. One of my directors, who represents a large national commercial construction firm, has indicated that commercial building in the past few years has been boosted by the growth of health and education sectors. His entire book of business increased 10 percent in real terms this year compared with last, and he is looking to next year to have the book of business increase 3 to 4 percent. However, he is expecting it to be flat in 2008, and his story squares with what I am hearing from bankers as well—namely, that the flow of commercial loans in the pipeline, although not rapidly falling off, is slowing, and it hasn’t been building as it was. The Greenbook baseline captures very well the pattern that I’ve been describing in its projection for nonresidential investment over the next few years. Now, turning to inflation, the two CPI reports that we received during this intermeeting period have not provided me with enough evidence that inflationary pressures have meaningfully diminished. The reports, however, have encouraged me to think that the forward momentum has been broken, but I’d like to see the next few CPI numbers be at least as good as those for July and August, if not better, to be convinced that that momentum has been broken. I’ve heard some hopeful comments regarding inflation in the past few weeks from several of my directors. Just a few months ago they were indicating that elevated energy prices and material prices had provided them with an opportunity to get more-generalized price increases, and they had wondered whether that was going to be a one-time catch-up opportunity or whether it would be persistent. Now it appears to have been a one-time opportunity, which is passing or has passed. Several of my directors reported last week that they have resorted to unbundling their prices to cope with the rising prices of energy and material costs. On their invoices, they are breaking out the price increases that are due to the increased cost of steel, copper, energy, and shipping in order to pass them on. Apparently, their customers are willing to accept price increases that are due to those increased energy and material costs. But the expectation on the part of both buyers and sellers is that, as energy and material costs dissipate, the ability to pass on price increases will be removed. Several of my directors said that they are not planning any price increases for the next year and that they suspect their commodity costs will be lower than they were this year as well. As others have mentioned, there has been some interest in the elevated unit labor costs in the second-quarter productivity and cost reports. As Dave noted, the compensation growth underlying unit labor costs was boosted when the BLS took on board the first-quarter unemployment insurance tax records. There is some suspicion that the dramatic increase in compensation had a lot to do with stock options and incentive pay, but the underlying data are not available yet, so we don’t know for sure. My staff was able to get some summary figures for Ohio. Compensation has been growing steadily in Ohio over the past several years, but the preliminary figures are flat for the first quarter of 2006. However, there was double-digit growth in three sectors—management of companies, finance and insurance, and utilities. These sectors are often the ones that show substantial growth in the first quarters because they pay out stock options and that’s often when those stock options are realized. So at least in my District there is no evidence of any broad-based acceleration in compensation, and I tend to agree with the staff’s view that it’s too early to incorporate those higher unit labor costs into the inflation outlook. At our last meeting, I expressed the opinion that whatever weakness we would see in GDP was more likely to reflect demand factors than supply factors, and therefore I saw risks to both our objectives. The current Greenbook baseline projection for GDP is even lower than it was at the time of our last meeting because of revisions, as Dave mentioned, to both supply and demand factors. I still think that, if the Greenbook projection comes true, softer demand is likely to be the more dominant explanation. Nevertheless, I would like to see further evidence that inflationary pressures have been checked, if not actually reversed, before I would conclude that the risks to our objectives are evenly balanced. Thank you, Mr. Chairman." FOMC20080625meeting--86 84,MR. EVANS.," Thank you, Mr. Chairman. Most of my contacts continued to report sluggish domestic demand, and they are not currently seeing any improvement in activity. In addition, their comments often focused on the substantially higher costs that they are facing for a wide range of nonlabor inputs. With regard to business activity, much of what we heard about the District and the national economy was a rehashing of preexisting developments. At our last meeting, we felt that there was substantial risk of a further softening in second-quarter growth, so the absence of new news is a positive development. With regard to specific sectors, exporters I have talked with continue to thrive, and steel producers are doing quite well. But any business associated with housing markets is very weak, and the motor vehicle outlook continues to worsen. All Detroit Three CEOs are expecting light vehicle sales to be less than 15 million units in 2008. The Seventh District has experienced substantial flooding in recent weeks, particularly in Iowa. We have been in contact with state officials and numerous businesses. The corn and soybean crops have experienced significant losses, though the range of estimates is wide. Higher estimates for lost corn output in Iowa are about 10 percent. That substantial loss would represent a national crop loss of just about 2 percent. In addition, although there have been transportation disruptions, especially on the Mississippi, our contacts expect these to be short-lived. So overall, our sense is that the economic damage seems to be relatively contained, especially in comparison with the floods in 1993, which hit a much wider geographic area and affected activity for a longer period of time. Turning to the national picture, the incoming data regarding growth generally have been positive. Indeed, the string of upward quarterly forecast revisions continues. In particular, I have been impressed by how much second-quarter GDP growth forecasts have moved up. This is not to say that we are out of the woods. Clearly, the continued difficulties in the housing and credit markets as well as the unrelenting increases in energy prices pose important downside risks to activity. Our Chicago Fed national activity index continues to be in territory I would characterize as a recession--the three-month moving average is minus 1.08 this past month. Still, the risk of the adverse feedback loop that concerned us so much clearly seems less likely today. Importantly, the financial situation seems better. Though conditions are still far from normal, institutions have had time to cope with bad portfolios, much as President Bullard mentioned. They have made significant progress in raising capital and have increased provisions against losses. I think our lending facilities have helped financial institutions gain time to facilitate the adjustment process. It seems well beyond our abilities, however, to engineer a return to ""normal financial conditions,"" given the extent of financial losses and overbuilding in housing. With regard to our economic projections, we expect growth this quarter to be similar to the Greenbook; but unlike the Greenbook, we are looking for the momentum to carry forward to a better second half of the year. Beyond this year, we think growth will run near potential. This is based on a fed funds rate path close to that in the futures markets. We are assuming a fed funds rate of 2� percent by the fourth quarter and 3� percent by the end of 2009. Turning to inflation, a number of factors present a concern for inflation expectations and our ability to bring inflation down. As I mentioned, my contacts spent a good deal of time talking about materials cost pressures, and many around the table have talked about those as well. Many manufacturers were citing large increases in energy and most commodity prices, and everyone was passing along some portion of these cost increases. I have one anecdote on this: In retail, Crate&Barrel reported on recent buyers' trips to Asia, saying that prices for items purchased there would be 15 to 20 percent higher for next year. Finally, wage pressures have been subdued thus far. Still, econometric analysis by my staff reminded me that wage inflation tends to follow price inflation not the other way around. So by the time we see wage pressures, either we are not behind the curve now, or it is ""Katie, bar the door!"" It is probably one or the other. [Laughter] Indeed, I am concerned that large and persistent changes in costs and in relative prices of high-profile items, such as energy, could change the inflationary mindset of businesses and households. The resulting increase in inflation expectations would pose a difficult challenge for monetary policy. Maybe it will end up being okay; maybe surveys will be right. But it is a big risk, and that risk is a bit large for my comfort. Looking ahead, we all see the substantial upside risk to price stability posed by the passthrough of higher costs and any possible increase in inflation expectations. While I hope I am wrong, I feel that we may need to accept a somewhat longer period of resource slack than we would like in order to address these risks and put inflation more firmly on a downward trajectory. Under our projection for GDP growth, the economy does not close the modest resource gaps we project will be in place at the end of 2008 until beyond the forecast horizon. Along with a flattening in energy and other commodity prices, such gaps should be sufficient to contain inflation expectations and bring overall PCE inflation near 2 percent in 2009 and 2010. That is our expectation. But my base case does not have inflation moving below 2 percent until after 2010, and that is even with more aggressive policy tightening than the Greenbook path. Now, turning to the long-term projections, I think that our forecasts for 2010--or at least the way that I think about it--do suffer from some difficulties. We would like to mention in the write-up that, at the end of the period, the range is between 1� percent and 2 percent, and we can infer policymakers' preferences from that. That is one interpretation. Given the inflationary pressures, that is harder and harder for many people to come up with. I think in some cases it requires a monetary policy response that is beyond what most people would expect that we could actually do. So I don't try to force my inflation forecast into my preferred range if it is too hard. Based upon monetary policy, it is more medium term. So I do tend to favor a longer period. I am somewhat indifferent between the first and the second options. I don't really see a lot of difference, but something that has a five-year forecast I think is useful. Whether or not it has the fourth year and whether or not it is core PCE or total are less important issues. One argument for this is an interesting body of research, which I have been exposed to only at conferences--and Jim probably knows it better than most--on learning and whether individuals in the economy can learn these rules without a variety of information. Some of the better papers that I have seen on that remind us that you need more pieces of information than just what the target is, whether it be 1� percent or 2 percent. You need some type of contour when people are learning with simplistic learning rules, like least squares learning. So I think a bit more contour on the forecast would be helpful. In my mind, that pushes you toward the five years of forecasting as opposed to a steady state or a five-to-ten-year forecast. I think that's an important element. On the trial run, I think we could do it sooner than that, but I know a lot of staff resources are involved. So I favor sooner rather than later. Thank you. " FOMC20060328meeting--225 223,MR. KOHN.," Thank you, Mr. Chairman. I think we’re getting to the difficult but interesting part of this tightening cycle. It’s always very difficult to be preemptive and forward looking. And with rates having risen to where they are, it’s getting harder. Reacting to the most recent data does risk overshooting, and I think those Taylor rule simulations, the equilibrium funds rate calculations, and alternative B suggest we already have, or are soon to have, a small degree of restraint in the system. Despite all this, I support raising the funds rate 25 basis points this meeting, and indicating, as in alternative B, that we may have to go further. I have a number of reasons for leaning on the side of such tightening. Resource utilization is high. We don’t know the NAIRU. It could be lower, due to changes in labor market structure or foreign competition. But I think we’re in a zone where we need to be very, very cautious about significant further increases in resource utilization. And I think we need to be presumptive in our policy that we’re damping that down. Unless we see evidence that it’s okay, unless we see evidence that prices are softening, and unless we see evidence that unit labor costs are particularly well behaved and there isn’t some inflation risk, I think our presumption must be that we need to get this economy slowed to a more sustainable pace. And I agree with your assessment, Mr. Chairman, of the strength of demand. I think without further policy increases we do risk rising resource utilization. There is still considerable strength in final demand. Some of this could be weather related. Some of it could be a catch-up from the fourth quarter. Undoubtedly it is, but we don’t know how much. And I think the underlying sense is that demand is strong. What little high-frequency data we have, such as the initial claims for unemployment insurance, suggest that the labor market continues to move right along into early March. I think that stopping now or indicating that the next move would be the last would cause a rally in financial markets, and we’d be concerned that financial conditions would no longer be consistent with better assurance that the economy is going to glide in here at high levels of resource utilization rather than further increases in resource utilization. In leaning toward restraint, I also give a little weight to the overall price increases. We’ve seen several years of rapid price increases in the overall CPI. There is the issue that President Lacker raised yesterday of these propagating through to core inflation through expectations. But it is also not entirely clear to me that the core index is the be-all and end-all for public welfare when the real price of energy has risen. And ignoring total inflation entirely I’m not sure is the right thing to do, if energy prices aren’t going to return to a real mean. So I give a little weight to total inflation being higher. Now, I haven’t bought into the comfort zone mantra, at least not yet. [Laughter] And I must say I’m a little bothered by the notion that we’re in the high end of the 1 to 2 percent comfort zone when at least three-tenths of that is these nonmarket price increases that grow out of estimations by the BEA. I’m told that our staff can’t even replicate their estimating procedure. So quite how much public welfare I want to rest on nonreplicable price calculations, I’m not sure. I think the market-based PCE is at 1½. We need to think very carefully about what index we might use if we do go to a comfort zone or a target kind of range. But at this stage of the cycle, given the strength in demand and high-level resource utilization, I’m convinced we should lean hard against any potential increases in inflation. And I’m mindful that, because inflation expectations are anchored, the Phillips curve is flat and it will take a while to see inflationary consequences once they start. I think that, before we stop tightening, we’d want to see a little more evidence that conditions were in place to cool demand. On the wording of the directive itself, I think that we are moving into a stage at which we’ll need a few more words to explain why we’re doing what we’re doing. For the last couple of years, the focus has been entirely on the balance-of-risk assessment and the fact that we’ve announced our rate increases and what we’re going to do, and people haven’t paid much attention to the rationale paragraph. Through this period, policy has been data-dependent to some extent. But, as we have all said in our speeches, we are becoming more data-dependent. And as we become more data-dependent, it behooves us to explain to the public what data we’re looking at. As we go forward from here, we’ll have to think carefully about how to phrase the rationale paragraph to help the public understand what the most important data are. I expect that importance to change from time to time. With respect to the specific wording under the revised alternative B, I was glad to see the phrase “appears likely to moderate to a more sustainable pace.” I think that captures what nearly everybody around the table was saying yesterday. In terms of productivity gains holding down unit labor costs, I see the inflation process working importantly through the labor market and through labor costs. I agree that compensation should catch up to productivity at some point. But I think we can take a bit of comfort from the relatively modest gains in unit labor costs, even making the corrections the Chairman did. One possible addition to make it more complete would be to say that “ongoing productivity gains and moderate increases in compensation have held the growth of labor costs in check.” And I agree with the use of “possible increases in resource utilization” because I’m not ready to say that 4.8 or 4.9 is below the NAIRU. I think that remains to be seen. And I agree with President Pianalto’s concern that the “may” could cause the markets to build in a little more tightening. Still, these are the words that seem to me to describe very accurately what I think we should be about: A little more tightening after today may be needed. We’re not sure, and the markets will just have to do what the markets do. We do have the minutes coming out in a couple weeks, which would clarify that. Sorry to go on so long." FOMC20050503meeting--58 56,VICE CHAIRMAN GEITHNER.," David, you referred in your remarks to the exercise shown in the package of materials for Monday’s Board briefing. I’m looking at the pass-through into core inflation of the rise in energy prices, import prices, and commodity prices. If back in December ’03, which is your baseline for this exercise, you had had a forecast for energy prices, commodity prices, import prices, and the dollar that is consistent with what happened, would you have expected your model to show this much pass-through to core inflation prices? Or would this result have been surprising?" CHRG-111hhrg63105--152 Mr. Newman," Chairman Boswell, Ranking Member Moran, and Members, thank you for the opportunity to testify before you today. The American Feed Industry Association is the largest organization devoted exclusively to represent the business, legislative, and regulatory interests of the U.S. animal feed industry and its suppliers. AFIA applauds this Subcommittee, its Members, and the full Committee for calling today's hearing. AFIA members manufacture more than 70 percent of the animal feed in the United States, which amounts to over 160 million tons annually. Feed also represents roughly 70 percent of the cost of producing meat, milk, and eggs. With the majority of our industry input supplies priced directly on, or in reference to, regulated commodity markets, we depend significantly on an efficient and well-functioning futures market for both price discovery and also risk management. Agricultural commodity markets were established to provide an efficient price discovery mechanism and a hedging risk management tool for producers and end-users. While this system encourages and requires speculative participants to provide liquidity, the significant increase of financial investors, as well as the special exemptions from speculative position limits that have been granted over time to Wall Street banks and others who are not end-users, has distorted the function of these markets. The agriculture commodity markets functioned effectively for over 60 years after the 1936 Commodity Exchange Act first implemented speculative position limits. However, this changed in 2000 when Congress codified earlier CFTC regulatory actions granting Wall Street banks and other financial institutions an exemption from speculative position limits for hedging over-the-counter swaps and index transactions. While there are several factors that have led to increased volatility and price swings in agricultural commodities, excess speculation by index funds is certainly one of these factors. As you are aware, the size and influence of these large financial players was never contemplated during the development of the original Commodity Exchange Act. Most of the index speculators tend to hold their positions rather than sell. This allows them to create artificial demands through their long-only positions and in essence really are bets on higher prices. The magnitude of this scenario is clear in the numbers. In 2003, index speculator investment in 25 physical commodities was $13 billion. In 2008, these investments jumped to $260 billion, an 1,800 percent increase in 5 years. In 2010, these investments remain at $265 billion, with three index funds representing 94 percent of that amount and one fund representing 52 percent of those investments. Earlier this year, we applauded the work by Congress to include provisions in the Act that would authorize CFTC to set reportable position limits on commodity contracts, as well as for aggregate and exchange-specific position limits. Within this process, AFIA members support the following items: First, speculative position limits that enhance market performance and the appropriate narrowing of cash and futures market values as they near contract delivery period; the retention and equal application of the existing speculative position limits for agricultural commodities; retaining the current bona fide hedge definition which is in place; the removal of speculative position limit exemptions for financial institutions and other nontraditional participants in agricultural commodity markets. While CFTC now has this authority, without removing these exemptions the speculative position limits will have a much more limited effect when they are put in place. Given the strong relationship between crude oil and corn futures markets brought on by the dramatic and rapid expansion of the ethanol industry, establishing and enforcing energy speculative position limits is also important to secure the reliability of the entire agricultural commodity complex. We support effective speculative position limits that work for both the bona fide hedger and the speculator. However, there is rarely a perfect solution to complex issues and waiting for a perfect solution before setting speculative position limits or taking other actions will only delay that much-needed transparency and controls required in these commodity markets. Therefore, we support implementation of interim limits where data is available and which can also be adjusted by CFTC with further data to confirm and support those changes. I would be remiss if I didn't express AFIA's appreciation to Chairman Gensler, Commissioner Chilton, and the other CFTC Commissioners for their extensive outreach during this entire process. Thank you for inviting me to participate in today's hearing. AFIA and its members stand ready to assist you in these efforts. I look forward to any questions. [The prepared statement of Mr. Newman follows:]Prepared Statement of Joel G. Newman, President and CEO, American Feed Industry Association, Arlington, VA Chairman Boswell, Ranking Member Moran and Members, thank you for the opportunity to testify before General Farm Commodities and Risk Management Subcommittee as you review implementation of provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 relating to speculation limits. I am Joel Newman, President and Chief Executive Officer of the American Feed Industry Association (AFIA), based in Arlington, Virginia. AFIA is the world's largest organization devoted exclusively to representing the business, legislative and regulatory interests of the U.S. animal feed industry and its suppliers. Founded in 1909, AFIA is also the recognized leader on international industry developments with more than 500 domestic and international members, as well as nearly 40 state, regional and national association members. Our members are livestock feed and pet food manufacturers, integrators, pharmaceutical companies, ingredient suppliers, equipment manufacturers and companies that provide support services to the industry. AFIA members manufacture more than 70% of the animal feed in the U.S., which amounts to over 160 million tons annually. Because feed represents roughly 70% of the cost of producing meat, milk and eggs, AFIA members are major contributors to food safety, nutrition and the environment, playing a critical role in the production of healthy, wholesome meat, poultry, milk, fish, eggs and pets. AFIA is a member of the Commodity Markets Oversight Coalition, which was formed in 2007, and is a broad coalition of organizations committed to protecting the interests of bona fide hedgers and derivatives end-users. We thank the Subcommittee for including Jim Collura in this hearing to speak on behalf of CMOC. His leadership has been invaluable to the Coalition. Your review of implementation of the Dodd-Frank Act by the Commodity Futures Trading Commission (CFTC) is both timely and appreciated by the men and women of the feed industry. As I have stated, feed represents approximately 70% of the on-farm cost of raising livestock and poultry. With the majority of our industry's input supplies priced directly on or in reference to regulated commodity markets, we depend significantly on an efficient and well-functioning futures market for both price discovery and risk management. Agriculture commodity markets were established to provide an efficient price discovery mechanism and a hedging/risk management tool for producers and end-users. While this system encourages and requires speculative participants to provide liquidity, the significant increase of financial investors, permitted by special exemption from speculative position limits, has distorted the function of these markets. Speculators are an important part of the commodity markets--without them there is no market. The agriculture commodity markets functioned effectively for 64 years after the 1936 Commodity Exchange Act first implemented speculative position limits. With these limits in place, the process of physical commodity customers using the futures markets as a price discovery and risk mitigation tool were able to rely on traditional speculator participation to provide a clear buyer/seller relationship and market liquidity. However, this changed in 2000, when Congress codified earlier CFTC regulatory actions granting Wall Street banks an exemption from speculative position limits for hedging over-the-counter swaps and index transactions. While there are several factors that have lead to increased volatility and price swings of agriculture commodities, excessive speculation by index funds is certainly one of these factors. As CFTC has recognized, speculator participation in these markets without position limits does have an impact on prices. These banks, which represent institutional investors, used the guise of ``hedging'' their invested capital to take advantage of the exemption. But in fact, their initial investments were speculative and were not hedging future needs or commitments for the underlying commodities. AFIA strongly supported ending this exemption, and we were very pleased when Congress took steps to address our concerns. Over the past few years, as the volatility and instability in the stock and financial markets exploded, speculative activity in the agricultural commodity futures markets grew substantially. In some crop contracts, there were times when the daily speculator trading volume was nearly equal to, or in the case of wheat, was more than the entire U.S. annual production volume of these same crops. This not only added to extreme price volatility as bona fide hedgers scrambled to mitigate their risks, but in many cases it pushed end-users out of the market. In at least one situation, this speculator activity pushed an organization into bankruptcy when the impact of margin calls caused by the extreme price run-ups drained the company's liquidity to unsustainable levels. As you are aware, from the Committee's analysis, when considering reforms for the futures markets and products, the size and influence of these very large financial players was never contemplated during development of the original Commodity Exchange Act (CEA). The recent dramatic increases in nearly all physical commodities values actually increased speculator demand, with the net result of commodity prices reaching unrealistic levels relative to true demand. Most of the index speculators tended to hold their positions rather than sell, which exacerbated the situation by producing artificially high demand accompanied by higher prices that negatively impacted nearly all end-users of the physical commodities. The magnitude of this scenario is clear in the numbers: In 2003, index speculator investment in 25 physical commodities was $13 billion; in 2008, these investments jumped to $260 billion--an 1,800% increase. In 2010, these investments remain at $180 billion, with three index funds representing 92% of these investments and one fund representing 61% of these investments. (Illustration 2) As a result, the feed industry was forced to pay higher prices for grains and other inputs, which were passed along to livestock, dairy and poultry producers and feed costs soared. Farmers, although receiving substantially higher prices for their commodities, were also hit by soaring costs for fertilizer and fuel, as similar speculator activities artificially further drove up oil prices. Simply put, agriculture, from farm to retail, had to deal with extreme price volatility on a number of fronts without the effective support of our primary risk mitigation tool--the futures markets--because those markets were severely compromised by Wall Street banks ability to avoid speculative position limits and invest substantial levels of monies in the physical commodity markets. This not only allowed them to avoid the volatility of the dust storm on Wall Street, it provided them a significant return on those speculative ``hedges'' because of their ability to influence the escalation of market prices by creating artificial demand. Earlier this year, we applauded the work by Congress to include provisions in the Act that would authorize the CFTC to set position limits on commodity contracts, as well as for aggregate and exchange specific position limits. Also, when commenting on CFTC's proposed position limits for energy contracts in March of this year, AFIA encouraged the Commission to consider such actions for other hard commodities to similarly protect agricultural commodities from the very large financial speculators that were masquerading as hedgers, parking their resources in physical commodity markets to ride out the extreme volatility then present in the stock and financial markets. By including clear authority for the CFTC to set a variety of reportable position limits, Congress took a solid and welcomed step toward our mutual goal of ensuring these commodity markets and products effectively serve their primary role of providing bona fide commercial hedgers reliable tools to manage their economic risks. With the expanded authority in place relative to speculation limits, AFIA is anxiously waiting for the CFTC to finalize its regulations and to put speculative limits into effect. We know this will take time and are hopeful the combination of the various categories of speculation position limits, combined with full implementation of the Act's other provisions, such as enhanced transparency and expanded regulation of nearly all derivatives, will assure bona fide hedgers of the viability of their futures-based risk management strategies. I would be remiss if I did not extend AFIA's appreciation to Chairman Gary Gensler and his fellow CFTC Commissioners for their openness and diligence in addressing our concerns, particularly during the time Congress was developing its package of reforms. Through frequent meetings, they provided frank and candid overviews of their established authorities. When Congress was deliberating its reform legislation, the CFTC team also provided regular updates on progress toward the reform goals we and others were supporting. Just as important, they helped us understand how certain provisions in the Act addressed our concerns while approaching them in a different manner than we had proposed. Importantly, the CFTC has been aggressive in its outreach over the past few months as it works to implement the Act. Like most supporters of reform in the futures industry, particularly as it relates to the topic of this hearing, AFIA would very much like to have speculation position limits set and in place today, as well the additional regulatory and transparency provisions. But we need the CFTC to ensure that when it sets limits, they also are ready to monitor and report trading activity, and ready to ensure compliance with and enforcement of the new law. It is critical for all bona fide end-users to know we are on a level playing field with speculators and each other. Modern production agriculture is complex. The linkages between producers, end-users and uses of physical commodities are constantly evolving. The feed industry, for example, is still adjusting to the dramatic and rapid expansion of ethanol and other bioenergy industries. The intersection of corn, soybeans and other oilseeds for feed, food and energy--not mention other industrial uses for these crops--is our new reality, one that poses additional competition and risk management challenges for each of our respective industry sectors. This has also had the effect of linking corn futures to crude oil futures, adding further volatility to the entire commodity complex. We are confident the CFTC is prudently moving as efficiently as it can to implement the speculative limits and other provisions of the Dodd-Frank Act under its existing and new authorities while making sure it clearly and fully understands the complexities of the derivatives markets. While being patient with the rulemaking process does produce certain levels of stress, we remain confident in and appreciative of the CFTC's efforts to date, and hope to remain so. This brings me back to the beginning of my testimony. AFIA again applauds the Subcommittee, its Members and the full Committee for calling today's hearing to check in on the CFTC's progress on speculation limits. Your individual and collective interest in making sure progress toward implementation is both steady and correct does a great deal to reduce stress levels among AFIA's members. I urge you to consider additional hearings on the Commission's progress toward implementing all provisions of the Act. Thank you for inviting me to participate in today's hearing. AFIA and its members stand ready to assist you in these efforts. I look forward to answering any questions you may have. Attachment Marshall [presiding.] Thank you, Mr. Newman.Mr. Sprecher. CHRG-111hhrg51698--459 Mr. Concannon," Thank you, Chairman Peterson, Ranking Member Lucas, and other Members of the Committee, for the invitation to speak today on this important legislation. You may be wondering why NASDAQ OMX, the operator of the largest equities exchange in the world, is testifying on OTC derivatives. Well, we currently own and operate 17 markets and eight clearinghouses in trade equities, fixed income, derivatives, and energy products around the globe. While I must admit that we have some self-interest in the reform of OTC derivatives, our interest is the product of almost 4 decades of experience in delivering efficient and transparent markets to investors. Over the past several years, trillions of dollars of investment instruments have been crafted through an unregulated web of interconnected counterparty relationships. Because these instruments are not valued in a transparent, efficient market with the opportunity for centralized clearing, unrecognized risk continues to be piled upon unrecognized risk. We at NASDAQ are confident of the beneficial effects of centralized clearing, transparency, and regulation for the OTC markets. It is possible to transform an OTC market to one that is centrally cleared and visible to all. We have done it. When NASDAQ was founded 37 years ago, our primary mission was to bring order, discipline, and fairness to the over-the-counter equities market. What we know from our experience is simple yet revolutionary for this market. These OTC instruments need to be centrally cleared to better distribute or mutualize the risk. Central clearing fundamentally means more parties are backing a transaction versus one or just a few. NASDAQ OMX recently became the majority owner of the International Derivatives Clearing Group, IDCG, a CFTC-registered clearing organization. IDCG has developed an integrated derivatives trading and clearing platform that will allow members to convert their OTC interest rate swaps into a cleared future product with the full benefits of centralized clearing. Building on decades of experience, NASDAQ OMX is bringing the values of organized markets, including central clearing, standardized margin, transparency, and real valuations, to what is a $458 trillion interest rate swap market. While there has been much discussion around the CDS market, you should be aware that the interest rate swap market is six times larger. IDCG is live today, operating a highly efficient market to clear and settle U.S. dollar-denominated interest rate swaps. I must commend the CFTC for its thorough review and professional timeliness in approving IDCG's operation December of last year. Thus, NASDAQ OMX is highly supportive of provisions in section 13 of your legislation that would protect our financial system and investors by requiring most OTC derivatives to be settled and cleared. In addition, we support the need to set some limited exemptions for derivatives that may contain complex contractual aspects rendering them inappropriate for clearing. Let me highlight one benefit of central clearing of interest rate swaps within the banking system. Current regulatory capital treatment for derivatives applies a higher capital charge for bilateral uncleared holdings. Simply, under accounting rules and international treaties such as BASEL I and BASEL II, bilateral trading of OTC derivatives introduces systemic risk while creating an extremely inefficient use of capital. We believe the entire financial system would benefit from a large capital infusion as a result of simply mandating centralized clearing. Capital efficiency is also greatly enhanced by the process of netting. With central clearing, financial institutions can net out their positions across the entire market and further reduce their required capital reserves, while at the same time reducing the complexity and risk of the bilateral world. We also support the efforts by the Federal Reserve, the FDIC, and the Office of Comptroller to evaluate the need for enhanced regulatory capital charges for non-cleared OTC transactions. We think that customers that use these derivatives should also demand that their transactions be subjected to clearing. According to a recent Bloomberg story, several State Attorneys General are investigating the opaque fees several local governments paid to obtain interest rate and other derivatives to hedge swings in borrowing costs for schools, states, and cities. We know that the larger issues of financial regulatory reform are beginning to receive consideration. We believe that it is important to apply modern regulatory concepts like principle-based regulation, practiced successfully by the CFTC and regulators around the world. Finally, we must be mindful that these OTC instruments ignore international borders. So we agree with President Obama that these issues cannot be handled with domestic action alone. For many reasons, working through multilateral structures like the G20 will ensure that global markets work together in what is a global problem. In this way, we will ensure that regulatory arbitrage is minimized and market participants are not driven to engage in jurisdiction shopping. Again, thank you for the invitation. I am happy to take questions. [The prepared statement of Mr. Concannon follows:] Prepared Statement of Christoper R. Concannon, Executive Vice President, Transaction Services, NASDAQ OMX, New York, NY Thank you Chairman Peterson and Ranking Member Lucas for the invitation to speak to you this morning regarding your legislation, the Derivatives Markets Transparency and Accountability Act of 2009. Some of you may be wondering why NASDAQ OMX, the operator of the world's largest cash equities exchange, is testifying regarding OTC derivatives. Well, NASDAQ OMX owns and operates 17 markets and eight clearing houses around the globe. Our markets trade equities, derivatives and fixed income products. Not only do we pride ourselves in operating our markets efficiently, but we are exceptionally proud of the efficiencies that we have delivered to these markets. In regards to OTC derivatives, I will admit that we have self interest in the reform of these markets. But this self interest is the product of almost 4 decades of experience in delivering efficiency and transparency to the financial markets. When we examine your legislation we see a policy initiative that will bring fundamental change to a market that is defined by counterparty risk, unknown systemic risk and opaque markets. While we continue to deal with the worst financial crisis since World War II, we can't simply wait for it to end before we study and implement needed reforms. Reforms can and should be implemented now. As your legislation recognizes, over the past several years and throughout the economy, trillions of dollars in investment instruments have been crafted through an unregulated web of interconnected, counterparty relationships. Even after all the billions in Federal subsidies, the books of banks and businesses are littered with these complex instruments whose value is opaque and potentially mispriced. These particular credit instruments continue to be traded in what's known as the over-the-counter or OTC market. Because these instruments are not valued in a transparent, efficient market with the opportunity for centralized clearing, unrecognized risk continues to be piled upon unrecognized risk. The negative aspects of the over-the-counter market have been documented well by the hearings of this Committee. There is no need to further expand on those findings. It is now time to implement change both by government action and by the markets themselves. The markets and clearing houses that sit before you today are here to explain how our markets worked throughout this horrible crisis. Very few people can sit before Congress today and explain how their systems discovered prices everyday; how their clearing houses absorbed the impact of major defaults such as Lehman; or how they were able to settle each and every trade. We represent the markets that worked while the OTC markets represent the opaque market that tied these unsuspecting victims into a complex web of financial disaster. The point is--centralized clearing worked as designed and it worked in many asset classes around the globe. We at NASDAQ are confident of the beneficial effects of centralized clearing, transparency and regulation for the OTC markets. NASDAQ made its name by being a pioneer in the over-the-counter cash equities market. Until NASDAQ came on the scene, the cash equities market also once operated similar to the current OTC derivatives market. NASDAQ was born out of a need to share information about stock trading in a central fashion, accessible to all, with a system designed to protect investors and facilitate discovery of the right price for each stock. We continue to operate on a simple principle that is the foundation of all markets: An informed and willing buyer and an informed and willing seller agreeing to trade is the best valid price discovery mechanism. It is possible to transform an over-the-counter market to one that is centrally cleared and visible to all. We have done it; when NASDAQ was founded 37 years ago our primary mission was to bring order, discipline and fairness to the over-the-counter equities market. What we know from our experience is simple, yet revolutionary for this market: These OTC instruments need to be centrally cleared to better distribute or mutualize the risk. Central clearing fundamentally means more parties are backing a transaction versus one or just a few. Centralized clearing gathers strength from more parties while delivering capital efficiency through the benefits of netting multiple risk exposures. Building on the decades of experience, NASDAQ OMX is bringing the values of organized markets including central clearing, standardized margin, transparency, and real valuations to what the Bank for International Settlements estimates is a $458 trillion over-the-counter interest rate swap market. While there has been much discussion about the credit default swap market, you should be aware that the interest rate swap market is six times larger than the credit default swap market. As you may know, NASDAQ OMX recently became the majority owner of the International Derivatives Clearing Group (IDCG). IDCG, an independently operated subsidiary of The NASDAQ OMX Group, has developed an integrated derivatives trading and clearing platform. IDCG is transforming the interest rate swap marketplace, allowing members to convert their OTC swaps into a cleared future product with the full benefits of central clearing. This CFTC approved platform will provide an efficient and transparent venue to trade, clear and settle interest rate swap (IRS) futures. One of the most compelling attributes of our IDCG endeavor is that it allows for all forms of execution. We have the ability to allow customers the flexibility to operate their business as they have, but with an independent and standardized view of the risk. This independence is the absolute core of a centrally cleared market place. By concentrating its focus on risk, IDCG can be open to multiple forms of execution. This flexibility allows for more of the market to participate in an open and consistent manner while all of the risk is marked-to-market by the same benchmark. I must commend the Commodity Futures Trading Commission (CFTC) for its thorough review coupled with professional timeliness in approving the application for IDCG to operate. With CFTC approval of IDCG's Derivatives Clearing Organization (DCO) license on December 22, 2008, IDCG is ``live'' today; operating a highly efficient market to clear and settle U.S. dollar denominated interest rate swap futures. We, along with IDCG, look forward to the day when vast parts of the over-the-counter market are no longer stored in the back-rooms of brokerage houses but are held in well-capitalized clearing houses transparent to all--including the regulators and public policymakers. Thus, NASDAQ OMX is highly supportive of provisions in section 13 of your legislation that would protect our financial system and investors by requiring most OTC derivatives be settled and cleared. We believe this section is good public policy and hope to see it enacted into law. In addition, we support the ability of the CFTC to set some limited exemptions for derivatives that may contain complex contractual aspects rendering them inappropriate for clearing. Let me offer one benefit of clearing in the interest rate swap space that will have an immediate and direct positive impact on the banking system. Current regulatory capital treatment for derivatives held by banks and other financial institutions applies a higher capital charge for bilateral, uncleared, holdings. If existing banks cleared their interest rate swap transactions through a central clearing house, significant capital would be released for the banks to apply to new lending or against other assets. Simply, under the current accounting rules, insolvency laws and international treaties (such as BASEL I & II), the current method of bilateral trading is not only less efficient--it is a more expensive use of capital. We believe the entire financial system would benefit from a capital infusion as a result of mandating centralized clearing. To put it as succinctly as I can, centralized clearing reduces the market, counterparty, and operational risk of a portfolio. In addition, it can also reduce capital requirements that today, unfortunately, are often being supplied with non-performing taxpayer money. Capital efficiency is greatly enhanced in conjunction with another benefit of central clearing: the process of netting. With central clearing, financial institutions can ``net'' out their positions across the entire market and further reduce their required capital reserves while at the same time reducing the complexities and risk of the bilateral world. We also support efforts by the Federal Reserve, the FDIC and the Office of the Comptroller to evaluate the need for enhanced regulatory capital charges for non-cleared OTC transactions. We, at NASDAQ, believe it is critical that all forms of risk are appropriately priced, and that regulatory capital rules provide meaningful incentives to drive OTC derivatives on to central clearing houses. We think that customers that use these derivatives should also demand that their transactions be subjected to clearing. According to a recent Bloomberg story, several State Attorneys General are investigating the opaque fees several local governments paid to obtain interest rate and other derivatives to hedge swings in borrowing costs for schools, states and cities--fees which were more difficult to challenge when neither information about execution pricing nor pricing of risk were publicly available. Certainly, if state and local governments adopted the mandate to only transact cleared products, the trend for clearing would be enhanced. The Bloomberg article is an addendum to my written testimony. We know that the larger issues of financial regulatory reform are beginning to receive consideration by you and your colleagues here in Congress. While we don't have detailed views on regulatory reform, we believe the key concept to keep in mind is to apply modern regulatory concepts like the principles-based approach to regulation practiced successfully by the CFTC and regulators around the world. We hope that the process of updating U.S. regulation will retain the CFTC's principle-based approach and expand that approach throughout our regulatory framework where appropriate. Mr. Chairman, NASDAQ OMX supports your interest in prohibiting over-the-counter trading of carbon offset credit futures. NASDAQ owns a carbon trading facility in Europe called NordPool. NordPool was the pioneer in carbon products--the first exchange worldwide to list carbon allowances (EUA) and carbon credits (CER). And, although NordPool is the number two marketplace for carbon in Europe, 70% of all trading now takes place in the OTC space, away from effective regulation and supervision. Therefore, it is impossible to know the exact volumes that are traded. Our experience in Europe suggest that the opaque use of OTC derivatives in the European Cap and Trade experiment contributed to the chaos and failure of that marketplace. We want NordPool to be part of the U.S. market solution for greenhouse gas emission reductions and look forward to working with you and the Committee towards ensuring that your legislation allows that expertise to be part of the equation. Finally, Mr. Chairman, we must be mindful that these OTC instruments ignore international borders and jurisdictions. So we agree with President Obama that these issues can not be handled only with domestic action. For many reasons, working through multilateral structures like the G20 will ensure that the global markets work together on what is a global problem. In this way we will ensure that regulatory arbitrage is minimized and market participants are not driven to engage in ``jurisdiction shopping.'' We understand that President Obama hopes to make these issues, and a coordinated global response, a key aspect of the G20 meeting in April and NASDAQ OMX supports the President's leadership on this matter. Again, thank you for inviting NASDAQ OMX to testify and for your efforts to bring transparency and order to these important marketplaces. We look forward to working with you and the full Committee membership as you seek to tackle these important public policy challenges. Additional ExhibitCalifornia Probes Muni Derivatives as Deficit Mounts (Update1)By William Selway and Martin Z. Braun[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] The investigations center on the investments that schools, states and cities buy with the proceeds of some of the $400 billion of municipal bonds they sell annually and on the interest-rate swaps designed to guard against swings in borrowing costs, authorities have said. Financial advisers are hired to solicit bids for the investments and to determine if their government clients pay fair rates in swaps, which are unregulated instruments not traded on exchanges. States ``almost have no choice but to join in because it involves their towns and cities and maybe even the states themselves,'' said Christopher ``Kit'' Taylor, the former executive director of the Municipal Securities Rulemaking Board, the municipal bond industry regulator. ``They're sitting there saying this is a situation where we may have been taken.''Continuing Probes Christine Gasparac, a spokeswoman for California Attorney General Jerry Brown, confirmed California's participation. She declined to comment further. The probe comes as the most populous U.S. state and the biggest issuer of municipal debt struggles to close a record $42 billion deficit through next year and faces credit rating cuts on $67 billion of debt. Connecticut has had a continuing probe. ``Our investigation is active and ongoing,'' Connecticut Attorney General Richard Blumenthal said in a statement. Florida Attorney General Bill McCollum has sent out 38 subpoenas asking firms for information on sales of derivatives, including guaranteed investment contracts, where governments place money raised from bond sales until it is needed for projects, said Sandi Copes, a spokeswoman for McCollum. Among the documents Florida requested were bids and communications between the firms and financial advisers related to the purchase or sale of municipal derivatives, according to the subpoena. Copes declined to comment further, citing the pending investigation. U.S. prosecutors and the Securities and Exchange Commission have searched for more than 2 years for evidence of collusion between banks and brokers to overcharge cities, states and local government agencies.Winning Leniency In February 2007, Charlotte, North Carolina-based Bank of America Corp. was granted leniency by the Justice Department for its cooperation in a national investigation of bid-rigging and price fixing involving municipal derivatives. In exchange for voluntarily providing information and offering continuing cooperation, the Justice Department agreed not to bring criminal antitrust charges against the bank. Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as changes in interest rates or the weather. ``This is a trillion-dollar market, and this goes back to the 1980s,'' said Michael D. Hausfeld, an antitrust lawyer representing municipalities, including Fairfax County, Virginia, in a class-action case against 30 banks.Rigged Bids Investigators are looking into whether bidding for guaranteed investment contracts was rigged. U.S. Internal Revenue Service rules require that the agreements be awarded by competitive bidding from at least three banks. Eight California municipalities, including Los Angeles, Fresno and San Diego County, filed civil class-action, or group lawsuits. The suits, most of which were consolidated with others in U.S. District Court in New York City, allege that banks colluded by deliberately losing bids in exchange for winning one in the future, providing so-called courtesy bids, secretly compensating losing bidders and allowing banks to see other bids. Brokers participated in the collusion by facilitating communication among banks and sharing in illegal profits, the civil class-action suits allege. Three advisers to local governments, CDR Financial Products Inc., Sound Capital Management Inc. and Investment Management Advisory Group Inc., were searched by the FBI in November 2006. More than a dozen banks and insurers were subpoenaed and former bankers at New York-based JPMorgan Chase & Co., Bear Stearns & Cos. and UBS AG of Zurich were advised over the past year that they may face criminal charges.New Mexico Now, Federal prosecutors are investigating whether New Mexico Governor Bill Richardson's Administration steered about $1.5 million in bond advisory work to CDR, which donated $100,000 to Richardson's political committees. CDR also advised Jefferson County, Alabama, on more than $5 billion of municipal bond and derivative deals. A combination of soaring rates on the bonds and interest-rate swaps is threatening the county with a bankruptcy that would exceed Orange County, California's default in 1994. Jefferson County paid JPMorgan and a group of banks $120.2 million in fees for derivatives that were supposed to protect it from the risk of rising interest rates. Those fees were about $100 million more than they should have been based on prevailing rates, according to James White, an adviser the county hired in 2007, after the SEC said it was investigating the deals. CDR spokesman Allan Ripp has said the company stands by the pricing of the swaps and said White's estimates were incorrect because they didn't take into account the county's credit profile, collateral provisions between the county and the banks and the precise time of the derivative trades. To contact the reporters on this story: Martin Z. Braun in New York at [Redacted].Last Updated: January 23, 2009 09:34 EST " CHRG-111hhrg58044--22 Mr. Price," Thank you, Mr. Chairman. Mr. Wilson is a constituent and I want to welcome him to our panel today. Mr. Wilson serves as the director of analytics for the Insurance Data Services Group at LexisNexis Risk Solutions. He joined Equifax in 1983, and his early experience included roles as a marketing analyst and as a field operations manager for electric gas and telephone utility customers, and he then served as manager of strategic planning and research before moving to Equifax Insurance Services in New Product Development. He has worked extensively on the development and introduction of the first credit scoring models, and has a wealth of knowledge in this area. In his current role with LexisNexis, he continues to support insurance risk scoring models and manages a team of statisticians and modelers, holds a B.A. in marketing from Oglethorpe, a grand university down in Georgia, and an MBA from Mercer University, another great education institution in Georgia. We want to welcome Mr. Wilson. " FOMC20080805meeting--56 54,MR. KAMIN.," Sure. As I mentioned, core import price inflation shot up very rapidly to over 10 percent in the second quarter, and our approach toward modeling and predicting core import price inflation focuses on three main sources of increase. First are increases in foreign cost pressures, which we proxy by CPIs, which have not been a particularly important driver of core import prices as of late, though they are not negligible. Then the other two, which are more important, are declines in the dollar, which push up our prices, and finally increases in commodity prices because a lot of our imports, even core imports, which exclude oil and high-tech products, still have a lot of commodity input into them. For the past few years, our experience has been that the pass-through of declines in the dollar into core import prices has been relatively moderate. It has definitely contributed materially to the increase in core import prices but not as much, we feel, as the run-up in commodity prices, which has had a pretty substantial effect. One way that we can sort of confirm that impression is that we know that the prices of imported material-intensive products that have the most commodity input have gone up much more rapidly than prices of finished goods, and that has been true over the past year as well. So for all of those reasons, we feel that commodity prices have been the prime impetus for the run-up in core import price inflation. Going forward, we take our guidance from the futures markets, which indicate that oil prices and other commodity prices will flatten out. As a result, we anticipate that, relatively shortly, core import price inflation also should start to decline. At the same time, our anticipation is that, compared with the past few years, the dollar will fall less rapidly going forward than in the past, and that should be another factor supporting our view that core import price inflation should diminish. " FOMC20060629meeting--120 118,MR. KOHN.," Thank you, Mr. Chairman. I support the alternative B action of 25 basis points and the language in the statement that was passed out last night. Although output has softened, it’s not clear how much and for how long. What is clear is that inflation has been running higher. That’s a given. That has been in the data. We’ve had some warning over the past weeks and months that inflation expectations aren’t as firmly anchored as we might have hoped they were. They have come down a bit, but when they’ve edged back down, it has been largely on expectations that we would be firming at this meeting and on the marking up of our path. So I think it’s important to cement that in and to take that action today. It’s important to recognize the inflation risks that we all acknowledged in our discussion yesterday. I think 50 basis points would be too much. The economy is slowing. There has been a considerable tightening of financial conditions over this year. Long-term interest rates are up 50 to 75 basis points over the past six months, including 50 basis points in real rates. This increase wasn’t just inflation expectations. Some of the increase has happened over the past couple of months, and I think it’s quite likely that we haven’t seen the full effects of those rate increases on activity. So we already have some slowing of activity, and I think there’s a little more to come, or at least some additional damping from tightening in the pipeline. We do need to keep our eye on the forecast here. As I said yesterday, a good deal of the inflation increase that we’ve gotten has been a consequence of energy prices and maybe the price effects in owners’ equivalent rent, which are so difficult to analyze and predict. These price effects should dissipate, so I’m certainly expecting inflation to come down as they come out. We need to be careful about inflation expectations and not overreact to incoming data on inflation, but we shouldn’t ignore them either. I think that would be a mistake. The whole thing is very uncertain, and I think that inflation, even after a move of 25 basis points, will remain the greatest risk to our objectives, at least until we get much more data that growth indeed is slowing to below potential. In that regard, I like the elements in the alternative B statement. In paragraph 2, it’s important to acknowledge that we recognize that the economy is moderating. That was a prediction last time, and I think we can be confident enough to say it’s an actuality this time, to recognize that a lot of that slowing is in the housing market, and to recognize the lagged effect of increases in interest rates. It’s important for the rest of the world to know that we have our eye on that. In paragraph 3, we need, as I said, to acknowledge that inflation has been too high and that there are some things working in a good direction, such as productivity gains and unit labor costs. There is a risk that inflation could remain higher than we want it to. In paragraph 4, it’s important to recognize that the slowing of growth should help to limit inflation pressures, at least keep them from building further, but that our primary focus is on inflation risks. This is a good time to step back a bit from predicting where interest rates are going to go because I think we’re less certain about where they are going to go, and so I was glad to see “some further policy firming may yet be needed” was taken out. We still have a prediction in there by saying “the extent and timing of any additional firming that may be needed.” It should be clear that in the view of the Committee the next move is more likely to be up than down. But it’s a less definitive statement than it was before, and I think it’s appropriate to take that slight step back at this time. Thank you, Mr. Chairman." fcic_final_report_full--431 Current Fed Chairman Bernanke and former Fed Chairman Greenspan disagree with Taylor’s analysis. Chairman Bernanke argues that the Taylor Rule is a descriptive rule of thumb, but that “simple policy rules” are insufficient for making monetary policy decisions.  He further argues that, depending on the construction of the par- ticular Taylor Rule, the monetary policy stance of the Fed may not have diverged sig- nificantly from its historical path. Former Chairman Greenspan adds that the connection between short-term interest rates and house prices is weak—that even if the Fed’s target for overnight lending between banks was too low, this has little power to explain why rates on thirty-year mortgages were also too low. This debate intertwines several monetary policy questions: • How heavily should the Fed weigh a policy rule in its decisions to set interest rates? Should monetary policy be mostly rule-based or mostly discretionary? • If the Fed thinks an asset bubble is developing, should it use monetary policy to try to pop or prevent it? • Were interest rates too low in –? • Did too-low federal funds rates cause or contribute to the housing bubble? This debate is complex and thus far unresolved. Loose monetary policy does not necessarily lead to smaller credit spreads. There are open questions about the link be- tween short-term interest rates and house price appreciation, whether housing starts are the best measure of the housing bubble, the timing of housing price increases rel- ative to the interest rates in –, the European comparison, and whether the magnitude of the bubble can be explained by the gap between the Taylor Rule pre- scription and historic rates. At the same time, many observers argue that Taylor is right that short-term interest rates were too low during this period, and therefore that his argument is at least plausible if not provable. We conclude that global capital flows and risk repricing caused the credit bubble, and we consider them essential to explaining the crisis. U.S. monetary policy may have been an amplifying factor, but it did not by itself cause the credit bubble, nor was it essential to causing the crisis. The Commission should have focused more time and energy on exploring these questions about global capital flows, risk repricing, and monetary policy. Instead, the fcic_final_report_full--207 And if a relatively small number of the underlying loans were to go into fore- closure, the losses would render virtually all of the riskier BBB-rated tranches worth- less. “The whole system worked fine as long as everyone could refinance,” Steve Eisman, the founder of a fund within FrontPoint Partners, told the FCIC. The minute refinancing stopped, “losses would explode. . . . By , about half [the mortgages sold] were no-doc or low-doc. You were at max underwriting weakness at max hous- ing prices. And so the system imploded. Everyone was so levered there was no ability to take any pain.”  On October , , James Grant wrote in his newsletter about the “mysterious alchemical processes” in which “Wall Street transforms BBB-minus-rated mortgages into AAA-rated tranches of mortgage securities” by creating CDOs. He es- timated that even the triple-A tranches of CDOs would experience some losses if na- tional home prices were to fall just  or less within two years; and if prices were to fall , investors of tranches rated AA- or below would be completely wiped out.  In , Eisman and others were already looking for the best way to bet on this disaster by shorting all these shaky mortgage-related securities. Buying credit default swaps was efficient. Eisman realized that he could pick what he considered the most vulnerable tranches of the mortgage-backed bonds and bet millions of dollars against them, relatively cheaply and with considerable leverage. And that’s what he did. By the end of , Eisman had put millions of dollars into short positions on credit default swaps. It was, he was sure, just a matter of time. “Everyone really did believe that things were going to be okay,” Eisman said. “[I] thought they were certifi- able lunatics.”  Michael Burry, another short who became well-known after the crisis hit, was a doctor-turned-investor whose hedge fund, Scion Capital, in Northern California’s Silicon Valley, bet big against mortgage-backed securities—reflecting a change of heart, because he had invested in homebuilder stocks in . But the closer he looked, the more he wondered about the financing that supported this booming mar- ket. Burry decided that some of the newfangled adjustable rate mortgages were “the most toxic mortgages” created. He told the FCIC, “I watched those with interest as they migrated down the credit spectrum to the subprime market. As [home] prices had increased on the back of virtually no accompanying rise in wages and incomes, I came to the judgment that in two years there will be a final judgment on housing when those two-year [adjustable rate mortgages] seek refinancing.”  By the middle of , Burry had bought credit default swaps on billions of dollars of mortgage- backed securities and the bonds of financial companies in the housing market, in- cluding Fannie Mae, Freddie Mac, and AIG. Eisman, Cornwall, Paulson, and Burry were not alone in shorting the housing mar- ket. In fact, on one side of tens of billions of dollars worth of synthetic CDOs were in- vestors taking short positions. The purchasers of credit default swaps illustrate the im- pact of derivatives in introducing new risks and leverage into the system. Although these investors profited spectacularly from the housing crisis, they never made a single subprime loan or bought an actual mortgage. In other words, they were not purchasing insurance against anything they owned. Instead, they merely made side bets on the risks undertaken by others. Paulson told the FCIC that his research indicated that if home prices remained flat, losses would wipe out the BBB-rated tranches; meanwhile, at the time he could purchase default swap protection on them very cheaply.  On the other side of the zero-sum game were often the major U.S. financial insti- tutions that would eventually be battered. Burry acknowledged to the FCIC, “There is an argument to be made that you shouldn’t allow what I did.” But the problem, he said, was not the short positions he was taking; it was the risks that others were ac- cepting. “When I did the shorts, the whole time I was putting on the positions . . . there were people on the other side that were just eating them up. I think it’s a catas- trophe and I think it was preventable.”  FOMC20050202meeting--61 59,MS. MINEHAN.," Vincent has asked each one of us to consider whether an explicit numerical specification of price stability would be helpful to us in furthering the achievement of our goals for price stability and maximum sustainable employment and in our communications either externally or internally. My own answer to that question is “no, I don’t think so.” This is not a knee-jerk reaction to the idea of inflation targeting or goal setting. However one wants to define the regime, I think setting an inflation target or goal—and I am using those terms interchangeably—can be very helpful in some cases. In particular, when countries have experienced very high rates of inflation or are just emerging as market economies, stating inflation goals can be useful in communicating with markets. Doing that can be useful in demonstrating serious policy intent on the part of a new government or central bank regime and in building general credibility. Brazil and Mexico come to mind when I think of countries where an inflation target or goal has been useful, at least over time, particularly in the face of political and other uncertainties. But the United States is not in that kind of situation nor is it particularly similar to the other countries or monetary unions that use inflation targets or goals—except perhaps the European Union and the U.K., both of which I would argue started at very different points with a new or newly independent central bank. We in the Federal Reserve have spent 25 or more years under two Chairmen first curbing inflation and then achieving a workable sense of price stability that’s built not on a specific number but on the absence of rising prices as a major consideration in everyday business and consumer decisions. Personally I’m comfortable with that definition. And I think it has been quite successful if you look at the way inflation expectations are anchored, at the volatility February 1-2, 2005 29 of 177 What we do in setting policy—how we actually conduct policy over the years—seems to me far more important and a far greater element of our credibility than what we say we are going to do. And, in fact, what we say could actually frustrate policy. Now, I know some of you are reacting the same way I think some of my colleagues in Boston do when I state this position. I can hear them. [Laughter] They would say: “Now, come on, Cathy, how much harm could it do to state a goal in terms of a range of inflation within which you as a policymaker would feel comfortable? Wouldn’t that have the advantage of being more transparent in your policy-setting and more forthright about your tolerances for inflation, both on the high and the low side?” There have been volumes written about this subject, and I’ve done some reading of that material in addition to work by the staff, which I think was extremely well done. In the end, however, I have to come at this with a more or less commonsense perspective that’s the result of my experience on the Committee and in the Federal Reserve System. I understand the argument for an inflation goal, but, to me, anyway, there’s at least a possibility that setting a numerical goal or even a range of acceptable inflation could present the risk of either being less transparent or, arguably worse, making a bad policy decision. If a particular goal for inflation is to be credible, then it would seem to me that markets would have to have some confidence that the Federal Reserve would react in predictable ways each time that goal is either met or missed. But inflation is not the only goal, as we’ve all said. Sustainable employment, or however you want to characterize the other part of our mandate, is a goal as well. So my policy preference for a given level or path of inflation would not be identical all the time. It would depend on what is happening in the real economy, just as in the first half of 2004 we tolerated rather rapid price growth on the basis of our calculation of the degree of excess capacity in the real economy and the temporary nature of the energy price increases. I know that over the long run there’s no tradeoff between growth and inflation and that price stability, however defined, is the best contribution monetary policy can make to economic prospects. But in the short run, when February 1-2, 2005 30 of 177 There needs to be flexibility to set policy with some sense of balance between the two goals. So if I commit to an inflation goal but don’t always adhere to that goal because of the need to be concerned about the real economy, how is stating the goal a form of better communication? Or alternatively, if I don’t balance the goals and make policy choices based on that balance, then I may be adhering to the inflation target but making bad overall policy. Now, I realize that the staff presented options allowing for all kinds of flexibility in setting and administering an inflation goal. The goal could be focused on the long run, it could be measured flexibly, the numbers could be changed, et cetera. But if it’s going to be all that flexible, how could it possibly make a difference in either how we’re viewed or how we actually operate? Frankly, I’m not sure I want to change how we’re viewed or how we operate. I think it has been pretty successful. Inflation goals or targets strike me as not unlike the performance metrics that are used to judge the effectiveness of operations. Anyone who uses such metrics knows that, while they’re useful, they can be very tricky. That’s because you actually get the performance you measure. Focus hard on costs, and innovation and quality go out the door. If you give people incentives to increase profits and make the share price go up, accounting ethics can be at risk. Performance metrics need to be multidimensional and surrounded by robust control systems if they’re to work in a way that both achieves the objective and balances how the overall organization functions. I don’t worry about this Committee’s ongoing commitment to price stability, no matter how many of the faces around the table change. What I do think could be at risk, if only marginally, is the balance and, yes, discretion that is vital to policymaking. In sum, I look at inflation targets or goals, however unthreatening they may appear, as a solution both in search of a problem and with a potential to cause one. I’m not in favor of going forward with an inflation goal, in case anybody is uncertain about that! [Laughter] But if, in the fullness of time, we decide to do it, I have some thoughts on how we could do it. I’ll share them with you later if that is necessary. [Laughter] February 1-2, 2005 31 of 177" fcic_final_report_full--433 Some combination of the first two factors may apply in parts of the Sand States, but these don’t explain the nationwide increase in prices. The closely related and nationwide mortgage bubble was the largest and most sig- nificant manifestation of a more generalized credit bubble in the United States and Eu- rope. Mortgage rates were low relative to the risk of losses, and risky borrowers, who in the past would have been turned down, found it possible to obtain a mortgage.  In addition to the credit bubble, the proliferation of nontraditional mortgage products was a key cause of this surge in mortgage lending. Use of these products in- creased rapidly from the early part of the decade through . There was a steady deterioration in mortgage underwriting standards (enabled by securitizers that low- ered the credit quality of the mortgages they would accept, and credit rating agencies that overrated the subsequent securities and derivatives). There was a contemporane- ous increase in mortgages that required little to no documentation. As house prices rose, declining affordability would normally have constrained demand, but lenders and borrowers increasingly relied on nontraditional mortgage products to paper over this affordability issue. These mortgage products included interest-only adjustable rate mortgages (ARMs), pay-option ARMs that gave bor- rowers flexibility on the size of early monthly payments, and negative amortization products in which the initial payment did not even cover interest costs. These exotic mortgage products would often result in significant reductions in the initial monthly payment compared with even a standard ARM. Not surprisingly, they were the mortgages of choice for many lenders and borrowers focused on minimizing initial monthly payments. Fed Chairman Bernanke sums up the situation this way: “At some point, both lenders and borrowers became convinced that house prices would only go up. Bor- rowers chose, and were extended, mortgages that they could not be expected to serv- ice in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ulti- mately, further appreciation could not be sustained and house prices collapsed.”  This explanation posits a relationship between the surge in housing prices and the surge in mortgage lending. There is not yet a consensus on which was the cause and which the effect. They appear to have been mutually reinforcing. In understanding the growth of nontraditional mortgages, it is also difficult to de- termine the relative importance of causal factors, but again we can at least list those that are important: • Nonbank mortgage lenders like New Century and Ameriquest flourished un- der ineffective regulatory regimes, especially at the state level. Weak disclosure standards and underwriting rules made it easy for irresponsible lenders to issue mortgages that would probably never be repaid. Federally regulated bank and thrift lenders, such as Countrywide, Wachovia, and Washington Mutual, had lenient regulatory oversight on mortgage origination as well. • Mortgage brokers were paid for new originations but did not ultimately bear the losses on poorly performing mortgages. Mortgage brokers therefore had an incentive to ignore negative information about borrowers. • Many borrowers neither understood the terms of their mortgage nor appreci- ated the risk that home values could fall significantly, while others borrowed too much and bought bigger houses than they could ever reasonably expect to afford. • All these factors were supplemented by government policies, many of which had been in effect for decades, that subsidized homeownership but created hid- den costs to taxpayers and the economy. Elected officials of both parties pushed housing subsidies too far. FOMC20050630meeting--11 9,MR. RUDEBUSCH.," I will review some general issues related to monetary policy and asset prices. Let me start—at the top of page 1—by assuming that an asset price can, in theory at least, be separated into a component determined by underlying economic fundamentals and a non-fundamental or bubble component. An asset price may be in line with its fundamentals, so the bubble component is zero, or bubbles could be positive or negative—perhaps representing irrational euphoria or pessimism. June 29-30, 2005 15 of 234 of monetary policy. For example, a booming stock market is usually followed by higher demand and increased inflationary pressures, so tighter policy would be needed to offset these consequences. Even for the Standard Policy response, it will likely be useful to identify, if possible, the separate components of the asset price. In particular, the bubble component may exhibit more volatile dynamics and be a pernicious source of macroeconomic risk, so optimal policy would likely react more to bubbles than to movements in the fundamental component. The second type of response, the “Bubble Policy,” follows the Standard Policy as a base case, but, in certain circumstances, it also takes steps to contain or reduce the asset price bubble. Proponents of a Bubble Policy argue that movements in the bubble component can have serious adverse consequences for macroeconomic performance that monetary policy cannot readily offset after the fact, so it is preferable to try to eliminate this source of macroeconomic fluctuations directly. Furthermore, because bubbles often seem to display a self-reinforcing behavior, a little preemption and prevention early on can avoid later excesses. A best-case scenario for these two policies is illustrated in the lower half of the first page. Under ideal circumstances, the policymaker knows the fundamental and bubble components, and as history unfolds, the Standard Policy would likely recommend higher interest rates to offset any economic stimulus generated by the bubble before the crash and lower rates afterward. A Bubble Policy would go further and try to mitigate the fluctuations in the bubble and achieve an asset price path like AP′t . This would likely require higher interest rates than the Standard Policy before the crash and lower rates afterward, and it will likely trade off near- term deviations from the central bank’s macroeconomic goals for better overall macroeconomic performance later on. The fundamental difference between the two policies is that the Standard Policy takes the bubble component essentially as given or exogenous, while the Bubble Policy takes into account the endogenous nature of the bubble component—specifically, a linkage between the policy instrument and the bubble. A decision tree for choosing between the Standard and Bubble Policies is shown on page 2. In brief, it asks three questions: (1) Can policymakers identify a bubble? (2) Will fallout from a bubble be significant and hard to rectify ex post? and (3) Is monetary policy the right method to use to deflate the bubble? The answer to the first question—can policymakers identify a bubble?—is “no” if the particular asset price appears aligned with fundamentals. Some have argued that this is nearly always the case because estimates of fundamentals are so imprecise and because asset prices reflect the collective information and wisdom of professional traders in organized markets. If policymakers cannot discern a bubble, then the Standard Policy is the only feasible response. June 29-30, 2005 16 of 234 policy cannot readily offset after the fact. A negative answer to this question is appropriate in two situations. First, if the bubble is in an asset market that is small in domestic economic terms—for example, a localized real estate market—then a central banker should avoid attempts at asset price realignment. Second, even when there are significant macroeconomic consequences from an asset price bubble boom and bust, if they occur with a sufficient lag so the policymaker can adopt a wait-and­ see attitude, then the Standard Policy is again appropriate. This second case seems relevant if fluctuations in the bubble component have only conventional effects on aggregate demand and supply through changes in wealth, the cost of capital, and balance sheets. Then, to a first approximation, the lags involved in these channels are about as long as the lags in the monetary transmission mechanism; therefore, the Standard Policy should suffice. For example, fluctuations in equity prices will affect wealth and consumer demand, but a nimble central banker can essentially offset these consequences by changing interest rates in reaction to—that is, after—the equity price movements. Now to the case where asset price movements have significant macroeconomic consequences and those consequences are hard to clean up after the fact through monetary policy. The most often mentioned possibility is that a bursting asset price bubble will lead to a broad financial crisis and credit crunch. Such financial instability is likely to be transmitted to the economy much more quickly than can be offset by interest rate policy. This may set the stage for invoking a Bubble Policy. Another example is when the asset price misalignment results in significant misallocations of resources, which distort aggregate demand and supply across sectors and over time and impede the achievement of the highest possible long-run economic growth. For example, the dot-com bubble spurred overinvestment in fiber optic cable and decimated the provision of venture capital for new technology startups for years. Of course, after the fact, it is difficult to unwind these problems with the blunt instrument of monetary policy, and, depending on the specifics, it is possible to conceive of a situation in which reducing the bubble in advance is a preferred policy strategy. The final hurdle before invoking a Bubble Policy involves assessing whether monetary policy is the right way to deflate the asset price bubble. Ideally, for the Bubble Policy, a moderate adjustment of interest rates could constrain the bubble and greatly reduce the risk of severe future macroeconomic dislocations. However, bubbles, even if identified, often do not appear influenced by monetary policy actions in a predictable way. Furthermore, even if changing interest rates could alter the bubble path, such a strategy may involve substantial costs, including near-term deviations from the macroeconomic goals of the central bank as well as potential political or moral hazard complications. Finally, even if monetary policy can affect the bubble, alternative strategies to deflate it, such as changes in financial regulations or supervision, may be more targeted and have a lower cost. June 29-30, 2005 17 of 234 questions for two historical episodes. The first episode is the run-up in the stock market during the late 1990s. In 1999 and 2000, one could have made the case that there was an equity price bubble in the high-technology sector and perhaps in the overall market as well. Also, during that time, the possible capital misallocation from the run-up in prices and the possible financial instability that might have followed a bursting of the bubble may have appeared difficult to rectify. However, it was also unlikely that monetary policy could have deflated the equity price bubble without substantial costs to the economy. In the event, of course, a Bubble Policy was not followed, but arguably, the consequences from any bubble boom and bust have been manageable. A different example is provided by the bond market collapse in 1994. One could argue that this “inflation scare,” which pushed up yields on 30-year bonds by over 2 percentage points, resulted in an asset price misalignment that was fairly apparent to the FOMC during the second half of 1994. If this bond bubble had persisted, the widespread propagation of the associated fears of higher inflation could have had severe consequences that would have been costly to unwind with monetary policy later on. Finally, with regard to deflatability, it did appear likely that monetary policy could guide bond prices back to fundamentals. Indeed, one interpretation of the FOMC’s actions in 1994 is that it purposefully and successfully contained a bond market bubble with sizable increases in the funds rate. It is an open question which of these two episodes is the more relevant one today. That concludes my remarks." fcic_final_report_full--153 The liquidity puts were approved by Citigroup’s Capital Markets Approval Com- mittee, which was charged with reviewing all new financial products.  Deeming them to be low risk, the company based its opinions on the credit risk of the underly- ing collateral, but failed to consider the liquidity risk posed by a general market disruption.  The OCC, the supervisor of Citigroup’s largest commercial bank sub- sidiary, was aware that the bank had issued the liquidity puts.  However, the terms of the OCC’s post-Enron enforcement action focused only on whether Citibank had a process in place to review the product, and not on the risks of the puts to Citibank’s balance sheet.  Besides Citigroup, only a few large financial institutions, such as AIG Financial Products, BNP, WestLB of Germany, and Société Générale of France, wrote signifi- cant amounts of liquidity puts on commercial paper issued by CDOs.  Bank of America, the biggest commercial bank in the United States, wrote small deals through  but did  billion worth in , just before the market crashed.  When asked why other market participants were not writing liquidity puts, Dominguez stated that Société Générale and BNP were big players in that market. “You needed to be a bank with a strong balance sheet, access to collateral, and exist- ing relationships with collateral managers,” he said.  The CDO desk stopped writing liquidity puts in early ,  when it reached its internal limits. Citibank’s treasury function had set a  billion cap on liquidity puts;  it granted one final exception, bringing the total to  billion.  Risk manage- ment had also set a  billion risk limit on top-rated asset-backed securities, which included the liquidity puts. Later, in an October  memo, Citigroup’s Financial Control Group criticized the firm’s pricing of the puts, which failed to consider the risk that investors would not buy the commercial paper protected by the liquidity puts when it came due, thereby creating a  billion cash demand on Citibank.  An undated and unattributed internal document (believed to have been drafted in ) also questioned one of the practices of Citigroup’s investment bank, which paid traders on its CDO desk for generating the deals without regard to later losses: “There is a potential conflict of interest in pricing the liquidity put cheep [ sic ] so that more CDO equities can be sold and more structuring fee to be generated.”  The re- sult would be losses so severe that they would help bring the huge financial conglom- erate to the brink of failure, as we will see. AIG: “GOLDEN GOOSE FOR THE ENTIRE STREET ” In , American International Group was the largest insurance company in the world as measured by stock market value: a massive conglomerate with  billion in assets, , employees in  countries, and  subsidiaries. But to Wall Street, AIG’s most valuable asset was its credit rating: that it was awarded the highest possible rating—Aaa by Moody’s since , AAA by S&P since —was crucial, because these sterling ratings let it borrow cheaply and deploy the money in lucrative investments. Only six private-sector companies in the United States in early  carried those ratings.  FOMC20080430meeting--292 290,MR. EVANS.," Thank you, Mr. Chairman. As I mentioned earlier, I would find some discussion about the transmission mechanism useful--at what rate we think the markets would be picking up the price of risk-free yield curves. I think that would help. To the extent that we can align this with other foreign central bank experiences, we might be able to draw on how they view that and what the financial market data look like. So I am comfortable with focusing primarily on options 2 and 5. I was thinking along the lines of President Hoenig, which is that the Federal Reserve tends to go slowly. Vince isn't here, but he often reminded us of that. Option 1 is the easiest one. If we have enough information about it, then that's fine. I think that's all I have. " FOMC20061025meeting--185 183,MS. MINEHAN.," As I noted yesterday, I’ve become somewhat less worried about the downside risk to the baseline outlook. So to some degree, that factor has changed a little since the last time. In fact, I think the baseline isn’t bad at all. Indeed, it’s a testament, again, to the resilience of the U.S. economy if we can actually pull off, as we seem to be doing, a gradual slowing of the powerful U.S. housing markets against the background of considerable geopolitical and energy market uncertainty and price pressures, not to mention the potential for both strong consumer retrenchment and financial market volatility. So we seem to be threading the line through a lot of risks on both sides of this baseline, and we seem to be doing it successfully in negotiating that soft landing. I think we should take some pride in that so far so good and that monetary policy has played a key role in this unwinding process. In that regard, I continue to believe that the cost to the central bank of being wrong on inflation risks is greater than being wrong on the side of growth at this time. If growth wanes more than is now expected, we can ease policy fairly quickly. Getting behind the curve on inflation could be a good deal more costly. Thus, I am pretty comfortable with the current stance of policy, which I see as slightly restrictive. At least for the time being, I think it balances the risk of being wrong on inflation with the risk of slower growth and is appropriate given the brighter tone of much of the incoming data, with the possible exception of residential investment. A risk-management argument could be made for raising rates, and certainly those less comfortable with the current and prospective levels of core inflation might find such an action attractive. I don’t, as I continue to worry some about downside risks to growth, and I am more or less comfortable with our forecast that, with no change in policy in the near term, inflation will gradually fall to just over 2 percent as measured by the core PCE in the next eighteen months or so. That projection, at least at this time, seems right. So I come down on the side of keeping the fed funds rate at 5¼. So that’s the policy choice. The next issue is what to say about it. I think it’s important to continue to emphasize some concern regarding inflation rather than to move to more of a balance of risks. Financial markets remain quite accommodative, and I really see no reason to encourage them to be more so, thinking that policy easing might occur sooner than they do now. I think that would be the outcome of alternative A. So I’d prefer alternative B. The next question is, which alternative B? We now seem to have B-, B+, and B. Let me just comment a bit on the variety of alternatives that have been raised. You know, I have a lot of regard for Governor Kohn, and I take his point—and Governor Kroszner’s point—about section 2. However, when reading through it myself, I did think that the reference to the third quarter might help the markets react better if, in fact, the Greenbook forecast is accurate about the number that we’re going to see on Friday, which is considerably less than what a lot of people in the market think we’re going to see. I thought that the reference to the third quarter was helpful there. But, again, I have a great deal of regard for the cumulative wisdom on the other side of that. With regard to section 3, I, too, believe that there is some benefit to making the change that’s suggested in the Bluebook of using the alternative A wording for section 3. The shorter wording does reflect the moderation that has occurred in energy and commodity prices, and it puts the level of resource utilization more front and center as an inflation risk. I also find that it’s somewhat shorter, which, in general, I think is desirable. In section 4, I found the B+ wording attractive because it suggests a concern regarding inflation that I heard around the table yesterday and somewhat of a diminution of deep concern about the downside risks. In a way, I think there is a benefit at the margin to getting away from stock phrases. But I take Governor Kohn’s point very seriously that one does that recognizing that there’s a potential for unknowable consequences. So while I am marginally in favor of B+, I am more than happy to go with alternative B, either as it’s presented, with the switch of section 3, or the new language for section 2. I’m easy, you might say. [Laughter]" CHRG-111hhrg51698--344 Mr. Short," I would add to Mr. Pickel's comment that clearing goes a long way to address many of the issues with CDS; whether that clearing would be done under ICE's clearinghouse, or any of the other competing clearing models such as CME, or some of the other industry participants. I think the counterparty credit risk and remediation, and the transparency the clearing would bring would benefit the market significantly. I will note that we don't believe that all CDS can necessarily be cleared. There are certain CDS that, due to the lack of standardization in the product and lack of liquidity, it really wouldn't make sense to clear. This Committee actually hit upon a very good framework to address that type of issue when it passed the farm bill. In the case of exempt commercial markets, when different contracts served a significant price discovery function, a similar template could be applied here where one CDS had attained a certain level of liquidity, or there was some systemic risk issue. You might require clearing of CDS at this point and not make it mandatory for all CDS. But, certainly, those CDS that are liquid, and capable of being cleared, we are in favor of having them cleared. " FOMC20081216meeting--177 175,MR. STOCKTON.," My guess is that, if our baseline forecast evolves in the way we are expecting here, you are still going to be worried about the downside risk to inflation even if, in fact, we were in the process of bottoming out because there will still be a very substantial output gap. On the commodity price side, things are fairly stable, and at least in our forecast, inflation expectations are probably drifting down some. On the other hand, there are upside risks to that inflation forecast as well. I do actually think that our baseline forecast, on the assumptions that we have had to make in constructing it, is reasonably well balanced because another possibility is, in contrast to the gradual downtrend that we're expecting in inflation expectations, that inflation expectations will be stickier, you will be able to convey a greater sense that you wouldn't want inflation over the longer haul moving down below 1 percent, we won't get as much disinflation into inflation expectations or into labor costs, and you'll get greater stability there than we're expecting. So to my mind, looking ahead, monitoring how those inflation expectations evolve in the context of an economy where things are weakening will be very important. " FOMC20050503meeting--69 67,MS. JOHNSON.," We collect import prices at the border, so to speak. So I can’t speak to the question of this showing through to retail prices. David might want to comment on that; I don’t know. Import price inflation has been surprising us a bit on the upside, and we have attributed part of that to higher global commodities prices. It shows up in our case in the industrial supplies types of categories, but we’ve seen some in the manufacturing area as well. When we break out the actual data for how import prices have moved, we’re getting contributions from both those pieces into import price inflation. So, relative to the last Greenbook, we have extended the period of elevated import price increases into the second quarter and a little into the third quarter because the global indexes of commodity prices—based on futures at this point for those periods—show the prices not rising further but remaining high, and we think it will take some time for that to be fully reflected in May 3, 2005 25 of 116 last year was that commodity prices tended to be showing up more rapidly in U.S. import prices than our models would suggest is the historical average. We have that as a second term, in addition to foreign prices and the exchange rate and so forth. So embedded in our story is that import prices were high in the first quarter and will decelerate somewhat in the second and third quarters, but not hugely and not as much as we had thought before. It involves a somewhat more extensive pass-through of high global commodity prices into import prices, and a little bit is probably still the effect of dollar depreciation at the end of 2004. Those things, in essence, go away thereafter, and we have import price inflation dropping down very much—to less than 1 percent in 2006. That is conditioned on two assumptions: the assumption we have been making routinely for the dollar of late—because we don’t know a better one to make—which is that it will change only little going forward; and the futures path for commodity prices. So the projection that import prices will decelerate in stepwise fashion through the second half of this year and into 2006 is very much a reflection of these two conditioning assumptions. And we don’t have a whole lot of information other than that." FOMC20070628meeting--132 130,MR. KOHN.," Thank you, Mr. Chairman. My projection was closely in line with that of the Greenbook, modestly below-trend growth for a few quarters, held down by a prolonged weakness in housing. As that drag abates, the economy picks up to potential and is held back from overshooting that potential by various factors, including the rise in the saving rate and slightly lower growth of government spending. Under these circumstances, core PCE inflation holds in the neighborhood of 2 percent. I do not really see much to push it one way or another at this point. The economy is producing very near its potential, as close as we can figure. Inflation expectations have been moving in a narrow range. Some of the transitory factors, such as owners’ equivalent rent, that we’re expecting to come down to reduce inflation have already done that to a considerable extent. So I don’t see them, moving forward, as having a big effect. Given the limited pass-through of energy and commodity prices into core prices, I would not expect much downward pressure on inflation from a leveling-out of those prices. I think that we are around 2 percent and that we will probably stay there, at least for a little while. In terms of risks, the recent data on capital goods, orders and shipments, and manufacturing activity suggest, as many have remarked, some reduced downside risk from business attitudes on spending. They do not suggest a great deal of strength in business capital spending, however. The fundamentals are less favorable than they were a couple of years ago, and the most recent data, which we received today, suggest a pretty flat or a modest upward tilt to capital spending in the second quarter. The data weren’t that strong, but they do suggest that what I feared in May—that we were in the midst of a cyclical adjustment that was going to make capital spending much weaker—has certainly abated. I agree with many others around the table that housing is a significant downside risk to the forecast, given the high level of inventories despite a major reduction in starts over the past year and the price-to-rent ratio being as high as it is. The further slide in housing may be gentle, as President Lacker said, but I do not think we’ve seen the bottom yet. You can go a long way at a gentle slope. [Laughter] We also have not yet really seen the full effects of the tightening in subprime credit terms or, obviously, of the recent increase in mortgage rates. I also see a big downside risk from consumption. The Greenbook has the growth of consumption sustained despite an increase in saving rates as the growth in disposable income exceeds the growth in GDP—and that is with the labor share recovering and the business profit share declining. I see two downside risks to that. One is that the saving rate will rise faster as the housing weakness feeds through both in terms of wealth effects and in terms of reduced availability of credit as terms tighten and there is less equity to borrow against, particularly for liquidity-constrained households. I also continue to see a downside risk to equity prices, although I have certainly been wrong so far. Nellie’s table presenting the difference between the staff’s forecast of profits and the market’s forecast of profits showed a huge difference for next year. So though I think the basic outlook is fine, I still see some downside risk on that side. On the inflation front, I, like others, see the better-than-expected core inflation as a hopeful sign; but it is recent and may be affected by temporary factors, and I do not think we need to get too enthusiastic about it. I do see several upside risks to inflation: the high level of total headline inflation, which could erode inflation expectations; business resistance to any erosion of profit margins as unit labor costs pick up; the high levels of resource utilization in the United States; and the tighter global conditions of demand on potential supply that others of you have mentioned. Let me say a word or two about my year-three projections. I projected output growth at 2½ percent, the unemployment rate at 4¾ percent, and core PCE inflation at 1.9 percent. I certainly saw my output and employment projections as a sense of what the steady state was. On the unemployment rate, I do think the odds are better that the NAIRU is lower than that it is higher than the staff’s 5 percent assumption. This judgment is partly based on the very moderate pickup in the employment cost index, and average hourly earnings growth has actually been coming off recently. On the behavior of core inflation, I don’t see much evidence that we are significantly beyond potential now, although I recognize that, with a very flat Phillips curve, it could be a long time before one figures that out. But I had growth of potential at 2½ percent, which is below what I infer to be the central tendency of the Committee. Regarding my reading of the decline in productivity growth, productivity over the past five quarters has been growing significantly below the staff’s estimate of 2½ percent. Some of it is cyclical. There could be a revision, as Presidents Plosser and Yellen have suggested. I confess to having asked David Wilcox about this at the break, and he said that the data are kind of ambiguous here and that it is much too early to predict a significant downward revision to employment. But I hope you are right. Now, some of the recent slowdown certainly must be cyclical, though I would have thought that labor hoarding and things like that would be much less in today’s flexible labor markets, with so much more use of temporary workers than there has been in the past. I would think that the cyclical effects on productivity would be muted, that businesses would move pretty promptly to adjust their labor forces to output. So I wonder how much cyclicality there is. The big uncertainty is in the construction industry and in the fact that construction employment hasn’t come down. We don’t quite understand why it hasn’t come down more. So perhaps productivity will pick up. But I still would look at the staff’s 2½ percent as having even just a little more downside than upside risk to it, given the fact that we have had more like 1 to 1½ percent in the past four or five quarters. So I stuck with the staff’s forecast of 2½ percent potential GDP. In some sense, our view of what the potential growth rate is isn’t all that important for monetary policy. We ought to be looking at the gap. We ought to be looking at the pressure of the level of production on the level of potential GDP. But I don’t think it’s quite that easy. We don’t know what that gap is. We have seen that the surprises over the past year or two have been in the behavior of the unemployment rate and capacity utilization relative to growth. So we do tend to look at our estimates of potential growth and the actuals coming in relative to those estimates and pass judgment on what’s happening to the output gap even when the unemployment rate doesn’t move. We just need to remember that potential growth is an entirely estimated number that we will never observe, and we need to be aware that it might not be quite as high as the central tendency indicates that my colleagues on the Committee apparently think it is. Thank you, Mr. Chairman." FOMC20061025meeting--274 272,MR. KOHN.," Thank you, Mr. Chairman. I’ll start at the top of the sheet but then jump around. So the answer to the first question is “yes”—I do think that an explicit numerical specification of price stability would be helpful and that the FOMC should move toward such a specification. I always thought this step was a close call in terms of its costs and benefits. There have been a couple of developments since January ’05, when we last discussed the topic, that have led me to change my position to favor this step. First, we’ve been through two more episodes—in the spring of ’05 and the spring of ’06—when a surge in actual inflation raised questions in financial markets about our intentions and expectations. In both cases, higher inflation expectations did not persist. But making our long-term intentions clearer should reduce the risk that temporarily heightened inflation pressures result in increases in expectations that become more permanent and more costly to reverse. A couple of studies in the past two years have tended to support the hypothesis that a numerical specification might help tie down expectations at least a little within the financial markets. Second, I think a lack of clarity on this question has increasingly muddied discussions in this Committee and communication with the public. Within the Committee, it has sometimes been difficult to discern whether differing viewpoints reflect diverse perceptions of the course of inflation and economic growth or of the desirable end point or path for inflation. The public does not know whether the comfort zones enunciated by various Committee members reflect the views of the Committee or only those of the individuals. Coming to an agreement on an end point and on the role that end point should play in policy and announcing that agreement should help our discussions and enhance the public’s understanding of our intentions. Having said that, I think we need to recognize that any explicit inflation specification is likely to exert some pull on policy. It will not simply institutionalize the Volcker or Greenspan policy regimes, as is sometimes said. It cannot help but to increase the Committee’s focus on particular numerical outcomes and projections for inflation. That’s good to the extent that it reduces the odds on a repeat of the cumulative errors of the 1970s, but it also may make it more difficult for the Committee to take actions that might be perceived at the time as inconsistent with achieving price stability in the next few years but that were still in the public interest—say, by countering financial distress, as in 1998, or by moving very, very aggressively against economic weakness, as in 2001, when core inflation was actually rising. A risk-management approach to policy may well call for aiming away from the price stability objective from time to time. I continue to believe that monetary policy over the past twenty-five years has been exemplary. We should be very cautious in tinkering with its design. Whatever we do must be clearly consistent with the dual mandate and be perceived as such. This is important for democratic legitimacy. The Federal Reserve Act includes maximum employment equally with price stability. I recognize and have often used the principle that price stability enhances maximum employment. But I also note that proposals introduced in the Congress over the past two decades to make price stability our primary objective have not had support, and they’ve gotten nowhere. I’m encouraged by the fact that Chairman Bernanke in his hearings didn’t meet too much opposition [laughter] but I think we need to recognize that there have been attempts to change our mandate and there has been no congressional support for those attempts. I think the last attempt was about ten years ago. The dual mandate is also good economics. Fluctuations around potential impede planning and long-term saving and investment decisions, just as do fluctuations around price stability. We need to take explicit account of these costs as we pursue our price stability objective, and this implies that we should tolerate deviations from price stability on occasion and that the time path to price stability should depend on the circumstances, including the likely costs in lost output along with the deviations from price stability. Support for the Federal Reserve in the population and among its elected representatives has never been higher, certainly never higher in my thirty-seven years at this institution. That support flows from the results of the past twenty-five years and from confidence that we know what we’re doing and will behave sensibly. This was the second type of credibility that Chairman Bernanke talked about at the last meeting. We should not depend on any announcement to have a substantial immediate effect on inflation expectations, where they count most for economic performance. Professional economic forecasters would have a number to coordinate on, and they probably will. It may help tie down expectations in financial markets, but even in financial markets, the effects are likely to be small. Long-run inflation expectations are already well anchored in the United States. Spreads over indexed debt move around quite a bit, even in inflation-targeting countries. For example, as we saw in the briefing on Monday, inflation compensation has fallen since July the same amount in Canada that it has in the United States. As the staff memo on price dynamics noted, the data do not support an inference that such an announcement per se would affect wage-setting and price- setting behavior. Such influences would come because our behavior and the economic results would change. These caveats and concerns lead me to favor a numerical definition of price stability without an explicit time dimension rather than an inflation target that we would expect to achieve in a defined time frame. I have in mind something along the lines of Chairman Bernanke’s suggestion in St. Louis three years ago—the long-run average inflation rate we will be seeking in order to meet the price stability mandate in our act. We would not expect to achieve this objective year by year or even necessarily on a two-year-ahead projection. That would depend on the circumstances. My expectation, or maybe it’s a hope, would be that the benefits of such a formulation would exceed its costs—that without greatly impeding the type of flexible policymaking that has so benefited the economic performance since 1980, it would help a little to tie down expectations, aid the public in making its plans, clarify internal and external communication, and make it more difficult for future FOMCs, when all of us have retired, to allow inflation to drift higher. I don’t have well-defined views on the exact specification of this definition—the index, its level, point or range, whether it should be expressed in terms of total or core—but these specifications will be critical in judging the eventual likely balance of costs and benefits. If we go down this route, we’ll have a lot of work to do. Besides the details of the specification, it’s vitally important that the Committee think through very carefully the role that any definition of price stability would play in policy formulation and that we convey our expectations to the public. It would have implications for all our modes of communication as well as for the inputs to policymaking and would call for considerable communication to the Congress and the public to prepare the way. Understanding what we’re doing and explaining it to the public in turn requires that the Committee come to a decision on the definition and the way it will be treated in policymaking. So I favor the “jointly” arm of Vincent’s chart. I can see some of the suggestions of aggregating the views of individual policymakers as a possible way station, but I’m concerned that such aggregation will raise as many questions as it answers. If we go to a numerical definition of price stability, we should be prepared to explain and justify it fully, and that requires the Committee to consider those implications explicitly. Thank you, Mr. Chairman." FOMC20071211meeting--148 146,MR. FISHER.," Mr. Chairman, I don’t think I could have said it better than Governor Kohn said it. I am on his wavelength. I would just add a couple of things that I would suggest we consider. First of all, with regard to the financial situation, which is obviously driving this conversation, I appreciate the medical pathology that the Vice Chairman suggested. We have gone now from cardiology, which is my thing, to this fever and the fever breaking, and so on. I combine it with a bit of the strawman that Governor Warsh raised. No one has suggested a panacea. No one has suggested that the existing pool of ersatz money, outside money, or shadow money is fully sufficient to relieve the stress the system is under. What has changed, however, since the August crisis is the process of price discovery. We are beginning to actually get realistic pricing. I spent twenty-one years buying distressed assets on Wall Street. I think I understand the process. It is a patient process, and it takes time. But I think that is the only difference. We have begun the process; it has a long way to go. We have enormous risks, and I fully agree with Vice Chairman Geithner that there is significant risk that might stem from this. But let’s not also understate the fact that some adjustment has begun and that is good news. I would suggest 25 basis points, Mr. Chairman, because I think we have to be very wary of shooting an entire bolt here. If we do 50 basis points plus the TAF plus the swap lines—this is all very subjective—my opinion is that we would scare the hell out of the markets. There is a significant risk if we send a signal, as was previously said—I think Brian may have said this— that we have information that other people do not have. President Lockhart referred to delicate psychology. From a risk-management standpoint, I think the psychology is the opposite of what he stated, which is that we are at risk of interfering with the beginning of the adjustment process that I just described. If people feel that we know more than they do, that we have greater fear of the downside, you are going to see a delay in that adjustment. They are wanting to step up and cherry-pick a little before you start going through the whole orchard. So those would be the two factors that I would suggest. I want to come back to the last point. Our job is to keep inflation at bay. The nominal anchor you mentioned is critical. I heard more people speak around this table about being worried about inflation than did not so speak. And a second-to-the-last point. I agree with President Poole and the suggestion of, I think, Charlie Plosser. I would like to be like the Reserve Bank of Australia and raise the rates despite the political election, if we had to. But I think the scrutiny of this institution will be intense, and my preferred mode is just to stay out of the way. I think it is politically very brave and possibly foolish to say that, well, if we do too much here, we can always pull it back. There will be a lot different circumstances next year, and I worry that we may do too much. I would be against 50 basis points. I would be in favor of 25 basis points, and I would be in favor of alternative B as stated, if I had a vote. Thank you, Mr. Chairman." CHRG-111hhrg63105--157 Mr. Jones," Good morning, Mr. Chairman, Members of the Subcommittee. I am Robert Jones, Senior Vice President of ABN AMRO Clearing in Chicago, a futures commission merchant. I serve on the Risk Management Committee of the National Grain and Feed Association, and I am here today to represent the views of the National Grain and Feed Association. We appreciate the opportunity to discuss position limits for enumerated agricultural commodities. Federal position limits are already in place for those commodities, and we believe they are at appropriate levels. Generally, we have found that the Commission understands the impacts of its actions on commercial businesses and is responsive to our concerns. However, the deadlines that have been set in the law are very challenging. For our industry, the price discovery occurs primarily in the futures market, so it's extremely important that we get these rules right. Given the choice, we would prefer to go a little slower and make sure we get it right, rather than rush rules through to meet a deadline and find out later about unforeseen consequences. To provide some context for this, I would like you to think back to 2008. Agricultural futures prices escalated rapidly, resulting in a disconnect of cash and futures values, otherwise known as convergence. Basis levels for producers, essentially the difference between the cash and the futures, widened dramatically. The situation increased risk for grain purchasers and hedgers and caused extreme financial stress due to massive margining requirements. At the same time, marketing opportunities for producers were limited. We believe that the expanded participation by nontraditional participants like index funds and pension funds played a role in the 2008 spike--not the only factor but a factor. Today, conditions exist that could lead to a repeat of that situation. If another investment-fueled futures spike occurs, grain buyers may be forced to limit their purchases from U.S. agricultural producers as occurred in 2008. Certainly buyers would be forced to consider tighter limits on forward contract purchases, and at the very time many producers would like to take advantage of those favorable prices. The NGFA believes that it would be imprudent for the CFTC to change current speculative position limits for the enumerated agricultural commodities. In particular, we have a strong reservation about an approach that would create a combined position limit for over-the-counter instruments and futures based on open interest levels. The majority of the risk management activity for the enumerated ag commodities involves futures traded on exchanges. The practical impact of a combined OTC and futures position limit likely would mean limits ratcheting steeply upward for futures. We fear the result would be a sort of perpetual motion machine leading to investment in enumerated ag commodities in ever-greater amounts and even wider basis swings occurring. In addition, the commodity exchanges, notably the Chicago Board of Trade and the Kansas City Board of Trade, have worked diligently to reestablish convergence in their wheat contracts. Getting it wrong on position limits could undo progress that the exchanges are making toward enhancing the performance of their contracts. Proper functioning of futures markets for traditional commercial users and producers should be the CFTC's overriding consideration in establishing position limits. A reliable relationship between cash and futures must be maintained. Convergence matters, not just sometimes, but consistently and predictably. The National Grain and Feed Association does not favor excluding investment capital from agricultural futures markets, as we believe it does provide liquidity to our markets. However, we believe that the CFTC must establish reasonable limits on an investment in the enumerated ag commodities so these relatively small markets are not overwhelmed by investment demand. Ignoring the unique characteristics of these markets could have highly undesirable consequences for agricultural producers and their traditional hedgers who use these markets for price discovery and risk management. Thank you, Mr. Chairman, for the opportunity to present NGFA's views today. And we will be happy to respond to any questions. [The prepared statement of Mr. Jones follows:] Prepared Statement of Robert Jones, Senior Vice President, ABN AMRO Clearing Chicago LLC; Member, Risk Management Committee, National Grain and Feed Association, Chicago, IL Good morning, Mr. Chairman and Members of the Subcommittee. I am Robert Jones, Senior Vice President of ABN AMRO Clearing Chicago LLC, a futures commission brokerage in Chicago. I serve on the Risk Management Committee of the National Grain and Feed Association (NGFA) and I am here today to represent the views of the NGFA. The National Grain and Feed Association is the national nonprofit trade association that represents more than 1,000 companies that operate an estimated 7,000 facilities nationwide in the grain, feed and processing industry. Member firms range from quite small to very large, both privately owned and cooperative, and handle or process in excess of 70% of all U.S. grains and oilseeds annually. Companies include grain elevators, feed mills, flour mills, oilseed processors, biofuels producers/co-product merchandisers, futures commission merchants and brokers, and related commercial businesses. A common thread for NGFA-member firms is that they rely heavily on efficient futures markets to provide price discovery and risk management for their commercial businesses. In particular, consistent and predictable convergence of cash and futures values is of primary importance to the NGFA. Establishing appropriate speculative position limits for the futures contracts utilized by these traditional commercial hedgers is critically important to maintaining the viability of futures contracts for risk management purposes. It also is essential in enabling our member companies to make forward contracting and other risk management tools available to farmer-customers. We are especially glad for the opportunity this morning to discuss position limits for the enumerated agricultural commodities--that is, wheat, corn, soybeans, livestock and cotton. As you know, Federal position limits already are in place for those commodities. We believe those limits are at appropriate levels and that the process for establishing those limits has worked well. However, the Dodd-Frank Act requires that the CFTC now establish speculative position limits for all commodities, including agricultural commodities. In the past, the NGFA generally had been supportive of occasional requests by futures exchanges to increase speculative position limits. However, futures price volatility in recent years and vastly increased participation by nontraditional participants has altered the situation and, at times, threatened the viability of exchange-traded futures for commercial grain hedgers. The rapid escalation of agricultural futures prices during 2008, and a resulting disconnect of cash and futures values, dramatically increased risks for grain purchasers/hedgers and caused extreme financial stress due to massive margining requirements. We believe that dramatically expanded participation in agricultural futures by nontraditional participants like index funds and pension funds played a role in the 2008 spike--not the only factor, but a significant one. Today, conditions exist that could lead to a repeat of those conditions. With investment capital now seeking enhanced returns and many advisers recommending commodities as an investment vehicle, it appears the stage could be set for another investment-fueled spike in futures prices--an increase we fear will be largely unrelated to market fundamentals and could again result in extreme financial stress. If this happens, grain buyers may be forced to limit their purchases from U.S. agricultural producers, as occurred in 2008. Certainly, buyers would be forced to consider tighter limits on forward contract purchases, at the very time that many producers would like to take advantage of favorable prices. Many Members of Congress have heard from producers about wider basis levels in recent years--that is, the difference between cash bids and futures values on-exchange. We believe strongly that artificially inflated futures values, due in part to participation of nontraditional investors, have led to a disconnect between cash and futures. The commodity exchanges, notably the Chicago Board of Trade and the Kansas City Board of Trade, have worked diligently to address the disconnect and to re-establish convergence in their wheat contracts. Getting it wrong on position limits could undo progress the exchanges are making toward enhancing performance of their contracts. For these reasons, the NGFA believes it would be imprudent for the CFTC to change current speculative position limits for the enumerated agricultural commodities. In particular, we have strong reservations about an approach that would create a combined position limit for over-the-counter instruments and futures based on open interest levels. The logic for not linking speculative position limits to open interest levels is as follows. The majority of risk management activity involving the enumerated ag commodities utilizes futures traded on-exchange. The practical impact of a combined OTC and futures position limit likely would mean limits effectively ratcheting steeply upward for futures--attracting greater investment and boosting open interest levels--which would trigger increased position limits--leading to yet greater participation levels and increased open interest--and triggering even higher position limits--and so on. We fear the result would be a sort of perpetual motion machine leading speculative investment capital to invest in enumerated ag commodities in ever-greater amounts, exacerbating artificially inflated futures values and leading us back to even wider basis swings. Instead, the NGFA strongly urges the CFTC to use proper functioning of futures markets for traditional commercial users and producers as the overriding consideration in establishing position limits. That means that a reliable relationship between cash and futures must be maintained. Convergence Matters! Not just sometimes, but consistently and predictably. We also urge the CFTC to be vigilant in reviewing corporate linkage issues through which investment firms or other nontraditional participants may technically comply with position limits through separate entities, while coordinating positions that would circumvent the intent of the rule. This would seem to us consistent with the Commission's intentions to monitor account ownership and control to help ensure compliance. Mr. Chairman, all these points lead back to one very important message: enumerated agricultural futures contracts must function effectively for traditional commercial hedgers and their farmer-customers. The NGFA does not favor excluding investment capital from agricultural futures markets. In fact, we believe that a desire to invest in our industry is a good thing. It forecasts growth and economic opportunity for U.S. agriculture and agribusiness. However, we believe Congress and the CFTC must act prudently to establish reasonable limits on investment in the enumerated ag commodities and help ensure that those relatively small markets are not overwhelmed by investment demand. Ignoring the unique characteristics of the enumerated agricultural commodities when setting position limits could have highly undesirable consequences for U.S. agricultural producers and the traditional hedgers who use these markets for price discovery and risk management. Thank you, Mr. Chairman, for the opportunity to present the NGFA's views. I would be happy to respond to any questions. " FOMC20060808meeting--58 56,MS. PIANALTO.," Thank you, Mr. Chairman. My outlook hasn’t changed very much since last spring, when I was contemplating the not-so-welcome cycle of slowdown in economic activity and some persistence in both headline and core inflation due to the lingering effects of large energy-price increases. In fact, the Greenbook projections for real GDP now reflect something close to the pessimistic end of where I thought things could be heading. The difference is that I have been thinking more of a cyclical slowdown and not so much of a slowdown in demand and supply, as reflected in the Greenbook baseline. The possibility that slack might not be widening as economic growth moves down puts the recent inflation numbers in a particularly bad light. I have been especially concerned about how broadly based the inflationary pressures appear to be. When you take energy components out of the CPI and you look at the median that Richard was referring to earlier, about 67 percent of the expenditure-weighted items in the CPI increased at an annual rate of 3 percent or more in June, which is about the same share that we have seen since March. As Richard mentioned, the PCE statistics yield basically the same results. In Procter & Gamble’s most recent earnings report, the company attributed its good earnings performance partly to the ability to pass on higher costs through to product prices, and I am hearing similar remarks about pricing power from our directors and District business contacts. Although my business contacts have been reporting some ability to pass on price increases now at the retail level, where in the past they were saying that it was very difficult to go beyond intermediate goods, they’re not so sure that they will get more than one-time catch-up adjustments. Most of my business contacts have not expressed concerns about an elevation in the long-term inflation trend. Nevertheless, I think there are clearly reasons to be worried about the risk of inflationary pressures intensifying over the balance of the projection period. I also think that there is a risk that we’re not going to see as much slack as is embedded in the Greenbook baseline. As in many other parts of the country, activity in the housing sector is slowing in the Midwest, particularly in the Fourth District, and the housing situation in the Fourth District could never be characterized as bubbly or frothy. Some of the veteran Realtors in my District with whom I have been talking are saying that this housing market is the worst that they can recall. Comments like these, although they are selected, do suggest some more uncertain prospects for the housing sector. My directors and business contacts have also been sounding a bit more cautious about the outlook for their sales, but at the same time their capital spending plans appear to be intact. They remain vocal about the ability to get productivity gains, and they remain disciplined about their hiring plans. So as I contemplate the weaker spending track that’s forecast in the Greenbook, I’m inclined to attribute more of it to the demand side of the economy than to the supply side. That is, I am expecting the Greenbook’s call for moderation in economic growth to result in a little more slack than appears in the Greenbook’s baseline. In a qualitative sense, my outlook carries lower inflationary pressure than the Greenbook baseline and thus is similar in spirit to the “lower NAIRU” alternative scenario. Separating the cyclical and structural performance of the economy, of course, is a real challenge, and it is natural, I think, to feel unsure about the real-time estimates and projection of slack. If the slower growth of potential output in the Greenbook baseline is accurate, it raises the possibility that the equilibrium real interest rate may be lower than it was in the last half of the 1990s. In summary, Mr. Chairman, I still think there are risks to both of our objectives. Thank you." fcic_final_report_full--239 Both private and government entities have gone to court. For example, the invest- ment brokerage Charles Schwab has sued units of Bank of America, Wells Fargo, and UBS Securities.  The Massachusetts attorney general’s office settled charges against Morgan Stanley and Goldman Sachs, after accusing the firms of inadequate disclo- sure relating to their sales of mortgage-backed securities. Morgan Stanley agreed to pay  million and Goldman Sachs agreed to pay  million.  To take another example, the Federal Home Loan Bank of Chicago has sued sev- eral defendants, including Bank of America, Credit Suisse Securities, Citigroup, and Goldman Sachs, over its . billion investment in private mortgage-backed securi- ties, claiming they failed to provide accurate information about the securities. Simi- larly, Cambridge Place Investment Management has sued units of Morgan Stanley, Citigroup, HSBC, Goldman Sachs, Barclays, and Bank of America, among others, “on the basis of the information contained in the applicable registration statement, prospectus, and prospective supplements.”  LOSSES: “WHO OWNS RESIDENTIAL CREDIT RISK? ” Through  and into , as the rating agencies downgraded mortgage-backed securities and CDOs, and investors began to panic, market prices for these securities plunged. Both the direct losses as well as the marketwide contagion and panic that ensued would lead to the failure or near failure of many large financial firms across the system. The drop in market prices for mortgage-related securities reflected the higher probability that the underlying mortgages would actually default (meaning that less cash would flow to the investors) as well as the more generalized fear among investors that this market had become illiquid. Investors valued liquidity because they wanted the assurance that they could sell securities quickly to raise cash if neces- sary. Potential investors worried they might get stuck holding these securities as mar- ket participants looked to limit their exposure to the collapsing mortgage market. As market prices dropped, “mark-to-market” accounting rules required firms to write down their holdings to reflect the lower market prices. In the first quarter of , the largest banks and investment banks began complying with a new account- ing rule and for the first time reported their assets in one of three valuation cate- gories: “Level  assets,” which had observable market prices, like stocks on the stock exchange; “Level  assets,” which were not as easily priced because they were not ac- tively traded; and “Level  assets,” which were illiquid and had no discernible market prices or other inputs. To determine the value of Level  and in some cases Level  as- sets where market prices were unavailable, firms used models that relied on assump- tions. Many financial institutions reported Level  assets that substantially exceeded their capital. For example, for the first quarter of , Bear Stearns reported about  billion in Level  assets, compared to  billion in capital; Morgan Stanley re- ported about  billion in Level  assets, against capital of  billion; and Goldman reported about  billion, and capital of  billion. FOMC20080318meeting--37 35,MR. STOCKTON.," Thank you, Mr. Chairman. As you know, we have made some very large changes to the economic projection in this round--so large, in fact, that we had to adjust the scale on the forecast evolution charts that we put in the back of the Greenbook. Obviously, the most notable change has been our adoption of the view that the economy is moving into recession. I thought it would be helpful to briefly review this morning our reasons for making that call at this time. In addition, I will lay out the rationale for the depth and duration of the weakness in real activity that we are now projecting. Finally, I will explain why, with so much more projected slack in resource utilization, inflation has, on average, been revised up from our January projection. We have noted on several occasions in the past few months that our decision to stick with a forecast in which the economy muddles through its current difficulties without falling into recession was a close call. Well, over the intermeeting period, we continued to accumulate a bleak array of economic indicators. Consumer confidence moved still lower and, in the case of the Reuters/Michigan measure, dropped to levels last registered in the early 1990s. Regional indexes of business sentiment continued to deteriorate noticeably, with steep drops in the measures reported for New York, Chicago, and Philadelphia. Although the weakness was less pronounced in the national ISM surveys, the composite indexes for both manufacturing and nonmanufacturing were below 50 in February. Small businesses--as reported in the survey conducted by the National Federation of Independent Businesses--and larger businesses--as captured by the Duke University Survey of Chief Financial Officers-- have turned very pessimistic. These indicators taken alone, or even in limited combination, might not be that troubling. But when viewed as a whole and especially when taken in conjunction with the many financial indicators that have been flashing recession signals for some time, the pattern of recent readings is disturbing. Furthermore, recession signals are no longer limited to surveys and financial indicators. Private payroll employment is estimated to have dropped 101,000 in February, and there were sizable downward revisions to earlier months that left employment showing declines in both December and January. Industrial production dropped 0.5 percent in February, and manufacturing IP fell 0.2 percent. The weakness in industrial production occurred not only in the series in which we use production worker hours to estimate output but also in series where we have measures of physical product. For both payroll employment and industrial production, diffusion indexes indicate that the weakness has been spread widely across industries. This morning's data on housing starts also suggest little end in sight to the ongoing recession in housing. Single-family starts fell more than 6� percent, to 707,000 units, in February, and permits dropped a similar amount. Both figures were very close to our expectations. Multifamily starts moved up to 360,000 units, but that figure follows some low figures late last year, and we wouldn't attach much signal to that reading. Moreover, while I certainly am not going to try to predict what the NBER will ultimately do, a number of the series consulted by the dating committee appear to have peaked late last year or early this year--at least on the currently published data. Real personal income, industrial production, payroll employment, and real manufacturing and trade sales all have local peaks sometime between October and January. All told, the evidence of a serious weakening of the economy appears to us more palpable now than it did in January. If one grants that the economy, from time to time, exhibits nonlinear behavior, then our forecast will need nonlinear changes to avoid making outsized errors. At this point, we've seen enough to make us think that recession is now more likely than a period of weak growth, and that is what we are forecasting. But having made that discontinuous change to our projection, I want to impress upon the Committee just how much this remains a forecast of recession; a lot has to happen that we haven't seen yet to be confident of this call. Indeed, there are several reasons to be skeptical that we have transitioned into recession. One striking feature of several surveys of business sentiment is that businesses appear more pessimistic about the overall economic picture than they do about the prospects for their own firms. Another cautionary reading comes from the motor vehicle sector. Sales have softened noticeably over the past couple of months, but they haven't tumbled as they might have if the economy had already moved into recession. In labor markets, initial claims for unemployment insurance, which had risen earlier in the year, have leveled off of late, with the four-week average running about 360,000 in recent weeks. That level of claims is not yet high enough to clearly signal the declines in private payrolls of between 150,000 and 175,000 that we expect will be occurring this spring. Finally, orders and shipments for nondefense capital goods flattened out late last year but as yet have not shown any signs of serious deterioration, which will be necessary shortly if our projected downturn in capital spending is to come to pass. For now, we are willing to treat these readings as suggesting that there is some upside risk to our forecast of a modest recession. One of the key features of past recessions, as viewed through the lens of our models, is a tendency to observe large negative residuals that are correlated across the major spending equations. We have built that feature into this projection. But this also remains a forecast because a pattern of correlated negative residuals is not yet clearly evident in the data. To gain some perspective on how the forecast would have looked had we not built in these recession effects, we showed an alternative scenario in the Greenbook that effectively removed these residuals. The result is a forecast that is similar to, though in the near term a bit weaker than, the one we showed in the January Greenbook largely because of higher oil prices and weaker housing prices. But we have marked down the baseline forecast considerably more than would be suggested by these factors alone. To be sure, we may have overreacted by moving to a recession call. But that possibility is counterbalanced by some clear downside risks even relative to this more pessimistic forecast. The recession that we are forecasting is relatively shallow. In our forecast, the depth of the downturn is limited in the near term by tax rebates, which provide a substantial boost to disposable income starting in May. This should help to buffer some of the drag on spending that is anticipated to result from declining employment, higher oil prices, and weaker household net worth. Moreover, domestic production benefits appreciably from the past and prospective decline in the exchange value of the dollar and the continued growth in the economies of our major trading partners--factors that help to provide a sizable boost to net exports this year and next. These influences result in a small upturn in real GDP in the second half, and the unemployment rate rises only 1� percentage points, to 5� percent. That is a small increase in unemployment even by the standards of the past two mild recessions. As I've noted, well-timed macro policies and substantial support from the external sector lead us to expect that this time will be different and that the unemployment rate will rise less than usual. But you should always be wary of forecasts that expect this time to be different. Another notable feature of our forecast is that, although the projected downturn in activity is shallow, the period of weak aggregate demand is lengthy, especially given the assumed low level of the real funds rate. For those of you so inclined, this might be a good time to check your Blackberries for e-mail or to get in a couple of games of BrickBreaker because I can assure you that I will not be offering much in the way of scientific insight on this issue. In our forecast, the growth of real GDP picks up next year for several reasons. Housing demand finally bottoms out, and accordingly, construction activity begins to arrest its steep decline. In addition, given our forecast of a flattening of crude prices, the drag from higher oil prices on consumer spending is expected to wane next year. Importantly, we also assume that there will be a gradual lifting of the restraint on spending as financial stress abates. The last influence is now assumed to lift more gradually than in our previous forecast and, along with an intensifying drag from lower house prices, accounts for much of the lingering weakness in this projection. Correspondingly, the unemployment rate falls to only 5� percent at the end of 2009. In our previous forecast, we had the effects of financial stress fading over this year, on the thought that, as it became apparent that the economy would avoid recession and that housing was bottoming out, risk spreads would narrow, credit conditions would loosen up, and spending restraint would ease. Obviously, in our current forecast, the economy experiences recession this year, and housing doesn't show much sign of stabilizing until next year. As a consequence, we don't begin to phase out the unusual restraint on spending resulting from financial stress until next year. This aspect of our forecast, even more than others, is largely guesswork. We just don't have much in the way of historical experience on which to calibrate the projection. In recognition of that uncertainty, we included in the Greenbook two alternative simulations. In the ""faster recovery"" alt sim, we assume a stabilization of housing later this year and a reversal of most risk spreads by the middle of next year. Under these assumptions, growth picks up more noticeably, and a tightening of monetary policy is required next year. Alternatively, one cannot rule out some further deterioration in financial conditions and an even longer period of subpar economic performance. In the ""greater housing correction with more financial fallout"" scenario, a steeper decline in home prices results in a deeper contraction in construction activity, a further widening of risk spreads, tighter lending conditions, and an additional deterioration in household and business sentiment. Although this scenario might sound extreme, it only pushes the outer edge of the 70 percent confidence interval for real GDP and unemployment. It is also sobering to recognize that this simulation results in a nominal funds rate path that skirts the zero bound. The bottom line: We know with probability 1 that the baseline forecast will be wrong. But with the downward adjustments that we have made to this forecast, we feel that there is significant probability mass on both sides of our projection. Despite marking down our forecast of real activity substantially this round, our projection of consumer price inflation, both headline and core, has been revised up in 2008 and is largely unchanged in 2009. Those revisions reflect marginally worse news on the incoming price data as well as further deterioration in some of the key determinants of price inflation. As for the news, our reading of the recent price figures is that core PCE prices probably did not rise as rapidly in January as is currently published but that they likely rose faster in February than might be suggested by a cursory examination of last Friday's CPI report. As we noted in the Greenbook, barring offsetting influences, we believe that the currently reported increase in core PCE prices of 0.3 percent in January will be revised down to 0.2 percent after the BEA incorporates the low reading on medical care services that was shown in the January PPI. As for February, the core CPI being unchanged was a favorable development. But a sizable fraction of the good news was in rents and medical care; rents receive a much smaller weight in PCE prices than in the CPI and, as I just noted, the PCE price index uses the PPI, not the CPI, for measuring medical costs. Incorporating medical care prices from this morning's PPI release suggests to us that core PCE prices rose about 0.15 in February. All told, we are projecting an increase in core PCE prices of 2.5 percent at an annual rate in the first quarter, 0.1 percentage point more than in January. We have also incorporated into this forecast a further jump in the cost of crude oil and higher import prices associated with the weaker dollar and more-rapid gains in commodity prices. Moreover, we have read the survey measures and TIPS spreads as suggesting that there may have been some deterioration in inflation expectations of late. Taken together, these less favorable developments more than offset the projected emergence of some slack in resource utilization. As a consequence, we are now projecting core PCE prices to rise 2.3 percent this year, up � percentage point from our January projection. Despite an unemployment rate that runs nearly � percentage point above our previous forecast, we have left unrevised our projection of core PCE prices in 2009 at 1.9 percent. Higher food and energy prices have resulted in a further upward revision to total PCE price inflation of nearly � percentage point, to 2.9 percent, in 2008. Total PCE price inflation for 2009 is unrevised at 1.7 percent. Before turning the floor over to Nathan, I want to let the Committee know that the three research divisions are undertaking a review of the structure of our policy documents. The Greenbook and Bluebook have grown in length and complexity over the past decade. Our objective in this review will be to improve the focus and flow of the documents and to eliminate the redundancy that has crept in over time so as to reduce the burden on you in reading the documents and the burden on the staff of producing them. We will, of course, consult with the Committee before implementing any substantive changes. Nathan will now continue our presentation. " FOMC20071211meeting--82 80,MS. YELLEN.," Thank you, Mr. Chairman. At the time of our last meeting, I held out hope that the financial turmoil would gradually ebb and the economy might escape without serious damage. Subsequent developments have severely shaken that belief. The bad news since our last meeting has grown steadier and louder, as strains in financial markets have resurfaced and intensified and as the economy has shown clear signs of faltering. In addition, the downside threats to growth that then seemed to be tail events now appear to be much closer to the center of the distribution. I found little to console me in the Greenbook. Like the Board staff, I have significantly marked down my growth forecast. The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real. Conditions in financial markets have worsened. Rates on a wide array of loans and securities have increased significantly since our last meeting, including those on term commercial paper, term LIBOR, prime jumbo mortgages, and high-yield corporate bonds. CDS spreads from major financial institutions with significant mortgage exposure, including Freddie and Fannie, have risen appreciably. In addition, broad stock indexes are down nearly 5 percent. At the same time, measures of implied volatility in equity, bond, and foreign exchange markets have all moved up, reflecting the greater uncertainty about the economy’s direction. The most recent data on spending have been discouraging as well. Data on house sales, prices, and construction have been downbeat, and foreclosures on subprime loans have moved even higher. Even with efforts such as those facilitated by the Administration to freeze subprime rates, foreclosures look to rise sharply next year, which may dump a large number of houses on a market already swamped with supply. This will exacerbate the downward pressure on house prices and new home construction from already elevated home inventories. Indeed, the ten-city Case-Shiller home-price index has declined more than 5 percent over the past year through September, and futures contracts point to another sizable decline over the next twelve months. I am particularly concerned that we may now be seeing the first signs of spillovers from the housing and financial sectors to the broader economy. Although the job market has remained reasonably healthy so far, real consumer spending in September and October was dead in the water, and households are growing more pessimistic about future prospects. The December reading of consumer sentiment showed another decline, and the cumulative falloff in this measure is becoming alarming. Gains in disposable income have been weakened. With consumer sentiment in the doldrums, house prices on the skids, and energy prices on the rise, consumer spending looks to be quite subdued for some time. This view is echoed by the CEO of a national high-end clothing retailer on our board, who recently emphasized to us that the positive chain store sales data in November were in fact artificially boosted by the Thanksgiving calendar shift and that the underlying trend for his business has worsened notably. My modal forecast foresees the economy barely managing to avoid recession, with growth essentially zero this quarter and about 1 percent next quarter. I expect growth to remain below potential throughout next year, causing the unemployment rate to rise to about 5 percent, much like in the Greenbook. This forecast assumes a 50 basis point decline in the federal funds rate in the near future, placing the real funds rate near the center of the range of estimates of the neutral rate reported in the Bluebook. I should emphasize that I do not place a lot of confidence in this forecast, and, in particular, I fear that we are in danger of sliding into a credit crunch. Such an outcome is illustrated by the credit crunch alternative simulation in the Greenbook. Although I don’t foresee conditions in the banking sector getting as bleak as during the credit crunch of the early 1990s, the parallels to those events are striking. Back then, we saw a large number of bank failures in the contraction of the savings and loan sector. In the current situation, most banks are still in pretty good shape. Instead, it is the shadow banking sector— that is, the set of markets in which a variety of securitized assets are financed by the issuance of commercial paper—that is where the failures have occurred. This sector is all but shut for new business. But bank capital is also an issue. Until the securitization of nonconforming mortgage lending reemerges, financing will depend on the willingness and ability of banks, thrifts, and the GSEs to step in to fill the breach. To the extent they do, that will put further pressure on their capital, which is already under some pressure from write-downs on existing loans and holdings of assets. Banks are showing increasing concern that their capital ratios will become binding and are tightening credit terms and conditions. Several developments suggest to me that this situation could worsen. In addition to the problems plaguing the adjustable-rate subprime mortgages, delinquencies have recently started to move up more broadly—on credit card and auto loans, adjustable-rate prime mortgages, and fixed-rate subprime mortgages. My contacts at large District banks tell me that, because the economy continues to be reasonably healthy and people have jobs, things are still under control. But if house prices and the stock market fall further and the economy appears to be weakening, then they will further tighten the lending conditions and terms on consumer loans to avoid problems down the road, and these fears could be self-fulfilling. If banks only partially replace the collapsed shadow banks or, worse, if they cut back their lending in anticipation of a worsening economy, then the resulting credit crunch could push us into recession. This possibility is presumably increasingly reflected in CDS and low-grade corporate bond spreads. Thus, the risk of recession no longer seems remote, especially since the economy may well already have begun contracting in the current quarter. Indeed, the December Blue Chip consensus puts the odds of a recession at about 40 percent. This estimate is within the range of recession probabilities computed by my staff using models based on the yield curve and other variables. Turning to inflation, data on the core measure continues to be favorable. Wage growth remains moderate, and the recent downward revisions to hourly compensation have relieved some worries there. Inflation expectations remain contained. As I mentioned, I expect some labor market slack to develop, and this should offset any, in my view, modest inflationary pressures from past increases in energy and import prices and help keep core PCE price inflation below 2 percent. Continued increases in energy and import prices pose some upside risk to the inflation outlook, but there are also downside risks to inflation associated with a weakening economy and rising unemployment. To sum up, I believe that the most likely outcome is for the economy to slow significantly in the near term, flirting with recession, and I view the risk to that scenario as being weighted significantly to the downside. In contrast, I expect inflation to remain well contained, and I view those risks as fairly balanced." FOMC20070807meeting--43 41,MS. JOHNSON.," The financial market turmoil over the intermeeting period has not been confined to U.S. markets. In today’s financially globalized world, events in one asset market frequently have consequences in other markets and other countries; both the level and the volatility of asset prices abroad have moved with U.S. asset market developments. Equity prices are generally down, although not in China. Yields on long-term sovereign fixed-income securities are also generally down. CDS spreads, corporate bond spreads, EMBI+ spreads, and similar measures are generally up. With so much action happening in global financial markets, you might have expected some major revisions to our outlook for foreign real growth and inflation. Yet with the exception of revisions to some second-quarter numbers because of surprises from incoming data, the baseline forecast this time is little changed from that in June. Two reasons for the lack of significant macroeconomic consequences in the rest of the global economy from these financial events seem particularly noteworthy. One is that there is no sector abroad in any of the major regions that corresponds to the U.S. housing sector and its direct ties to credit problems related to subprime mortgages. The second reason is that we do not observe any telltale signs, such as overexpansion by one or more industries or fragile household balance sheets, that would suggest that some repricing of risky assets and perhaps some restraint in credit creation would trigger significant changes in real economic behavior of firms or households. The global economy expanded strongly in the first half of this year with the underlying strength broadly distributed across regions and sectors. As a result, it is in robust condition and is likely able to withstand the adjustment proceeding in financial markets without substantial risk to continued real expansion or creation of inflationary pressures. Of course, we cannot be certain that continued or more- intense disorderly conditions in financial markets will not trigger a negative macroeconomic reaction, nor do we know for sure that problems are not already present but are not yet visible to us. So we see the events of the past several weeks as giving rise to an abundance of downside risk to our forecast of real activity rather than to changes in the baseline. Despite a basically unchanged outlook for the rest of the global economy, two elements of the international forecast merit some further discussion: global oil market developments over the intermeeting period and the staff’s judgment that U.S. real imports of goods and services will expand at a rate about 1 percentage point lower than we projected in June. On July 31, the spot price for WTI rose above $78 per barrel and attracted attention for having reached a new peak value. Although that price subsequently moved back down somewhat, the spot WTI price was about $7 per barrel higher on the day we finalized the Greenbook forecast than it was on the comparable day in June. In part, the upward shift in the spot WTI price reflected an unwinding of most of the unusual discount for WTI relative to Brent and other grades of oil that persisted from mid-March until recently as a result of large inventories of WTI at certain locations. By comparison, the spot price for Brent crude oil rose nearly $4 per barrel over the same interval. The upward pressure on spot prices appeared to arise from the supply side, with production restraint by OPEC a factor. However, although prices moved up noticeably at the front of the curve, futures prices for oil dated later this year and early next year moved up much less; and futures prices for crude oil in late 2008 and beyond actually moved down. As a consequence, the oil futures curve returned to what is called “backwardation,” meaning that the spot price is above futures prices, which tend to flatten out at more- distant dates. Putting all this together, our forecast for the U.S. oil import price is more than $4 per barrel higher for the very near term than it was in June, but it is little changed over 2008. So the impact of higher oil prices on our trade deficit is limited. Whereas some upward push to consumer prices abroad might result from the recent increases in crude oil prices, our expectation, based on futures markets, that they will prove transitory means that few sustained pressures on inflation should result. Our forecast for the growth of total U.S. imports of goods and services has been revised down about 1 percentage point for the second half of this year and nearly that much for next. The resulting annual growth rates of 2¾ percent in the near term and 3 percent next year are about 3 percentage points below the growth we are projecting for real exports of goods and services. Although in the near term slightly weaker projected imports for oil and natural gas are part of the story, further out weaker growth in imported core goods and services largely account for the revision. For these two categories, the downward revision reflects the changes in this forecast to the projected level of the dollar and to the path for U.S. real GDP. We have made some small adjustments to our outlook for the constituent currencies in our broad dollar index that by chance are offsetting, leaving the staff forecast for the rate of depreciation of our real broad dollar index going forward about the same as in June. However, the depreciation of the dollar that has already occurred since your June meeting resulted in a downward shift in the current-quarter starting value for our forecast path of about 1¼ percent. That real depreciation works to restrain imports of core goods and of services somewhat, especially in the near term. Parenthetically, it also has a stimulative effect on our exports of core goods and services. The lower path for U.S. GDP growth going forward is the primary explanation of our downward revision to projected import growth. With U.S. GDP now expected to grow at an annual rate of 2 percent, rather than 2½ percent, imports of both core goods and services decelerate more than in proportion, as our best estimate of the income elasticities for each of these categories is above 1. Of course, the baseline path for U.S. real GDP takes into account the lower imports and the simultaneous nature of the determination of GDP and its components. But the information contained in the annual revision to past U.S. GDP growth and the prospect of lower potential GDP going forward was “news” to our import model and led us to make the downward revisions I have just described. With growth of real exports of goods and services revised up only slightly, their positive contribution to real GDP growth is just a bit more positive. In contrast, the negative contribution from real imports is now significantly smaller in absolute value. As a result, the overall arithmetic contribution from real net exports to real GDP growth over the forecast period is positive at an annual rate of about ¼ percentage point. Such an outcome would mean that real net exports have contributed or will contribute positively to real GDP growth in each of 2006, 2007, and 2008. From the perspective of real GDP, a positive contribution from real net exports is one very reasonable criterion for external adjustment, should it be sustained. Brian will now continue our presentation." FOMC20070321meeting--3 1,MR. DUDLEY.,"1 Thank you, Mr. Chairman. Financial markets have become much more turbulent since the last meeting—especially in subprime mortgages and associated securities, in U.S. and global equities, and in foreign exchange markets. The good news is that markets have generally remained liquid and well functioning, with a minor exception on the New York Stock Exchange on February 27. Moreover, there are few signs of significant contagion from the subprime mortgage market into the rest of the mortgage market or from subprime mortgage credit spreads to corporate credit spreads more generally. In general, the debt markets have been mostly unruffled by recent developments. I plan to focus my attention on four major market developments. First, the substantial turmoil in the subprime mortgage market—I talked about the risk that this market might unravel at the January FOMC meeting; that certainly occurred more quickly and more forcefully than I anticipated. Second, I want to talk a little about the decline in U.S. equity prices and the accompanying rise in actual and implied price volatility. Third is the sharp correction in the so-called “carry trade” in foreign exchange markets. The low interest rate currencies such as the yen and the Swiss franc have appreciated, with the greatest moves coming against their higher-yielding counterparts. Finally, I’ll talk a bit about the sharp downward shift in market expectations about the path of the federal funds rate target over the next year and a half. Two key questions motivate my comments. First, is the market turbulence driven mainly by fundamental developments, or does it reflect mainly a shift in the risk appetite of investors? Second, what is the ongoing risk of contagion from the market area that has experienced the most stress—the subprime mortgage market—to other markets? Regarding the subprime mortgage market, the deterioration appears driven mostly by fundamental developments. As you know, the delinquency rates for subprime adjustable-rate mortgages have risen sharply. In contrast, as shown in exhibit 1 of the handout, there has been little change in delinquency rates for fixed-rate mortgages. Most significantly, delinquency rates for the 2006 vintage of subprime adjustable-rate mortgages have climbed unusually quickly. As shown in exhibit 2, the last vintage that went this bad so fast was the 2001 vintage, and that had a much different economic environment—one characterized by a mild recession and a rising unemployment rate. The deterioration in the quality of subprime mortgage credit has led to a sharp widening in credit spreads for the ABX indexes. The ABX indexes 1 Material used by Mr. Dudley is appended to this transcript (appendix 1). represent the cost of default protection on a basket of collateralized debt obligations that are backstopped mainly by subprime mortgages. As shown in exhibit 3, although this widening has been most pronounced at the bottom end of the credit quality spectrum (BBB-minus and BBB), it has rippled upward to the higher-rated tranches that are better protected. Exhibit 4 shows how the credit deterioration initially registered in the ABX indexes as market participants sought to buy protection. In milder form, this deterioration also registered in the underlying collateralized debt obligations and asset-backed securities. The widening of the credit spread in the ABX indexes was probably exaggerated by the fact that there was an asymmetry between the many that were seeking loss protection and the few that were willing to write protection. This can be seen in two ways. First, as shown in exhibit 4, the spread widening was more pronounced in the ABX index than in either underlying collateralized debt obligations or asset-backed securities. Second, as shown in exhibit 3, the ABX spreads have come down a bit from their peaks even as the underlying market for subprime mortgages, as reflected in the ongoing viability of many mortgage originators, has continued to deteriorate. The deterioration in the subprime market has undermined the economics of subprime mortgage origination and securitization. This is especially true for those mortgage originators with poorer underwriting track records. Their loans can no longer be sold at a sufficient premium to par value to cover their origination costs. In addition, the costs that they must incur to replace loans that have defaulted early have increased sharply. In several cases, these difficulties have caused banks to pull their warehouse lines of credit. Several of the large monoline originators are bankrupt, distressed, or up for sale—they are highlighted in red in exhibit 5. Moreover, several of the diversified lenders, such as HSBC, have indicated that they are tightening credit standards and pulling back from this sector. The result is that the volume of subprime mortgage originations is likely to fall sharply this year—perhaps dropping one-third or more from the 2006 rate of slightly more than $600 billion. This tightening of credit availability to subprime borrowers is likely to manifest itself through a number of channels. These channels include (1) a drop in housing demand, as borrowers who would have been able to get credit in 2006 no longer qualify under now toughened underwriting standards; (2) an increase in housing supply, as the rate of housing foreclosures increases (notably, the Mortgage Bankers Association reported last week that the rate of loans entering the foreclosure process in the fourth quarter of 2006 reached a record level of 0.54 percent, the highest level in the history of the thirty-seven-year-old survey); and (3) additional downward pressure on home prices, which in turn threatens to increase the magnitude of credit problems, delinquencies, and foreclosures. In considering these channels, it is important to emphasize that the credit strains in the subprime sector are unlikely to have peaked yet. The reset risk on the adjustable-rate portion of the subprime loans originated in 2005 and 2006 will be felt mainly over the remainder of 2007 and 2008. Most of the adjustable-rate loans are fixed for two years at low “teaser” rates. When yields adjust upward once the teaser rate period is over, some borrowers may have insufficient resources to service these debts. The good news—at least to date—is that spillover into the alt-A mortgage and conforming mortgage areas is very mild, both in terms of credit spreads and in terms of loan performance. Although there has been some rise in delinquency and foreclosure rates for higher-quality residential mortgages, these rates are still low both qualitatively and historically. Moreover, there is little evidence that the subprime problems have hurt mortgage loan volumes. For example, the Mortgage Bankers Association index of mortgage applications for purchase has increased in the past three weeks. Turning next to the U.S. equity market, it is less clear-cut whether the decline in prices and the rise in volatility are fundamentally based. As several observers have noted, equity valuations do not appear to be excessive. If that is the case, then why have equities been more turbulent than corporate and emerging-market debt, for which spreads remain unusually narrow? Although this point is legitimate, two fundamental developments that make U.S. equity prices less attractive deserve mention. First, equity analysts have been reducing their earnings forecasts for 2007. Although the top-down view of the equity strategists for the S&P 500 index has not changed much, on a bottom-up basis, earnings expectations have dropped sharply. As shown in exhibit 6, the aggregate forecasts of the individual sector analysts now indicate a growth rate in S&P 500 earnings for 2007 of about 6 percent, down from about 9 percent at the beginning of the year. In contrast, S&P 500 earnings have grown at an annual rate of more than 10 percent for four consecutive years. It should be no surprise that falling earnings expectations could weigh on equity prices. Second, uncertainty about the growth outlook has increased. This shows up clearly, for example, in our most recent primary dealer survey. Because greater uncertainty about the growth outlook presumably implies greater risk, the rise in uncertainty should—all else being equal—result in lower share prices. In contrast, it is easier to explain the modest widening of corporate credit spreads. In theory, lower share prices and higher volatility imply a greater risk of default, which should imply wider credit spreads. Corporate credit spreads have behaved in a manner consistent with this. Josh Rosenberg from the research group at the Federal Reserve Bank of New York recently investigated this issue. He found that the spread widening in the high- yield corporate debt sector was consistent with past periods in which the implied volatility for equities rose sharply. Exhibit 7 summarizes one key result. The widening in the BB-rated corporate spreads in the week after the February 27 retrenchment was of a magnitude similar to that of other instances in which implied equity-price volatility as measured by the VIX index rose sharply. In the most recent episode, the VIX index rose 848 basis points, and the BB corporate spread rose 27 basis points. This rise compares with an average rise of 21 basis points in the BB spread in the ten cases in which the VIX rose most sharply. The rise in the most recent episode is well within the range of historical experience. In many other areas in which asset prices have moved sharply, risk-reduction efforts appear to have played the biggest role. For example, in the foreign exchange markets, the biggest currency moves were in the currency pairs associated with so- called carry trades, such as the yen and Swiss franc for the low-yielding currencies and the Australian and New Zealand dollar for the high yielders. Exhibit 8 indicates the change in the yen versus the Australian dollar, the New Zealand dollar, the euro, the British pound, and the U.S. dollar during three separate periods—the week before the February 27 stock market selloff, the week of the stock market selloff, and the past two weeks. The high-yielding currencies appreciated the most during the run-up to the February 27 selloff, fell the most during the February 27 week, and have recovered the most against the yen over the past two weeks. The changes in speculative positioning in foreign exchange future markets tell a similar story. Exhibit 9 shows the change in the share of the open interest position held by participants in the noncommercial futures market. Over the past few weeks, net short positions as a percentage of the overall open interest in the yen have dropped, and long positions in the British pound and Australian dollar have dropped. An examination of how Treasury yields, stock prices, exchange rates, and credit spreads have moved also indicates that risk-reduction efforts have been important. Exhibit 10 shows the correlation of daily price and yield movements in 2007 before February 27. As one can see, the correlations were quite low. In contrast, the correlation matrix in exhibit 11 shows the correlation of daily price moves for the period beginning on February 27. Most of the correlations have climbed sharply, suggesting that risk positioning is driving price and yield movements. Finally, short-term interest rate expectations have shifted substantially since the last FOMC meeting. As shown in exhibit 12, near-term expectations have shifted, with market participants now expecting a modest reduction in the federal funds rate target by late summer. However, the federal funds rate futures curve is still above the curve at the time of the December FOMC meeting. In contrast, longer-term expectations have shifted more sharply, with a larger move toward easing. As shown in exhibit 13, the June 2008/June 2007 Eurodollar calendar spread is now inverted by about 60 basis points. This calendar spread is more inverted than it was at the time of the December 2006 FOMC meeting. Compared with the shift in market expectations, the forecasts of primary dealers have not changed much. Exhibits 14 and 15 compare dealer expectations with market expectations before the January FOMC meeting and before this meeting. The horizontal bold lines represent market expectations. The blue circles represent the different dealer forecasts. The green circles represent the average dealer forecast for each period. The two exhibits illustrate several noteworthy points. First, the average dealer forecast has not changed much since the January FOMC meeting—the green circles in the two charts are in virtually the same position. Second, the amount of dispersion among the dealers’ forecasts has not changed much—in fact, the range of the blue circles is slightly narrower currently. Although many dealers now mention that their uncertainty about the growth outlook has increased, that does not appear to have been reflected in their modal forecasts. Third, there is now a substantial gap between the dealers’ average forecast and market expectations—the gap between the horizontal bold lines, which represent market expectations, and the green circles, which represent the average dealer’s view, has increased. Why is there a large gap between the dealers’ forecasts and market expectations? I think there are three major explanations. First, the dealers’ forecasts are modal forecasts and do not reflect the downside risks that many dealers now believe have emerged in the growth outlook. Second, dealer forecasts often lag behind economic and market developments. Only when “downside risks” grow big enough to pass some threshold are dealers likely to alter their modal forecasts. Third, some of the downward shift in market expectations may represent risk-reduction efforts. An investor with speculative risk positions that would be vulnerable to economic weakness might hedge these risks by buying Eurodollar futures contracts. This hedging could push the implied yields on Eurodollar futures contracts lower than what would be consistent with an unbiased forecast of the likely path of the federal funds rate. Nevertheless, the potential gap between market expectations and the Committee’s interest rate expectations may pose a bit of a conundrum for the Committee. If the Committee were to shift the bias of its statement in the direction of neutral, market expectations with respect to easing would undoubtedly be pulled forward and might become more pronounced. After all, most dealers expect that the Committee will not change the inflation bias of the January FOMC statement. In contrast, keeping the bias unchanged in order to keep market expectations from shifting further in the easing direction might be inconsistent with the Committee’s assessment of the relative risks regarding growth and inflation. If the Committee were to keep the bias unchanged even when its views had changed, the communication process might be impaired. On a housekeeping note, I wish to bring to the Committee’s attention the changes to the “Morning Call” with the Trading Desk. They were discussed in a memo distributed to the Committee last week. Under the new format, which we plan to implement on Thursday, the call will be open to all members of the Committee, and you will have the option of participating in the 9:10 a.m. discussion of reserve management issues, the 9:20 a.m. portion covering recent developments in global markets, or both portions. The March 15 memo outlines the new procedures for joining these calls. Finally, there were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the January FOMC meeting. Of course, I am very happy to take questions." FOMC20070918meeting--124 122,MR. KOHN.," Thank you, Mr. Chairman. The repricing of risk and rechanneling of credit flows under way I believe will exert restraint on spending, especially in the near term, but over the longer run as well. A critical channel of contagion that came into play in the intermeeting period was the involvement of the banks as providers of credit and liquidity backstops in the ABCP market. As a consequence, uncertainties about real estate markets, the performance of nonprime mortgages, and structured-credit products came to rest as greater uncertainty about bank exposures. The classic flight to safety under way—the desire to protect capital and liquidity—has caused banks and those providing them credit to become more cautious. This has resulted in greatly reduced funding in term markets spreading the constriction of credit potentially well beyond the mortgage and leveraged-loan markets we talked about in early August. Like so many around the table, I feel that I can honestly say that the uncertainties around the output forecast were indeed larger than usual this time. Fortunately, we don’t have many degrees of freedom to test hypotheses about the sorts of relationships that we’re talking about here. I think we can expect effects on spending to be greatest in the short and intermediate terms, while markets are disrupted and while participants are struggling to find new ways of intermediating credit that address the perceived shortcomings of the previous practices. In the short run, to preserve capital and liquidity while secondary markets are impaired, banks have tightened terms and standards for loans. You can see this directly in the rise in spreads in the prime jumbo market, but it must be true for other less easily observed credits as well. Some credits, such as nonprime mortgages and leveraged loans, just haven’t been available for a while. An already weak housing market has been most directly affected, and construction sales and prices will probably fall substantially further because of the reduced demand along with a large overhang of unsold homes. Consumption spending is also likely to be trimmed. Tighter terms for home equity lines of credit and second mortgages mean not only that housing wealth is declining but also that it is probably less liquid and more expensive. To the extent that asset- backed security markets are affected and lenders have questions about consumer balance sheets, the cost of consumer credit could well rise also. Household confidence has apparently been affected by the adverse financial market news. Investment spending may also be held down by uncertainty, by a sense that consumer demand will be growing less rapidly. I have been struck in listening to presidents around the table report about their Districts that the tone has shifted noticeably toward less optimism, slower growth, and more caution on the part of our business respondents. It has been one of those shifts that you hear every couple of years around the table that are different from what might have been anticipated, say, from reading the Beige Book. There is also some tightening of credit conditions in the business sector—for example, for commercial real estate credit, as some have noted, and for credit for below-investment-grade firms. As a consequence, some downshift in GDP is highly likely over the next few quarters, and without policy action, we would most likely end up with a substantially lower GDP a few quarters out. Indeed, in the Greenbook, the output gap is noticeably wider at the end of ’08 despite near-term policy easing of 50 basis points. I also noted downside risk to my output forecast. It seems to me that, in this period when markets are adjusting, those risks are most skewed. The potential for adverse interactions seems large, as nervous creditors assess the implications of declines in house prices, volatile earnings of commercial and investment banks, and setbacks in overall confidence. I think there is a non-negligible risk that the constrictions in credit availability would feed back on the economy and, in turn, feed back on credit supply. As market participants are better able to distinguish and assess risk, liquidity will be re-established in many markets. Although we have seen some improvement in the past week or two, markets are still quite dysfunctional in many regards. Like others, I think it could take a while to discover how to structure securitizations that have the requisite transparency and appropriate principal-agent incentives to restore investor confidence and to recalibrate the roles of securities markets and banks. The process could be particularly drawn out in mortgage and related markets, which are likely to be affected for some time by uncertainties about the prices of houses and about the performance of mortgages. Moreover, some effects of the recent turmoil will be longer lasting. Risk spreads in a great variety of markets are likely to be at higher, more- realistic, and more-sustainable levels; banks should be charging more for credit liquidity backstops; less leverage in the financial sector implies a need for return on the greater amount of capital involved in intermediation, including at banks; and some credit conditions at any given fed funds rate will be tighter one year from now than they were a few months ago. I have concentrated on problems for growth, but the upside inflation risks have not disappeared. Unit labor costs have been rising. Markups, while still high, have come in, affording a reduced cushion for absorbing labor costs. Resource utilization remains high by historical standards. Import prices may prove problematic. Although commodity prices may level out as in the staff forecast, foreign economies also are producing at high levels. Pressures on the costs of finished goods could increase, especially if the dollar declines further. My expectations for the most likely path for inflation have been revised just a tick lower, given the favorable incoming data and the lower path for economic activity relative to potential, which will increase competitive pressures in labor and product markets. For now, given this outlook, we need to concentrate on the potential effects of the disruptions to financial markets on the real economy when we consider policy in the next portion of this meeting. Thank you, Mr. Chairman." CHRG-111hhrg53021--10 Mr. Lucas," Thank you, Mr. Chairman and thank you to both Chairmen for holding this joint hearing to hear the Treasury's proposal to regulate over-the-counter derivatives, as well as examine the legislation that the House Agriculture Committee passed a few months ago. I, as Ranking Member of the House Agriculture Committee and senior Member of the Financial Services Committee, I would like for this occasion to examine the issue from two different perspectives. The Agriculture Committee has been very active in exploring the role derivatives play in the marketplace, and in the overall economy. The Committee has held numerous hearings to gain further information and insight into the complex nature of credit default swaps and how they should be regulated. In February of this year, as the Chairman noted, the Agriculture Committee passed H.R. 977, the Derivatives Markets Transparency and Accountability Act. No one can argue that the concepts of transparency and accountability are wrong, but we must make certain that our actions call for an appropriate level of regulation that will respect the nature of the marketplace and encourage product innovation and economic growth. Derivatives do serve a valid purpose in the marketplace when used with judgment. They are essential for managing risk. We must consider that there are numerous industries that have legitimate price risk and there must be a way to mitigate that. Derivatives provide a legitimate means for managing that risk. The financial problems that we have seen recently are not the result of merely the existence of derivatives, but rather because there are problems in measuring their true performance, or knowing with certainty the depth and breadth of the over-the-counter market, or knowing with confidence the creditworthiness of the counterparty. Simply put, the marketplace can be protected from market failures if regulators are fully aware of the threat. Ignorance of this relatively new financial instrument caused much of the financial failures. We now know that these complex markets need better models and methods for oversight and transparency. However, we must be careful not to overreach and force businesses into very expensive clearing operations that cost capital that they do not have, or force them out of risk mitigation all together. Business will then be forced to manage risk with higher prices, which will ultimately be passed on to consumers. The need to avoid artificial costs for business was the reason I opposed the clearing requirement in H.R. 977. There is considerable concern that section 13, as currently drafted, which relates to the clearing requirement will stifle invasion in the over-the-counter market. CFTC needs more authority to waive the clearing requirements in section 13 so new and safer products can get to the market in a timely fashion. This would recognize the fact that not all contracts can be cleared and that there is a need for customized contracts. These are just a few of the concerns I have on my part as we move forward today. Again, I thank you for the opportunity to discuss the issues regarding these important financial institutions. And Secretary Geithner, I look forward to your testimony and the answers to the questions posed by the panel. Thank you, Chairman. " CHRG-111hhrg53021Oth--10 Mr. Lucas," Thank you, Mr. Chairman and thank you to both Chairmen for holding this joint hearing to hear the Treasury's proposal to regulate over-the-counter derivatives, as well as examine the legislation that the House Agriculture Committee passed a few months ago. I, as Ranking Member of the House Agriculture Committee and senior Member of the Financial Services Committee, I would like for this occasion to examine the issue from two different perspectives. The Agriculture Committee has been very active in exploring the role derivatives play in the marketplace, and in the overall economy. The Committee has held numerous hearings to gain further information and insight into the complex nature of credit default swaps and how they should be regulated. In February of this year, as the Chairman noted, the Agriculture Committee passed H.R. 977, the Derivatives Markets Transparency and Accountability Act. No one can argue that the concepts of transparency and accountability are wrong, but we must make certain that our actions call for an appropriate level of regulation that will respect the nature of the marketplace and encourage product innovation and economic growth. Derivatives do serve a valid purpose in the marketplace when used with judgment. They are essential for managing risk. We must consider that there are numerous industries that have legitimate price risk and there must be a way to mitigate that. Derivatives provide a legitimate means for managing that risk. The financial problems that we have seen recently are not the result of merely the existence of derivatives, but rather because there are problems in measuring their true performance, or knowing with certainty the depth and breadth of the over-the-counter market, or knowing with confidence the creditworthiness of the counterparty. Simply put, the marketplace can be protected from market failures if regulators are fully aware of the threat. Ignorance of this relatively new financial instrument caused much of the financial failures. We now know that these complex markets need better models and methods for oversight and transparency. However, we must be careful not to overreach and force businesses into very expensive clearing operations that cost capital that they do not have, or force them out of risk mitigation all together. Business will then be forced to manage risk with higher prices, which will ultimately be passed on to consumers. The need to avoid artificial costs for business was the reason I opposed the clearing requirement in H.R. 977. There is considerable concern that section 13, as currently drafted, which relates to the clearing requirement will stifle invasion in the over-the-counter market. CFTC needs more authority to waive the clearing requirements in section 13 so new and safer products can get to the market in a timely fashion. This would recognize the fact that not all contracts can be cleared and that there is a need for customized contracts. These are just a few of the concerns I have on my part as we move forward today. Again, I thank you for the opportunity to discuss the issues regarding these important financial institutions. And Secretary Geithner, I look forward to your testimony and the answers to the questions posed by the panel. Thank you, Chairman. " FOMC20080625meeting--133 131,MR. KOHN.," Thank you, Mr. Chairman. I support the action and language of alternative B; Brian's striking of ""near-term"" is fine with me. This is a tough situation, as we all remarked yesterday. Commodity prices are at the center of the problem that we find ourselves in. In my view, we didn't cause the rise in commodity prices. We may have contributed a little around the edges, but whatever we contributed was a necessary byproduct of what we needed to do to cope with what was happening to the U.S. economy, and we can't reverse the rise in relative prices without tremendous cost to the U.S. economy. Or even the rise in headline inflation, we couldn't undo that without putting a huge amount of slack in the economy to force down wages, sticky prices, et cetera, and that would not be appropriate. I think the classic response that we've all been talking about is to take a temporary increase in inflation and in unemployment that facilitates the relative price changes that need to happen, concentrate on second-round effects, and make sure those increases are temporary. I think that's inadvertently what we've fallen into here. Given the housing and financial shocks, the 2 percent fed funds rate of alternative B is consistent for now with continuing along the path of the temporary increases in inflation and unemployment. Unlike many of you, I don't see the current rate as extraordinarily accommodative, given what else has happened in financial markets. There is no insurance in the staff forecast, right? The Greenbook forecast has zero insurance in it. My own forecast was a little stronger than the Greenbook's. I think all of ours were a little stronger than the Greenbook's, but even if I marked up r* by � point or 1 point, that's not a huge amount of insurance in the circumstances that we're facing. I note that no one sitting around this table predicted a decline in the unemployment rate over the balance of the year; so everybody has 5� percent or higher unemployment rates predicted by the end of the year. The staff thinks that the current 5� percent is a little too high. So they are expecting the unemployment rate to come down in the next month or two. Given this, we're all expecting the unemployment rate to rise over the balance of the year. I would think, given the lags in policy, that if you thought policy was hugely accommodative, you'd see some decline in the unemployment rate over the next six, seven, or eight months. I think our own forecasts suggest that some insurance might be here, but not the amount that I'm hearing some of you talk about. I don't see the consistency there. My own view is that there's probably a little insurance in it, and it's appropriate for now. I agree that the next move in interest rates is more likely to be up than down. I assumed, like President Yellen, that it would be at the end of this year or at the beginning of next year. The rising unemployment that we all expect should help damp inflation and inflation expectations and make it very hard to pass through all these cost increases that we're hearing from businesses that they want to pass through and certainly make it hard for wages and cost pressures to rise. So I agree with everyone else that the weight in the two tails has shifted. There's less weight in the downside risk tail for output and more weight in the upside risk tail for inflation. The statement does a very nice job of saying that explicitly, and I think that we just need to await incoming data and information about inflation expectations, costs, and whatnot to see when the appropriate time to move will be. Because I don't think there's a tremendous amount of insurance in there, I think we can afford to be a little patient and data dependent here. Thank you, Mr. Chairman. " FOMC20060629meeting--199 197,MS. DANKER.," I’ll be reading the directive wording from page 29 of the Bluebook and the assessment of risk from the table that was handed out with Vincent’s briefing. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 5¼ percent.” And “Although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.” Chairman Bernanke Yes Vice Chairman Geithner Yes Governor Bies Yes President Guynn Yes Governor Kohn Yes Governor Kroszner Yes President Lacker Yes President Pianalto Yes Governor Warsh Yes President Yellen Yes" FOMC20080318meeting--41 39,MR. SHEETS.," Over the intermeeting period we have lived through an experience that manifests the upside risk to our inflation forecast; and I would indicate that, with the � percentage point markup to headline foreign inflation in 2008 in our forecast, the vast majority of that is a reflection of these red-hot commodity markets, which then presses the question to us, Well, what is going on there? Certainly, in the case of the demand in these markets, by now I would have expected to have seen some attenuation or a bit of softening. Really, it seems to be quite the opposite. The demand since the first of the year has accelerated. Some other factors are at work as well--idiosyncratic supply stories, electrical outages that made it harder to smelt aluminum and copper, and so on. So there are some supply factors as well. The demand side seems to be important, and to the extent that demand remains strong, I am not sure where these commodity prices are going to top out. The futures path is a reasonable guess at sort of the balance of supply and demand. There is also some upward pressure on these prices from the depreciation of the dollar. But to the extent that commodity prices move up, I would say that we will probably be marking up our forecast of foreign inflation next time. Just a broader comment on the linkages between the U.S. and the foreign economies-- again, I was surprised at the strength of demand in these commodity markets. I would have expected by this point to have seen more marked evidence of slowing in the foreign economies. So we have marked down our forecast for 2008 in line with these prospective developments, the further slowing in the United States, and the financial stresses. But we didn't mark down our forecast very much, just a tenth or two, and mainly in Canada in Q1; and the data that we have in hand are not pointing to a dramatic slowing. We are expecting more of that to come through in the second and the third quarters. " FOMC20071031meeting--37 35,MR. HOENIG.," Thank you, Mr. Chairman. I will talk a little about the District this time. It continues to perform well, with ongoing weakness in the housing sector offset by strength in agriculture and energy. As has been true for a while, construction activity remains mixed, with weakness in residential construction offset by continued strength in commercial construction. In terms of residential construction, both the number of single-family permits and the value of residential construction contracts declined in September, and home inventories rose with slower home sales, as is happening elsewhere. However, District home prices measured by the OFHEO index edged up in the second quarter and remain stronger than in the nation as a whole. On the commercial side, after a robust spring, construction activity has slowed but has remained solid. Energy regions, such as Wyoming, report strong activity. But even in the non-energy regions, activity remains solid. Office vacancy rates were stable, and absorption rates declined. In addition, developers reported more-stringent credit standards, and they expected credit availability to remain tight. Consumer spending softened in September. Mall traffic was flat, and retailers reported that sales were down slightly. In addition, auto dealers reported that sales fell further in September as high gasoline prices cut demand for our SUV sales and for vans. In other areas, though, activity appears to remain at least moderate. For example, travel and tourism remain healthy. In addition, manufacturing activity picked up slightly in October. Solid increases among producers of durable goods offset a weakening among producers of food, chemical, and other nondurable goods. Even so, purchasing managers remain optimistic about future activity, as most forward-looking indexes strengthened or held steady. Finally, we continue to see strength in agriculture and energy. District producers are selling a bumper crop at high prices as poor crop conditions in the rest of the world trimmed global inventories and boosted export demand. In addition, robust meat demand kept cattle and hog prices above breakeven levels. The sharp rise in farm income led to a surge in farm capital spending in the third quarter and is expected to rise further in the fourth quarter. Turning to the national economy, my outlook for growth is basically unchanged from our last meeting. Generally speaking, economic indicators have been a bit stronger over the intermeeting period, as described here, but financial markets continue, obviously, to exhibit some stress. The senior loan officer survey suggested moderate tightening of credit conditions. That is consistent with our estimates of slower growth in the current quarter. As before, though, I remain more optimistic than the Greenbook about both the near-term outlook and the longer-run growth potential for the economy. Specifically, I think growth over the forecast period will average about 2½ percent. My forecast is based on maintaining the fed funds rate at its current level of 4¾ percent through the middle of next year before reducing it to its more neutral level late next year or early 2009. With regard to trend growth, I continue to expect a decline in potential growth from about 2¾ percent to 2½ percent by 2010. Disappointing housing data have led me to mark down my near-term forecast for residential investment. I continue to expect that residential investment will decline through the first part of next year before turning up in the second half. Also, after strong growth in the first half of this year, nonresidential construction is likely, perhaps, to slow significantly over the next year and a half. Supporting growth in the near term will be moderate growth in consumer and government spending along with strength in exports driven by the lower dollar and robust foreign growth. Turning to the risks to the outlook, I believe they remain on the downside as far as real output but have not worsened noticeably since our last meeting, especially with that action. I believe that construction, both residential and nonresidential, and slower consumer spending from higher energy prices constitute the main risks to the outlook. With regard to the inflation outlook, recent data on core inflation continue to be, as noted here, favorable. I expect core PCE inflation to average about 1.8 percent over the forecast period—remember, assuming no change in the fed funds rate—but I also expect that overall PCE inflation next year will moderate as the effects of higher food and energy prices wear off. However, I do remain concerned about the upside risk to inflation as well. Greater dollar depreciation and higher energy and commodity prices, along with greater pass-through from all three, could push inflation higher for a period of time. In addition, I am also concerned about the implications of the gradual upcreep in the TIPS measures of expected inflation for the long-run path, and I am receiving more anecdotal information, in discussions with individuals in our region, about a change in expectations about inflation as they continue to deal with some rising prices in materials and other goods. Thank you, Mr. Chairman." FOMC20060510meeting--83 81,MS. YELLEN.," Thank you, Mr. Chairman. Incoming data on the pace of economic activity surprised me slightly to the upside, although the indications are that housing is continuing to cool. Such an upside surprise is of concern, given that we are probably in the neighborhood of full employment and inflation is already on the high side of a range I consider consistent with price stability. I have also been slightly surprised, and unpleasantly so, by incoming data on core inflation. Beginning on the real side, recent data might signal greater underlying momentum in aggregate demand, portending more of the same going forward. But other developments during the intermeeting period portend slower growth this year. In particular, energy prices and longer-term interest rates have risen surprisingly and substantially. Taking all these factors into account, we have marked down our forecast for real GDP growth a bit for the latter half of 2006 and for 2007. We see growth coming in slightly below trend starting in the second half of this year and the unemployment rate moving up toward 5 percent. This forecast assumes that policy is tightened at this meeting and once more over the next several meetings. One development on which I would like to comment briefly is the rise in long-term interest rates. Since the beginning of this year, the nominal ten-year Treasury rate is up about 75 basis points. About 50 basis points of this increase is accounted for by a rise in the real component, at least as measured by TIPS rates. It seems natural to assume that this increase in real long rates will restrain future growth, but the outcome for economic activity is not unambiguous: It depends on what caused real rates to rise in the first place, and the causation is far from obvious. For example, higher long-term rates could reflect rational market expectations of a significantly stronger domestic economy over the next few years. But such an explanation does not strike me as particularly plausible because, although recent data are slightly on the strong side, they are not dramatically strong. Moreover, the uptick in real rates appears to be especially pronounced in implied yields at the long end of the curve—in the distant future, in periods well beyond a plausible forecast horizon. A second possibility is that higher U.S. interest rates reflect a shift in global capital flows away from the United States, perhaps due to the unwinding of the carry trade or growing concern about the U.S. current account deficit. Such a shift might account for the sharp drop in the dollar over the same period. In simple models, such a shift in portfolio preferences has ambiguous effects on domestic demand because the depreciation in the dollar could stimulate aggregate demand by more than higher yields depress it. It’s not my intention to overemphasize the risk that growth will not slow. My point is simply that, although the rise in bond rates seems likely to help slow the economy, we should not take it for granted. Turning briefly to inflation, I’m uncertain whether the recent bulge reflects various special factors, as David mentioned, some pass-through of energy and commodity prices, or pressures from resource utilization. Parsing the CPI report, I found it difficult to discern evidence that the uptick does reflect pass-through of energy and commodity prices into core inflation. I would be quite concerned if the uptick reflects pressures from resource utilization and turns out to be persistent. However, half a dozen measures of slack that we monitor suggest no noticeable change in slack since late March. These measures also suggest that we are in the vicinity of full employment and not noticeably beyond it. Data on both productivity and labor compensation are largely reassuring. My final comment concerns the rise in inflation compensation since our last meeting. While the possibility of some loss of Fed credibility certainly can’t be dismissed, I believe we should not overreact. First, the rise we’ve seen is not out of line with the typical volatility in this series. Second, we must remember that inflation compensation includes not only expected inflation but also an inflation risk premium. Of course, both of these elements could be higher because of a lessening of credibility. But the inflation risk premium could also be higher because the world now strikes market participants as a riskier place, perhaps because of geopolitical concerns that have nothing to do with credibility. Indeed, a growing perception that the world is riskier could explain both the uptick in inflation compensation due to a rise in the inflation risk premium and some of the rise in TIPS yields due to higher real interest rate risk. Factor analysis performed by our staff suggests a strong correlation with the common factor for the term premium and longer-horizon, but not shorter-horizon, breakeven inflation rates and TIPS yields. My point is that determining what has caused inflation compensation to go up is not an easy matter, and concluding that it’s due to a lessening of credibility may be premature. So overall, while we have revised our core inflation forecast up slightly, we continue to be fairly optimistic that inflation will remain reasonably well contained going forward. Inflation in the core PCE price index of around 2 percent over the next year or so seems like the most likely outcome to us." FOMC20080121confcall--48 46,CHAIRMAN BERNANKE.," All right. Thank you. Let me make a few comments. Thank everyone for your input and your concerns, which I appreciate. This is a very, very difficult situation, and no one can know exactly how this is going to work out. But let me try to respond to a few points that were made. First of all, as I indicated earlier, I would not be proposing this if I didn't think that we were seriously behind the curve in terms of economic growth and the financial situation. I said that on January 9, and since then the markets and the data have only gotten significantly worse. I do believe that we are at least 100 basis points behind the curve in terms of neutrality, and so I am quite comfortable with this order of magnitude of move. Frankly, I think the evidence is very much in favor of it. With respect to what the real rate is, I would combine my response to you with a comment to President Fisher, which is that real rates depend on expected inflation, not past inflation. Inflation is a lagging indicator. We cannot wait until inflation is down before we begin to act. We have to look at the future. We have seen oil prices down $10 already. We just have to make a judgment. With the economy slowing and with oil prices likely to moderate, the best guess is that inflation will be well controlled going forward. If that is not the case, we can begin to address it. But I do believe that, from a forecast viewpoint, we don't have a negative real interest rate, and we don't necessarily have inflation above 4 percent. I would like to address the issue of the lesson of 2001. I don't think that the problem with 2001 was the rate at which the interest rate was cut. The interest rate was cut more than 500 basis points, including three intermeeting moves of 50 basis points each in 2001. Nevertheless, at the end of that episode, inflation was too low, which is evidence I think that in some sense the response was even inefficiently slow. Not that they could have necessarily done better, but clearly it was not the cut itself that led to inflation problems. Governor Kohn's points notwithstanding, and it was very difficult to know ex ante what was right, if there is a concern there it has to do with how quickly the rate was raised starting in 2004 going forward, when the economy was already on a growth path. I think we have learned from that. I think we will be very sensitive to that. Let me just add that I do intend to be talking more about the outlook and about policy. I am sure that I will do my best to communicate where I think we are and how we are going to manage policy going forward. I have talked specifically about the need to be aggressive in the short run, particularly when financial stability is at stake. So again, my fundamental point is that we are behind the curve. We need to do something to get up there. Why does that help markets? Well, I think there are issues of psychology and dynamics and damage that could be done if we let the markets twist and turn for another nine days. But the fundamentals are also involved. The markets essentially--in their incredible efficiency--are bringing into the present concerns about very bad outcomes that might happen in the future. With fair value accounting, mark to market, and all of those things, the risk that house prices might fall 20 or 30 percent, even the small risk, is affecting today's credit ratings and credit markdowns. We can help the markets in a fundamental sense by assuring them that we are aware of these risks and that, though we are not going to necessarily stop a slowdown, we will do our best to minimize the tail risks of a really bad outcome that are right now driving today's market reactions. That would help the monoline insurers in the sense that, if the markets become convinced that those risks are much smaller, then the obligations of the monolines insurers will be less, and the willingness to advance capital might be greater. Again, if I thought that we were where we should be and this was just a question of placating the markets, I would not be here talking to you. But I think that we need to move, and if we move now, we will get a bonus in terms of at least some hope of reducing the fear and the uncertainty that is currently in the markets. So I do think it matters whether we move today or move nine days from now. I recognize the risks, but in the two years that I have been here in this position, we have not moved intermeeting. We waited a long time to move in September after our intermeeting statement. I don't think that we are trigger happy. I don't think we are perceived as trigger happy. I think that we need to be catching up to where the right interest rate is, and that is the essence of the issue. I guess that is all I have to say. As I said, Governor Mishkin is not here. For what it is worth, he authorized me to say that he supports the action and the statement. We are currently at a very critical juncture. We are being watched very carefully. We have to demonstrate our willingness to address these very, very serious risks. I think we ought to go ahead and take this step, and I hope that you can support this action. Are there any other comments? President Hoenig. " FinancialCrisisReport--575 Agent will be responsible for efficiently selling credit risk assets.” 2573 The Hudson term sheet provided additional information about the liquidation agent role and the “Credit Risk Assets” that would have to be liquidated: “Goldman as Liquidation Agent, will liquidate any asset determined to be a ‘credit risk’ within 12 months of said determination. Credit Risk assets will include: any asset downgraded by Moody’s or S&P below Ba3 or BB-, any asset that is defaulted or would be experiencing a credit event as defined by the PAUG [Pay As You Go] confirm. There will be no reinvestment, substitution, discretionary trading or discretionary sales. After closing, assets that are determined to be ‘credit risk’ securities will be sold by the Liquidation Agent within one year of such determination.” 2574 The Hudson Offering Circular repeated that information and added: “The Liquidation Agent will not have the right, or the obligation, to exercise any discretion with respect to the method or the price of any assignment, termination or disposition of a CDS Transaction; the sole obligation of the Liquidation Agent will be to execute such assignment or termination of a CDS Transaction in accordance with the terms of the Liquidation Agency Agreement. ... [T]he Liquidation Agent shall have no responsibility for, or liability relating to, the performance of the Issuer or any CDS Transaction, Reference Obligation, Collateral Security or Eligible Investment.” 2575 Goldman charged a 10 basis point ongoing fee for serving as the Hudson Liquidation Agent, 2576 which resulted in its being paid a total fee of approximately $3.1 million. 2577 While Goldman was marketing Hudson in 2007, a client asked why the liquidation agent was “afforded up to 12 months to sell a credit risk asset.” 2578 The Subcommittee was unable to find Goldman’s contemporaneous response, but when asked the same question, Darryl Herrick, the Hudson deal captain, told the Subcommittee that there was “headline risk” associated with the downgrade of an asset, and twelve months gave Goldman “flexibility to try to get a better price later.” 2579 When asked whether the “flexibility” to delay a sale violated Hudson’s prohibition against discretionary trading by the liquidation agent, Mr. Herrick said that Goldman had 2573 2574 2575 2576 2577 2578 2579 10/2006 “Hudson Mezzanine 2006-1 Flipbook, ” GS MBS-E-009546963, Hearing Exhibit 4/27-87. Goldman Sachs Hudson Mezzanine Funding 2006-1, LTD Preliminary Termsheet, GS MBS-E-001557869. 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196 at 234. 10/2006 “Hudson Mezzanine 2006-1 Flipbook,” GS MBS-E-009546963, Hearing Exhibit 4/27-87. See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0239. 10/6/2006 email from Michael Halevi to Olivia Ha, GS MBS-E-014338525. Subcommittee interview of Darryl Herrick (10/13/2010). “discretion based on a rule,” and that the liquidation agent provisions had been vetted with the credit rating agencies which “probably wanted the deal to avoid forced sales.” 2580 FOMC20050809meeting--59 57,MS. JOHNSON.," The staff outlook for real GDP growth abroad is little changed this time from that in the June Greenbook. Economic expansion in our foreign trading partners has rebounded from its subdued first-quarter pace, and we expect that it will firm somewhat more later this year and next. Nevertheless, three elements of our baseline outlook this time are sufficiently changed from the previous forecast that they warrant attention today: first is the very sizable, positive change that recent data have implied to the contribution to U.S. real GDP growth from the external sector; second, the long-awaited announcement by Chinese officials of a change in their exchange rate regime; and third, yet another discrete upward revision in our projection for global oil prices. We now estimate that net exports made an arithmetic positive contribution of 1.4 percentage points to real growth in the second quarter, a figure slightly less than that reported by the BEA in the advance real GDP data for the quarter. With June nominal trade data yet to be released, both the BEA and we must guesstimate that number in constructing a second-quarter figure for real GDP. Our estimate of the contribution is now significantly larger than the 0.55 percentage point that we had incorporated into the June forecast. The nominal trade data for May surprised us with stronger exports and a bit weaker imports than we had anticipated. These data account for 0.5 percentage point of the revision. The remainder of the revision to the contribution owes to a markdown of imports in line with the advance NIPA data, which contained a different translation gap between the balance of payments data and the national income data than that for Q1, which in turn had been the basis of our projection. The overall revision to second-quarter imports is somewhat greater than that to exports. We now estimate that real imports of goods and services actually declined in the second quarter whereas real exports grew at over a 12 percent annual rate; very strong nominal exports in April were followed by even slightly larger exports in May. August 9, 2005 18 of 110 this quarter in our baseline forecast and is about minus 0.4 percentage point over the next year. The July 21 announcement by Chinese officials of a change in their exchange rate regime ended speculation about when such a move would come but left many other questions unanswered. Following the initial 2.1 percent revaluation of the renminbi in terms of the dollar, the exchange value of the Chinese currency has fluctuated very narrowly. Essentially no information has yet been provided about the composition of the Areference@ basket of currencies that is now part of the regime. Scope has now apparently emerged for future moves in the exchange rate in terms of the dollar, but some official statements have emphasized that such further change will be gradual. To construct our forecast of activity abroad, we needed to make a specific assumption about the Chinese exchange rate regime going forward. Holding the renminbi pegged at its current dollar exchange rate seemed to give too little recognition to the major step we thought was implied by the announcement. But we saw as arbitrary any specific projection we might make of further bilateral appreciation of the renminbi against the dollar. Accordingly, we chose to harmonize our treatment of the renminbi and most other currencies. For the purposes of the forecast, we have projected that the renminbi will appreciate slightly in nominal terms—at a rate comparable to that we project for the euro, the yen, the Canadian dollar—and have made small adjustments to other Asian emerging market currencies as well. This trend nods in the direction of the downward pressure that we judge will at some point be visible on the dollar as a result of the financing burden of our growing external indebtedness. We realize that when it occurs this pressure is not likely to be evenly distributed across all bilateral dollar exchange rates with other currencies. Nor is it likely to occur smoothly and gradually over time. However, we do expect that the real index of the dollar in terms of all our important trading partners is likely to move down on balance over a reasonably long horizon because of global imbalances. Adding the renminbi into that mix has resulted in a slightly more rapid rate of real dollar depreciation than we had previously been incorporating into the staff forecast. August 9, 2005 19 of 110 Various factors appear to have contributed over the past six weeks to the upward pressure on oil prices; most of them relate to risks to the available supply reaching the market. Destruction by fire of a large oil platform owned by India was particularly important because it provided light, sweet crude. The death of Saudi Arabian King Fahd appears to have raised political risks in the world=s largest oil exporter, even though the new king, Abdullah, had been managing most of the kingdom=s business during the 10-year illness of the late king. Warnings of an unusually active hurricane season have raised concerns about a possible repeat of the kind of supply interruptions experienced last year. Other issues of regular maintenance or delays in completing new sources of supply have arisen as well. These various events all occurred against a background of perceived strong world demand and little spare capacity. Possible political risks are seen as creating uncertainty with respect to supply from Iraq, Iran, Venezuela, Russia and other global trouble spots. In the event of any serious disruption in such a trouble spot, there is little scope for other sources of supply to fill the resulting excess demand. As a result, market participants see little likelihood that prices will decline in the future. The far-dated contract for delivery in December 2011 is up to $59 per barrel. To date, the global economy has absorbed the rise in prices with few signs that overall economic activity will ease off in response. Higher oil prices have boosted consumer price inflation in some regions. However, inflation expectations appear to remain well anchored, and our baseline forecast calls for CPI inflation abroad to recede a bit next year. This projection depends importantly on oil prices remaining elevated but flattening out early next year, as anticipated in the futures curve. Renewed upward pressure on global oil prices remains a risk to the forecast, however, as higher oil prices for consumers tend to erode domestic demand in importing countries and regions, and oil exporters take some time before increasing their expenditures. David and I will be happy to answer any questions." CHRG-111hhrg52397--142 Mr. Price," I want to pick up on some of the questions that my colleagues have asked about driving business overseas. Mr. Pickel, if I may, and I apologize for being out earlier, but in your testimony you note that, ``Mandating that interest rate swaps and credit default swaps being traded on exchanges is likely to result in only higher costs and increased risk to manufacturers, technology firms, energy producers, utility service companies and others, who use OTC derivatives in the normal course of their business. It will put American businesses at a significant disadvantage to their competitors around the world.'' And when you say ``American businesses,'' you do not mean the clearinghouses, you mean American businesses? " FOMC20070628meeting--218 216,MS. SMITH.," I will be reading the directive from page 29 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ percent.” And the risk assessment: “In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” Chairman Bernanke Yes Vice Chairman Geithner Yes President Hoenig Yes Governor Kohn Yes Governor Kroszner Yes President Minehan Yes Governor Mishkin Yes President Moskow Yes President Poole Yes Governor Warsh Yes" FinancialCrisisReport--456 VAR Levels Show Net Short. The primary factors that influence VAR are: (1) the relative size and correlation of positions, and (2) the volatility of trading. 1907 While VAR is computed by applying a complex algorithm to trading data, the VAR measure directly reflects position size and correlation, and volatility – or a combination of both factors. 1908 Changes in VAR levels over time can also provide information about the general magnitude and direction of trading positions. In the fourth quarter of 2006, the Mortgage Department’s permanent VAR limit was $20 million, of which it consumed only $13 million. 1909 Early the next year, on February 5, 2007, the Mortgage Department exceeded its limit with a VAR of $20.5 million. 1910 On February 8, 2007, a senior risk manager recommended that the Mortgage Department’s permanent VAR limit be increased to $30 million to accommodate anticipated increased price volatility in the mortgage markets that year. 1911 A senior manager concurred and increased the Mortgage Department’s permanent VAR limit to $35 million, which remained the Mortgage Department’s “permanent” limit throughout 2007. 1912 Almost immediately, however, the Mortgage Department breached its new limit, and its VAR continued to climb. Over the course of a single quarter, the Mortgage Department’s VAR jumped from $13 million at the end of 2006, to $85 million in the first quarter of 2007 – a 550% VaR calculation); 4/23/2007 email from Robert Berry to Daniel Sparks and SPG Trading Desk, “Mortgage VaR, ” GS M BS-E-009708690 (adjustments to VAR calculations). 1906 See, e.g., 8/21/2007 email from Tom Montag to Gary Cohn, GS MBS-E-016344758; 8/21/2007 email from Michael Dinias, “Trading VaR Analysis, ” GS MBS-E-009742070; Subcommittee interview of David Viniar (4/13/2010) and Joshua Birnbaum (10/1/2010); 2/24/2007 email from Robert Berry to David Viniar and others, “FW : Mortgage VaR,” GS MBS-E-009778897. 1907 See generally “The Risks of Financial Modeling: VaR and the Economic Meltdown,” before the U.S. House of Representatives Committee on Science and Technology, Subcommittee on Investigations and Oversight, H.R. Hrg. 111-48 (9/10/2009), at 4 (W ritten Testimony of Richard Bookstaber); Philippe Jorion, “Value at Risk: The New Benchmark for Managing Financial Risk (3d ed. 2007) at 64. 1908 See id. Based on these factors, VAR is generally lower if a desk has many small and non correlated (well diversified) positions that are trading at steady and predictable price levels. By contrast, VAR is higher if a desk is holding a small number of very large and highly correlated positions that are trading at volatile and unpredictable price levels. The position size/correlation and volatility factors may also operate independently. Thus, even if the desk has a large number of relatively small and non correlated positions, VAR tends to rise as the volatility of trading rises. Similarly, even if there is little volatility in trading, VAR tends to rise as the desk ’s position sizes become larger and increasingly correlated. The two factors also reinforce one another – large position sizes combined with high volatility tend to increase VAR dramatically. 1909 Market Risk Management & Analysis, Quarterly Market Risk Review, December 2006, GS MBS-E-009583144, Hearing Exhibit 4/27-54; see also 2/6/2007 email from MarketRisk,“MarketRisk: Mortgage Risk Report (cob 02/06/07),” GS M BS-E-009980807 (Mortgage SPG VaR Limit 20). 1910 1911 1912 2/8/2007 email from Michael Dinias, “VaR limit for Mtg SPG,” GS MBS-E-009980807. Id. Id. increase. Goldman’s Chief Risk Officer, Craig Broderick, told the Subcommittee that he would be concerned about any breach of a VAR limit, and would certainly investigate the doubling of a business unit’s VAR, but he admittedly took no action when the Mortgage Department’s VAR more than quintupled over the course of a single quarter. Mr. Broderick attributed the steep rise in CHRG-111hhrg48868--59 Chairman Kanjorski," Thank you very much, Mr. Ario. And now our next witness will be Ms. Orice Williams, Director of Financial Markets and Community Investment at the Government Accountability Office. Ms. Williams.TESTIMONY OF ORICE M. WILLIAMS, DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT, UNITED STATES GOVERNMENT ACCOUNTABILITY OFFICE (GAO) Ms. Williams. Mr. Chairman and members of the subcommittee, I appreciate the opportunity to participate in this morning's hearing on AIG and issues related to its Federal assistance. I will be providing an update on the status of our ongoing work on issues surrounding the Federal Reserve's and Treasury's assistance to AIG and potential competitive implications for commercial property/casualty markets where AIG insurance companies are major players. When you and Ranking Member Bachus asked GAO to initiate this work in January, we pulled together a multi-disciplinary team that includes staff knowledgeable about insurance and economics, including our Chief Actuary and Chief Economist. Our work is divided primarily into two areas: In the first area, we are exploring the goals of the assistance, progress in achieving these goals, and challenges AIG faces in repaying the Federal assistance as well as how the Federal Reserve and Treasury are monitoring AIG's restructuring efforts; however, it is important to note that GAO is prohibited by law from auditing the Federal Reserve's monetary policy activities, which includes the emergency authority the Federal Reserve is using to address the current financial crisis. Therefore, our review is based on publicly available information. Second, we are examining allegations that the assistance provided to AIG has afforded its property and casualty insurers an unfair advantage in certain markets and that they are pricing in a way that is not consistent with their risks. Now I will share a few of our preliminary findings. The Federal Reserve and Treasury officials told us that the goal of the continued assistance has been to avoid systemic risk from a rating downgrade or rapid failure of the company that would further destabilize financial markets. The Federal Reserve has been monitoring AIG's operations since September and Treasury is beginning to more actively monitor AIG's operations as its role has expanded. Although the ongoing Federal assistance has generally prevented further downgrades in AIG's credit rating, AIG has had mixed success in fulfilling its other restructuring plans. For example, while AIG has terminated its securities lending program, its efforts to sell certain business units has been more challenging in the current economic environment. GAO also faces ongoing challenges from the continued overall economic deterioration and tight credit markets. AIG's ability to repay its obligations to the Federal Government has also been impaired by its falling revenue and ability to sell its assets, as well as further declines in the value of its assets. Now I will briefly discuss our ongoing work on the potential impact of AIG's Federal assistance on the commercial property and casualty market. Specifically, we are reviewing potential effects on AIG's pricing practices. As you know, some of AIG's competitors have expressed concerns that Federal assistance to AIG has allowed AIG's commercial property and casualty insurance companies to offer coverage at rates that are inadequate for the risk involved. To date, we have spoken with numerous State insurance regulators, insurance brokers, and insurance buyers. The general consensus thus far is that while AIG may be pricing somewhat more aggressively in order to retain business in light of damage to the parent company's reputation, they have not seen indications that this pricing was inadequate or out of line with previous AIG pricing practices. However, we have found no evidence to date that Federal assistance has been provided directly to AIG's property/casualty insurers. To the extent that the property and casualty insurers would have been adversely affected by a credit downgrade or failure of the parent, AIG's insurance companies have likely received some indirect benefit. In closing, I would note that the extent to which the assistance provided by the government will achieve its goal of preventing systemic risk continues to unfold and will largely be influenced by AIG's success in meeting its ongoing challenges to try to restructure its operations and maintain goodwill. Our work is ongoing at this time. We have not drawn any final conclusions about whether or how the assistance has impacted the overall competitiveness of the commercial property and casualty market and will face a number of challenges in doing so. Mr. Chairman, this completes my oral statement. I would be pleased to answer any questions that you or members of the subcommittee may have at the appropriate time. [The prepared statement of Ms. Williams can be found on page 231 of the appendix.] " CHRG-111hhrg51698--9 Mr. Buis," Thank you, Chairman Peterson, Ranking Member Lucas, and Members of the Committee. It is indeed an honor to be able to testify on this important issue before the Committee. We got involved in this last winter and spring, when we started receiving numerous phone calls from farmers. As wheat prices hit record levels, corn prices were also in the record category. Farmers were calling and saying they couldn't market their grain the way they would normally market it, which is, by and large, being able to price their grain after harvest for delivery. When they were precluded, they were told that the reason was many of the local elevators and co-ops were running up against their credit limits because the prices of the commodities were going up to the limit day after day and having to meet those margin calls; and their only alternative was to quit offering futures contracts after harvest. So, we contacted the CFTC and urged them to take a look at it, not long after they held a hearing. There were a number of people there, but they started out the hearing, and basically they went through all of their data and concluded before the hearing was even over that nothing out of the ordinary was happening. Well, Mr. Chairman, something out of the ordinary was happening. Farmers, who were probably the original derivative, were being precluded from the marketplace at a time when they could have really capitalized on the higher market prices. So we were a little frustrated with the reaction. As the year went on, we began to find out more and more that really what was causing higher food prices, really what was causing higher input costs was the excessive speculation that was going on in the commodity markets. Whether you look at oil, whether you look at grains, you look at any of the inputs, fertilizer, they were all based on either energy and/or future feed use or future use for other processing. As a result, farmers and ranchers didn't get the high prices and had to wait for prices to come down at harvest in order to sell their wheat and other commodities. We also witnessed something that I don't think anyone can explain, and that is the cotton market virtually doubled overnight. Our impression is that we have a lot of cotton in storage. It is difficult to move. As a result, it was definitely a speculative market that lasted a very short time. I have yet to meet a cotton farmer that got those pries up in the 90 cents range for their cotton. So we were impacted tremendously. I think it caused higher food prices, which impacted consumers. It caused a divisive attitude among agriculture producers, because livestock producers were being told that corn prices and feed prices were going to go even higher. So they had to lock in their prices. I just got back from Central Valley of California, Mr. Chairman, and many of those producers that locked in feed prices because they believed all the speculative reports that prices were going to continue to rise, and they did the prudent thing in locking in their future feed uses, and now they are all in as bad a financial shape as I have ever seen in the dairy industry. It is the same for other livestock producers and livestock processors. Ethanol companies did the same thing. They were all sort of wrapped up in this speculative environment. So I really commend you for your efforts, both last year and this year, to move forward. It is badly needed. Your legislation is right on target establishing speculative limits for all commodities, the increased transparency, providing the resources for CFTC, and including even carbon credits to be traded on the marketplace and a regulated marketplace. Actually being able to give the regulators a chance to know how much money is in there, who it is by, whether it is commercial, whether it is speculative, or whether it is under an exemption or over-the-counter or foreign exchanges has to be done. I think it is the most important thing for the rural economy, which, as you know, has certainly flipped in the last few months. Thank you, Mr. Chairman. [The prepared statement of Mr. Buis follows:] Prepared Statement of Tom Buis, President, National Farmers Union, Washington, D.C. Good afternoon, Mr. Chairman and Members of the Committee. I appreciate the opportunity to testify on behalf of the farm, ranch and rural members of National Farmers Union (NFU). NFU was founded in 1902 in Point, Texas, to help the family farmer address profitability issues and monopolistic practices while America was courting the Industrial Revolution. Today, with family farm, ranch and rural family members, NFU continues its original mission to protect and enhance the economic well-being and quality of life for family farmers and ranchers and their rural communities. Last spring, NFU called upon the Commodity Futures Trading Commission (CFTC) to conduct a thorough and comprehensive investigation regarding the activity and volatility in the commodities markets. In particular, the role of speculative commodity futures trading, both on and off-exchange, in increasing that volatility, with much of that trading hidden from view of the CFTC in the derivatives and other off-exchange markets. Farmers and ranchers are generally relieved to end the 2008 agriculture market roller coaster, but they are extremely anxious as they approach the 2009 production year. During 2008 we witnessed periods of record or near record nominal prices for many commodities traded on U.S. exchanges. As the year ended, we have also witnessed a historic collapse in market prices for major grains and dairy products. NFU was frustrated by remarks from some CFTC officials who suggested that the market volatility was simply a response to market fundamentals. This assessment did not adequately explain the price shock in the cotton market or lack of convergence between cash and futures markets during the contract settlement period. This assessment also failed to explain why many farmers were precluded from utilizing traditional market risk management tools, such as forward cash contracts, because of excessive margin risk to those who typically would offer such products to their customers. As speculators created a market bubble and attitude that higher prices were set to stay, crop, livestock and dairy producers locked in higher inputs and feed costs. The false signals were not reserved for agricultural producers, but extended beyond production agriculture to the ethanol and biodiesel industries and input suppliers, all locking in higher feedstocks and supplies. The 2008 economic collapse and bursting of bubble have jeopardized the economic livelihoods of all these players, which will ripple throughout our rural communities. This impact will not be short-lived, as it could take up to a year or longer before the negative impact is resolved. In these times of despair, commodities and industries become pitted against each other creating a divisive environment in which to establish helpful policy. As you can imagine, it was very frustrating for farmers who were paying record amounts for inputs, but could not implement effective marketing plans or strategies to take advantage of the higher prices for their crops. While this activity was occurring in 2008, the media, with help from food processors, held fast to the position that farmers and ranchers were getting rich from record high commodity prices and cited these prices as the sole cause of increasing retail food prices. Nothing could have been further from the truth. The reality of what happened has come to light as commodity prices have plummeted, yet retail food costs remain high. The effort being made by this Committee to ensure that we do not experience a repeat of 2008, is to be commended. It became obvious, in a number of areas, that modernized regulations were warranted to ensure the mistakes of the past are not repeated. The broad, bipartisan support for increased oversight and transparency with the House-passed Commodity Markets Transparency and Accountability Act of 2008 provided a good starting point. The Derivatives Markets Transparency and Accountability Act (DMTAA) of 2009 would be of even greater benefit to agricultural producers and the entire economy. In a letter to the CFTC last year, NFU cited the single biggest concern among producers as a lack of market transparency. This is still the case. Provisions within the DMTAA, seek to inject necessary transparency through the detailed reporting and disaggregation of market data and the over-the-counter (OTC) transparency and record-keeping authorities as outlined in the legislation. Without these provisions, the public will continue to be in the dark regarding who is involved in commodity markets and to what capacity. These new authorities are needed to ensure regulators are able to keep pace with the use of new financial and market instruments that result in market manipulation, fraud or excessive speculative market volatility. NFU has called for an investigation to determine the role and impact that OTC trading and swaps have on markets. Without full access to data and other information concerning these types of trading activities, it is impossible to determine whether manipulation, fraud or excessive speculation is occurring. DMTAA requires all prospective OTC transactions to be settled and cleared through a CFTC regulated clearinghouse or other appropriate venue. The addition of principles for the designated clearing organizations, including (1) daily publication of pricing information; (2) fitness standards; and (3) disclosure of operational information, will protect the integrity of the new OTC requirements by assuring the clearinghouses remain transparent. The legislation also requires the CFTC to study and report on the effects of potential position limits within OTC trading. Again, this information will enhance the public's confidence that markets are not being manipulated, fraudulently exploited or overwhelmed by speculation and if so, corrective action can be launched. When the CFTC proposed increasing speculative position limits in 2007, NFU filed public comments in opposition to such action. Speculators have an important role to play in the commodity markets in terms of providing market liquidity. However, when left unregulated and allowed to become excessive, the positive attributes that speculators bring to the markets undermines the legitimate price discovery and risk management functions these markets were designed to provide to commercial market participants. DMTAA establishes new standards and limits for all commodities. Moreover, we are pleased to see the establishment of a Position Limit Agricultural Advisory Group. By involving producers and traditional users of the market in making recommendations concerning position limits, the new limits will be legitimized and fair. With the rapid growth of market speculation, we are in unchartered waters today and we believe this third-party review function can significantly help in ensuring market integrity in the future. NFU believes the CFTC needs to take a broader look at the concept of manipulation and it implications for price discovery. Unfortunately, the CFTC's test to determine manipulation requires that an individual or group of traders acquire a market position that enables them to consciously distort prices in noncompliance with market fundamentals. What the CFTC is failing to recognize is that the deluge of money from Wall Street, hedge funds and other large traders in and of itself is driving prices in ways that may not reflect the fundamentals of the underlying markets. In 2006, NFU became an approved aggregator for trading carbon credits on the Chicago Climate Exchange (CCX). Currently, we are the largest aggregator of agricultural soil carbon offsets to CCX. The CCX is the world's first greenhouse gas emissions registry, reduction and trading system, trading more than 86 million tons of carbon offsets to date. As carbon trading continues to advance rapidly, NFU appreciates the provision within the legislation that will protect the integrity of carbon credit trading by requiring those contracts to be traded on a designated contract market. Furthermore, the cross pollination between the CFTC and the U.S. Department of Agriculture to develop procedures and protocols for market-based greenhouse gas programs will help ensure these markets will perform a legitimate function for participants and the public in general. This legislation will begin to answer many of the questions from 2008. We are currently enduring the train wreck caused in large part by the dysfunction of the futures market--in 2008. NFU strongly endorses this bill and looks forward to its swift approval; I am hopeful Congress will continue its bipartisan efforts to establish greater oversight of the commodity and energy futures markets. I thank the Committee for the opportunity to be here today and look forward to any questions you may have. " CHRG-110shrg50369--27 Mr. Bernanke," In 2007, the price of oil rose by about two-thirds, and I suspect--and the futures markets agree--that it is much more likely that oil prices, while remaining high, will not increase by anything like that amount going forward. If oil prices and food prices do stabilize to some extent, even if they do not fall, that will be sufficient to bring inflation down as we have projected. Now, you are correct, though, that we do have to be very cautious. While we cannot do much about oil prices or food prices in the short run, we do have to be careful to make sure that those prices do not either feed substantially into other types of prices, other goods and services produced domestically, and that they do not dislodge inflation expectations or make the public less confident that the Federal Reserve will, in fact, control inflation, as we will. So we do have to watch those things very carefully, and will watch them very carefully. Senator Shelby. Is that what some of us would talk about, the psychology of inflation? " CHRG-111hhrg74855--11 Mr. Upton," Thank you, Mr. Chairman, and I do appreciate having this important hearing today. We have two very distinguished panels and we are fortunate to be able to hear their thoughts and concerns for the legislation. H.R. 3795 as reported out of the Ag Committee has some serious flaws that would negatively impact the energy sector and I, like many members of this subcommittee, oppose the legislation in its current form, and it is my understanding that both Mr. Waxman, Mr. Markey, Mr. Barton do share my concerns and I hope that we can work together to change the bill before it is brought to the House floor as early as next week. As written, H.R. 3795 could lead to an increased energy cost for all Americans and disrupt our nation's energy markets. By limiting access to certain risk management tools as this legislation does, the ability of energy providers to hedge their market risks would be jeopardized and their customers would be vulnerable to increased price volatility. I understand that there is an appetite among many of my colleagues to create new regulations to curb systemic risk in the economy as a whole but this legislation engulfs markets that are working properly, and in doing so creates new problems that our economy and energy consumers do not need during these very difficult times. The legislation will undermine authorities that Congress gave FERC to investigate and penalize market manipulation. As part of the Energy Policy Act of '05, FERC was given the authority to protect electric and natural gas markets against manipulation or fraud by ensuring the transparency of those markets. FERC's ability to exercise these authorities to the full extent Congress intended would be in question with the passage of this bill. Additionally, under current law, FERC regulates interstate transmission and sale of electricity to ensure that electricity prices are just and reasonable. However, this legislation would disrupt transmissions markets by creating what would amount to contradictory regulation by the CFTC. So this bill, H.R. 3795 in current form I don't believe is ready for primetime and I would hope that in the tough times of double-digit unemployment and a sagging economy as we try to get our businesses back to work and employing folks that this legislation will not move as it is. Let us work together to get it right. I look forward to the testimony and questions and I yield back. " FOMC20080130meeting--309 307,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Let me just say that I am completely comfortable with the way you just framed the case, not just for thinking about and talking about strategies for how we take this back at the appropriate point, but I also don't have any problem with the way you talked about how you'd frame it in public. I thought that was fine. When I talked about the need for humility, it was just in our capacity to design optimal strategies for the timing and the slope of the path to reversal at this stage. I think it's going to require more time. A few things about the policy action and the statement. Obviously I support 50, and I support the language in alternative B, paragraph 4, as written. The Chairman laid out in public earlier this month a basic strategy that said that policy would be directed at providing an adequate degree of insurance against the downside risks, given the nature of those risks. It was said with more nuance and eloquence, but basically that was the thrust of the strategy. I think that the balance of evidence we have--even with all the uncertainty about what equilibrium is, what the appropriate level of the real rate is, and what it actually is--suggests that we have not gotten policy to that point. Therefore, getting that strategy in place is likely to require further action. It's very hard to know when or how much. It's very hard to know what should frame that choice now for us, I think. As many of you said, markets have to go through a further set of adjustments, and I think that has to work through the system. Our job, again, is not to artificially interfere with that process or to substitute our judgment for what the new equilibrium should be in that context. Our job should be to make sure that adjustment happens without taking too much risk that it tips the financial system and the economy into a much more perilous state that would be harder for us to correct and require much more policy response. There's a big difference between a world in which housing prices fall 20 percent and one in which they fall 40. If everybody thinks they have to prepare for a world in which they fall 40, we're going to take much greater risk that we have a scale of financial trauma and credit crunch that would produce the odds of a deeper recession. What we face now is not the choice, as I think President Poole said, between a mild recession now and higher-than-expected inflation over time. The risk we face, as the Chairman said several times, is the choice between a mild, short recession and a deeper, more protracted outcome. The scale of financial market fragility we now face, you could even say solvency in parts of the financial system, is a function of the confidence we create in our willingness to get policy to a point that provides meaningful protection against an adverse outcome. I think the experience of the past five or six meetings suggests that we cannot carefully enough design a message that can lean against expectations in the market about the likely path of policy that we judge to be excessive and that makes us uncomfortable without taking too much risk that it will just undermine confidence in our willingness to get policy right. We just don't have that capability. We thought about it and tried it in lots of different ways, but everything we experienced over the past four months justifies the judgment that we can't lean against those expectations without taking too much risk that we undermine confidence in our capacity to get policy to the point at which we're giving some insurance. It would be a mistake to try to recalibrate expectations now relative to the stance of policy as stated in the Chairman's statement and our statement last week. It would be a mistake to recalibrate back to a point that looks more like October. Everything we know suggests that it's probable that the data will get still worse from here and that the financial markets will be in a state of considerable fragility and tenuousness for some time. To sort of zig at this meeting, to recalibrate more toward a sense of balance in the face of that reality, just means that we're likely to have to zag back again. I just think that would risk our looking as though we're ambivalent and have to correct again because of that. That would just be uncomfortable. It's hard to know--I think Governor Kroszner said it right in many, many meetings--whether we face the risk of a grinding, downward, self-reinforcing set of pressures on balance sheets that raises the risk of deeper trough in housing and creates more caution and deleveraging and the economy moves slowly down or whether we face the risk of much more acute cliffs in asset prices with much greater consequences for confidence and the fragility of the financial system. It is hard to know, but I think both would be very uncomfortable for us. Again, I strongly support the language in B as it is. Even though I understand the rationale, I'd be very uncomfortable with dialing back that statement as it now exists to something that suggests we're closer to balance. " FOMC20050503meeting--77 75,MS. MINEHAN.," Thank you, Mr. Chairman. New England and the nation seem to have hit a couple of bumps along the road to steady growth. We, like the Greenbook, don’t expect the bumps to turn into potholes or disturb much except the speed of travel slightly. But we were again May 3, 2005 31 of 116 In New England, Beige Book contacts were remarkably upbeat in early April, and available data reported a sense of solid growth in the region. However, several recent indicators and a sense of caution suggest the possibility of an emerging slowdown in the region. On the positive side, employers added jobs in February and March, and the quarterly total was positive as well. Unemployment rose slightly, but this was due entirely to a stabilization in the regional labor force after a period of decline. Unemployment claims moved down, and both the traditional help-wanted index and Monster.com’s index of online job postings increased at a solid pace. As the weather brightened, tourism did as well; and business travel in Boston has been strong, at least relative to last year. With average revenue per room rising at a nearly 13 percent pace, hotels looked poised for a good year. Surprisingly, even in this service industry, productivity improvements are possible, as average hotel staffing reportedly has dropped from 80 per 100 rooms in 2000 to 62 per 100 rooms in 2004. This is said to be the result of technological change and the growing popularity of online booking. Beige Book contacts in retail and manufacturing were, on the whole, rather optimistic. Moderately growing demand and increased pricing power were keeping margins strong, and a continued emphasis on productivity growth and conservative capital spending left most of our contacts confident of meeting their revenue and profit goals for the year. Higher costs for oil and oil-related inputs and for certain types of skilled labor were a concern, and many contacts commented on a generally more inflationary business environment. Indeed, providers of business and strategic consulting services reported strong growth, with one contact stating that cost containment is not as big an issue as it was but that strategic matters were becoming more important. Overall, confidence seemed good, and that was reflected in the various regional surveys of May 3, 2005 32 of 116 doubt about both current conditions and the future. This was likely due to concerns about rising oil prices, as local prices for home heating oil rose at a 14½ percent pace, double the national average, and gasoline prices rose sharply, as they did elsewhere. Residential real estate markets, while still strong, leveled off and softened at high price points. Actually, I think President Lacker is probably not asking enough for his home. [Laughter] I don’t find that I’m getting as many offers for mine. And a regional index of leading economic indicators pointed to slower growth ahead. These tentative indications of a slowdown could well evaporate, however, and some moderation in demand may be good, particularly given the stronger pricing environment. Data for the nation have been disappointing in April, both on the demand side and on the price side. The latest news in labor markets is three days away, and while that could surprise on the upside, given recent claims and help-wanted data, the numbers for March were more subdued than we had expected. Equally disappointing were durable goods orders and trends in manufacturing output, though as a partial offset to this I found the April loan officer survey data interesting in that they suggested strength in C&I [commercial and industrial] lending. Contractions were also seen in retail sales, with and without autos, and in home building, although from a fairly strong base. Advance GDP data suggest unintended inventories accumulated as the first quarter ended, reflecting a slowdown in final demand and a drag from net exports. As in New England, this could well be just a bump in the road. And given the unwelcome nudging up of core price data, it might be helpful in curbing further inflation. It does bear watching, however, as we gauge how fast to adjust policy. At this point, my view is that it would be unwise to overreact to the recent indications of softening. They could well be temporary, as many have noted. May 3, 2005 33 of 116 challenges over the past year or so quite important to keep in mind. Whatever its cause, I think the resilience of the U.S. economy has been a hallmark for at least most of the last decade, and I think we would be wise to keep that in the front of our forecast. Right now, given the uptick in prices, we aren’t making much progress in getting back to some sense of neutral as far as policy is concerned. Our forecast in Boston and that in the Greenbook suggest that growth will continue at a pace that will use up at least some excess capacity by the end of the forecast period. Recognizing that estimating precisely when an output gap will close is chancy at best, I believe we need to continue to move policy to a point that is not stimulative by the time that gap closes and that doing so gradually will help to ease the impact on the economy. If incoming data continue to disappoint, we may find it necessary to pause along the lines that the fed funds markets expect. Conversely, upside surprises, particularly on the price front, are also possible. So I would not rule out a faster pace of upward policy movement if circumstances warrant later in this year. The point is, I think, that our vision of the future is now a bit cloudier than it was. That takes me to the real action at this meeting—not so much what we do but what we say about it. I’ve been uneasy with our use of the “measured pace” language because it seems to provide a level of certainty to market participants that could encourage inappropriate risk-taking. Indeed, while risk spreads have widened from their low points, they still remain quite low. However, there has been concern that taking away the “measured pace” language would be disruptive in that it would seem to say only one thing: that policy accommodation would be removed at a faster pace than previously. But weaker-than-expected incoming data may have provided a greater sense of two-sided risk, and that may have offered us a good opportunity. We may now have the chance to drop “measured” from our lexicon, while preserving the flexibility to take any action May 3, 2005 34 of 116 I think we ought to make the most of this opportunity and get out of what has been perceived as a policy pledge. The economy has become more uncertain. Our commitment to price stability and maximum sustainable growth continues unabated, of course, but we are less certain about the policy path we will need to take to fulfill those goals. Let’s go back now to simply saying what we’re doing and why and let the market assign its own probabilities to future policy changes. Thank you." fcic_final_report_full--173 As one recent study argues, many economists were “agnostics” on housing, un- willing to risk their reputations or spook markets by alleging a bubble without find- ing support in economic theory.  Fed Vice Chairman Donald Kohn was one. “Identification [of a bubble] is a tricky proposition because not all the fundamental factors driving asset prices are directly observable,” Kohn said in a  speech, cit- ing research by the European Central Bank. “For this reason, any judgment by a cen- tral bank that stocks or homes are overpriced is inherently highly uncertain.”  But not all economists hesitated to sound a louder alarm. “The situation is begin- ning to look like a credit-induced boom in housing that could very well result in a systemic bust if credit conditions or economic conditions should deteriorate,” Federal Deposit Insurance Corporation Chief Economist Richard Brown wrote in a March  report. “During the past five years, the average U.S. home has risen in value by , while homes in the fastest-growing markets have approximately doubled in value.” While this increase might have been explained by strong market fundamen- tals, “the dramatic broadening of the housing boom in  strongly suggests the in- fluence of systemic factors, including the low cost and wide availability of mortgage credit.”  A couple of months later, Fed economists in an internal memo acknowledged the possibility that housing prices were overvalued, but downplayed the potential im- pacts of a downturn. Even in the face of a large price decline, they argued, defaults would not be widespread, given the large equity that many borrowers still had in their homes. Structural changes in the mortgage market made a crisis less likely, and the financial system seemed well capitalized. “Even historically large declines in house prices would be small relative to the recent decline in household wealth owing to the stock market,” the economists concluded. “From a wealth-effects perspective, this seems unlikely to create substantial macroeconomic problems.”  FOMC20050920meeting--21 19,MS. JOHNSON.," Thank you, Mr. Chairman. Spot prices for crude oil were especially volatile over the intermeeting period, as uncertainty about the consequences of possible hurricane damage, along with other risks, drove up prices before Katrina hit the Gulf shore and as evolving expectations of the near- and medium-term implications of the storm damage induced fluctuations in the weeks following Katrina. In the last few days, concerns about Tropical Storm Rita have been added to the mix. As has been our practice, we again relied on the futures markets to sort through the uncertainties about crude oil supply and demand over the forecast period, and our projection of WTI [West Texas intermediate] prices through the end of 2007 is drawn from the futures curve as of September 12. September 20, 2005 10 of 117 U.S. crude oil production in the Gulf remains at about 50 percent of the level before Hurricane Katrina, with some of this reduction offset by release from the Strategic Petroleum Reserve. We expect that repairs to the damaged facilities will occur over time and have incorporated into the forecast a gradual recovery that is completed early next year. Consequently, we have bumped up our projection for crude oil imports in the first quarter to account for the transitory shortfall. The net effect of these developments is that we have raised our projected price for spot WTI oil by $1.40 per barrel in the fourth quarter of this year and by $1.80 per barrel next year. However, in the near term we have raised our projection for the U.S. oil import price by more, $2.60 per barrel in the fourth quarter and just below $2 per barrel in the following quarter, to reflect the change in mix toward imports of refined product and the rise in product prices as well as crude prices. The net result is a forecast for the oil import bill that is notably higher in the near term, but is less so by the end of next year. Other elements of the external forecast that were affected by Hurricane Katrina include the shipments of non-oil goods into and out of the United States through the region=s port facilities. The immediate percentage impact on exports is judged to be a bit larger than that on non-oil imports, as imports have greater flexibility to be diverted to other ports. The port facilities are reopening quickly, and these effects, particularly on a net basis, should be small. In addition, the current account balance will be positively changed by receipts by U.S. insurance firms of payments owing to reinsurance abroad and, to a lesser extent, by aid contributions from other countries to the U.S. economy. These items will appear as transfer receipts in the nontrade portion of the current account. On balance, this range of impacts from Katrina is expected to be transitory and of limited magnitude. The outlook for foreign growth and inflation is, of course, also influenced by the change in our forecast for global energy prices and by the changes projected for the U.S. economy. In the near term, these two factors work in the same direction to lessen foreign growth. Over a longer horizon, with U.S. growth projected to rebound next year, they are partly offsetting. Upward pressure on inflation from energy prices is a growing concern of central banks and officials abroad. The event of Hurricane Katrina reinforced the trend toward elevated oil prices that has been unfolding over the past few years. In some foreign countries, particularly emerging-market economies, officials have controlled domestic energy prices to blunt the effects of higher global prices. As elevated oil prices have continued, foreign officials have started to remove or lessen these subsidies, with consequent effects on inflation pressures. David will continue our presentation. September 20, 2005 11 of 117 building models that bear no resemblance to economic reality and praised—or at least I think it was praised—for then having the good sense to essentially ignore those models through the wise use of add factors. That mixed message reminded me of a story told by Nobel laureate Ken Arrow. During World War II, Arrow was assigned to a team of statisticians to produce long- range weather forecasts. After a time, Arrow and his team determined that their forecasts were not much better than pulling predictions out of a hat. They wrote their superiors, asking to be relieved of the duty. They received the following reply, and I quote “The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.” [Laughter] I’ll have to admit that we face more than the usual challenges in the period ahead. Over the next few months, I suspect that we will encounter considerable difficulty extracting the macroeconomic signal from economic data that could be profoundly affected by the consequences of this disaster. But as we set ourselves to that task, it will be important not to lose sight of the fact that the larger influences of monetary and fiscal policy, financial conditions, and global energy developments, rather than the hurricane, are likely to dominate the macroeconomic outcome a year hence. In that regard, while it might seem like ancient history and a world away, most of the macro data that we received since the August Greenbook provide a window on how these forces were shaping economic developments prior to Katrina. In brief, we saw the balance of the incoming information as broadly consistent with our view that the economy had been growing at a brisk pace early in the second half. In particular, the household sector seemed especially buoyant. Sales of motor vehicles were receiving a considerable boost from the employee discount programs. And last week’s retail sales report for August suggested consumer spending excluding motor vehicles had been well maintained. Meanwhile, housing activity remained strong, with both starts and sales holding near historic highs. I should mention that this morning’s release showed housing starts in August remaining above 2 million units at an annual rate—close to our expectations. Even the external sector appeared poised to make a contribution to current-quarter growth, rather than being the drag we had earlier anticipated. September 20, 2005 12 of 117 The incoming information on new orders and shipments for nondefense capital goods also has been on the soft side of our expectations. Spending on computers looks to be on track for a 16 percent increase in the current quarter, a relatively modest gain for this component and well below our previous projection. And outlays for capital goods outside of the tech area have been about flat since the turn of the year. As you may recall, equipment investment was surprisingly strong in the second half of last year, and we may now be experiencing some payback for the earlier strength. It is also possible, however, that higher oil prices could be damping business confidence, raising uncertainty about the outlook and making firms more reluctant to invest. And, of course, we can’t rule out the possibility that the recent weakness in equipment spending reflects a dearth of profitable investment opportunities, which would raise questions about the underlying thrust of aggregate demand going forward. For now, we think it is too early to reach that conclusion, but the recent softness here certainly raises that risk. Putting these pluses and minuses together, we thought the economy was on track for growth in the vicinity of 4 percent in the second half of this year. We were encouraged in that interpretation by the ongoing improvement in labor markets. Gains in private payrolls had averaged about 175,000 in recent months, and with the readings on initial claims remaining in the low 300,000s, a continuation of those increases seemed likely. Looking a little further down the road, there had been the usual crosscurrents in the key factors influencing the contours of our forecast. Oil prices continued to rise, siphoning off even more purchasing power from households. But, we were surprised yet again by the strength in housing prices, with the OFHEO [Office of Federal Housing Enterprise Oversight] repeat-transactions index up about 13 percent in the year ending the second quarter. The associated upward revision to housing wealth more than offset a slightly weaker stock market to boost overall household net worth over the projection period. All in all, it seems likely that, absent the hurricane, we would have been presenting to you a forecast that was very similar to that in the August Greenbook. September 20, 2005 13 of 117 As we noted in the Greenbook, our assessment is that, with a few wrinkles, the influence of Katrina on economic activity will trace out a pattern similar to that we have seen after previous disasters. Output will be depressed in the near term by the disruptions to production in the region and elsewhere. As those disruptions ease, activity begins to recover. And then once rebuilding efforts really get under way, output receives a considerable boost. In reality, aspects of all three of these phases operate simultaneously—but with different intensities as time passes. In that regard, one can’t fail to be impressed with how rapidly some aspects of the recovery process already are occurring—in many cases, faster than was initially expected. Some evacuees are finding employment elsewhere; many firms are either temporarily or permanently relocating offices and employees; and workarounds are being found for some of the transportation bottlenecks that have developed. Still, there is no denying that the disruptions remain substantial. About 15 percent of total U.S. oil production and 7 percent of U.S. natural gas output remain shut in at facilities located in the Gulf. As Karen noted, four refineries are still off line and full recovery may not occur for several more months. Activity in the chemical, shipbuilding, and food processing industries—to name just a few—remains seriously impaired. More broadly, business has been disrupted throughout the region. And while many businesses have been effective in developing workarounds, these adjustments are often less efficient and more expensive than before. In our forecast, we have assumed that these disruptions pull down the level of activity in the third and fourth quarters, lopping more than ½ percentage point off the annualized growth of real GDP in the second half of this year. Accompanying this hit to growth, payroll employment is expected to drop 250,000 in September—a shortfall of about 400,000 relative to trend. Employment is then expected to stage a gradual recovery in subsequent months. Although rebuilding activities are already under way, those activities don’t really show through with any macroeconomic force until early next year. In that regard, the draining and environmental cleanup of New Orleans will slow the rebuilding phase compared with past hurricane recoveries. The dynamics of the recovery process will be influenced importantly by the response of the federal government. We have assumed an $85 billion fiscal package, about $70 billion of which is spent over the next two years. This spending is projected to provide a powerful counterbalance to the depressing effects of Katrina and is a chief reason why activity is projected to approach the pre-hurricane baseline by the middle of next year. September 20, 2005 14 of 117 package is appropriately scaled to our estimates of the extent of the damage that has occurred and the dimensions of the economic disruptions. Even with that scaling, I should note that we have the federal government footing the bill for a vastly larger share of the losses than is typical—nearly dollar for dollar in our forecast relative to the 25 percent reimbursement rate that is more the norm. One obvious risk that you confront is that the hurricane, viewed from a macroeconomic perspective, could prove less disruptive to activity and that a massive dose of fiscal stimulus is about to be layered on top of an economy that was already nearing its productive limits. In those circumstances, there is the potential for some overshooting in output with accompanying upward pressure on inflation. But Katrina has amplified some of the downside risks to the outlook as well. Prior to the storm, we were already concerned about the cumulative effects of the rise in energy prices over the past two years. As we noted in our briefing yesterday, there is at least some evidence that sharp jumps in the price of oil have at times in the past been associated with outsized effects on consumption. With the retail price of gasoline having risen above $3.00 per gallon in much of the country, there is certainly cause to be concerned. As a macro guy, I hope that those of you involved in supervision haven’t been too hard on home equity lending, because pretty soon people are going to need a loan to fill up their SUVs. [Laughter] Moreover, the price of gasoline is not the only drain on consumer budgets. Households will face another hurdle this winter when the bills for heating oil and natural gas come due. So this source of downside risk seems likely to be with us for some time. For now, there simply isn’t much hard evidence to suggest any nonlinear response is gaining traction. As I noted earlier, consumer spending has continued to surprise us to the upside. Although last Friday’s report on sentiment showed a substantial deterioration, that drop closely matched our expectations. The forecast is predicated on a gradual recovery in sentiment by the end of the year. If that were not to occur, we would become more concerned about a greater retrenchment in consumer spending. Of course, the cumulative effects of higher energy prices also pose some nonlinear risks to the inflation outlook. Three channels, not entirely independent of each other, would seem to be of greatest concern: a broad-based breakout to the upside in inflation expectations; an intensified push on the part of workers to restore real wages for the ground lost to higher energy prices; and an effort by businesses to more aggressively repair damage that may have occurred to profit margins from rising energy costs. September 20, 2005 15 of 117 expectations moved up to 4.6 percent, the highest level since 1990, while expectations for the next 5 to 10 years edged up to 3.1 percent, just above the narrow range in which they have held over the past several years. However, we suspect that the enormous increase in gasoline prices that took place over the first half of the month was a contributor to this development, and we would counsel waiting for a few more readings before concluding that there has been a consequential deterioration in inflation expectations. That view receives some support from TIPs [Treasury inflation-protected securities]-based measures of inflation compensation, which have also increased, but by much less than the survey reading. We also don’t see much evidence that we are on the verge of a substantial acceleration in labor compensation motivated by efforts of workers to restore real wages. Abstracting from the surge late last year that we believe was related, in part, to stock option exercises and bonuses, the growth of hourly labor compensation has been reasonably stable over the past few years. And while the labor market has tightened up, we don’t hear much from our business contacts to suggest that the competitive environment has changed in a way that would have altered their ability or inclination to grant substantially larger pay increases in the period ahead. Finally, there is a concern that the steep rise in energy costs has placed the margins of some businesses under pressure and that efforts to restore margins could result in more upward price pressure than is currently anticipated in the forecast. To be sure, there is considerable heterogeneity across industries. However, as best we can judge, in the aggregate, the margins of nonfinancial non-energy producing corporations have reached high levels over the past couple of years despite pressures from energy costs. Hence, businesses either have been reasonably successful in passing through higher energy costs or have implemented other offsetting efficiencies. Looking forward, we think that we have made adequate allowance for further pass-through of higher energy prices, but we acknowledge that there are considerable uncertainties about the magnitude of that effect. September 20, 2005 16 of 117 While we do not believe that we have yet experienced nonlinear effects on either output or inflation, any further upward movement in energy prices would certainly intensify the risks of such outcomes. With another storm moving toward the Gulf, we will be watching The Weather Channel closely in the next few days. Before closing, I would like to draw your attention to some substantial changes in both the content and format of the Greenbook’s green sheets that we implemented this round. As far as we can determine, this is the most significant change in the forecast presentation in a few decades. We recognize that we may have imposed some transition costs on those of you who were used to the previous format. But our objective was to make the presentation more user-friendly and to make the forecast and how it has changed between rounds more transparent to you and your staffs. Obviously, we are open to suggestions for further improvement and, if past is prologue, we should be able to work them into the Greenbook at some point in the next few decades. [Laughter] Karen and I will be happy to take your questions." FOMC20060328meeting--90 88,MS. YELLEN.," Okay. I guess my view is that it’s a risk, but at the moment, by various measures, we’re pretty close to, not beyond, full employment. The unemployment rate has declined unusually rapidly over the last year, but a simple Okun’s law calculation—and I think that the staff has commented on this in the past, if I’m not mistaken—would assess the decline we’ve seen in the unemployment rate during 2005 as especially large, given what output growth was. In that sense, the unemployment rate is now giving us a reading of less slack in the economy than we would get from other indicators. Our forecast is that the mysterious decline in the unemployment rate last year will be reversed so unemployment will hold steady, even with growth at the magnitude that the Greenbook is projecting (around 3¾ percent). That’s what the error-correction mechanism is about. So I’m optimistic about inflation because I see us ending 2006 at roughly full employment, with the unemployment rate in the vicinity of its current level. I’m also optimistic about inflation because we’ve been persuaded that since the 1980s we’ve seen very little pass-through of energy- price increases into core inflation. That has been a source of considerably more optimism on our part than on Greenbook’s part in that it continues to project pass-through of energy and commodity prices into core inflation through 2006." FOMC20061212meeting--47 45,MR. STOCKTON.," On the first question—we think the slowdown in energy prices, the flattening out of energy prices, the actual decline of energy prices is probably going to be worth about ¼ percentage point of deceleration in core prices going forward." FOMC20050920meeting--100 98,MR. KOHN.," Thank you, Mr. Chairman. Like President Geithner and many others of you, I do view this as one of those rare situations in which we can truly say the outlook is more uncertain than usual. [Laughter] But that should not deter us from proceeding with our “measured pace” of rate increases. The pre-Katrina data themselves suggested some potentially interesting questions about the outlook, which could have implications for policy going forward. I was especially struck by the weakness in capital spending, despite high and rising profits and strength in other aspects of the so-called fundamentals. It’s possible that business caution has increased again, perhaps out of concern about the effects of the rapid run-up in energy prices on demand since last spring. But at the same time, house prices on the OFHEO index continued to rise at a very rapid pace through the second quarter, supporting household spending and further increases in resource utilization. The expansion was continuing but had become even more unbalanced—more reliant on declining household saving rates induced by rising house prices. Core inflation was coming in lower than expected again. But the potential for future price increases, absent a further tightening of policy, was suggested by upside surprises on one measure of labor costs, rising resource utilization, and the threat that increases in energy costs could feed through to underlying September 20, 2005 76 of 117 I agree with the staff’s assessment that the most likely outcome from Katrina is that the economy will not be materially deflected from the path it was on. After the initial disruptions, fiscal stimulus, rising house prices, and still favorable financial conditions, along with the economy’s natural resilience, should overcome any drag from higher energy prices and should keep activity increasing at a good clip in an economy that is already producing at a high level of resource utilization. Under these circumstances, inflation pressures will not abate. And judging from the tendency for the output gap to continue to shrink this year, we’ll probably need at least a couple of rounds of rate increases to keep the economy near its potential and to prevent inflation from trending higher. Katrina has greatly added to uncertainty, and not just about the extent of the near-term disruption or the effects on energy markets. The more difficult uncertainties relate to how people may react to what has happened, how the government will decide to respond, and how businesses and households will react to these governmental actions and to whatever the path of energy prices turns out to be. How these uncertainties are resolved will affect the economy’s medium-term prospects. But at this point, that added uncertainty doesn’t look particularly asymmetrical in its implications for the path of policy. The risks are still two-sided. Growth could be stronger than anticipated, for example, owing to greater government spending and new tax incentives, with implications for inflation. But on the other side, the rise in energy prices may have less of a persistent effect on core inflation than the staff has predicted. The feed-through of energy prices to core inflation has declined appreciably over time, September 20, 2005 77 of 117 August may have it right that higher energy prices will have more of a negative influence on demand than a positive effect on long-term inflation. The skews in the probabilities for the most likely outcomes were highlighted by the Michigan survey on Friday, pointing to extra weight on the possibility of weaker growth from increasing energy prices that affect consumer psychology and spending but also pointing to potentially higher inflation if expectations do become unanchored. And these skews themselves have offsetting implications for policy. Moreover, uncertainty isn’t going to be reduced by pausing or slowing the pace of tightening. This uncertainty isn’t about the response of the economy to past or future monetary policy actions. Raising the funds rate, as expected, isn’t likely to undermine sentiment or spending. Indeed, pausing, slowing down, or being more ambiguous about our expectations for policy going forward could confuse the public about our view of the situation. In sum, this is a situation in which we should make our best guesses as to the likely outcome, however bad those guesses may be, and act on them, continuing the “measured pace” of tightening for now. Thank you." CHRG-109shrg30354--41 Chairman Shelby," Mr. Chairman, as the cost of energy, as you have noted, is often volatile, in part because of its seasonal use and in part because of factors beyond our control. Historically, energy prices have been excluded from the measure of what you call core prices in the consumer price index. If there is a sustained increase in energy prices, would it be more appropriate for policymakers to rely upon an inflation measure which includes the energy cost? In other words, does the exclusion of energy prices from the definition of core prices pose any problems for economists trying to understand the health of our economy at the present time? " CHRG-109hhrg22160--10 Mr. Greenspan," Mr. Chairman and members of the committee, in the seven months since I last testified before this committee, the U.S. economic expansion has firmed; overall inflation has subsided and core inflation has remained low. Over the first half of 2004, the available information increasingly suggested that the economic expansion was becoming less fragile and that the risk of an undesirable decline in inflation had greatly diminished. Toward midyear, the Federal Reserve came to the judgment that the extraordinary degree of policy accommodation that had been in place since the middle of 2003 was no longer warranted and in the announcement released at the conclusion of our May meeting signaled that a firming of policy was likely. The Federal Open Market Committee began to raise the federal funds rate at its June meeting, and the announcement following that meeting indicated the need for further, albeit gradual, withdrawal of monetary policy stimulus. Around the same time, incoming data suggested a lull in activity as the economy absorbed the impact of higher energy prices. Much as had been expected, this soft patch proved to be short-lived. Accordingly, the Federal Reserve has followed the June policy move with similar actions at each meeting since then, including our most recent meeting earlier this month. The cumulative removal of policy accommodation to date has significantly raised measures of the real federal funds rate, but by most measures it remains fairly low. The evidence broadly supports the view that economic fundamentals have steadied. Consumer spending has been well maintained over recent months, buoyed by continued growth in disposable personal income, gains in net worth, and accommodative conditions in credit markets. Households have recorded a modest improvement in their financial position over this period, to the betterment of many indicators of credit quality. For their part, business executives apparently have become somewhat more optimistic in recent months. Capital spending and corporate borrowing have firmed noticeably, but some of the latter may have been directed to finance the recent backup in inventories. Mergers and acquisitions, though, have clearly perked up. Even in the current, much improved environment, however, some caution among business executives remains. Although capital investment has been advancing at a reasonably good pace, it has nonetheless lagged the exceptional rise in profits and internal cash flow. As opposed to the lingering hesitancy among business executives, participants in financial markets seem very confident about the future and, judging by the exceptionally low level of risk spreads in credit markets, quite willing to bear risk. This apparent disparity in sentiment between business people and market participants could reflect the heightened additional concerns of business executives about potential legal liabilities, rather than a fundamentally different assessment of macroeconomic risks. Turning to the outlook for costs and prices, productivity developments will likely play a key role. The growth of output per hour slowed over the past half year, giving a boost to unit labor costs after 2 years of declines. Going forward, the implications for inflation will be influenced by the extent and persistence of any slowdown in productivity. To date, with profit margins already high, competitive pressures have tended to limit the extent to which cost pressures have been reflected in higher prices. The inflation outlook will also be shaped by developments affecting the exchange rate of the dollar and oil prices. Although the dollar has been declining since early 2002, exporters to the United States apparently have held dollar prices relatively steady to preserve their market share, effectively choosing to absorb the decline in the dollar by accepting a reduction in their profit margins. However, the recent somewhat quickened pace of increases in U.S. import prices suggests that profit margins of exporters to the United States have contracted to the point where foreign shippers may exhibit only limited tolerance for additional reductions in margins should the dollar decline further. The sharp rise in oil prices over the past year has no doubt boosted firms' costs and may have weighed on production, particularly given the sizable permanent component of oil price increases suggested by distant-horizon oil futures contracts. However, the share of total business expenses attributable to energy costs has declined appreciably over the past 30 years, which has helped to buffer profits and the economy more generally from the adverse effect of high oil and natural gas prices. All told, the economy seems to have entered 2005 expanding at a reasonably good pace, with inflation and inflation expectations well anchored. On the whole, financial markets appear to share this view. In particular, a broad array of financial indicators convey a pervasive sense of confidence among investors. Over the past two decades, the industrial world has fended off two severe stock market corrections, a major financial crisis in developing nations, corporate scandals, and of course, the tragedy of September 11, 2001. Yet overall economic activity experienced only modest difficulties. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward. Yet history cautions that people experiencing long periods of relative stability are prone to excess. We must thus remain vigilant against complacency, especially since several important economic challenges confront policy-makers in the years ahead. Prominent among these challenges in the United States is the pressing need to maintain the flexibility of our economic and financial system. This will be essential if we are to address our current account deficit without significant disruption. Central to that adjustment must be an increase in net national saving. This serves to underscore the imperative to restore fiscal discipline. Beyond the near term, benefits promised to a burgeoning retirement-age population under mandatory entitlement programs, most notably Social Security and Medicare, threaten to strain the resources of the working-age population in the years ahead. Real progress on these issues will unavoidably entail many difficult choices. But the demographics are inexorable and call for action before the leading edge of baby boomer retirement becomes evident in 2008. Another critical long-term economic challenge facing the United States is the need to ensure that our workforce is equipped with the requisite skills to compete effectively in an environment of rapid technological progress and global competition. But technology and, more recently, competition from abroad have grown to a point at which the demand for the least-skilled workers in the United States and other developed countries is diminishing, placing downward pressure on their wages. These workers will need to acquire the skills required to compete effectively for the new jobs that our economy will create. Although the long-term challenges confronting the United States economy are significant, I fully anticipate that they will ultimately be met and resolved. In recent decades, our nation has demonstrated remarkable resilience and flexibility when tested by events, and we have every reason to be confident that it will weather future challenges as well. For our part, the Federal Reserve will pursue its statutory objectives of price stability and maximum sustainable employment, the latter of which we have learned can best be achieved in the long run by maintaining price stability. This is the surest contribution that the Federal Reserve can make in fostering the economic prosperity and well being of our nation and its people. Mr. Chairman, thank you very much and I look forward to your questions. [The prepared statement of Hon. Alan Greenspan can be found on page 59 in the appendix.] " FOMC20060808meeting--50 48,MS. YELLEN.," Thank you, Mr. Chairman. So far the economy has stuck pretty close to the script of the soft landing sketched out in the June Greenbook. Real GDP growth slowed markedly in the second quarter. Housing construction has declined sharply, and house prices have decelerated; this situation suggests that our policy actions have taken hold in this interest-sensitive sector. The recent sharp rise in oil prices should also put a damper on growth of real income and consumer spending. Most forecasters now expect below-trend growth in the current quarter. Nonfarm payroll employment has shifted down to a more-sustainable pace, and the unemployment rate has risen to 4.8 percent, just a bit below standard estimates of the NAIRU. Core inflation, although uncomfortably high, came in 0.2 percentage point below the June Greenbook’s forecast in the second quarter. In addition, despite further large increases in the price of oil, inflation expectations held firm. In light of these developments, a reasonable forecast is for growth to continue to run slightly below its potential rate, the unemployment rate to edge up, and core inflation to recede gradually. At our last meeting, I laid out some of my concerns about downside risks to the outlook for growth and upside risks to inflation. Quite honestly, I cannot say that the recent data have done much to assuage my angst on either account. The recent falloff in housing activity and the deceleration in house prices have been faster than expected. The current Greenbook has residential investment falling at an annual rate of 14 percent in the second half of this year, nearly twice as fast as projected in June. These surprises intensify the risk of a sharper slowdown as the lagged effects of our past policy actions come fully into effect. For example, the housing slowdown could become an unwelcome housing slump as envisioned in one of the Greenbook alternative scenarios. A large homebuilder in our District summarized the views of many of our contacts when he recently commented that “the housing market has not yet popped, but a hissing sound is now clearly audible.” [Laughter] He pointed to rapidly rising cancellations as a particularly ominous sign. I will be watching the incoming data closely for signs as to whether the housing slowdown remains orderly as hoped or takes a steeper downward slide, posing a greater risk to the economy. My concerns about inflation have also been somewhat heightened by the recent data or, more precisely, revisions to past data. Core measures of inflation continue to be well above my comfort zone. Of course, after the experience of last year, when core inflation was revised up by a considerable amount, I approached this year’s annual NIPA revision with some considerable trepidation. I was relieved to see that the core PCE price inflation data came out of the revision relatively unscathed, revised up just 0.1 percentage point for 2005; but other aspects of the report were somewhat less reassuring for the inflation outlook. First, the rate of labor productivity growth over the past three years has been a bit slower than we thought, primarily because of downward revisions to the rate of capital accumulation, so that the Greenbook now projects structural productivity growth of 2.7 percent, about ¼ percentage point slower than we thought back in June. This revision suggests somewhat less downward pressure on inflation emanating from cost reductions and, therefore, greater upside risks to inflation. But that wasn’t the only surprise tucked away in the annual revision. The upward revision to compensation growth over the past four quarters implies that growth in unit labor costs over the past year has been more rapid than we had believed. I had thought that there was a good chance that compensation per hour and unit labor costs would increase relatively moderately going forward, helping to contain inflationary pressures. The data revision was thus a bit of a wake-up call for me, and I have revised upward my views on the outlook for compensation and unit labor costs. My reading of the report is that the revised data provide a clearer and less sanguine picture of the trend in this measure of compensation. However, the employment cost index was in line with expectations in June and continues to show moderate growth. Moreover, even with revisions to productivity and compensation, the markup in the nonfarm business sector remains very high by historical standards, suggesting that firms do have room to absorb costs. Overall, I view the inflation outlook as highly uncertain, with a pronounced upside risk. As I mentioned at the last meeting, we just don’t have a good handle on why core inflation has risen of late or how persistent this rise will be. While it is comforting to attribute the increase to energy and commodity-price pass-through, empirical evidence suggests that pass-through effects have been quite modest since the mid-1980s. If so, the door is open for other explanations that may have a more lasting influence and require a more aggressive policy response. Something that makes me even more uncertain about the inflation outlook is that standard backward-looking Phillips curve models of inflation appear to be breaking down. It has been widely noted that the estimated effect of resource utilization on inflation in such models has become much smaller over time. But equally striking is the finding that the sum of coefficients on lagged inflation when freely estimated appears to have fallen as well, suggesting that inflation has become far less persistent. In fact, our staff finds that, in looking over the past ten years, it is better to assume that core inflation will return to its sample average over the next four quarters than that it will remain in its recent range or follow a standard Phillips curve model. Interestingly, this decline in the persistence of core inflation has occurred at roughly the same time that long-run inflation expectations, as measured by the Survey of Professional Forecasters, appear to have become well anchored, and this may not be a coincidence. Economic models with forward-looking inflation expectations tell us that, if the central bank has credibility and holds to a fixed long-run inflation target, then inflation will be less persistent than is implied by the standard backward-looking Phillips curve model. Indeed, the puzzle for macroeconomists has been why we see so much inflation persistence. Perhaps we no longer do. If that is true, inflation may decline faster than the Greenbook expects. Admittedly, the past ten years form a relatively small sample from which to draw definitive conclusions. But the inflation process may have changed in a fundamental way, and we should be open to that possibility. I would like to stress that this evidence and the analysis concern the simple correlations of the inflation data that are used for forecasting. The evidence does not relate to structural relationships, and therefore it does not necessarily inform us about how our policy decisions affect the economy or about the best course for policy. In summary, although my modal forecast is relatively benign, I remain very concerned about risks to both growth and inflation." CHRG-111shrg57322--546 Mr. Birnbaum," Sorry. Which information? Senator Coburn. The information of the fact that the housing market, the prices in the housing market, as you testified earlier, as an indicator, that you were seeing softness in that market, you were seeing a decelerating increase in prices, then you saw a flat price, then you saw a deceleration of price. " FOMC20071211meeting--104 102,MR. HOENIG.," Thank you, Mr. Chairman. I’ll start on the local level. Overall our District economy continues to perform generally well, with ongoing weakness in the housing sector being offset by strength in agriculture, energy, and manufacturing. We have seen some slowing in employment growth over the past few months, but this appears in part to be a supply consideration. Our directors and business contacts continue to report that the labor markets are, in fact, tight across much of the District with shortages of both skilled and unskilled labor and rising wage pressures. There is some reduction in employment, obviously in the housing sector, but that is being offset by these other considerations. I would also note that manufacturing activity remains basically solid, with manufacturers reporting strong export orders. The District’s manufacturing index moved upward in November and still points to moderate growth. In addition, District manufacturers’ capital spending plans actually rose but remained below most of last year’s readings on balance. Turning to spending, general retailers reported a rebound in sales in the latter part of October and early November. Automobile dealers, on the other hand, did report weaker sales and have also become more pessimistic on future sales. Travel and tourism continues to expand in our region, with District airline traffic figures solid, particularly in the Denver area. Likewise, hotel occupancy figures have continued to increase from already strong levels in the region. As has been true for some time, housing activity, as I said, remains soft. For example, the value of residential contracts dropped again in October, and the rate of decline in residential permits steepened again in the past few months in our region. Offsetting this weakness in housing, though, is considerable strength in agriculture and energy. District energy producers continue to expand their capital investments as they are relatively confident that oil and gas prices will remain firm over the longer term. In fact, their capital expenditures have been slowed by a continuing shortage of labor and access to some equipment. Our larger regional banks are still reporting fairly good conditions. The deal flows seem to be coming through, although they are looking at those carefully, just given the environment that they find themselves in on a national level. Finally, price pressures remain mixed. Most businesses report rising input costs, both labor and materials, but differ in their ability to pass those costs on at this point. In transportation, input costs are passed through one for one through customer surcharges. Other businesses continue to find it a little more difficult to pass through the higher costs, but they are beginning to push harder on that as we talk to them. Let me turn to the national outlook. Weakness in incoming data and continuing stress in financial markets obviously are noteworthy, and others have noted that here today. Compared with the Greenbook, however, I see stronger growth in both the short run and the longer run. I expect fourth-quarter growth to be closer to 1 percent, not the zero percent in the Greenbook, and the economy to strengthen slowly through a good part of 2008, starting out slowly obviously and then picking up as we go through the year. Comparing my views with those in Greenbook, the basic difference appears to be largely in some of the judgmental adjustments in the Greenbook concerning spillovers from the housing and financial stress to consumer spending. The current Greenbook forecast, as others have noted, is similar to the Blue Chip Bottom Ten forecast, which suggests to me that it might be better seen as the downside risk outlook not necessarily the most likely outlook at this point. The first half of 2008, as I said, is likely to be somewhat slower than I previously projected because of the high energy prices and continued drag from housing. However, I expect that growth will gradually strengthen as we move toward the end of 2008 and then remain there through the rest of the forecast period. Having said this, I realize that the downside risk to economic activity does remain elevated. The housing slowdown could be deeper and last longer, and continuing financial turmoil could further affect consumer and business spending. However, while financial factors remain a risk to the outlook, in my view the economy, though it will grow below its potential, can weather these forces and is being supported by the policy actions that we have taken in the past two meetings. Against this outlook for economic growth, let me turn now to the inflation outlook. Year- over-year overall and core inflation rates have risen. In addition, Greenbook’s 2008 forecast for overall and core PCE inflation has increased since our last meeting. While below-trend growth in the near term may exert some downward pressure on inflation, the combination of higher prices for oil, commodities, and some services and dollar depreciation should place upward pressure on both overall and core inflation going forward. Over the past several years, the pass-through of dollar depreciation and higher oil prices to inflation has been limited in part because of longer-term inflation expectations remaining, as we said, anchored. My concern is that, if we continue to lower the fed funds rate into a rising inflation environment and the dollar continues to depreciate, these expectations may become unhinged perhaps more quickly than we would like to think. In this environment, I think we should not lose sight of not just the downside risk to the real economy but also some very serious upside risk to inflation. Thank you." CHRG-111hhrg74855--28 Mr. Butterfield," Thank you very much, Mr. Chairman, for convening this important hearing. I am not an expert on these matters and I have tried to learn as much as I can but from what I can understand, these products minimize risk in a capricious system for end users. Unfortunately, excessive over-the-counter trading by speculators continues to increase the risk for system irregularity and unpredictability. I am pleased given the number of important domestic priorities vying for our attention that Congress is paying close attention to reforming the way we regulate derivatives. We simply cannot afford the risk of allowing the system to operate like an open casino and I appreciate the work thus far done on this bill by the two committees. Still, as the chairman stated it is critical that this subcommittee question the imprecise definitions in the bill given the potential problems such ambiguity would create for end users. Last year, the newspaper in my district reported on the importance of derivative for one of North Carolina's largest utilities, Progress Energy. Manned, round-the-clock progress power traders make OTC trades to hedge against risk and find the lowest energy prices that are available. These activities are critically important to minimize risk. According to our State utility commission officials interviewed in the article, electricity rates would be at least double, that is double, without the success of Progress' trading department. I mention this to illustrate just how critical these financial instruments are in controlling costs for consumers. I welcome and encourage the transparency this legislation would create and I am hopeful that the legislation will be crafted in a way that ensures that end users can continue to enjoy these cost-cutting benefits. I look forward and thank the witnesses for their testimony today and this microphone is not working. " CHRG-110hhrg46596--103 Mr. Neugebauer," Sure. What about the pricing? Was everybody's pricing the same? " FinancialCrisisReport--289 In contrast to decades of actual performance data for 30-year mortgages with fixed interest rates, the new subprime, high risk products had little to no track record to predict their rates of default. In fact, Moody’s RMBS rating model was not even used to rate subprime mortgages until December 2006; prior to that time, Moody’s used a system of “benchmarking” in which it rated a subprime mortgage pool by comparing it to other subprime pools Moody’s had already rated. 1118 Lack of Data During Era of Stagnant or Falling Home Prices. In addition, the models operated with subprime data for mortgages that had not been exposed to stagnant or falling housing prices. As one February 2007 presentation from a Deutsche Bank investment banker explained, the models used to calculate “subprime mortgage lending criteria and bond subordination levels are based largely on performance experience that was mostly accumulated since the mid-1990s, when the nation’s housing market has been booming.” 1119 A former managing director in Moody’s Structured Finance Group put it this way: “[I]t was ‘like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.” 1120 In September 2007, after the crisis had begun, an S&P executive testified before Congress that: “[W]e are fully aware that, for all our reliance on our analysis of historically rooted data that sometimes went as far back as the Great Depression, some of that data has proved no longer to be as useful or reliable as it has historically been.” 1121 The absence of relevant data for use in RMBS modeling left the credit rating agencies unable to accurately predict mortgage default and loss rates when housing prices stopped climbing. The absence of relevant performance data for high risk mortgage products in an era of stagnant or declining housing prices impacted the rating of not only RMBS transactions, but also CDOs, which typically included RMBS securities and relied heavily on RMBS credit ratings. Lack of Investment. One reason that Moody’s and S&P lacked relevant loan performance data for their RMBS models was not simply that the data was difficult to obtain, but 1117 9/30/2007 email from Belinda Ghetti to David Tesher, and others, Hearing Exhibit 4/23-33. 1118 See 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14- 0001-16, at 3. 1119 2/2007 “Shorting Home Equity Mezzanine Tranches,” Deutsche Bank Securities Inc., DBSI_PSI_EMAIL01988773-845, at 776. See also 6/4/2007 FDIC memorandum from Daniel Nuxoll to Stephen Funaro, “ALLL Modeling at Washington Mutual,” FDIC_WAMU_000003743-52, at 47 (“Virtually none of the data is drawn from an episode of severe house price depreciation. Even introductory statistics textbooks caution against drawing conclusions about possibilities that are outside the data. A model based on data from a relatively benign period in the housing market cannot produce reliable inferences about the effects of a housing price collapse.”). 1120 “Triple-A Failure,” New York Times (4/27/2008). 1121 Prepared statement of Vickie Tillman, S&P Executive Vice President, “The Role of Credit Rating Agencies in the Structured Finance Market,” before U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Cong.Hrg. 110-62 (9/27/2007), S&P SEN-PSI 0001945-71, at 46-47. that both companies were reluctant to devote the resources needed to improve their modeling, despite soaring revenues. FinancialCrisisReport--581 Stanley’s representative again urged Goldman to begin the liquidation process: “Just so you know, my opinion stays the same, I’d like to see a bid list before three o’clock today.” 2611 Morgan Stanley told the Subcommittee that the Hudson assets had been in near continuous decline, and Goldman’s refusal to liquidate assets shortly after they became Credit Risk Assets allowed them to decline further, rather than limiting losses for bondholders. By February 21, 2008, Morgan Stanley had calculated that the liquidation delay had cost it $130.5 million; the next week it calculated the losses had increased to $150 million. 2612 Morgan Stanley told Goldman that by delaying the liquidation of the Credit Risk Assets, Goldman was in violation of the terms in the Hudson 1 offering circular, in particular the provision: “The Liquidation Agent will not have the right, or the obligation, to exercise any discretion with respect to the method or the price of any assignment, termination or disposition of a ... Credit Risk Obligation.” 2613 On February 29, 2008, Morgan Stanley sent Goldman a letter demanding that it immediately initiate liquidation of $1 billion in Hudson Credit Risk Assets: “As Liquidation Agent, [Goldman] is currently responsible for liquidating approximately $1,000,000,000 of Credit Risk Obligations. The transaction documents clearly state that [Goldman] would not exercise investment discretion in its role as Liquidation Agent. [Goldman] has not yet liquidated a single Credit Risk Obligation, notwithstanding that some date back to August of 2007. The [Goldman] employee handling the liquidation has explained this by stating that he believes the price for these obligations will increase in the future and it is better for the deal to liquidate these obligations at a later date. ... The Liquidation Agency Agreement states that “the Liquidation Agent ... shall not provide investment advisory services to the Issuer or act as the “collateral manager” for the Pledged Assets . ... While the Liquidation Agency Agreement provides that the Liquidation Agent must complete the process of liquidating the relevant assets within twelve months, it does not provide the Liquidation Agent with any right to delay the liquidation process based on the exercise of Investment discretion. To the contrary, the Liquidation Agency Agreement and the [Offering Circular] clearly state that no discretion or investment advisory services are ever to be provided by the Liquidation Agent.” 2614 2610 2611 2612 Transcript of 2/13/2008 telephone call between Morgan Stanley and Goldman, HUD-CDO-00006894. Id. 2/21/2008 email from Vanessa Vanacker to M r. Pearce, HUD-CDO-00004882. 2/29/2008 letter from Morgan Stanley to Goldman, HUD-CDO-00006877. 2613 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, section entitled, “Disposition of CDS Transactions by the Liquidation Agent Under Certain Circumstances,” GS MBS- E-021821196 at 241. See 2/29/2008 letter from Morgan Stanley to Goldman, HUD-CDO-00006877. 2614 2/29/2008 letter from Morgan Stanley to Goldman, HUD-CDO-00006877 [emphasis in original]. CHRG-111shrg55117--71 Mr. Bernanke," Well, from the Federal Reserve's perspective, we have basically a two-pronged approach. One is to work with banks to work out commercial real estate projects which are no longer performing, in very much the same spirit as we have work-outs for residential mortgages that are not performing. There, as with residential mortgages, there is an incentive to do that if the costs of foreclosure are sufficiently high. I think one slightly positive thing is that I don't think that commercial real estate experienced quite the increase in prices or the bubble component that housing did, but nevertheless it is still under a lot of pressure. The second element of our program is the TALF, which now also will allow borrowing from the Treasury's PPIF program also to come in and buy CMBS through the TALF. Whether Congress wants to take additional steps, you know, you could intervene with guarantees or other kinds of support that would have fiscal implications. It would mean the Government was bearing risk. So I haven't really seen a full-fledged proposal and I would be somewhat reluctant to strongly endorse one. I think really the Congress has to make those tradeoffs between the fiscal cost, the fiscal risk, and what is, I will agree, a very real risk on the side of foreclosures and problems in commercial real estate---- Senator Menendez. As I talk to this industry, Mr. Chairman, they tell me that at least presently, there isn't--they seek the private marketplace. They are not really seeking the Government. But there isn't a private marketplace, certainly not in a sustainable way, for what is coming down the road. And so the question is, do we wait again for the crisis to happen, or do we anticipate where it is headed and seek to stem it because otherwise we have significant risk to our economy. I am just wondering, do you think that what you have today as tools is sufficient to meet that challenge in the days ahead or not? " CHRG-111hhrg58044--213 Mr. Snyder," Thank you, Ms. Waters. That will differ from insurer to insurer. There are dozens of variables that are considered. Many different credit variables, as well as other variables, such as prior loss experience. In automobile insurance, make and model of car. In homeowner's insurance, prior loss experience, proximity to a fire station, and on and on. The whole effort is to try to combine these factors, to be as accurate as possible in predicting future risk of loss and therefore, pricing for it. Ms. Waters. Do you think it would be helpful to set some standards so that people can have a good understanding about what is taken into consideration no matter what insurance company you go to, rather than having all of these variables that are not identified in any insurance policy that I know of, to tell people how the decision was made? Should we have some standards? " CHRG-109hhrg31539--194 Mr. Bernanke," And we have very little control over energy prices themselves. Our objective is to make sure that it doesn't get into a wage-price spiral where energy prices spill over into other-- " CHRG-110shrg50414--158 Mr. Bernanke," On the grounds that the prices that we now see are what I called fire-sale prices, prices that are seen when you sell into an illiquid market. " FOMC20060808meeting--81 79,MR. KROSZNER.," Thank you very much. As the comments indicate, this is probably the most challenging time that we have had before us in my long history here at the FOMC. [Laughter] The mix of continuing inflation pressures and decelerating growth are providing more concerns on both fronts than I have heard around the table and than I myself have had since I’ve been here. First let’s think about some of the growth prospects. I broadly share the Vice Chairman’s view that the fundamentals are in place for reasonable growth going forward. Certainly there are some risks. But whether we are looking at survey-based measures, at orders and shipments, or at a variety of different things, we don’t really see signs of very significant deceleration or contraction. We see more a moderation that would be either in line with the Greenbook or a bit lower than the Greenbook. Certainly a key risk to growth that a lot of people have discussed is residential investment. If you look at where we are in residential investment, we’re back only to mid-2003; 2004 and 2005 were incredibly strong years. So being in 2003 is not that bad. If you look at the graph, residential investment falls off rather precipitously to get us back to 2003 with great rapidity. The question I have is whether it will flatten out or whether it will go down further. The Greenbook forecasts have gradually been moving down and now reflect more downward pressure going forward. I think that we’re not seeing the full effects on house prices reflected in the numbers because in the housing market, for reasons I don’t think we fully understand, there tend to be queuing rather than just price changes. So it may take a while for the price data to actually reflect the lower effective prices that people are seeing. Obviously house prices will have a potentially important effect on the wealth effect and on consumption down the line, which I think the Greenbook does a good job of putting into place. Another challenge is elevated prices for energy and commodities. Energy prices, particularly, may be taking a little bite out of people’s disposable income. On the other hand, we have been seeing continued strong business fixed investment. A small concern I have is, if we continue to hear about slowing consumption and reports from Wal-Mart and others that retailing is really slowing, why are these businesses producing? Are they investing to produce goods that people will want to buy, or will we see in nine months or a year that maybe some misallocation of resources has occurred and that things aren’t as strong as we had thought? There’s no particular sign of such misallocation of investment. It just seems that there is a bit of tension between the discussions of continued strength of capital expenditures and the statements of business contacts that they are going to continue to invest even though they see a slowing coming down the line. This is a variation of what Governor Warsh was saying—it’s almost as though they are saying that some other sector will have that slowing, not their sector. In some sense, we should take very cold comfort from the fact that the economy may be slowing. We had quite a discussion about how there’s not much of an inflation–output tradeoff, but at least in this period there are real questions of whether you do get much benefit in terms of lower inflation from slower growth. There may be some benefit, but it seems to be attenuated compared with the past. Obviously some of the recent numbers on inflation continue to be worrisome, but fortunately both the survey measures and the market-based measures seem to be reasonably contained looking forward. Survey measures, whether of the man in the street or of the professional forecaster, seem to be quite flat. The TIPS rates for both the near-term forwards and the longer-term forwards have not moved up much. Some of the near-term forwards have moved up a bit, but that doesn’t seem surprising given the rise in energy prices that we have seen both from the Middle East and from issues in Alaska. The real key is looking forward as to what is likely to occur. Are the things we’re seeing now transitory factors or persistent factors? That’s a very, very difficult call. Reasonable arguments have been made that a number of these factors, particularly with respect to shelter services, are perhaps a bit more short-lived. Shelter services are about 19 percent of core PCE and about 30 percent of core CPI, and obviously they have been leading the band up. As many people have said, we have been seeing price increases in a lot of areas, but I don’t put quite as much stock in that because many of the categories in both the PCE and the CPI are arbitrary. The issue is really what the relative size and the relative importance are. Shelter services and owners’ equivalent rent, which composes a vast majority of shelter services, are an important piece. I think that there’s a reasonable chance that this factor is likely to be transitory, although it may last for several months and possibly quarters. But that is the key question—whether these forces are likely to be transitory or likely to be more persistent. Coming back to inflation expectations, that’s really where I see the markets both registering their view of persistence and telling us something about whether they believe that we will keep inflation well contained. At least so far, those expectations are suggesting that we will. It’s extremely important that we maintain those expectations. It’s very costly to try to regain credibility if credibility is lost. I think the markets are willing to say, “Well, there may be some transitory inflation, and we’re willing to wait and see whether to mark up our longer-term expectations.” Certainly once longer-term expectations are marked up, the situation becomes highly problematic because it’s very difficult to rein in the changes in expectations, particularly in behavior. So basically I think we need to keep a very, very watchful eye on where expectations are going. I’m heartened that they haven’t moved too far despite, as many people have said, high core PCE prices for a number of years and elevated levels in the most recent numbers. Thank you, Mr. Chairman." FOMC20050202meeting--113 111,MS. JOHNSON.," I don’t know that I would link it to that particularly. I think it is in part, but I can’t tell you how much, a result of the integration of trade—or reintegration of trade—that’s going on in Asia, so that exports that previously came to us from Japan now pass through China for some final stage of processing. There’s a sense in which the gains that China is making are coming at the expense of other Asian trading partners and are not of much significance. On the other hand, if the China and Hong Kong line had gone up at the same time that this “Other Asia” line went down, I think I would have had to say that I shouldn’t show them separately but should add them together or something. But it did not. I’d point more to the high-tech sector as a factor. In terms of the risks to this global forecast, we have oil prices, our basic standard risk. But the issue of whether the high-tech sector is going through a temporary inventory lull and is going to rebound or not is the biggest question mark for the Asian emerging-market countries. I think that accounts for the falloff in trade at the end of last year—that is, the falloff in exports more broadly and in IP [industrial production]. I think that’s all wrapped up in the high-tech question." CHRG-110shrg50369--74 Chairman Dodd," Great questions, too, and we will come back to those maybe in a little bit. Senator Reed was raising with me privately the issue as well, and I think it is worth exploring. The issue of the question of the value of the dollar, the rising price of oil, the dollar denomination oil pricing, whether or not that can shift in these commodities generally is an interesting issue. But let me turn to Senator Bayh. Senator Bayh. Thank you, Mr. Chairman. Mr. Bernanke, thank you for you--Chairman Bernanke, I should say. Thank you for your presence today, and thank you for your service to our country. I think you have your priorities right. You mentioned that the risks in the forecast are to the downside and that our principal concern at this moment--you have to strike a balance, but our principal concern should be avoiding an economic downturn of severity and duration while continuing to focus on inflation in the longer term. As you and some of my colleagues have pointed out, the genesis of much of this originated in the housing sector, particularly with some of the subprime type mortgages. And it seems to me that you, in setting monetary policy, erred on the side of--not erred, but you have been more aggressive than less and tried to minimize the downside risk to the economy. And that is as it should be. My question to you is: Should not Congress do the same in addressing the housing problem? The President has the voluntary Hope Now initiative you have outlined. I think it would be charitable to say that the results of that have been modest to date. You indicate there is not a lot of data, but it certainly does not seem as if it has had much of an impact. There are some proposals, fairly narrowly circumscribed ones before us, that would focus on this issue, allowing bankruptcy courts, only with regard to outstanding subprime mortgages, to revisit some of these issues, only when the borrowers have passed a strict means test. The interest rates would be set at prime plus a risk premium, and if the homes were ever resold, the lenders would participate in the upside, any potential upside, if the property would revalue. Now, the President has threatened to veto this initiative, and some have claimed that it would add as much as 2 percent to the cost of a mortgage. I find that to be not a credible analysis when it, by definition, does not apply to future mortgages. This is a one-off event, the greatest housing downturn in the last 50 years, fairly narrowly circumscribed. So my question to you is: Just as you have emphasized being more aggressive at this moment, should not we? And as an economist, is it credible to think that this would add 2 percent to the cost of a mortgage moving forward in this narrowly circumscribed manner? " FOMC20051213meeting--122 120,MS. BIES.," Thank you, Mr. Chairman. First, let me say that I support the 25 basis point increase today. And I give my sympathy to Brian, who has heard our many different viewpoints in the last week. I think he has done a good job of trying to get all our ideas out here in a reasonable balance. My initial feeling was that I really didn’t want to keep the word “measured” in the statement; I wanted to drop it as part of this change. But for the reasons everybody has suggested, I can accept the wording in alternative B as it is now. Mr. Chairman, you talked about some of the risks to the long-term side of the market. I think that is a serious concern because so much of the pricing these days seems not to involve looking at the longer-term risks, and it’s so critical to what is currently driving investment and risk-taking. And for that reason, I guess I’d like to leave the words as they are now. But the big change that I would like to see is a move away from forward-looking language as we get to the point where there is more uncertainty about future policy. It was easy for the last thirteen meetings to say, “We’re on a trend; the funds rate is way too low and we have to get it back up.” So it was easy for us to signal ahead. But as we signaled ahead, the market looked at what we were saying we were going to do as opposed to what the data were saying we would do. We, in effect, have taken the risk away from the market, especially at the long end, because market participants think we’re going to signal ahead of time and they will have time to get out of their long positions. In my view, we should go back to structuring section 4 to say basically where we think the risk is. Then I’d take the second part of that sentence and put it down in section 5, because it’s still a December 13, 2005 83 of 100 around this table is going to say that we’re not going to follow the mission of the Fed. So if we’re going to put in a tautology, I’d put it in part 5. And in part 4 I’d just indicate our assessment of the risks—that we think the risks are balanced or that the risk to growth or for inflation is greater. That would give the markets the message that they need to go back to looking at the data to figure out what we’re going to do, rather than our laying out for them what our next policy moves are going to be. As we get to the cusp, that risk perspective is really important. We saw when we turned from the bottom and rates were heading back up again that it disrupted the markets. But we need the markets to be ready to absorb that kind of risk because, as we sit around this table, we do not know exactly how we’re going to engineer getting out of this pattern of moving 25 basis points at each meeting. And I think the way to do it is to focus on where we see the risks and to stop giving any kind of signal on what our likely moves are going forward. I would like to see that happen at the next meeting." CHRG-109hhrg31539--20 Mr. Bernanke," Well, if you look at the options on futures, which suggest something about the uncertainty the traders feel about oil prices, you see it is quite a wide range. There is a possibility in their mind that prices might fall $20 and a possibility in their mind that prices might rise $20. So there is a lot of uncertainty about what those prices will do. But our best guess is just to look at where the futures quotes are, and that suggests that energy prices should stay roughly in the area where they are today. " FOMC20080430meeting--196 194,MR. KROSZNER.," Thank you, Mr. Chairman. As many speakers before me have said, this is a pretty close call, and reasonable cases can be made for both alternative B and alternative C. If you look at financial market conditions, you can see your favorite indicator and say whether things have eased or not eased. One indicator that I look at when thinking about the transmission of monetary policy is the LIBOR�OIS spread, which has gone up very significantly. A lot of shortterm borrowing is priced off of that. If we wanted just to keep policy where it was six weeks ago, we would actually have to cut more--not that I'm suggesting that we should. But if you use that spread as the relevant indicator, it would suggest that, if one were to keep the same stance, or potentially the same stance, of monetary policy, you'd have to cut a lot. It doesn't seem as though our liquidity facilities have been effective on this particular dimension. We had been hopeful that they would be, but they don't seem to be. Even with some of the things that we voted on yesterday, we're still going to see very elevated spreads in some of these markets, still making borrowing costs relatively high and so disrupting the traditional monetary transmission mechanism. So that's where I would argue for alternative B. Another argument for alternative B is the potentially protracted slowdown. I agree very much with President Stern. As I've talked about a lot before, this sort of slow burn is related to the housing market. The repair and recovery of those markets is going to take a long time. The spreads are still quite elevated in a number of these markets. So providing more cushion against the downside risk there for those markets and then thinking about how that risk affects the potential for broader downside risks, in which the housing market seems to be a potential trigger point for negative nonlinear dynamics, again suggests that moving down 25 basis points now is prudent. The key, of course, that people have been talking about is inflation pressures going forward--inflation expectations. Here a case can be made on either side with some cogency. One challenge we have right now is that we have a lot of differences in the way to read inflation expectations. Looking at the five-year-ahead versus the five-to-ten-year-ahead, we've seen them spread apart quite a bit and now start to come back together, with the next five years starting to move up but the five-to-ten-year-ahead moving down. We have a number of other measures of expectations, some of which have moved up quite significantly but maybe primarily because of some relative price movements rather than underlying inflation trends. One thing that is comforting for me on the alternative B side is that during the last year to 18 months, when we have had very low--below 5 percent--unemployment rates, we have seen very little evidence of high wage pressure. I find it unlikely that it is going to increase as the unemployment rate goes above 5 percent, and I think, as many people around the table do, that unemployment may sustain itself above 5 percent for quite some time. We also haven't seen some of the real shocks to energy and commodity prices feed through to core. Now, that still could be coming. But we've seen very elevated prices in these areas for quite some time--six to nine months--and the most recent readings from the PCE index suggest that they haven't fed through. Maybe that is still to come, and I think to be worried about that is reasonable. It is also reasonable to be worried about implications for the dollar if we were to go for alternative B rather than alternative C. But the language in alternative B can provide some comfort to the markets that we are unlikely to be pushing much further, given what we see and what we expect, but that we are open to that possibility. We certainly have a very long time between this meeting and the next meeting. We're going to be getting two employment reports, GDP, and a lot of other information, so we may need to revisit some of these issues. But at this point I would come down for alternative B with the language that we have. I think it gives us the appropriate flexibility, and I don't see sufficient evidence of an unhinging of inflation expectations or actual inflationary pressures, at least with respect to core, to say that we need to take a pause now. Thank you, Mr. Chairman. " FOMC20070807meeting--122 120,MS. YELLEN.," Thank you, Mr. Chairman. I think the inflation news has continued to be encouraging, but the risks remain on the upside. With respect to growth, the prospects have worsened, and I think there is greater downside risk for the reasons that we have discussed. I think the market response to these events is not inappropriate. They perceive a greater likelihood that we will need to cut the fed funds rate sooner and more deeply than seemed likely only a few weeks ago, and I think we should essentially try to leave those expectations in place today to indicate that we intend not to respond to asset prices or to the problems of particular dealers or financial institutions directly but to assess the economic consequences of the turmoil. So the question is, What is the right language to do that? The alternative B language that is proposed is trying to achieve exactly what I think is appropriate. So I agree with the goal of alternative B. I’m simply concerned about some of the actual language that is proposed. Particularly I worry about the language in paragraph 4. When you say “although the downside risks to growth have increased somewhat, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate,” that’s like saying—perhaps because I respond so strongly to the word “predominant”—that, yes, we see greater downside risk, but we don’t care; we remain totally focused on inflation. [Laughter] That bothers me. That’s how it comes across to me. I don’t think the intention is to make it that way. So I would make two proposals to soften it. I think what we need to do is dial it down, but I do think that inflation risk remains to the upside. I would second two suggestions that have already been made. I would second President Fisher’s suggestion that we remove the word “predominant” from paragraph 4. We might say, “The Committee remains concerned about the risk that inflation will fail to moderate as expected.” Now, I do think the downside risk has increased on the growth side. I’m not sure it is actually necessary to say so explicitly, and I think dialing down paragraph 4 by simply removing “predominant,” along with the additional language that is proposed in line 2, might be sufficient. But I think that we actually do agree that downside risks have increased. If we want to express that, I would endorse President Poole’s suggestion that we move the language about downside risks to paragraph 2, saying something after “for some households and businesses, and the housing correction is ongoing.” We could then say, “Although the downside risks to growth have increased somewhat, nevertheless the economy seems likely to continue to expand at a moderate pace.” So we would get it in there. Basically we would say that we see it, but nevertheless we think most likely the economy will grow at a moderate pace. If financial turbulence diminishes and markets stabilize, not having downside risks to growth in paragraph 4 and continuing to express some asymmetric bias, some worry about inflation, we’ll be comfortable living with that going forward, and it is a good summary of where we are. So those are my suggestions." FOMC20060808meeting--72 70,MR. KOHN.," Thank you, Mr. Chairman. As many of you have remarked, the inflation news over the intermeeting period was not favorable. Core consumer prices continued to run at an elevated level, and the CPI actually came in on the high side of expectations. The shortfall in the PCE that President Yellen referenced was, I think, more of those mysterious nonmarket components. Petroleum prices rose further, implying additional feed-through going forward. Prices of other commodities, as Karen remarked, were on average unchanged to somewhat higher, suggesting not only continuing cost pressures on producers but sustained strength in global demand. Early estimates of unit labor costs for the second half of last year and the first half of this year show a faster increase than had been estimated and anticipated. The compensation data for the early part of this year, in particular, are subject to very large revisions. Even the now-faster growth doesn’t necessarily indicate that the economy has been operating beyond its sustainable potential, given the likelihood of some catch-up with past productivity gains, the still quite elevated profit margins, and the moderate increase in the ECI. But at the very least, the unit labor cost story doesn’t provide as much comfort about future inflation as it did previously. Largely as a consequence, the staff revised up its inflation forecast for 2006 and 2007, and that response seems reasonable to me. At the same time, some developments over the intermeeting period help me feel a touch more comfortable, or perhaps a touch less uncomfortable, with the downward trajectory for inflation after the bulge. One of them that a number of you have mentioned from surveys is that the long-term inflation expectations in the market remained stable or even edged down a little despite higher energy prices and, importantly, despite downward revisions to the expected path of monetary policy. If I were forecasting today, I would forecast a slightly higher inflation rate, but I would also forecast a slightly higher unemployment rate than I did before. To be sure, output gaps, as you’ve mentioned, don’t play a large role in determining inflation, but certainly the growth of demand relative to potential has some effect on the competitive conditions that businesses are facing and on their ability to pass through costs. From the information that we received over the intermeeting period, growth slightly below the growth rate of the economy’s potential seems more likely than it seemed a month or so ago, and this would inhibit the pass-through of higher energy and labor costs. Weakness in the housing sector has deepened, and we have not yet seen the full implications of the rise in long-term and short-term interest rates over the first half of the year. This weakness seems to be having an effect on housing prices as well as on activity. The effects of a lower expected trajectory for housing wealth and the increase in interest rates this year haven’t begun to show through to consumption, judging from the minus 1½ percent saving rate. The energy-price increases of recent weeks will take something more out of consumption. Recent data are consistent with a below-trend track for the growth of economic activity: Private domestic final purchases increased at a rate of only 2 percent in the second quarter. The consumption and investment data for late months in the quarter don’t suggest an acceleration going into the third quarter. The growth of employment has been running slightly below what would be a steady-state pace if participation were to remain stable, and participation has edged higher. The greater increase than had been anticipated in inventories in the second quarter suggests little impetus or even a small drag from inventory accumulation in the third and fourth quarters. The growth of federal government spending seems to be dropping back a bit as Katrina-related expenditures top out. Moreover, the recent higher rates of core inflation, though they are puzzling to a considerable extent, must reflect some influences that are unlikely to be repeated indefinitely into the future. One of those is the rise in oil and energy prices. The recent rise clearly has been associated with escalating tension in the Mideast and other producing areas, as well as the recent cutback in supply from Alaska. At some point, the risks of supply disruptions, while remaining very high, should level out. As a consequence, so, too, should energy prices, which will reduce core inflation as the feed-through fades. Another factor boosting inflation in recent months was related to rising rents and, in particular, to an even greater increase in owners’ equivalent rent. The staff has assumed that owners’ equivalent rent will rise in line with other rents and that both will continue to increase fairly rapidly but less rapidly than they did. That seems reasonable to me, given the increased availability of houses and apartments on the market that would, at some point, seem to limit the rise in rents as well as house prices. So my conclusion is that the staff forecast of a gradual moderation of core inflation after the second quarter is a reasonable expectation, although I am very worried about upside risks to inflation. The inflation rate looks as though it will end up a tad higher than either the staff or I thought likely at the time of our June meeting. Thank you, Mr. Chairman." CHRG-110hhrg44903--145 Mr. Cox," I think, first of all, you are absolutely right about the general perspective of investors when it comes to fair value accounting. Investors appreciate it. On July 9th of this year, the SEC hosted a roundtable, it is what we call our hearings, on this topic; and we heard from a wide variety of participants in the marketplace. The general consensus was that fair value has been a help to investors in these difficult circumstances. They want more of it, not less of it, and that it has not been the cause of volatility in the markets or other problems that we have seen in the current market turmoil. We, also at that same roundtable, got into the kinds of issues that Tim is talking about. There are, particularly in Europe as they consider fair value, existential questions about fair value or not. I don't think we are having that debate just now in the United States. The real question is, you know, at the margin when you are away from instruments that the market generates prices for and you have a model that is trying to generate your price, but at the same time that asset is throwing off some cash, do you have to value it at zero? There are practical questions that people want answers to, and we are hoping that we can provide those answers in something like real time in the form of guidance. I don't think that there is, when it comes to fair value, necessarily a conflict between the investor protection mission and the systemic risk mission. I think fair value, properly used, can be very helpful. " FOMC20061025meeting--81 79,MR. LACKER.," Thank you, Mr. Chairman. The Fifth District survey for October just released today shows manufacturing flattening out after a run-up last month, though expectations remain upbeat. Services firms note solid increases in revenues, and overall District job growth remains strong. Among retailers, big-ticket sales were softer, and housing-related sales slowed further; but with other retailers, the picture brightened, with sales and traffic notably stronger. The housing sector continues to slow, with sales weakening further in the D.C. area and modest price reductions occurring in other large markets. Some cities in the Carolinas, however, continue to report modest increases in home sales prices and even permits, and in many locations, activity varies significantly across different price ranges. District labor markets remain tight, and our surveys indicate that expectations are for some additional wage pressures in the next six months. This commentary includes the now-usual reports of shortages of particular skills. Our price measures moderated some, but they remain elevated. The national outlook has changed only marginally in the past five weeks. At our last few meetings, we have seen the staff mark down their forecast for second-half growth as the pace of the contraction in housing activity has become clear. The information that has come in over the past several weeks does not suggest any steepening in the rate of decline, and if anything, there are scattered signs suggesting that we might be getting close to the bottom. Except for housing, the economy still appears to be in good shape. Consumer spending is holding up well. Employment is tracking labor force growth. Commercial construction is fairly robust, and business investment spending continues to grow. So we’re still not seeing any major spillovers from the housing market to other economic sectors. Housing is certainly going to subtract from headline growth over the next couple of quarters, but I expect GDP growth to return to close to potential at some point next year, and I remain more optimistic than the staff about when that will occur. There is a risk that output growth will come in lower than I anticipate because of a more severe deterioration of the housing markets or more substantial spillover effects on other spending categories. Although it’s certainly too early to rule this out, I think the probability of such an outcome has receded in recent weeks. So my outlook for real growth is about the same as it was in September with, if anything, a tad less downside risk. The inflation outlook has not improved since our last meeting. The September core CPI reading was 2.9 at an annual rate, identical to the August reading, and core PCE inflation for September is estimated at an annual rate of about 2.1 percent, I think. I grant that three-month core PCE inflation has come down off its May peak of close to 3 percent. I do take some comfort in the fact that core inflation did not remain so high, but that measure of inflation has been right about 2¼ percent for three straight months. The Greenbook forecast has it stepping up to 2.4 percent for the next six months and falling below 2.2 percent only in the second quarter of 2008. So three-month core PCE inflation is now as low as it gets for the next year and a half in the Greenbook forecast, and at the end of 2008, core inflation will have been above 2 percent for five straight years. I have my doubts about the prospects for even the modest decline described in the Greenbook. The notion that slowing real growth will bring inflation down much has already been heavily discounted around this table—and rightly so, in my view, given the tenuous status of the relationship between real gaps and inflation. The recent fall in energy prices may help, but relying on tame energy prices is problematic, I think. It would encourage the public to believe that we will allow core inflation to rise whenever energy prices surge. That belief is, for me, the leading hypothesis explaining the run-ups in core inflation that we saw last fall and earlier this year. We are likely to see some significant swings in energy prices in the years ahead. So help from this direction is by no means certain. More broadly, I believe we should be leery of letting a relative price move core inflation around. There was a lot of discussion at our last meeting about the state of inflation expectations, and a number of people pointed to evidence that market participants did not seem to believe we intend to bring inflation down to the center of the 1 to 2 percent range. This is confirmed by the Bluebook, which provides a very useful compilation this time from various sources of market expectations for core PCE inflation, and they are all clustered around 2¼ percent. If the Greenbook forecast is realized and core inflation gradually comes down to 2.1 percent over the next two years, it’s hard to believe these expectations would fall much. So with core inflation running around 2¼ percent and not likely to come down much soon and with expectations apparently settled at about the same rate, I’m deeply concerned about inflation. Thank you." FOMC20080805meeting--106 104,MR. FISHER.," Mr. Chairman, I may have to leave the lunch early. So before I start, I do want to bid Rick adieu. Rick, I remember describing you as charming in one of our early meetings. You have charmed me by your intellect and devotion. Anyway, I'm going to miss you. So I wanted to say that in case I do have to leave early. Mr. Chairman, in the intermeeting period, I spent almost as much time in President Rosengren's District as I did in my own--part as vacation but the rest consulting with some advisers and mentors in the People's Republic of Cambridge at my alma mater. [Laughter] I mention this because I want to underscore that, in arguing a perspective, I tend to move away from the rather felicitous circumstances that prevail in my District. Even though things are slowing, we still expect employment growth to come in a little short of 2 percent a year, and our banking situation thus far is holding up rather well. In terms of my national soundings, and you know the list and the group is familiar with it, the anecdotal evidence from everyone--from the bankers to the credit card companies to retailers to fuel producers, food producers, energy companies, shippers, equipment manufacturers, homebuilders, and entertainment companies--confirms reports of progressively higher obstacles to growing their top lines and continued efforts to drive down their cost of goods sold through reducing their head counts, running very tight inventory cycles, tightening their operating expenses, and reexamining and in many cases cutting back significantly on cap-ex. Nationally I expect continued anemia on the growth side. We are, as you know, not at the extreme but at the low end of expectations for economic growth. I would expect zero growth as we approach year-end. As I said earlier, from our perspective we're only about two-thirds through the peak-to-trough correction on housing, and I view that as a continued weak influence. So the summary is that most of my contacts are planning around expectations of a prolonged U.S. and advanced-country slowdown and have a rather woeful outlook as to the growth side. At the same time, there is also a woeful concern with regard to price pressures--intensifying cost pressures affecting their margins at a time when the stock market is most unforgiving of people who miss their mark. Even in the First District, I might note. I want to quote the Beige Book report from Boston: ""Almost all contacted manufacturers voiced concerns about elevated . . . costs. . . . Respondents generally have raised their selling prices in recent months. . . . Over one-half of contacts expect to increase their selling prices further in the second half of 2008 and/or early 2009."" It went on to say that, while some contacts express worry that price increases have led or will lead to loss of market shares, others indicate that--and these are the key operative words--""customers have become more receptive to price increases because they see them as a consequence of generalized cost pressures."" Mr. Chairman, that passage captures the message that I'm receiving from my CEO and CFO contacts around the country. By and large, we appear to be transitioning from vigilance on the price front to acquiescence. Inflation expectations are, I think, becoming unmoored, and I believe they are, if not already adrift, at risk of drifting. On the small business front, I do like to look at Bill Dunkelberg's recent reports from the National Federation of Independent Business. His most recent report indicates that the percentage of small business owners citing inflation as ""the number one problem they face,"" rose to 20 percent in June, the highest rating since 1982, and that 41 percent of his respondents report raising selling prices. At the other extreme of size, to put this in perspective, Wal-Mart's CEO for the United States reported last week--and I quote this: ""My biggest concern is inflation. This month we had an experience that Wal-Mart has never ever""--that's literally what he said--""had before, which is that a major supplier told us we need a 9 percent increase or we will not supply you at all."" Now, he did not mention the name of that supplier. It could have been Unilever, which saw the volume of goods it ships slip 0.5 percent year over year in the second quarter. Yet according to our conversations but also quoted in the Wall Street Journal on August 1, Unilever's CEO reported that he ""raised average prices on his thousands of products 7.4 percent,"" and then added that he ""doesn't plan to reverse any price increases."" Or it could have been one of the largest snack food companies, whose CFO has informed us that, after taking and having stick a 9 percent increase in price in March--I reported this at our last meeting--they will effect another 9� percent increase in October. Here's the pithy quote he gave me: ""Thus far we've been bleeding out price increases to our customers. Now our strategy is to bludgeon them--to broadcast our increases in the expectation that competitors will do the same."" I doubt the supplier to Wal-Mart was Kodak. Last week the New York Times reported that ""hurt by higher manufacturing and materials costs, the company said it will combat these cost pressures by passing on to consumers and raising prices on some products by as much as 20 percent."" I have lots of examples of similar responses. President Evans indicated similar pressures. President Lockhart did too. I'm not going to go through them. I will add, by the way, the one thing that surprised me. Despite Disney's brilliant annual report of record earnings, they, too, plan to raise their single day prices by 5 percent, to $60, in the next quarter. There is also a growing feeling, which I haven't heard before, among semiconductor manufacturers that, after years and years of constant price deflation, they expect that there may--and the operative word is ""may""--be a bottoming out because of the raw materials prices they face and the wage prices and pressures they are receiving in China, which has become a major semiconductor manufacturer. One might take heart from the recent correction in commodity prices. I agree with Steve that we have to be very careful about that. My smartest energy contacts have been expecting a correction in prices. Markets were overshooting. Natural gas prices have reacted to recent developments like the Barnett Shale and, even more important, the so-called Haynesville Play in Louisiana. The ""oilies"" note that increased Saudi supply hit our shores with the normal six-week lag. They were talking about production increases in May and June, and those have just hit our shores recently. So they're not surprised at the price reaction at the pump. But none feels that the basic demand�supply situation has been dramatically altered--much as you argued, Steve--and most expect structural prices to obtain at or near current levels. Now, what does ""at or near current levels"" mean in terms of price impact? I had a long conversation with the CEO of Burlington Northern, and just for data purposes, in terms of what they call their RCAF--an automatic costadjustment contract that covers 25 percent of the goods shipped by their rail--their third-quarter RCAF is 17 percent. The 75 percent of products that are not covered by that automatic contract are subject to a fuel surcharge. That fuel surcharge at $120 a barrel is a 30 percent increase for the third quarter. One might also take comfort in the purported calmness in compensation growth seen so far, along the lines of what I read in the Financial Times by Mark Gertler on July 29. I don't hear confirmation of that benign argument among business operators. First, as President Evans and Mr. Stockton pointed out in our last meeting, labor compensation is not a good predictor of inflation. I remember Dave said that it's not that labor costs, which are a significant chunk of business costs, don't matter but that you can't necessarily take comfort from the well-behaved compensation thus far that you are not going to confront some inflation problems going forward. Now, the last anecdote I want to give you illustrates that point. Yesterday I had a lengthy visit with the CFO of General Mills. Until their fiscal year '08, which ended in May, they priced over many years an average increase of 0 percent. They took 2� percent as the year ended, and they're taking another 5 percent this year. They are having to reexamine their elasticity models, he said. Here is what he said that worried me the most: They are finding those models less predictive because (a) ""everybody is raising prices,"" and (b) consumer perception is that inflation is back. So, again, vigilance is giving way to acquiescence. Mr. Chairman, I do want to comment very briefly on something I mentioned last time, which regards calculating the cost of goods sold. I am hearing more and more from companies that have shifted production to China a verification of the 18 percent number that the ministry gave us. Whether it's a hospital producer whom I talked to in California or a Black & Decker tool assembler in China, they're complaining not only about cost increases of 15 to 20 percent, depending on whether you're operating in the north or south, but also about the employee contract law that was just put into place, which in essence allows for almost an old-fashioned scala mobile Italian/French model, which feeds a wage�price spiral, and it is beginning to infect their wage cost and inject rigidities into their ability to operate in China. So overall, Mr. Chairman, I am concerned, obviously, about economic growth. I think we, as President Lockhart mentioned, are in a very difficult spot. We have three enormously worrisome scenarios facing us. I think we have to be very careful how we word ourselves on inflation. Last night at 6:00 National Public Radio opened their Marketplace report with this headline: ""The Fed Fuels Your Pain."" We have a perception issue that we must address, and there are two ways to do it. One is by being strong in terms of how we argue the case of inflation. The other is to act by raising rates. I'm going to listen very, very carefully because, frankly, I'm undecided here as to what the right approach is. But I think we have to be careful when we state a balance of risks, which are enormous, that we don't understate the fact that inflation is now being accommodated in the minds of the marketplace. Thank you, Mr. Chairman. " FOMC20080318meeting--3 1,MR. DUDLEY.,"1 Thank you, Mr. Chairman. To start, I just want to update people on what happened overnight in markets. Equities rebounded a bit in both Asia and Europe, and bond yields reversed some of the decline that they saw on Monday. The dollar was slightly weaker against the yen and the euro but still in the range that it established. It did not go back below the lows that it reached early on Monday. I would say that generally the markets' function was okay. The big issue was bank funding pressures in Europe were evident for dollar funding. The funds rate bid as high as 3� percent, which is quite surprising on the eve of a meeting in which we are likely to reduce the federal funds rate target. Term funding pressures, if you look at the onemonth or three-month LIBOR�OIS spread, are basically unchanged from Monday, when they were up quite sharply from last Friday. Before talking about what markets have been doing over the six weeks since the last FOMC meeting, I'm going to talk a bit about the Bear Stearns situation. In my view, an old-fashioned bank run is what really led to Bear Stearns's demise. But in this case it wasn't depositors lining up to make withdrawals; it was customers moving their business elsewhere and investors' unwillingness to roll over their collateralized loans to Bear. The rapidity of the Bear Stearns collapse has had significant contagion effects to the other major U.S. broker�dealers for two reasons. First, these firms also are dependent on the repo market to finance a significant portion of their balance 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). sheets. Second, the $2 per share purchase price for Bear Stearns was a shock given the firm's $70 per share price a week earlier and its stated book value of $84 per share at the end of the last fiscal year. The disparity between book value and the purchase price caused investors to question the accuracy of investment banks' financial statements more generally. The contrast in the behavior of investment bank equity prices versus credit default swap (CDS) spreads is revealing. Share prices fell sharply, but the CDS spreads narrowed a bit, indicating a lower risk of default. For example, Lehman's stock price fell 19 percent, but its CDS narrowed by 20 basis points, to 450 basis points, yesterday. This underscores the difference between the $2 per share buyout price for Bear Stearns--less value than people thought--and the introduction of the Primary Dealer Credit Facility (PDCF)--a reduction in the risk that a liquidity problem could drive a firm into insolvency. I have a few words about the PDCF, before moving to a discussion of market developments since the January FOMC meeting. The PDCF should help to restore confidence among repo investors. It essentially creates a tri-party repo customer of last resort--us. When investors have concerns about the ability of a dealer to fund itself, they are reluctant to roll over their own repo transactions. The reason is the fear that the clearing bank may not send their cash back the next morning when the overnight repos mature. This fear may not be misplaced. If the clearing bank is worried about whether investors will stay put, the clearing bank may decide to keep the cash. In that case, the investors would be stuck with the securities that collateralize the repo transactions. The PDCF should break that chain of worry by reassuring the clearing bank that the Fed will be there as a lender to fund the repo transactions. The repo investors are reassured that the clearing bank will send back their cash the next day and thus are willing to roll over their repo transactions. At least that's the theory. As noted, the PDCF should provide some comfort to the counterparties of these firms that these firms will, in fact, be able to fund their obligations. Yesterday, the major money market mutual fund complexes did roll their outstanding repos with the major investment banks. However, the jury is still out on whether the PDCF will be sufficient to stabilize confidence. High use of the PDCF would result in a large increase in the amount of reserves added to the banking system. I think it is important to go on record on that because, if that were to occur, over the short run the New York Desk might not be able to drain reserves sufficiently quickly to keep the federal funds rate from trading extremely soft to the target. We will make all efforts to make the ""short run"" as short as possible. But realistically, there is a good chance that the federal funds rate could trade soft relative to the target, especially through the end of the current reserve maintenance period. In fact, yesterday we saw that, although it started the day quite firm, the funds rate crashed at the end of the day, and the effective fed funds rate for the day was 2.69 percent. It depends, in large part, on the volume of use of the PDCF. Stepping back from developments of the past few days, recent weeks have been marked by rapid and, at times, disorderly deleveraging of financial holdings within the global financial system. As I discussed last week, the most pernicious part of this unwinding has been the dynamic of higher haircuts, missed margin calls, forced selling, lower prices, higher volatility, and still higher haircuts, with this dynamic particularly evident in the mortgage-backed securities market. I'll be referring to the handout from here. Over the past six weeks, we have surveyed a number of hedge funds and one REIT about the haircuts they face for financing different types of collateral. As shown in exhibit 1, the rise in haircuts has been most pronounced in non-agency mortgage-backed securities. But even agency MBS have seen a significant widening of haircuts in recent weeks. The collateral funding pressures have been particularly evident for residential-mortgage-backed securities collateral. This is due to several factors including very unfavorable fundamentals for housing, a high level of uncertainty about the ultimate level of losses, and an overhang of product for sale, both currently and prospectively. In our discussions with market participants, unleveraged players have been unwilling to step in to buy ""cheap"" assets for several reasons. First, there are few signs that housing is close to a bottom. Second, a significant amount of product sits in weak hands and, thus, could be dumped on the market. Third, this particular asset class has characteristics that exacerbate price volatility and, therefore, risk. For example, when spreads widen and yields climb, prepayment speeds slow. This extends duration. When the yield curve is upward sloping for longer maturities, the rise in duration generates an increase in yields. The rise in yields also reduces housing affordability, which puts further downward pressure on home prices, increasing prospective losses on the mortgage loans that underpin the securities. Signs of distress in this market include the following. First, a sharp widening in option-adjusted mortgage spreads--as shown in exhibit 2, option-adjusted spreads for conforming fixed-rate mortgages have widened considerably since the January 30-31 FOMC meeting, though they have come in quite a bit over the past couple of days. That's good news. Second, jumbo mortgage spreads relative to conforming mortgages rates remain very wide. As shown in exhibit 3, this spread has averaged more than 100 basis points this year. The current yield on prime jumbo loans is around 7 percent, a margin of about 3� percentage points over ten-year Treasury note yields. Third, mortgage securities prices continue to fall. For example, as shown in exhibit 4, the prices for AAA-rated tranches of the ABX 07-01 vintage continue to decline. Fourth, Fannie Mae and Freddie Mac reported large fourth-quarter losses, and their stock prices and CDS spreads have performed accordingly (exhibit 5). The sharp decline in the equity prices has made the companies reluctant to raise new capital, despite the prospects of higher-margin new business, because additional share issuance at the current share prices would lead to massive dilution for existing shareholders. Fifth, the yield levels on many mortgage-backed securities have climbed significantly above the yield on the underlying mortgages that underpin the securities. This is the opposite of how securitization is supposed to work. This phenomenon reflects the glut of supply of such securities on the market and the added risk premium attached to assets that are typically held on a mark-to-market basis. Although the residential mortgage market is the epicenter of the crisis, distress has been evident much more broadly--with the municipal market fully implicated in the period since the January meeting. The deleveraging process evident among financial intermediaries operating outside the commercial banking system has led to a widespread repricing of financial assets. When available leverage drops, riskadjusted spreads have to rise for leveraged investors to earn the same targeted rate of return as before. This helps explain why the problems in the residential mortgage market have infected financial markets more generally, leading to wider credit spreads (exhibits 6 and 7) and lower equity prices (exhibit 8) both in the United States and abroad. As leverage is reduced and spreads widen, financial arbitrage implies that all assets should reprice. The risk-adjusted returns from holding different asset types should converge--recognizing that the degree of leverage that is available in markets may differ across asset classes in accordance with divergences in price volatility, liquidity, transparency, and other characteristics. Of course, the notion of convergence to equivalent risk-adjusted returns is an equilibrium concept, and we are not in equilibrium. The events of the past week underscore that point. But there are plenty of other examples of disequilibrium at work. For example, for mortgage-backed securities, the losses implied by the prices of the AAA-rated ABX index tranches appear to be high even relative to the darkest macroeconomic scenarios. The municipal bond market is also a good example of how market valuations can become unusually depressed when supply increases rapidly. Then the value inherent in the securities becomes broadly known, this mobilizes new money, and risk-adjusted returns come back down relatively quickly. Term funding spreads also indicate greater stress within the financial system. As shown in exhibits 9 and 10, the spreads between one-month and three-month LIBOR� OIS spreads have widened sharply in recent weeks, even before Bear Stearns's demise. We are sitting today at 56 basis points for the one-month LIBOR�OIS spread and 77 basis points for the three-month LIBOR�OIS spread, about the same as yesterday morning. As you are all aware, we have been active in responding to the growing market illiquidity. Exhibit 11 illustrates the results of the TAF auctions. Note how propositions and the number of bidders have increased recently and the spread between the stop-out rate and the OIS rate has risen over the past few weeks. Even before the Primary Dealer Credit Facility was implemented this weekend, we were in the middle of a historic transformation in the Federal Reserve System's balance sheet. We are increasing the supply of Treasuries held by the public (either outright or borrowed) and reducing the supply of more-illiquid collateral held by the private sector. Even excluding the uncertain impact of PDCF borrowing, this shift will speed up noticeably over the next month or two. Our current plans are to increase the size of the TAF to $100 billion, scale up the single-tranche RP book to $100 billion, renew and increase the size of the foreign currency swaps with the ECB and the SNB to $36 billion outstanding (if fully subscribed), and implement a $200 billion TSLF program. Exhibit 12 shows how these programs are likely to change the composition of the Federal Reserve's SOMA portfolio. As can be seen, when all the current programs are fully phased in by May, Treasury holdings will have shrunk to about 45 percent of the total portfolio, down from about 97 percent last July. At the same time that financial markets have been under severe stress and the macroeconomic growth outlook has deteriorated, the inflation news has also been disturbing. Several market-based indicators are adding to investors' concerns about the inflation outlook. First, commodity prices have increased sharply. As shown in exhibit 13, the increases have been concentrated in both energy and agricultural prices. Of course, subsidies to stimulate the production of ethanol from corn have been an important factor. By diverting corn production to this purpose, the linkage between energy and grain prices has been significantly strengthened. Second, the dollar, after a period of stability that lasted from mid-December into February, has begun to weaken anew (exhibit 14). This has gotten considerable attention in the press and abroad as the dollar has hit new lows against the euro and has fallen below 100 against the yen. Up to now, the decline has generally been orderly, and the downward slope of the broad real trade-weighted dollar trajectory shown in exhibit 14 has not changed much. The foreign exchange markets are clearly very skittish. In particular, there has been considerable focus on China and the Gulf Cooperation Council (GCC) countries and their willingness to maintain their pegs against the dollar. For China, investors expect its crawling peg to move faster. As shown in exhibit 15, the Chinese yuan is now expected to appreciate about 11 percent against the dollar over the next year, up from an 8 percent pace at the beginning of the year. For the GCC countries, there is speculation that some of these countries might decouple from the dollar. However, on a one-year-forward basis, market participants are currently building in only a couple of percentage points of expected appreciation. Breakeven rates of inflation have continued to widen. As shown in exhibit 16, both the Board staff's and the Barclays measures have broken out above the ranges evident in recent years. It is difficult to differentiate how much this widening reflects a higher risk premium due to greater uncertainty about the inflation outlook versus higher expected inflation. But either way, it is probably fair to say that inflation expectations have become less well anchored over the intermeeting period. I will say, however, that yesterday breakeven rates of inflation came down very sharply--the move was 15 to 20 basis points. Today, we are back in the range we were in, but that is only today. Short-term rate expectations continue to move lower. As shown in exhibit 17, federal funds rate futures now anticipate a trough in yields a bit below 1.5 percent. The yields implied by Eurodollar futures prices have also shifted sharply lower, as shown in exhibit 18. The trough in yields is expected to be reached in late summer or early fall. Our formal survey of primary dealers, which we normally show you, was conducted more than a week ago, and it is clearly out of date (these exhibits are included in the appendix to the handout). So let me focus on what the dealers' expectations were as of yesterday. They changed quite a bit over the past week. Most dealers expect either a cut of 75 or 100 basis points: There are eight for 100 basis points, ten for 75 basis points, and two for 50 basis points. This compares with the slightly more than 100 basis points built into the April federal funds rate contract (yesterday the April fed funds contract implied a 1.95 percent effective fed funds rate for the month). There were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the January 30-31 FOMC meeting. Of course, I am very happy to take questions. " CHRG-111hhrg53244--36 Mr. Bernanke," Well, for a good bit of the recent years the commercial real estate market was actually pretty strong even as the residential market was weakening. But as the recession has gotten worse in the last 6 months or so, we are seeing increased vacancy, declining rents, falling prices, and so more pressure on commercial real estate which is raising the risk of lending to commercial real estate. So that is certainly a negative. As I was mentioning to the chairman, the facilities for refinancing commercial real estate, either through banks or through the commercial mortgage-backed securities market, seem more limited; and so we are somewhat concerned about that sector and paying close attention to it. We are taking the steps that we can through the banking system and through the securitization markets to try to address it. " FOMC20070321meeting--75 73,MR. MOSKOW.," Thank you, Mr. Chairman. Conditions in the Seventh District are similar to what I reported last time. Business activity continues to expand at a modest pace. However, while my contacts expressed some increased uncertainty, most of them maintained a positive view about the outlook for the second half of the year. As we know, the two sectors that generated the most uncertainty this round are housing and business investment, and so I want to concentrate some of my comments on those two areas. On the housing front, my contacts continue to be unsure about how soon the turnaround will be. A director from Pulte Homes saw hints of a better tone in the market but acknowledged that signs were still tentative. He did say that the larger builders have reduced their stock of speculative homes. Another director, who is CEO of U.S. Gypsum, thought it would be a couple of months before he had a better idea whether the market had hit bottom. Furthermore, he thought that, even after the market hits bottom, it would be quite a while before building materials recovered to normal sales levels. As we were discussing, the subprime situation could be a serious problem for the macroeconomy in a couple of ways. One would be a major spillover to house prices—it’s too soon to tell about this now, but new spring listings should shed some light by our next meeting. The other would be significant fallout to other credit market segments, and we don’t see this yet either. I contacted both GM and Ford, and they said that the subprime mortgages held by their credit subsidiaries had deteriorated, but they had not seen increased defaults in other portions of their portfolios. Notably, they had not seen any unusual problems in auto loans, and we generally heard this sentiment of a lack of spillover from bankers as well. On the supply side, given the ample liquidity in financial markets, it seems unlikely that the subprime problem will cause major changes in overall credit availability or pricing. Turning to business investment, none of my contacts reported any major changes in capital spending plans one way or the other. That said, I did sense that businesses had become a bit more cautious, as David mentioned. A CEO of a major bank thought that some of this caution was due to the news in the subprime market, but he didn’t think that this was impinging on spending in a meaningful way. As noted by the head of a major private-equity firm, who is on our board, the recent volatility in financial markets has not significantly altered the availability or terms for financing, even for riskier projects. Private-equity firms continue to raise large sums, as Janet discussed. So although I’m more concerned about the outlook, I don’t see the forces in play that would generate a major retrenchment in capital spending. Inventories are another factor that has weighed on growth recently. We’ve heard mixed reports from District contacts about how far along they are in the inventory-adjustment process. In steel, the process seems to be taking longer than expected, but in motor vehicles, both GM and Ford now are generally comfortable with their inventory positions and currently are not planning any major changes in their assembly schedules. Finally, some sectors of the economy appear to be on good footing. Healthy labor markets continue to support solid gains in consumer spending, and as Karen discussed, growth abroad continues to support export demand. After balancing all the factors, we marked down our near-term forecast for GDP a bit but retained the basic contours of our previous projection. The most important difference between our forecast and the Greenbook is that we do not see as much short-term weakness, but the uncertainty surrounding this forecast has increased. By itself, the change to the growth outlook this round would suggest slightly less inflation risk, but other factors point to continued concern about inflation. The past couple of readings on consumer prices have been disappointing. Oil prices are higher than at our last meeting, and unit labor costs accelerated noticeably over the past year. Furthermore, labor markets remain tight. So while the benefits of some factors, notably the earlier declines in energy costs, will be transitory, pressures from high labor costs are likely to persist. Markups remain high enough to absorb some cost increases, but these margins could evaporate quickly, as they did in the late ’90s. In the end, we did not materially change our outlook for inflation. We continue to project that core PCE prices will increase about 2¼ percent both this year and next. This inflation rate is too high for my taste, and I think for many of us, and I’m not confident that inflation will moderate adequately as we move into 2009. One reason for my concern is highlighted in the Bluebook—namely, that the private sector seems to be betting that our inflation objective is 2 percent or higher. So I continue to think that over the forecast period as a whole the risks to price stability exceed the risks to sustainable growth." FOMC20080318meeting--49 47,MR. HOENIG.," Thank you, Mr. Chairman. I thought I would talk a bit about some events in our region that I think have global implications--that is to say, I will talk a bit about agriculture. You have heard others here this morning talk about some of the price movements, and I think it is worth perhaps spending a few minutes on their effects. First of all, agricultural commodity prices have surged to record highs, driven by obviously strong demand, lean supplies, and a weak dollar. Since the fall of 2007, winter wheat prices have doubled, and corn and soybean prices have risen about 70 percent, to record highs. Rising crop prices are boosting farm income. In real terms, U.S. net farm income is expected to climb to the second highest level on record, trailing only 1972, when abrupt sales of U.S. wheat to Russia pushed up farm income. An emerging concern is the growing disarray in futures markets for agricultural commodities caused by a surge in investment by index and hedge funds going forward. Recent reports indicate that hedge and index fund investment in futures markets for corn, soybeans, and wheat rose from $10 billion in January 2006 to $45 billion this past January. Early this month, index funds held more than 40 percent of the long positions on wheat contracts on the Chicago Board of Trade. At this rapid pace of investment--since the beginning of this year averaging $1 billion per week--the funds would own the nation's entire 2008 corn, wheat, and soybean crops by early 2009. Now, that is obviously theoretical, but that is how much money is going into this market. The resulting market disarray is constraining the traditional use of commodity futures to hedge market risk. Grain elevators, which use futures to hedge their contracts to purchase crops from producers for future delivery, are facing much larger than normal margin calls on their futures positions. Some reports indicate that lenders are beginning to restrict their funding of elevator hedges. As a result, an increasing number of elevators are limiting their contracts for crop purchases to no more than sixty days in advance of the delivery instead of the normal one to two years. Now, this surge in crop prices and farm income is pushing up farmland values. According to our bank's agricultural credit survey in the fourth quarter of 2007, non-irrigated cropland values jumped 20 percent over 2006 levels, with strong gains also reported in irrigated cropland and ranchland. Our directors and other contacts report a further strong gain since the beginning of the year, and some have reported as much as a 20 percent increase in the first quarter alone. Adjusted for inflation, the average price of farmland across the nation now tops the early 1980s peak, which immediately preceded the plunge in the early to mid 1980s. To date, crop production budgets suggest that the recent run-up in farmland values is supported by current revenues from crop production. However, farm input costs have also risen sharply, driven by higher energy costs, suggesting that a drop in crop prices could quickly erode farm cash flow and undermine these values. District bankers report a surge in farm capital spending. In February, sales of four-wheeled major equipment rose 45 percent above 2007 levels, and combine harvester sales were up 13 percent. Farm equipment prices have risen sharply, and our directors and other contacts report that some equipment dealers are rationing purchases among their customers. In the past month, anecdotal reports from District contacts indicate that nonfarm investors have boosted their farmland purchases. Our contacts at a national farm management company based in Omaha stated that the number of inquiries for farmland purchases by corporate interests has jumped significantly recently. Similarly, one of our directors reported that a hedge fund with assets of more than $7 billion is expected to invest $500 million in cropland from Texas and Nebraska. This fund recently purchased nearly 25 square miles of corn acreage in western Nebraska. Now, we continue to watch for signs of rising leverage, but to date farm debt levels have risen modestly only, and agricultural banks seem to remain healthy. Bankers report continued use of cash to finance farmland purchases, but I would note that leverage is being brought into the picture, and I think that will accelerate as opportunism and greed have their way. Total farm lending in the District banks has increased a modest 14 percent over the past four years, with most of that growth being in farm real estate lending. But District bank examiners and respondents to our surveys reported that the Farm Credit System was being more aggressive in funding farm real estate transactions. Real estate mortgage loans held by the Farm Credit System rose about 12 percent in 2007. Asset quality at our ag banks remains, at this point, solid. Noncurrent assets--all assets, not just farm loans--at ag banks are up only slightly from a year ago and remain well below historical averages. Net loan losses are still very low. Earnings have remained solid primarily because of cost control and very low loss provisions. I am very pleased, but I will tell you that, going forward, in terms of the surveys with the kinds of pressure and price appreciation going on, I think the push for leverage is just beginning. At the national level, in terms of the Greenbook, every indication is that the economy is slowing. Whether it is recession or very slow growth is a matter of degree, but I think our projections are in the same direction as the Greenbook. Turning to the inflation outlook, I am concerned, as I have said before, about the upside risk to inflation. Though I certainly agree with others around the table that weaker economic activity may put some downward pressure on goods price inflation, I think we can also agree that a number of factors could push inflation higher, including rapidly rising commodity prices worldwide and a weaker dollar. As discussed in the Bluebook, there is some indication that inflation expectations may be moving higher as well. As I have indicated before, I am increasingly concerned that, in our need to respond to signs of economic weakness, we risk losing our hard-won credibility on inflation. For the past four years, core PCE inflation has averaged about 2.1 percent, considerably above the numbers that this Committee has put forward in its long-term projections. Frankly, I do not think that many people outside this room think that this Committee can deliver the longer-run projections that we have put forward. I don't think that we can keep inflation expectations anchored only by talk if actual inflation rises further in the months ahead and we continue to ease policy in a rising inflationary environment. This is something that we need to keep in mind as we discuss our policy options today. Thank you. " FOMC20071211meeting--130 128,MR. LACKER.," Thank you, Mr. Chairman. I favor a ¼ point reduction in the funds rate and the language of alternative B. Perhaps more than usual I think it is important to preserve some flexibility now to respond to incoming information. I would not be surprised if we want to reduce the funds rate another ¼ point at the end of January, but I don’t want to send a signal that would encourage market participants to presume another cut then. So I guess I am in the “grudgingly” camp to which President Yellen referred. Besides, I would welcome a permanent move away from the balance-of-risk-assessment machinery. I do believe we face a good-sized risk of things unraveling and substantially weaker growth in the near term. But my sense is that the risk just isn’t large enough to make me want to support 50 basis points now. While I wouldn’t be surprised with a January rate cut, I don’t think it should be a foregone conclusion. I think we need to be more deliberate about such actions as we go forward. The magnitude of the fallout from our mortgage problems could be substantially clearer in the first half of next year. If the fallout turns out to be smaller and more manageable than we fear, the downside risks to growth prospects could dissipate, even though we still would be working through a bulge of mortgage resets and defaults. Some of us have given a warning that we may need to reverse course promptly and raise rates should conditions improve. You know, it is always attractive to comfort ourselves as we cut interest rates and to promise ourselves that we are willing to do so, but there always seems to be a reluctance to start a sequence of funds rate increases after a series of rate cuts. The usual thing is a fear of sort of an exaggerated reaction in the yield curve. These pressures are likely to be especially acute if, when the time comes, we are still in the midst of significant distress among subprime mortgage borrowers and the housing market. That seems likely. So I think we need to be realistic about prospects for reversing field. To the extent that such pressures would be hard to resist—and I think they would be—we should be very cautious, more cautious than we otherwise would be, about lowering rates. Another reason to be cautious is that overall inflation is well above our targets. As David Stockton pointed out, we have a record of forecasts for food and energy prices based on futures market prices coming in too optimistic over the past several years. I think we need to be concerned about that. I am concerned that market participants might have come to believe that we have placed our concerns about inflation entirely on hold for the duration of the housing market difficulties we face. Such a lexicographic reaction function is what led to the stop-go policy pattern in the pre-1979 era. So I believe it would be a mistake to take our eyes entirely off inflation right now. I am doubtful that a forceful restatement of our assessment of upside inflation risk will be very effective in that regard. We have been doing that, and I think it is falling on increasingly deaf ears. I think that we may come to believe that action is required to back up that sentiment. If inflation drifts up or overall inflation doesn’t come down, I think we need to be prepared to respond to real weakness less than we otherwise would have before. Thank you." FOMC20070918meeting--132 130,MR. MADIGAN.,"3 Thank you, Mr. Chairman. To guard against the contingency that our security procedures have broken down and the Committee’s policy drafts are being monitored by unknown forces, the staff has taken countermeasures by circulating multiple drafts of table 1. [Laughter] Of the two drafts circulated this morning, I will be referring to the draft labeled, perhaps too obviously, September 18, 2007. To summarize, alternatives A and B would both reduce the target federal funds rate 50 basis points today to 4¾ percent but would differ in their risk assessment. Alternative A would conclude that, even after the 50 basis point easing, the downside risks to growth would outweigh the upside risks to inflation, whereas alternative B elides an assessment of the balance of risks but cites heightened uncertainty about the outlook. Alternative C reduces rates 25 basis points and describes the risks as tilted to the downside. Alternative D leaves the stance of policy unchanged but would characterize the risks to growth and inflation as now balanced. Based on your remarks this morning and the proposals by nearly all the Reserve Banks to reduce the primary credit rate, it seems likely that most or all of you favor some easing in the stance of policy today. Thus, the questions this morning would seem to be how much to reduce rates as well as the rationale for that action and the type of forward-looking language to provide. The modal outlook in the staff’s Greenbook forecast would seem to argue clearly for policy easing before long. The staff has interpreted recent financial developments as likely to inflict an appreciable and fairly immediate adverse shock on aggregate demand. As Dave noted, real GDP growth is projected to slow to 1 percent in the fourth quarter and to remain nearly that sluggish in the first quarter. The economy skirts recession, but real activity expands only 1¾ percent next year, less than potential, so modest slack emerges, and the unemployment rate rises to nearly 5 percent, a bit above the staff’s downward-revised estimate of the NAIRU. This slack contributes to an edging down of core inflation to just under 2 percent, and declines in energy prices help push total PCE inflation down to 1¾ percent next year. Beyond next year, real growth gradually strengthens to around its potential rate. As I noted earlier today, the central tendencies of your out-year projections suggest that most of you would find a PCE inflation rate leveling out in the vicinity of 1¾ percent, in conjunction with economic growth returning to a potential rate of around 2½ percent—a rate a bit higher than estimated by the staff—to be an appealing outcome. Of course, while you may be satisfied with such an outcome, the key question is what monetary policy path would be most likely to produce it. In the staff’s baseline assessment, a 50 basis point easing in the federal funds rate over the next few months sufficiently cushions the blow of the current financial shock to keep the expansion going in coming quarters while still allowing inflation to settle down to rates that 3 Materials used by Mr. Madigan are appended to this transcript (appendix 3). most of you evidently would find consistent with price stability. If your own modal outlook is similar to the staff’s baseline assessment, you might find the selection of any of alternatives A, B, or C at this meeting to be appropriate. An immediate 50 basis point reduction, as in alternatives A and B, would accelerate the drop in the actual federal funds rate by just a month or two relative to the Greenbook. A 25 basis point easing today coupled with an assessment that the risks are tilted to the downside, as in alternative C, and an expectation on your part that another easing would likely be forthcoming would also be essentially consistent with the staff outlook. Thus, your choices among those three approaches might depend importantly on risk-management considerations. Several of the Greenbook alternative simulations explore the possibility that policy might need to be eased more aggressively. In the “greater housing correction” scenario, the subprime mortgage market is assumed to remain closed over the entire projection period rather than to recover partially as in the baseline, and housing prices decline 20 percent over the next two years, rather than just a few percent. In such circumstances, aggregate demand weakens considerably below baseline, and the Taylor rule suggests that the funds rate should gradually be eased to 4¼ percent by 2009. The “greater housing correction with larger wealth effect” scenario, in which the effects of the greater housing contraction are augmented by a larger sensitivity of household spending to household wealth, points to an even greater easing. Another possibility is that forced acquisition by banks of large volumes of ABCP, leveraged loans, and other assets erodes their capital ratios, bringing them closer to regulatory thresholds and benchmarks negotiated with rating agencies, and that banks respond by tightening credit terms and standards. Partly because episodes featuring sharp changes in credit availability are relatively rare, assessing these effects is fraught with uncertainty. But the “bank capital crunch” scenario in the Greenbook, which was based loosely on the early 1990s headwinds episode, suggests that policy might need to be eased significantly and quickly, with the funds rate dipping to 3¼ percent by June. If Committee members are inclined to put appreciable weight on the possibility that something resembling any of these three scenarios could transpire, they might be inclined toward alternative A—an immediate reduction in the funds rate of 50 basis points at this meeting coupled with an assessment that the risks remain tilted to the downside. The effects of a preemptive easing of policy—working through the standard transmission channels of lower long-term yields, a lower exchange value of the dollar, and higher equity prices and household wealth—might help cushion the economy from a sharp weakening of aggregate demand. In current circumstances, a relatively aggressive easing of policy and the sense that more could be coming if needed might be particularly helpful in thawing financial markets or at least in preventing a harder freeze and thus might work importantly through credit channels as well as directly through open market prices. A relatively large and immediate reduction in the federal funds rate might go some considerable distance toward alleviating concerns on the part of market participants regarding further erosion in the value of assets held as collateral. It might also be seen by investors as a signal that the Federal Reserve will act forcefully to sustain economic growth, helping to limit lenders’ concerns about losses. By reducing the fears of market participants and bankers about counterparty credit exposures and credit risks more generally—or at least helping to prevent them from worsening—a prompt and sharp easing of policy might help avert a significant tightening in credit terms and standards and thus sustain growth in aggregate demand. In this way, monetary policy might be directed proximately at improving the functioning of financial markets but ultimately at the Committee’s longer-run objectives. This argument is easy both to misconstrue and to exaggerate—easy to misconstrue because it may appear that policy is responding directly to asset prices and easy to exaggerate because policy easing cannot do much to dispel the fundamental economic losses already in train, for example, on subprime mortgage investments. But it may be able to help prevent them from contributing to a cumulative weakening of activity that would increase credit risks more generally and feed back adversely onto growth. On the other hand, the Committee may not be persuaded that the hit to aggregate demand will be as severe as projected by the staff in its baseline forecast, let alone in the weaker alternative simulations in the Greenbook. Members may feel that at least some of the history of financial crises over the past two decades suggests that financial markets can bounce back fairly quickly once the immediate crisis has passed and that the real economy can be surprisingly resilient in the face of temporary financial disruptions. Both 1987 and 1998 come to mind, as was pointed out previously, as episodes in which, at least arguably, the restraining effects of financial events on the domestic economy were not nearly as severe as policymakers feared. A separate point is that many of you see potential GDP growth as a bit more robust than the staff, suggesting that you may also see equilibrium real short-term interest rates as a bit higher. Coming back to the near-term outlook for aggregate demand, even if you think that the staff may be right about the likely degree of forthcoming financial restraint, you may be quite uncertain on that score. Any of these arguments may motivate you to consider the approach of alternative C. Under that alternative, you would ease 25 basis points today and issue a statement that characterizes the downside risks to growth as outweighing the upside risks to inflation. Such an assessment would position you well to respond to incoming signs of economic weakness, should they appear, by easing policy at some point over the next meeting or two. This approach might also be seen as advantageous if you are particularly concerned that the Committee would find it difficult to quickly reverse easing moves that subsequently proved to be unnecessary. You might also prefer a 25 basis point rate cut for now if you are concerned that investors could misread a 50 basis point easing as a sign that the Committee was responding directly to asset prices, potentially exacerbating moral hazard by encouraging excessive risk-taking. Alternative B may be seen as the middle ground between alternatives A and C. Alternative B would adopt the more aggressive 50 basis point policy easing of alternative A but would not make an explicit assessment of the balance of risks and thus would provide no direct indication that the Committee was considering a further easing move. As noted in the Bluebook, adoption of alternative B would be consistent with the 50 basis point downward revision to the Greenbook-consistent measure of r*. Policy easing of roughly that magnitude over the next several quarters would also be consistent with the optimal policy calculations under a 2 percent inflation rule as well as with a number of the policy rules presented in the Bluebook. Even if you are not sure that the adverse effects on aggregate demand of ongoing financial developments will be as severe as built into the Greenbook baseline, you may be concerned enough to judge that a 50 basis point easing of policy today would provide a measure of insurance that could prove valuable if, as seems likely at a minimum, further financial aftershocks become evident. As I noted, the risk assessment proposed for alternative B is relatively open-ended. The current version suggests being explicit that uncertainty about the economic outlook has increased; for that reason, it does not provide an explicit risk assessment. You may believe, given considerable uncertainty about the implications of financial developments to date and their likely course going forward, that characterizing the balance of risks would be quite difficult and may lack credibility. For the same reasons, you may find appealing the noncommittal approach of this alternative regarding future rate actions. As Bill Dudley noted, market expectations for the path of monetary policy have fallen sharply over the intermeeting period. At the moment, market participants seem to put substantial odds on both a 25 basis point and a 50 basis point easing today— although, given the modest improvement in credit markets over the past few days, the former is now seen as somewhat more likely. Short-term rates would likely drop a little under alternative B and more sharply under A, whereas they might move up a little under C. Longer-term yields could decline noticeably under alternative A if the statement and the action prompted greater concern among market participants about the outlook. The inconclusive risk assessment of alternative B would likely surprise market participants and might prompt some volatility as they attempted to discern your message. But all things considered, the rate actions and the statements associated with alternatives B and C do not seem sharply at odds with expectations, and we would not expect large net market reactions." FOMC20051101meeting--125 123,MR. SANTOMERO.," Thank you, Mr. Chairman. The Third District’s economy continues to expand, with growth moderating toward its potential pace. After accelerating in the second quarter, employment growth in the region decelerated in the third quarter back toward its first-quarter pace. But unemployment rates remained steady for the three-state region and remained lower than the November 1, 2005 50 of 114 Consumer spending for general merchandise has held steady. There is some anecdotal evidence that consumers are limiting discretionary spending due to higher energy costs. And there is some concern among retailers that fourth-quarter sales may come in below plan because of subdued consumer sentiment and higher winter heating bills. Construction continues to be a strong sector for our regional economy. Housing construction and sales remain strong in the District, and nonresidential construction has been on an improving trend since the beginning of the year—with the usual month-to-month volatility. Regional manufacturing activity accelerated in October. The index of general activity in our manufacturing survey rebounded sharply from 2.2 in September to 17.3 in October. The other forward-looking indices in the survey, including those for new orders and shipments, also showed a nice bounce, as did the index of future activity. Perhaps the improvement in expectations should have been expected, since our September survey was taken in the early days after the Katrina event. Indeed, in response to special questions, half of our firms reported that they had experienced some change in demand or problems related to the Gulf Coast hurricanes. The changes in demand, some positive and some negative, were generally slight. Problems relating to obtaining energy and other materials, as well as transportation problems, were characterized as being somewhat more significant. Despite these problems, our firms did experience an increase in activity last month. Again, the most troubling aspect of our latest survey is the significant increase in price indices. The prices paid index rose sharply in October for the second consecutive month and is at its highest level since 1980. The prices received index also jumped last month, suggesting that some of the higher-priced inputs are being passed on to consumers. The core PCE and core CPI share a November 1, 2005 51 of 114 the high-inflation period of the late 1970s and early 1980s, I think these early indications of possible pass-through bear watching. In my view, the national economy seems to be evolving along the lines we had expected at our last meeting. The economy appears to have weathered the hurricane in reasonably good shape. And, abstracting from those hurricane effects, the economy has retained a good bit of positive momentum. Of course, uncertainty remains about the magnitude of the hurricane effects, so there’s a wider band of uncertainty around the economic outlook than there was pre-hurricane. On the negative side, higher winter heating bills could result in significantly slower consumer demand. But on the positive side, next year’s rebuilding activity could result in a bigger boost to activity than expected. The growth risks seem to be balanced, and these hurricane effects are most likely to be temporary. The bigger risk, in my view, is on the inflation side. Core inflation remains contained at this point, and empirical studies suggest energy price pass-through to the core has typically been small. Where we’ve gotten into trouble during the earlier energy price shocks is when we’ve let inflation expectations get away from us. Indeed, the only departure between headline inflation and core CPI inflation as large as the current one occurred during past energy price shocks. In those cases, accommodative monetary policy resulted in rapid increases in core inflation. We cannot allow inflation expectations to become unanchored, and I don’t believe we will. As the energy infrastructure is rebuilt and energy markets stabilize, much of the run-up in headline inflation should reverse itself, as many people have suggested. This will help keep inflation and inflation expectations contained. We’ve already seen a decline in crude oil and gasoline prices. The latter is particularly welcome, as it could buoy consumer sentiment as we head toward the buying November 1, 2005 52 of 114 Nonetheless, in my view, inflation pressures remain elevated. So the prudent course of action today is to continue to gradually move rates up nearer to the range of the equilibrium real rate. As we near that range, our language is going to have to evolve, as a number of us have indicated. I don’t think today is the day for a major change in language, but I would welcome the discussion that many have suggested we need to have. Thank you, Mr. Chairman." CHRG-111hhrg51698--120 Mr. Duffy," I didn't have a chance to answer the Congressman. I think it is important for the record that I do so, right, because he talked about not having credit default swaps around or anywhere else as of 10 or 11 years ago, and that is absolutely true. But you also have to remember that product innovation in financial services is as critical as it is to research and development of any other business. So in order for economies to grow, we need to have new products that people can manage their risk properly with that to help us continue to grow and bring us into new centuries. So, that is really important for product innovation to move forward. And as far as rampant speculation, when you look at regulated exchanges with limits proposed on their trading, spending a big part of a portion of their own budgets--we are public companies--to make certain that we don't have rampant speculation that could turn into manipulation, it is critically important to the success of any publicly traded company such as CME Group. So, no, we don't condone excessive speculation or rampant speculation, as you put it, sir, but we do believe that there is a buyer for every seller, a seller for every buyer. The more liquidity there is, the better price the person that is trying to hedge their risk will get for the product. Thank you, Mr. Chairman. " CHRG-111hhrg63105--226 Mr. Murphy," I wanted to return to something the Chairman was asking about, and ask Mr. Duffy and Mr. Sprecher if they would comment a little more. When we went through the Dodd-Frank process, we were very worried about making sure we found the right balance, that our clearinghouses were out there allowing things to be cleared that could be, but that we didn't put regulatory pressure on you to take products that you couldn't price and therefore we would create additional risk. This New York Times article was a little troubling because it was talking about secrets in a way that I think is a little theatrical, but there is a fundamental underlying issue that I am curious about how you guys approach this? You need people that are clearinghouse members to be solid enough that if there is a problem they can help solve that with capital calls and other things; but at the same time, it seems like there is a possibility that people could set those limits so high that only a handful of people can participate, and you do create an anti-competitive marketplace, how do you guys approach finding that balance? Mr. Duffy, you talked about being open, but I don't know what that means. And that balance seems like it is a critical one to find, that we get the competition we are looking for without creating additional risk. " FOMC20050322meeting--204 202,MR. KOHN.," Thank you, Mr. Chairman. I agree with your proposal, and I agree with your analysis that the loss function is shifting and that we need to be very careful not to get behind the curve here. I think the proposed language will put people on notice that we understand that that loss function is shifting and that this is where our concerns are. So, I agree with the proposed language. I’d like to make a few comments on the previous discussion. The difference between the alternative B and alternative C balance-of-risk statement—namely, what to assume about policy— was exactly one of the issues that divided the second Ferguson Subcommittee. I was, at that point, in what is now the alternative C column, and I was a tiny minority on that—at least, I felt like a tiny minority on that subcommittee. But we’ve been around this several times. And, actually, most of you didn’t like the alternative C language, though I think it ultimately could be useful. I do worry somewhat about President Minehan’s proposal to remove both the balance-of-risk language and the “measured pace” language. I think something forward-looking ought to remain in the statement. Maybe it doesn’t need to be formulaic; maybe, as suggested, when we debate it, we could change it from time to time. I think it’s important that markets aren’t more certain than we are about our actions, but, to the extent that we can tell them something true about what we’re going to do and where we expect things to come out, I believe asset pricing will be better. I don’t think we should be inserting uncertainty into the market just to insert uncertainty into the market. If we know something about or have a sense of where we’re going, somehow saying that in some way will make asset prices more reflective of reality. My third point is that there is a tradeoff here between how quickly the draft statements get out to the Committee—and get more or less written in cement—and the reaction to what goes on at the meeting and to very current information. I think we’re in a very difficult position: As soon as March 22, 2005 91 of 116 meeting is very, very hard to reflect there. So I think we need to recognize that that tension, which will never actually be resolved, is there as we try to get the statement wording out earlier and earlier." FOMC20071211meeting--109 107,VICE CHAIRMAN GEITHNER.," Thank you. The outlook for real activity has deteriorated somewhat since our last meeting. In our modal forecast we now expect several quarters of growth below potential with real GDP for ’08 a bit above 2 percent. The sources of the deterioration in the outlook for us are pretty much as outlined in the Greenbook. What separates us from the Greenbook still is about 40 or 50 basis points of different views on what potential growth is. Our view of the likely path of the output gap is similar. So as in the Greenbook, we expect a deeper contraction in housing activity and prices. We expect nominal and real income growth to slow more than we expected and consumer spending also to moderate more than we had anticipated. Part of that lower path of real spending is, of course, due to energy prices. We also expect the rate of growth in business fixed investment to slow a bit more than we had previously thought, and these changes are in part, but not solely, due to the expected effects of tighter financial conditions. For a given path of the nominal fed funds rate, they are tighter now than they otherwise would have been because of the fall in the estimated neutral rate. In our view, growth in the rest of the world will slow a bit, but along with the effects of the decline in the dollar, it will still provide enough pull for net exports to contribute positively to growth, offsetting part of, but just part of, the deceleration in domestic demand growth. Our forecast for core inflation is little changed. We expect the core PCE deflator to rise at a rate just under 2 percent over the forecast period. Like many of you, we see considerable downside risks to the forecast for growth, and they have intensified since our last meeting. The Greenbook alternative scenarios on housing and the credit crunch seem plausible, perhaps more likely to happen together than to happen independently, and I think reality is likely to fall somewhere between the baseline Greenbook scenario and these two darker alternatives. The risk to the inflation forecast still seems closer to balance in the forecast period. The higher forward curve of energy prices and the lower path of the dollar will raise headline inflation a bit and, in the near term, the core inflation path. But these pressures should be offset by the fall in anticipated pressure on resource utilization, not just here but also globally where the economies that have been growing above potential are likely to slow as monetary policy tightens. I think it’s important to recognize that breakevens in inflation at longer horizons have stayed relatively stable in the context of the fairly substantial move in the dollar, the fairly substantial move in actual and expected energy and commodity prices, and the very dramatic change in expectations of how the Fed is likely to respond to the change in the balance of risks to growth. In light of these changes to the outlook and the risks to the outlook, we’ve lowered our expected path for the fed funds rate. We now think it’s likely that the Committee will reduce the target rate to 3.75 percent over the next few quarters, and this puts our real and our nominal fed funds rate assumption for ’08 a bit under the new path in the Greenbook. We’d raise it back in ’09. But our fed funds rate path is significantly above the market’s estimate. As you’ve all recognized, conditions in markets have deteriorated substantially since our last meeting, but the basic dynamic is still the same. Actual and anticipated losses to financial institutions have risen as the prices of a large range of assets have fallen. Uncertainty over the path of housing prices in the real economy and complexity in valuing assets and structured financial instruments that are most exposed to those risks make it very hard for markets to know with confidence the likely dimension of total losses and who is most exposed to them. Financial institutions have seen a sharp increase in their cost of funds, a substantial shortening in maturities at which they borrow, and a significant reduction in their ability to liquidate or borrow against their assets. Most banks have seen a very large and unanticipated expansion of their balance sheets as they’ve been forced or have chosen to provide funding in various forms. As banks and other financial institutions have moved to position themselves to deal with a more adverse economic and financial environment, they have become much more selective in how they use their liquidity and capital. The consequence of those actions is evident in the sharp increase in the cost of unsecured borrowing and the spreads on secured financing. Now, it’s important to recognize that, although a source of this pressure is concern about macroeconomic risk and its consequence for credit loss and asset values, the consequences of the adjustment by institutions to this new reality are very severe liquidity pressures in markets. These are particularly acute in Europe, and they are—at least in the market’s expectations—likely to persist well beyond year-end. These pressures are the symptom of the underlying problem, as fever is the sign of the immune system’s response to an infection. But just as high fevers can cause organ failure before the infection kills the body, illiquidity itself can threaten market functioning and the economy. The longer we live with these conditions—large spikes in demand for liquid risk-free assets, a general shortening of funding maturities, a limited amount of available financing even against high-quality collateral, the risk of substantial liquidation of financial assets, and the chances of runs on individual institutions’ funds—the more we are vulnerable to a self-reinforcing adverse spiral that leads to a greater retrenchment in credit supply than fundamentals might otherwise suggest and with a greater effect on growth. I don’t think the past four to six months have been kind to those who have argued that this was just a mild and transitory bump. As in August, I think we have to be willing to treat both the fever and the infection and, if you step back a second, the appropriate policy response to this set of challenges will entail a mix of measures. Monetary policy will probably have to be eased further to contain the risk of a more substantial and prolonged contraction in demand growth. I think we will probably need to continue to adjust our various liquidity instruments. We may need to encourage some institutions to raise more equity sooner than they otherwise might choose to do. We need to be very careful to avoid making both types of the classic errors in supervision in financial crises. These are, on the one hand, actions that would amplify the credit crunch by forcing banks to protect their ratios by selling more assets à la New England or, on the other hand, the commission of what you might call irresponsible forbearance à la Japan in the hopes of masking weakness and stretching out the pain. We also need to be careful to keep thinking through more adverse scenarios for the economy and the financial system and the policy responses that may be appropriate if they materialize. The United States is, I think, a remarkably resilient economy still. Outside of housing, we don’t have the same imbalance in inventories with the same degree of overinvestment in other parts of the economy that we have had going into past downturns. Corporate balance sheets still seem relatively healthy. The world economy is no doubt stronger. Current account imbalance is coming down. Our core institutions entered this adjustment period with a fair amount of capital. It is very encouraging to see so many of them start to raise capital so early. The financial infrastructure is more robust. Inflation expectations imply a fair degree of confidence in our ability to keep inflation low over time. The speed and the extent of the adjustment that we’ve seen in housing and by financial institutions to this new reality are really signs of health, of how well our system works. But we need to be cognizant that the market is torn between two quite plausible scenarios. In one, we just grow below potential for a given period of time as credit conditions adjust to this new equilibrium; in the other, we have a deep and protracted recession driven as much by financial headwinds as by other fundamentals. There are good arguments for the former, the more benign scenario, but we need to set policy in a way that reduces the probability of the latter, the more adverse scenario. Thank you." FOMC20080130meeting--272 270,MS. PIANALTO.," Thank you, Mr. Chairman. Like the Greenbook, my projection for the real economy incorporates a sharp decline in the equilibrium real fed funds rate. Given the large risks facing the real economy, I think we need to take precautions against having a restrictive fed funds rate target. I think a 50 basis point cut in the target fed funds rate today may be large enough to eliminate that possibility, although there is plenty of uncertainty around that estimate, as we have been discussing. Based on my analysis, comments from my business contacts, and what I have heard from all of you at this meeting, I feel very comfortable supporting this position today. The economic environment has been volatile and highly uncertain, and I realize that my outlook could change appreciably in the weeks and months ahead. I can imagine that my economic projections will evolve in a way that supports even further reductions in the fed funds rate target. At the same time, as I said yesterday, I am concerned about inflation risks and that they may now be elevated. I can also imagine scenarios that would lead me to want to pursue a more restrictive policy than would be appropriate based on the downside risk to growth alone. At some point, on the margin, inflation concerns could become my dominant concern. We know that inflation expectations play a crucial role in determining the inflation outlook. We have been talking about that. But, unfortunately, we don't really know all that much about what it is going to take to unanchor inflation expectations. It is hard to know for certain how far out on the ice we can skate without needing to worry that the ice has become too thin. I know that we are bringing our best thinking to bear on this issue by developing diagnostic tools such as the decomposition of inflation compensation into its component parts, as we talked about yesterday and this morning. I hope that we are going to come to learn that these tools are useful guides to policy, but we just don't have enough experience with them to know how much confidence to place in their estimates. Yesterday Governor Kohn told us about his conversation with Paul Volcker and that Paul Volcker told him that unfortunately we do have experience of seeing the erosion of public confidence in our ability to meet our price stability objective, and we know from this experience that it makes the attainment of price stability more costly. But today I support the policy directive expressed in alternative B. My concerns today are more with the downside risk to economic growth. Given what I know today, I think it is the right course of action. I have discovered during the past couple of weeks that I can be very nimble when it comes to the reduction in our fed funds rate target. If inflation developments require, I want to be just as nimble in the other direction. Thank you, Mr. Chairman. " FOMC20081007confcall--81 79,MS. DANKER.," Yes. The vote will encompass both the directive and the policy statement that were distributed earlier today, with the exception of the final sentence in the second paragraph of the draft policy statement, which says, ""Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation."" Chairman Bernanke Vice Chairman Geithner Governor Duke President Fisher Governor Kohn Governor Kroszner President Pianalto President Plosser President Stern Governor Warsh Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes " CHRG-110hhrg41184--44 Mr. Bernanke," Well, if they continue to rise at this pace it is going to create a very difficult problem for our economy, because on the one hand it is going to generate more inflation, as you describe, but it is also going to create more weakness because it is going to be like a tax. It is extracting income from American consumers. So if that happens, it will be a very tough situation. We are going to have to make judgments looking at the risk to both sides of our mandate and make those judgments at that time. But I think it is relatively unlikely that we will see the same kinds of enormous increases in energy prices this year that we have seen in 2007. Mr. Miller of California. So you feel confident your projection of a decrease in the long-term throughout the year will come true; that you project this point that you see oil decreasing as the year progresses? " FOMC20060510meeting--116 114,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. The basic contours of our forecast are essentially unchanged since March and are very similar to the Greenbook’s. However, the balance of risks has changed a little in our view, somewhat to the upside on inflation. But as in March, we expect core PCE inflation to run a little over 2 percent in ’06 and to moderate slightly below that in ’07 as tighter policy works to slow overall demand growth. We expect real growth to rise in the vicinity of its potential rate— 3¼, 3½ percent—throughout ’07. So we are a little higher than the Greenbook in that sense. As before, this forecast rests on some important assumptions: that little or no slack is left in resource utilization, that inflation expectations are held in check, and that term premiums remain relatively low by historical standards. The recent moves in medium-term inflation expectations and the rise in the other components of forward interest rates cast some doubts on these last two assumptions. For these and other reasons, we see a little more uncertainty around our central forecast than we did in our last meeting. However, on the growth outlook, on balance the recent data seem to confirm the picture of real GDP moderating toward potential. We face the familiar sources of risk to the downside, but not all the risks are to the downside. We may be underestimating the momentum in final demand growth. I think it is important to note that it is hard to find evidence in credit spreads or in equity prices of a substantial growth slowdown in prospect. On inflation, recent developments are not all that dark, but neither have they been entirely reassuring. Let me just go through the factors that we think are critical to the outlook on the inflation side. Almost every measure of underlying inflation that we look at is now above the level we generally associate with price stability. Headline inflation has been running and is still running substantially above core, and even with interest rates close to long-run measures of equilibrium, the staff forecast does not anticipate much moderation in core inflation over the two-year or even three-year or four-year period. Compensation growth does not yet appear to have accelerated significantly, and the growth of unit labor costs has remained reassuringly moderate. However, compensation to us seems likely to strengthen, and it is unlikely that productivity growth is going to accelerate significantly from current levels. Demand growth is still probably running a bit above potential here and in large parts of the world economy; with real short-term rates still quite low around the world and monetary policy only just beginning to tighten in many of those economies, global pressure on resource utilization may intensify or at least continue at its current intensity rather than moderate. And the rise in energy prices and commodity prices, of course, suggests a fair amount of strength in global demand. Our assumption that energy prices follow the futures curve means that our forecast is, of course, still vulnerable as it has been over the past three years to further upside surprises. It would be easier to discount this risk if we could determine with confidence the extent to which temporary supply factors rather than unrecognized or unanticipated strength in global demand have accounted for the trajectory of energy prices over the past few years. We face a lot of uncertainty about the likely path of the dollar, and the prospect of a significantly weaker dollar adds another source of upside risk to inflation and expected future inflation. We obviously have some uncertainty about the extent to which margins will prove flexible in the face of higher cost pressures. Finally, we have seen a material rise in long-term inflation expectations in the United States over the past several months, and this should make us somewhat less confident that we can assume that the gap between headline and core will be closed with headline moving down to core. Inflation expectations seem to have risen more here than in other countries, and the recent changes in the relationship between changes in short-term expectations about U.S. monetary policy and changes in breakeven inflation rates is somewhat disconcerting, with expectations deteriorating when statements by Committee members were interpreted as lowering the probability of moves beyond our meeting today. This pattern is more troubling than the size of the rise in medium-term inflation expectations. And I just want to make one comment in response to something Janet said. Even if we could tell with confidence how much of this rise in breakeven inflation was about uncertainty or inflation risk premiums and how much was actually about future expectations about inflation and even if we thought a substantial amount of that was uncertainty, it is not clear that that would be particularly reassuring in terms of credibility or in terms of its implications for monetary policy. So underlying inflation is less contained than we would like it to be, and it is expected to moderate less than we might hope. Both short-term and long-term measures of expectations have moved up uncomfortably, and we see somewhat greater upside risk to our inflation forecast than we did in March. Now, what might we learn over the next six weeks that would change our view about the outlook and its implications for monetary policy? We actually think it is unlikely that data are going to provide us with very strong signals that policy is markedly off track, but there are two important things to watch. One is the behavior of long-term inflation expectations. If those expectations were to continue to rise, that would obviously be a source of concern; and if inflation expectations were not responsive to changes in expectations about the path of the funds rate, that would also be troubling. On the data front, we at least will want to watch to see if the expected moderation in manufacturing activity in the United States materializes. If, in contrast, manufacturing activity here sustains its recent pace, it might suggest that growth abroad has picked up more than we thought or that the dollar is having a bigger effect in stimulating exports than we anticipated. These conditions would increase concern about upside risks to our central forecast because, of course, that forecast relies on a slowdown in overall domestic demand growth mitigating upward pressure on inflation over the forecast period. Just a few points to end on the topic of uncertainty: Even though the fundamental news is pretty positive and reassuring, we are now at the point where the limits of our knowledge about the underlying forces that affect the outlook for aggregate demand, supply, and inflation matter more than they have in the recent past. Relatively small differences, differences well within the limits of our knowledge about trend growth and productivity or employment or other factors, have more impact on our choices about monetary policy in the near term than they would have had over the past two years. What should we conclude from the substantial rise in real forward rates that we have seen over the past few months? This move, which has occurred across the major economies, brings expected real rates more in line with long-term averages, reducing, if not eliminating, the anomalistic line we had such trouble understanding. Now, does this mean we have less to do in terms of future tightening than we thought? Maybe. Or it might mean that monetary policy has been more stimulative than we thought and that we will have to do more to make up for that going forward. The fact that we cannot fully explain why these measures of expected real rates have moved around as much as they have just adds to the uncertainty we face today about how tight policy actually is. It is also a bit of a puzzle that measures of uncertainty about future interest rates have not increased very much, and I do think it is important that we try to continue encouraging—it is uncomfortable to say this—or to at least avoid discouraging an increase in uncertainty that is more commensurate with what we are experiencing ourselves. [Laughter] Monetary policy works through expectations, but our job is harder when we are not truly sure what we want to do to those expectations. Trying to make sure that we are not pushing down uncertainty as we continue to make sure that the markets understand that we’re going to work to keep inflation low and stable remains our principal challenge. Thank you." FOMC20060131meeting--85 83,MS. YELLEN.," Thank you, Mr. Chairman. Recent data on economic activity, as summarized by the fourth-quarter GDP figure, have been surprisingly weak. But there are good reasons to believe that much of the softness will prove temporary, so I tend to agree with the Greenbook and other forecasts in expecting a rather sharp rebound in the current quarter. That said, I want to sound a note of caution. This view is based on incomplete data for the fourth quarter and a paucity of information concerning activity in the first quarter. It is not inconceivable that the weak numbers for the fourth quarter could presage a more-prolonged, sluggish phase as the lagged effects of past policy tightening and higher oil prices take effect. This caution is heightened by my concern that the economy faces some pretty big downside risks, especially having to do with the interrelated issues of possible overvaluations in housing markets and low term premiums in bond markets. These risks are highlighted by the alternative simulations in the Greenbook concerning a rise in the saving rate and a higher term premium. In summary, I see the Greenbook’s view of real activity for this year as very reasonable, but downside risks to that forecast give me pause. Turning to inflation, core PCE inflation over the past twelve months—at 1.9 percent—has come in higher than I would like to see. But assuming that growth slows to trend later this year, my outlook for inflation in 2006 is more optimistic than the Greenbook. One reason stems from work our staff has done on the extent of pass-through from energy prices to both labor compensation and core price inflation. As I’ve said before, the evidence suggests to us that there has been relatively little pass-through since the early 1980s, perhaps due to the credibility of our commitment to the stability of core inflation. Under our assumption of very little pass-through, we expect the core PCE price index to rise around 1¾ percent, both this year and next. The Greenbook shows an increase of 2¼ percent this year, presumably reflecting larger energy-price pass-through, and then a drop to about 1¾ percent in 2007 as the effects of energy prices subside. So though I differ with the Greenbook on inflation in 2006, over the longer period I think we’re about on the same page. So as I look at the total picture, I would say that the overall outlook is quite positive. The economy is near full employment with real GDP tending toward trend-like growth. Core inflation is within a reasonable range but a bit on the high side. Needless to say, it’s fitting for Chairman Greenspan to leave office with the economy in such solid shape. And if I might torture a simile, I would say, Mr. Chairman, that the situation you’re handing off to your successor is a lot like a tennis racquet with a gigantic sweet spot. [Laughter] Positive though the situation is, it also obviously raises the issue of how much higher the funds rate needs to go to keep the economy on this desirable trajectory. There are a number of ways of looking at this question, all yielding similar answers. First, a funds rate of 4½ percent rests right near the center of the range of estimates for the equilibrium funds rate. Along the same lines, our staff ran simulations of FRB/US to calculate the net effect of monetary policy actions over the past several years on real GDP growth. The results are that, after adding importantly to growth over the last few years, past policy accommodation is roughly neutral in terms of growth this year and next. A second approach is to compare a funds rate of 4½ percent with the recommendations of Taylor- type rules. Such calculations suggest that a 4½ percent funds rate this quarter is a bit on the tight side now but should be about right later this year under the Greenbook forecast. The long-run simulations in the Bluebook are a third method to judge the stance of policy. These simulations show the funds rate optimally peaking at a little over 5 percent, well above where we are now. But a major factor accounting for this relatively high peak is the Greenbook’s assumption, incorporated in the Bluebook simulation, that energy pass-through pushes up core PCE inflation to 2¼ percent this year. And as I’ve emphasized, we’re not convinced that this much pass-through is likely, and our lower inflation forecast implies a lower peak for the funds rate along an optimal path. Taken together, then, these approaches suggest to me that if we tighten policy at this meeting, as I think we should, we will be close to the appropriate peak in the funds rate based on what we know now. As for the future path of the funds rate, I believe it should be highly dependent on unfolding events and cannot be prejudged with any degree of confidence. So the bottom line is that we need to position ourselves for flexibility in our policy choices going forward." CHRG-111hhrg51698--309 Mr. Pickel," Thank you, Chairman Peterson, Ranking Member Lucas, and Members of the Committee. Thank you again for asking us to testify before this Committee, this time regarding the Derivatives Markets Transparency and Accountability Act of 2009. It is worth noting at the outset that OTC derivatives have continued to perform their important risk management function during the current market turmoil. It is our hope that policymakers will keep in mind the relative health of OTC derivatives throughout the market downturn as you consider measures which might profoundly change the way these markets function. As I noted before this Committee in December, the roots of the current global financial crisis lie in imprudent decisions, particularly with respect to residential housing. OTC derivatives were not the cause of the current financial crisis. OTC derivatives have remained available, despite the recent market turmoil. This has enabled companies to hedge risk that would have had a significant adverse financial impact on them, but for a well-functioning OTC derivatives market. Parties to OTC derivatives have received the benefit of their bargain, and the legal certainty provided by the Commodity Futures Modernization Act is a big reason for this. OTC derivatives serve a very valuable purpose. They allow companies to manage risks like interest rate risk, foreign exchange risk, commodity price risk and credit risk. The financial system and the economy as a whole are stronger and more resilient because of OTC derivatives. OTC derivatives are a way for businesses to obtain protection against market events that they cannot control. Despite many claims to the contrary, it is also worth remembering that the overwhelming majority of OTC market participants use collateral to protect themselves against loss. The Agriculture Committee has a great deal of experience with the OTC derivatives market. Going back to the earliest days of OTC derivatives, this Committee helped create the framework for legal certainty which underpins the health and success of the U.S. OTC derivatives business. This legacy of leadership has helped create a thriving, vibrant risk management industry, which even today, amidst the global financial meltdown, continues to employ thousands of Americans and provide tax revenue to states and the Federal Government. However, portions of this bill would severely harm these markets and prevent them from functioning properly in the United States, while also impairing the ability of American companies to hedge their risk. More importantly, the consequences of certain of the provision of this bill would harm many mainstream American corporations. Many American corporations use OTC derivatives to hedge their cost of borrowing or the operating risks of their business. Many of those who do business overseas need to hedge their foreign currency exposure. Some American corporations may also hedge their commodity or credit exposure. The current wording of the bill would have a disastrous effect to the large majority of these corporations by taking away risk management tools that American corporations use in the day-to-day management of their business. Regarding some specific provisions of the legislation, let me make the following comments: Section 6 would effectively eliminate the hedge exemptions for entities which use the futures market to gain exposure to certain asset classes, or which facilitate risk management by other entities which cannot or choose not to use the futures markets. The effect of this provision would be to severely limit the use of the hedge exemption and thus access to the futures markets. This would likely result in more costly hedging, increased volatility, reduced liquidity and a deterioration in the price discovery function of futures markets. Section 11 of the bill authorizes the CFTC to impose position limits on OTC transactions if the agency determines that transactions have a potential to disrupt a contract traded on a futures markets or the underlying cash market. There is a lack of credible evidence or academic studies to support the proposition that derivatives markets cause imbalance in cash markets. In addition, this provision allows the CFTC to order otherwise regulated institutions such as banks and broker dealers to terminate their privately negotiated contracts. This provision effectively gives the CFTC the authority to cancel OTC derivative contracts. We have also concerns about the mandatory clearing provisions of section 13. Clearing can provide benefits and in appropriate cases should be encouraged. However, it is not clear what justification there is for a requirement that all OTC contracts should be cleared. To the contrary, since the advent of the OTC derivatives market, bilateral credit arrangements have been used to settle contracts smoothly and efficiently. There is simply no evidence suggesting anything other than the bilateral credit arrangements contained in standard ISDA documentation work extremely well. Finally, section 16 makes it unlawful to enter into a credit default swap unless the person entering into the transaction would experience a financial loss upon the occurrence of a credit event. This provision would effectively eliminate the credit default swap business in the United States. This provision would mean that a dealer could not hedge its risks. Therefore, the only participants in the CDS market would be counterparties which each had perfectly matched risk which they had sought to hedge. The number of such persons is likely to be extremely small. In conclusion, OTC derivatives markets play an important role in the U.S. and world economy. Despite exaggerated reports to the contrary, they did not cause the market meltdown and, in fact, have helped mitigate the effect of the downturn for many institutions. OTC derivatives remain an essential element in returning our financial system to full health, and harming these markets is not in keeping with that goal. This Committee is to be commended for addressing these questions and seeking answers to help set right our economy. But to the extent oversight of OTC derivatives markets need review and reform, it should be part of a larger dialogue on reform of the financial system in general. I look forward to your questions, and I thank you for inviting us today. [The prepared statement of Mr. Pickel follows:] Prepared Statement of Robert G. Pickel, Executive Director and CEO, International Swaps and Derivatives Association, New York, NY Mr. Chairman and Members of the Committee: Thank you very much for allowing ISDA to testify at this hearing regarding the ``Derivatives Markets Transparency and Accountability Act of 2009''. We are grateful to the Committee for seeking a broad range of views as it considers legislation addressing the bilaterally negotiated or OTC derivatives industry. It is worth noting at the outset that these markets have continued to perform their important risk management function during the current market turmoil. It is our hope that policymakers will keep in mind the relative health of OTC derivatives throughout the market downturn as you consider measures which might profoundly change the way these markets function.About ISDA ISDA, which represents participants in the privately negotiated derivatives industry, is the largest global financial trade association, by number of member firms. ISDA was chartered in 1985, and today has over 800 member institutions from 56 countries on six continents. These members include most of the world's major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on over-the-counter derivatives to manage efficiently the financial market risks inherent in their core economic activities. Since its inception, ISDA has pioneered efforts to identify and reduce the sources of risk in the derivatives and risk management business. Among its most notable accomplishments are: developing the ISDA Master Agreement; publishing a wide range of related documentation materials and instruments covering a variety of transaction types; producing legal opinions on the enforceability of netting and collateral arrangements; securing recognition of the risk-reducing effects of netting in determining capital requirements; promoting sound risk management practices; and advancing the understanding and treatment of derivatives and risk management from public policy and regulatory capital perspectives. ISDA continues to provide clarity and certainty to the risk management industry through our collaborative initiatives with market users and policymakers worldwide.OTC Derivatives and the Current Market Turmoil As I noted before this Committee in December, the roots of the current global financial crisis lie in imprudent lending decisions, particularly with respect to residential housing but also extending to other areas including consumer receivables, auto finance and commercial development. These imprudent decisions were reinforced by credit ratings of securities composed of these loans which proved to be grossly overconfident, and by faulty risk management practices of some of the institutions investing in those securities. These securities should not be confused with derivatives. One thing that should by now be clear is that OTC derivatives were not the cause of the current financial crisis. In fact, had the Commodity Futures Modernization Act of 2000 (CFMA) not been passed we would find ourselves in exactly the same financial crisis we are in today. Indeed the crisis might be worse, as the CFMA created legal certainty for OTC derivatives and thus allows market participants to hedge risk through privately negotiated risk management contracts. It is worth noting that the OTC derivatives market has continued to function despite the recent market turmoil. This has enabled companies to hedge risks that, without a well functioning OTC derivatives market, would have had a significant adverse financial impact on them. The derivatives markets have remained open and liquid and fulfilled their hedging purposes while other asset prices have collapsed. OTC derivatives serve a very valuable purpose: they allow companies to manage risks, like interest rate risk, foreign exchange risk, commodity price risk and credit risk. The financial system and the economy as a whole are stronger and more resilient because of OTC derivatives, and those that disparage their use, or confuse them with asset backed securities and collateralized debt obligations (or CDOs, an acronym that leads to some confusion with the straightforward credit derivative instrument CDS) which have proved illiquid and difficult to value in the current crisis, threaten to damage a sector of the financial services industry that remains healthy. Some point to the large outstanding notional value of OTC derivatives as somehow representing a source of concern. It is important to understand first that notional values represent an underlying quantity upon which payment obligations are calculated. For example two parties may agree to an interest rate swap with a notional value of $10 million. Under that contact one party will pay to the other a fixed rate of interest on that $10 million, while the other will pay a floating rate of interest on that same amount. At no point do the parties exchange $10 million, and at no point is $10 million dollars at risk. Nevertheless, when referring to notional amounts of OTC derivatives, that is precisely what people are doing: notional amount refer to hypothetical amounts of money, not money that is actually at risk. However there is an even more fundamental point to be made about notional amounts: to the extent they represent actual money at risk, they are representing risk that is being hedged. Notional figures indicate how much protection parties have purchased against some underlying, uncontrollable risk. In general policymakers have concluded that encouraging risk management is sound public policy, and so it would seem to still be the case today. OTC derivatives are a way for businesses to obtain protection against market events that they cannot control. It is also worth remembering that the overwhelming majority of OTC market participants are collateralized to protect themselves against loss. Standard industry practice requires counterparties to secure one another against the possibility that the other party will fail to make its required payments. The ability to access this collateral in the event of default is protected under Federal law, and this has proved to be an important way to minimize the fallout of insolvency in the current market.The Draft Bill The Agriculture Committee has a great deal of experience with the OTC derivatives market. Going back to the earliest days of OTC derivatives this Committee helped create the framework for legal certainty which underpins the health and success of the U.S. OTC derivatives business. The Futures Trading Practices Act of 1992 gave the CFTC exemptive power and directed the agency to use this authority to exempt swap agreements. When the Commission acted in ways which called into question the viability of that exemption this Committee adopted an amendment in the 1999 Agricultural and related agencies appropriations act which reinforced the enforceability of OTC derivatives and prevented the CFTC from challenging their exemption under the law. In 2000, of course, this Committee led the way in adopting the Commodity Futures Modernization Act which most clearly established the legal framework for the U.S. OTC markets. And as recently as last year this Committee reaffirmed that framework when it passed the CFTC Reauthorization Act of 2008. This legacy of leadership has helped create a thriving, vibrant risk management industry which even today, amidst the wreckage of the global financial meltdown, continues to employ thousands of Americans and provide tax revenue to the states and Federal Government. However portions of this bill would severely harm these markets and prevent them from functioning properly in the United States while also impairing the ability of American companies to hedge their risks. More importantly the consequences of certain of the provisions of this bill would harm many mainstream American corporations. Many American corporations use OTC Derivatives to hedge their cost of borrowing or the operating risks of their business. Many of those who do business overseas need to hedge their foreign currency exchange rate exposure. Some American corporations may also hedge their commodity or credit exposure. The current wording of the bill would have a disastrous effect for the large majority of these corporations by taking away basic risk management tools that American corporations use in the day to day management of their of business. Below are a few selected provisions of the legislation which bear particular mention:Section 6: Trading Limits This section requires the CFTC to establish position limits for all commodity futures contracts traded on an exchange or exempt commercial market which offers significant price discovery contracts. These position limits would be required to be established for all commodities, including financial commodities. As an initial matter we question whether it is necessary to establish position limits for financial commodities given that the markets are broad, liquid and have an effectively limitless supply. The section would effectively eliminate the hedge exemption for entities which use the futures market to gain exposure to certain asset classes, or which facilitate risk management by other entities which cannot or choose not to use the futures markets. The effect of this provision would be to severely limit the use of the hedge exemption and thus access to the futures markets. This would likely result in more costly hedging, increased volatility, reduced liquidity and a deterioration in the price discovery function of futures markets. It is also of note that this provision is based on the unproved, and if several credible studies are to be believed disproved, theory that speculation creates higher prices.Section 11: Over-the-Counter Authority This provision authorizes the CFTC to impose position limits on OTC transactions if the agency determines that the transactions have the potential to disrupt a contract traded on a futures market, or the underlying cash market. As stated above, there is a lack of credible evidence or academic studies to support the proposition that derivatives markets cause imbalances in cash markets. Supply and demand inexorably determine prices. In addition, this provision allows the CFTC to order otherwise regulated institutions such as banks and broker/dealers to terminate their privately negotiated contracts. This seems to represent an unwarranted intrusion into the jurisdiction of other Federal regulators. Lastly, as OTC derivatives contracts are privately negotiated agreements between two counterparties this provision effectively gives the CFTC the authority to cancel private contracts. This fundamentally undermines legal certainty, would make it difficult for parties to calculate how much capital to hold against such contracts and would likely cause a significant decrease in OTC activity.Section 13: Clearing This section requires that all currently exempted and excluded OTC transactions must be cleared through a CFTC regulated clearing entity, or an otherwise regulated clearinghouse which meets the requirements of a CFTC regulated derivatives clearing organization. The provision gives the CFTC the authority to provide exemptions from this requirement provided that the transaction is highly customized, infrequently traded, does not serve a significant price discovery function and is entered into by financially sound counterparties. Clearing can provide benefits and in appropriate cases should be encouraged. However it is not clear what justification there is for a requirement that all OTC derivatives should be cleared. To the contrary, since the advent of the OTC market bilateral credit arrangements have been used to settle contracts smoothly and efficiently. These arrangements have been supported by Federal law and policy, which promotes netting and close-out of bilateral agreements in the event of the bankruptcy of a counterparty. These arrangements have been tested both in the market and in the courts and have been successfully used to settle thousands of OTC trades. During the current market turmoil we have witnessed the failure or default of a major OTC dealer (Lehman Bros.), two of the largest issuers of debt in the world (Fannie and Freddie), and a sovereign country (Ecuador). Indeed, on an almost weekly basis there are failures which call into action the carefully crafted settlement provisions of ISDA documentation. In every case the contracts have settled according to their terms and according to market expectations, with net settlements changing hands being much smaller than media pundits had anticipated (in Lehman's case, approximately $5bn changed hands in respect of CDS contracts). There is simply no evidence suggesting anything other than that the bilateral credit arrangements contained in standard ISDA documentation work extremely well. While clearing should be encouraged, and market participants continue to work with Federal and international regulators to create a viable clearing solution for OTC derivatives, mandating clearing of all OTC derivatives is unwarranted.Section 16: Credit Default Swaps This provision makes it unlawful to enter into a CDS unless the person entering into the transaction would experience a financial loss upon the occurrence of a credit event. This provision would effectively eliminate the CDS business in the United States. As written the provision would make it impossible for sellers of protection to hedge their own risks. Most dealer firms, which by and large are federally regulated banks, run a hedged portfolio which seeks to minimize their losses in the case of a loss on a particular contract. Thus for CDS, a dealer firm will seek to ensure that if it has to pay out protection under a CDS contract it will within its own portfolio have a hedged position to minimize its loss. This provision would mean that a dealer could not hedge its risks. Therefore the only participants in the CDS market would be counterparties which each had perfectly matched risks which they sought to hedge. The number of such persons is likely to be extremely small. This provision would also have the effect of turning all CDS into insurance contracts as it requires parties to a CDS to show a loss. As such under most state insurance statutes a party to a CDS would be required to be regulated by state insurance law, thus bringing federally regulated institutions under the authority of local state authorities. As noted above this provision would effectively end the CDS business in the U.S. As noted in this testimony and elsewhere the credit derivatives market has continued to function throughout the downturn, providing a way for market participants to hedge credit risk and express a view on market conditions. Limiting access to credit derivatives would create disincentives to lending at a time when Federal authorities are seeking to promote lending in order to restart the economy. It is difficult to see what public purpose would be served by destroying these currently healthy and important markets.Conclusion OTC derivatives markets play an important role in the U.S. and world economy. Despite hyperbolic reports to the contrary they did not cause the market meltdown, and in fact have helped mitigate the effect of the downturn for many institutions. To the extent some participants in the markets have suffered losses related to derivatives, or failed to adequately secure themselves or their counterparties against the possibility of losses, this reinforces the need for sound risk management practices and a careful review of the actions of regulators charged with overseeing these institutions. OTC derivatives remain an essential element in returning our financial system to full health, and harming these markets is not in keeping with that goal. This Committee is to be commended for addressing these questions and seeking answers to help right our economy. But to the extent oversight of OTC derivatives markets needs review and reform it should be part of a larger dialogue on reform of the financial system in general. Acting hastily is likely to have unintended consequences and prove counterproductive. " FinancialCrisisReport--576 Failure to Liquidate. In July 2007, after the credit rating agencies began the mass downgrades of RMBS securities, the first RMBS securities underlying the Hudson CDO lost their investment grade ratings, and the CDS contracts referencing those assets qualified as Credit Risk Assets requiring liquidation. 2581 Within three months, by October 15, 2007, over 28% of the Hudson assets qualified as Credit Risk Assets. 2582 As liquidation agent, Goldman should have begun issuing bids to sell the assets at the best possible price and remove them from the Hudson CDO, but it did not. In October 2007, Goldman began to contact Hudson investors to discuss transferring its liquidation agent responsibilities to a third party. That transfer required investor consent. Benjamin Case took notes of two telephone conversations he had with a Hudson investor, National Australia Bank (NAB), discussing the issues. 2583 In the calls, Mr. Case explained why Goldman had yet to liquidate any of the Credit Risk Assets, explaining that Goldman was waiting for asset prices to improve. 2584 He also reported that Goldman was considering an amendment to the Hudson transaction that would extend the maximum liquidation period, as well as make other structural changes to the Hudson deal. 2585 According to his notes, Mr. Case informed NAB that Goldman was seeking to transfer its liquidation role to a third party with more liquidation experience, because that change: “will be in the best interest of investors – the credit obligation term was originally written with the expectation that was unlikely to happen. ... Good for several reasons: 1. Large institutional assets manager will be able to access more liquidity b/c [because] they can access other broker dealers and get good pricing[.] 2580 Id. Mr. Herrick was not employed by Goldman when its CDO assets were downgraded and triggered its liquidation agent duties. 2581 1/3/2008 email from Shelly Lin to Mr. Sparks, GS MBS-E-021880171 (attached file, “Deal Summary,” GS MBS-E-021880172). 2582 2583 Id. 10/15/2007 email from Naina Kalavar, “NAB/Hudson Mezz Update 2,” GS MBS-E-015738973. Mr. Case used this email to circulate his notes of the two telephone conversations. 2584 Id. at 2. The notes included the following: “[C]urrent distressed nature of the assets has been fully priced in and has not moved over the past 2 months – if unwound those cds would be at 80-90 points, that is % points to be paid up front to unwind swap – equiv of 20 cents to dollar in cash bond terms ... Across entire universe of loans already in liquidation – been generally se[e]n 50-60-70 % recovery rates. Rates are not coming back high enough to make the market opt[i]mistic that bonds will come back to recover princi[pal]. ... Our view that there is upside in waiting an[d] evaluating mtkt conditions before liquidating. ... W e think that the shorts may get impatient – minor rallies from short covering – domino effect/momentum creates a rally b/c shorts get nervous at little rally – this provides potential upside to waiting to liquidate. ” 2585 Id. at 3. Such an amendment would require investor consent. 2. Even keeping the deal the way it is, the decision of when in the 12 month period to liquidate could be better handled by an experienced manager[.] 3. Potential amendment could be made to benefit the deal by giving more flexibility to agent.” 2586 CHRG-109hhrg23738--11 Mr. Greenspan," Mr. Chairman and members of the committee, I am pleased to be here to present the Federal Reserve's Monetary Policy Report to the Congress. I am surprised to hear it is the 35th time. In recent weeks, employment has remained on an upward trend; retail spending has posted appreciable gains; inventory levels have been modest; and business investment appears to have firmed. At the same time, low long-term interest rates have continued to provide a lift to housing activity. Although both overall and core consumer price inflation have eased of late, the prices of oil and natural gas have moved up again, on balance, since May and are likely to place some upward pressure on consumer prices, at least over the near term. Slack in labor and product markets has continued to decline. In light of these developments, the Federal Open Market Committee raised the federal funds rate at its June meeting to further reduce monetary policy accommodation. That action brought the cumulative increase in the funds rate over the past year to 2.25 percentage points. Should the prices of crude oil and natural gas flatten out after their recent runup, the forecast currently embedded in futures markets, the prospects for aggregate demand appear favorable. Household spending, buoyed by past gains in wealth, ongoing increases in employment and income, and relatively low interest rates, is likely to continue to expand. Business investment in equipment and software seems to be on a solid upward trajectory in response to supportive conditions in financial markets and the ongoing need to replace or upgrade aging high-tech and other equipment. Moreover, some recovery in non-residential construction appears in the offing, spurred partly by lower vacancy rates and rising prices for commercial properties. However, given the comparatively less buoyant growth of many foreign economies and the recent increase in the foreign exchange rate of the dollar, our external sector does not seem poised to contribute steadily to U.S. growth. A flattening out of the prices of crude oil and natural gas, were it to materialize, would also lessen upward pressure on inflation. Thus our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation. This generally favorable outlook, however, is attended by some significant uncertainties that warrant careful scrutiny. With regard to the outlook for inflation, future price performance will be influenced importantly by the trend in unit labor cost, or its equivalent, the ratio of hourly labor compensation to output per hour. Over most of the past several years, the behavior of unit labor costs has been quite subdued. But those costs have turned up of late, and whether the favorable trends of the past few years will be maintained is unclear. Hourly labor compensation as measured from the national income and product accounts increased sharply near the end of 2004. However, that measure appears to have been boosted significantly by temporary factors. Over the past 2 years, growth in output per hour seems to have moved off the peak that it reached in 2003. However, the cause, extent and duration of that slowdown are not yet clear. Energy prices represent a second major uncertainty in the economic outlook. A further rise could cut materially into private spending and thus damp the rate of economic expansion. Judging from the high level of far-future prices, global demand for energy apparently is expected to remain strong, and market participants are evidencing increased concerns about the potential for supply disruption in various oil-producing regions. More favorably, the current and prospective expansion of U.S. capability to import liquefied natural gas will help ease longer-term natural gas stringencies and perhaps bring natural gas prices in the United States down to world levels. The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates. The yield on 10-year Treasury notes, currently near 4.25 percent, is about 50 basis points below its level of late spring 2004. This decline in long-term rates has occurred against the backdrop of generally firm U.S. economic growth, a continued boost to inflation from higher energy prices, and fiscal pressures associated with the fast-approaching retirement of the baby-boom generation. The drop in long-term rates is especially surprising given the increase in the federal funds rate over the same period. Such a pattern is clearly without precedent in our recent experience. Two distinct but overlapping developments appear to be at work: a longer-term trend decline in bond yields; and an acceleration of that trend of late. Some, but not all, of the decade-long trend decline in that forward yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real-term premium that seems due to a moderation of the business cycle over the past few decades. This decline in inflation expectations and risk premiums is a signal development. As I noted in my testimony before this Committee in February, the effective productive capacity of the global economy has substantially increased, in part because of the breakup of the Soviet Union and the integration of China and India into the global marketplace; and this increase in capacity in turn has doubtless contributed to expectations of lower inflation and lower inflation-risk premiums. In addition to these factors, the trend reduction worldwide in long-term rates surely reflects an excess of intended savings over intended investment. This configuration is equivalent to an excess of the supply of funds relative to the demand for investment. What is unclear is whether the excess is due to a glut of savings or a shortfall of investment. Because intended capital investment is to some extent driven by forces independent of those governing intended saving, the gap between intended saving and investment can be quite wide and variable. It is real interest rates that bring actual capital investment worldwide and its means of financing global savings into equality. We can directly observe only the actual flows, not the savings and investment tendencies. Nonetheless, as best we can judge, both high levels of intended savings and low levels of intended investment have combined to lower real long-term rates over the past decade. Since the mid 1990s, a significant increase in the share of world gross domestic product produced by economies with persistently above-average savings, predominantly the emerging economies of Asia, has put upward pressure on world savings. These pressures have been supplemented by shifts in income toward the oil-exporting countries, which more recently have built surpluses because of steep increases in oil prices. Softness in intended investment is also evident. Although corporate capital investment in the major industrial countries rose in recent years, it apparently failed to match increases in corporate cash flow. In the United States, for example, capital expenditures were below the very substantial level of corporate cash flow in 2003, the first shortfall since the severe recession of 1975. That development was likely a result of the business caution that was apparent in the wake of the stock market decline and the corporate scandals early this decade. Japanese investment exhibited prolonged restraint following the bursting of their speculative bubble in the early 1990s; and investment in emerging Asia, excluding China, fell appreciably after the Asian financial crisis in the late 1990s. Whether the excess of global intended saving over intended investment has been caused by weak investment or excessive savings--that is, by weak consumption--or, more likely, a combination of both does not much affect the intermediate-term outlook for world GDP or, for that matter, U.S. monetary policy. What have mattered in recent years are the sign and the size of the gap of intentions and the implications for interest rates, not whether the gap results from a saving glut or an investment shortfall. That said, saving and investment propensities do matter over the longer term. Higher levels of investment relative to consumption build up the capital stock and thus add to the productive potential of an economy. The economic forces driving the global saving-investment balance have been unfolding over the course of the past decade, so the steepness of the recent decline in long-term dollar yields and the associated distant forward rates suggests that something more may have been at work over the past year. Inflation premiums in forward rates 10 years ahead have apparently continued to decline, but real yields have also fallen markedly over the past year. Risktakers apparently have been encouraged, by a perceived increase in economic stability, to reach out to more distant time horizons. These actions have been accompanied by significant declines in measures of expected volatility in equity and credit markets. History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and at times may lead to financial excess and economic stress. Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks. And certainly the exceptionally low interest rates on 10-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of home building, home turnover, and particularly in the steep climb in home prices. Whether home prices on average for the nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor. The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Historically, it has been rising real long-term interest rates that have restrained the pace of residential building and have suppressed existing home sales, high levels of which have been the major contributor to the home equity extraction that arguably has financed a noticeable share of personal-consumption expenditures and home-modernization outlays. The trend of mortgage rates or long-term interest rates more generally is likely to be influenced importantly by the worldwide evolution of intended saving and intended investment. We at the Federal Reserve will be closely monitoring the path of this global development few, if any, have previously experienced. As I indicated earlier, the capital investment climate in the United States appears to be improving following significant headwinds since late 2000, as is that in Japan. Capital investment in Europe, however, remains tepid. A broad worldwide expansion of capital investment not offset by rising worldwide propensity to save would presumably move real long-term interest rates higher. Moreover, with term premiums at historical lows, further downward pressure on long-term rates from this source is unlikely. We collectively confront many risks beyond those I have mentioned. As was tragically evidenced again by the bombings in London earlier this month, terrorism and geopolitical risk have become enduring features of the global landscape. Another prominent concern is the growing evidence of antiglobalization sentiment and protectionist initiatives, which if implemented would significantly threaten the flexibility and resilience of many economies. This situation is especially troubling for the United States, where openness and flexibility have allowed us to absorb a succession of large shocks in recent years with only minimal economic disruption. That flexibility is, in large measure, a testament to the industry and resourcefulness of our workers and businesses. But our success in this dimension has also been aided importantly by more than two and a half decades of bipartisan effort aimed at reducing unnecessary regulation and promoting the openness of our market economy. Going forward, policymakers will need to be vigilant to preserve this flexibility, which has contributed so constructively to our economic performance in recent years. In conclusion, Mr. Chairman, despite the challenges I have outlined and the many I have not, the U.S. economy has remained on a firm footing, and inflation continues to be well contained. Moreover, the prospects are favorable for a continuation of those trends. Accordingly, the Federal Open Market Committee in its June meeting reaffirmed that it believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects, as needed, to fulfill its obligation to maintain price stability. Thank you very much. I look forward to your questions. [The prepared statement of Hon. Alan Greenspan can be found on page 53 in the appendix.] " FOMC20060629meeting--107 105,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. I guess I’d say the center of gravity of this discussion is a little stronger than the Greenbook, and I think that’s pretty much where we are, too. We expect real GDP growth to follow a path pretty close to potential in the balance of ’06 and in ’07, and we expect core PCE inflation to moderate gradually to around 2 percent in ’07. This forecast assumes a monetary policy path close to that of the Greenbook, somewhat under the market’s forecast. Since May, in our view, the balance of risks has shifted a bit toward the less-favorable mix of somewhat more downside risk to real growth and somewhat more upside risk to inflation. Relative to the Greenbook, however, this implies that we have a stronger trajectory for demand growth and a slightly lower path for inflation. On the growth side, I guess I’d say we see a pretty healthy adjustment process under way with a change in the composition of growth. We don’t see the incoming data, the anecdotes, and the recent developments in financial markets as supporting the view that real growth is likely to stay significantly below potential over the full forecast period. We had already anticipated the slowdown in residential investment that has now materialized; therefore, we didn’t see that as a basis for revising down our forecast. We believe the changes in household wealth in general have less effect on consumption than the Board staff believes, and as a result we expect a more modest deceleration in growth. We expect stronger employment growth, too, and we have a stronger view of the rate of growth in private investment going forward. The world economy still looks pretty robust to us. So overall, in our view, this supports a forecast for the economy to be growing at a rate a bit above 3 percent over the next year and a half. But the risks to this forecast of growth seem a little less balanced than they did in May. We see less chance that the expansion is going to reaccelerate to a pace significantly above potential, and we see a bit more chance for a weaker outcome. The principal source of downside risk to us remains the possibility that households are going to reduce consumption growth significantly because they feel less rich, less secure, less comfortable borrowing, and less certain about the future. On the inflation outlook, we have moved up our expected trajectory for core PCE price inflation, but we still expect this measure to moderate, as I said, to around 2 percent by the end of ’07. This forecast is pretty favorable. It rests on the familiar fundamental forces of energy prices, if they follow the futures curve, becoming a source of moderation to price pressure going forward. Strong productivity growth keeps unit labor costs from accelerating sharply. Profit margins adjust to absorb any increase in unit labor costs that might come if labor’s share starts to move back toward its historical average. Growth of aggregate demand moderates to potential— it probably has already moderated to potential—which attenuates the risk of further upside pressure on resource utilization going forward. Most important, long-term inflation expectations have come down a bit. They remain in the range of the past few years, and they have proven responsive to changes in policy expectations in a more reassuring way than we saw very recently. As in May, however, we believe the risks to this forecast are still somewhat to the upside because of the following: Headline inflation and near-term inflation expectations have been running substantially above core for some time. Virtually all the ways we try to capture underlying inflation have been running above core. The recent rise in core may imply more momentum in inflation dynamics. You might say that long-term inflation expectations are a little higher than we want over time, and they may have been too responsive to changes in the incoming data. The medium-term trajectory for the dollar seems likely to be down. Profit margins, for reasons we don’t fully understand, have been very high and have been rising, and maybe that tells us something about inflation psychology that we don’t see in the long-term breakevens and TIPS. The long-term forecasts of inflation that the staff presentations give us show a lot of persistence of inflation. Inflation falls very, very slowly over time; and if that path is right, it could cause some further damage to inflation psychology. If you just step back and look at how much our expectations and the markets’ expectations about the terminal rate, the funds rate at which we’d stop tightening, have changed over the past two years, it’s really remarkable. The expectations eighteen months ago were about 200 basis points below where we are now. That change may imply that we will learn in retrospect that we were too loose for too long, and therefore we’ll have to do more than we thought to counteract that effect on inflation. That’s a possibility, not a prediction. So as I said in the beginning, in some sense the balance of risks has shifted in a way that complicates the monetary policy choice for us, and the shift leaves us with less confidence about the appropriate path for policy going forward. On balance, monetary policy appears to be getting some traction in the United States, and the expansion still looks to be in good shape. Inflation risks seem a bit tilted to the upside, and monetary policy needs to continue to be directed at ensuring significant moderation in the trajectory of inflation over the next few years. Thank you." CHRG-111hhrg51585--15 Mr. Price," Thank you, Mr. Chairman. It is extremely important for us to be discussing the Lehman Brothers bankruptcy in the context of the full committee. But I would also suggest and like to draw attention to the fact that we still haven't had a hearing on the collapse of Bear Stearns, which undeniably shaped the public expectations for the government bailout of Lehman Brothers. On April 7, 2008, Ranking Member Bachus and 16 members of this committee sent a letter to the chairman requesting a hearing specifically on Bear Stearns, which has not yet occurred. We have not had a hearing focused specifically on the events that led to the Lehman bankruptcy, derivatives, or the SEC's now defunct Consolidated Supervised Entities Program, which supervised Lehman and the four other investment banks. In the wake of Bear Stearns, and leading up to the bankruptcy of Lehman, many investors continued to purchase bonds or commercial paper issued by Lehman Brothers. In a normal functioning market, without suspicion of government backing or bailouts, investors would have likely been much more cautious, investing elsewhere and spreading their risk. Protecting risk seems to be the primary issue that has brought us here today. Our Nation has a system that, though painful, works extremely well in times of great challenge. It is the bankruptcy system. And I would suggest that the Lehman bankruptcy actually unfolded relatively smoothly. While many would like to attribute this unprecedented event to the inadequacies of the bankruptcy system, the more accurate culprit is the government's unpredictable meddling in the market. This certainly contributed more than any insufficiencies within the Bankruptcy Code. The situation with Lehman Brothers, the government created an unreasonable expectation that led to increased economic turmoil. Part of getting this country back on track is getting the government out of the market and out of the business of eliminating risk. Investments involve risk and reward. If we take away all the risk, there will be no reward for anyone, no opportunity for anyone, and no reason to invest in the future. We should look at that. " FOMC20060328meeting--92 90,MR. GUYNN.," Thank you, Mr. Chairman. I share the view of most that the slow growth in the fourth quarter of last year was, in fact, a temporary aberration that will be offset by strong first- quarter growth in the neighborhood of 4½ to 5 percent. Auto sales have already bounced back, and defense spending is unlikely to continue declining. And business investment spending looks to be strong. Like most outside forecasters and the Greenbook, our Atlanta BVAR and DSGE models are projecting that GDP growth will be around 3¼ percent or so in the second half of 2006 and into 2007. Our models also have core PCE inflation holding between 1¾ and 2 percent and the fed funds target rate peaking at about 5 percent. Although I would characterize this outlook as solid, and even encouraging, some significant uncertainties and risks surround the outlook. I’d like to comment on several of those risks and, in doing so, include some observations from our region’s experience and contacts that seem to be relevant. The first set of uncertainties in my own mind revolves around how the residential real estate adjustment will unfold—something Dave and Janet have already talked about. Although the decline in construction and sales and the slowing in price appreciation seem to be orderly so far, there clearly could be a more disruptive set of changes that we do not now foresee. As I reported at our last meeting, we are now seeing some significant downward price adjustments and cancellation of some major condominium projects in our red-hot, speculation-driven coastal Florida markets. At the same time, other markets are seeing more-modest adjustments, and it appears that builders are cutting back in response to demand signals. I don’t mean to imply that a major pullback in real estate would cause a precipitous drop in economic growth—that would be inconsistent with most of our simulations and analyses. Yet growth in that sector could slow even more than we now expect, especially if mortgage rates should continue to increase. Adding to the unknowns with regard to residential construction is the timing of the kick that will be associated with Hurricane Katrina rebuilding. The Greenbook has built in a measurable near-term contribution from that reconstruction, but I continue to believe that we’re going to be surprised at how protracted that rebuilding is going to turn out to be. That brings me to a second concern—our admitted uneasiness with how well we can explain the behavior of long-term interest rates in this cycle, something we talked about earlier but have not done so much recently. Despite the new academic look that I’m working on, [laughter] I don’t think I can add any genius to the possible explanations already offered by the current and the past Chairmen, Vice Chairman Geithner, and others. But I was here at the FOMC table for the heyday of the so-called new economy, when we thought for quite a while that we could explain some significantly different behavior, some important elements of our economy, only to learn in hindsight that some of those phenomena turned out to revert to past relationships and past experience. Clearly, an unexpected uptick in the long-term rates, including mortgage rates, would not come as a complete surprise. It would affect both household and business spending. I see it as a risk that we should be careful not to dismiss too quickly. The two uncertainties I’ve just talked about represent downside risks to output. There’s another development that I think tends to offset those downside worries. Job growth has been strong; in fact, in our region we are hearing more and more reports of shortages of new workers in a number of industries and with certain job skills. At the same time, much has been made of stagnant wages for some workers. My staff has analyzed data on the wages and on the types of jobs being created relative to those being destroyed and has found that, although the wage dynamics did deteriorate between 2001 and 2003, wage relationships have since returned to historical norms. Moreover, business surveys from both the National Association for Business Economics and the National Federation of Independent Businesses suggest that, although firms put a lid on wage increases during the 2001-04 period, the net projection of firms that are raising wages has become more widespread, and it is now about the same as it was during the 1990s. This rebound suggests to me that wage growth from net job creation is now lending more support to spending than it has in the recent past, taking some of the pressure off other sources of funding, such as home equity extraction. As our recent post-FOMC meeting statements have indicated, upside inflation risks also remain. It’s still not clear to me that we’ve seen the full long-term adjustment by households and businesses to elevated energy prices. I continue to hear reports of more energy and other commodity cost pass-throughs that people would like to make, and reports of rollbacks of earlier energy surcharges are few and far between. Although I’m not a proponent of the NAIRU way of thinking about the relationship between unemployment and expected pressure on inflation—a relationship that is hard to see in any recent empirical data—we do need to watch more carefully than ever for new bottlenecks and price pressures in a solid expansion that is now four years old. In fact, even though I see that the risk at our current and expected policy setting is getting close to balance, as a good central banker I remain at least a bit more concerned about the potential for inflation to edge somewhat higher. I will not argue tomorrow for a significantly tighter policy to help push the inflation rate moderately down, within the range most of us have said we view as our objective. But I do not think we want to risk a higher level of inflation at this point and risk having inflation expectations begin to deteriorate. I believe the kinds of uncertainty that I’ve just talked about demonstrate that our reading on the path of policy and the proper policy setting over the period ahead has become more difficult to get just right and more difficult to explain. And I think that suggesting that future policy action will be determined by the evolution of the economic outlook lends credence to the spirit of the recent post-meeting statements. Thank you, Mr. Chairman, and welcome back." FOMC20080625meeting--148 146,MR. BULLARD.," Thank you, Mr. Chairman. U.S. economic data have been stronger than expected during the intermeeting period. The earlier, very aggressive moves in January and March taken by the FOMC were viewed in part as insurance against the possibility of a very serious downturn brought on by financial market turmoil. That very serious downturn has not materialized. Tail risk has diminished significantly. This means that this Committee has put too much economic stimulus on the table and must think about ways to remove it going forward. Failure to do so will create a significant inflation problem on top of problems in housing and financial markets. Slack might be helpful, as mentioned by Governor Kohn, but those effects are small compared with expectations effects. I think it is too early to tighten at this meeting. Therefore, I am supporting alternative B with the language proposed by President Plosser. But the Committee has to think carefully about how and when to embark on a path for interest rates that will set us up to achieve price stability in a reasonable time frame. My sense is that this will require more-aggressive tightening of policy than currently envisioned in staff simulations. Financial market problems have been described here as a slow burn, and I think that may well be an apt description. Many firms in this sector took on too much risk and, in retrospect, had poor business models. I expect that this will take a long time to unwind. Despite this, the systemic risk component of the situation has diminished considerably. Systemic risk is in part a function of the degree of surprise in the failure of a financial institution that was perceived to be in good health. Surely by now few market participants would be surprised to encounter the failure of certain institutions. Failures, should they occur, can be handled in an orderly way. Certain investors would lose out in such an event, to be sure, but my sense is that the panic element that would be associated with systemic risk would not be present. I believe that we should start to downweight systemic risk concerns substantially going forward because it is no longer credible to say that market participants are surprised to learn of problems at certain financial institutions. Thank you. " FOMC20070628meeting--130 128,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. The outlook looks a little better, I think. The United States looks okay, and the world looks very strong. Housing here seems as though it will get worse before it gets better, but the rest of the economy seems to be doing reasonably well—with output and investment spending perhaps a bit firmer than we thought they would be and employment growth and income growth looking reasonably good. We have not significantly changed our central projection. We still see an economy growing around 3 percent over the forecast period, about our estimate of potential, with core PCE inflation falling just below 2. This assumes a path for the nominal fed funds rate that is flat for several more quarters, essentially the same as in the Greenbook and in the market now. The risks to this outlook, though, have changed. We see less downside risk to growth but still believe the risks to our growth forecast are weighted toward the weaker outcomes. Although the recent inflation numbers have been good, they probably exaggerate the moderation of underlying inflation, and we see, therefore, continued upside risk to our inflation forecast. I still think this latter risk should remain our more consequential concern. Relative to the Greenbook, we have a bit more growth because of our higher estimate of growth in the labor force and a bit less inflation, but these differences are small, smaller than they have been, and they do not have significant implications for our views on monetary policy. The markets’ perceptions of fundamentals have in some respects moved in our direction in the past few weeks. I say “in some respects” because we need to be attentive to the rise in implied inflation that you see in TIPS. Our view and the markets’ view of the expansion, the risk to the outlook, and implications for monetary policy have converged. This means that the effective stance of monetary policy is a little tighter than it was. A few important issues going forward: On the growth front, I still think that the probability of weakness exceeds that of strength. There is still a significant risk that we will see a more substantial adjustment of house prices, perhaps drawn out over a sustained period of time with greater adverse effects on confidence and spending. Of course, if employment and income growth stay reasonably strong, the effects of that potential scenario should be manageable. If not, we will have more to worry about. I note that some major financial institutions are now starting to report signs of rising delinquencies in consumer credit products outside mortgages such as automobile loans and leases. This is the first time that I have heard that report in a significant sense, and maybe it is a sign of some vulnerability ahead. The strength of demand growth outside the United States has been helpful, and we agree with the Greenbook that it looks likely to continue for some time. But things could be kind of bumpy out there, particularly in places like China, and monetary policy in much of the world is only now starting to move short-term real rates higher into positive territory. On the inflation front, it seems early to declare satisfaction or victory, not particularly because of the recent reacceleration in headline inflation but just because of the role of transitory factors in the recent moderation in core and the rise in breakevens in TIPS. We cannot be fully confident yet that a constant nominal fed funds rate at current levels will deliver an acceptable inflation forecast. We do not, in my view, need to try to induce right now a further tightening of financial conditions to push core inflation down further and faster. But we need more time before we can justify shifting to a more balanced risk assessment of inflation or something equivalent, something that would have the effect, for example, of indicating satisfaction with current levels or of suggesting that the risks are balanced around the path of inflation that we see in our central tendency projections. With financial markets, we are at a delicate moment. The losses in subprime are still working their way through the system. Rating agencies are likely to downgrade a larger share of past issues, more than they have already. The marks that people show indicate that both hedge funds and dealers in a lot of this stuff may still have a way to go to catch up with the movement in market prices. This dynamic itself could induce a further reduction in willingness to finance new mortgages. You could see pockets of losses in the system, liquidity pressures in hedge funds and their counterparties, and further forced liquidations. It is possible that we will still have a bunch of that effect ahead of us, even if no big negative shock to demand occurs and induces a broader distress in consumer credit. We could also see it spread to commercial real estate. We could see a broader pullback from CDOs and CLOs as well, either from a general erosion of faith in the rating models—as Bill said, it is a possibility—or from just concerns about liquidity in those instruments. We could see a sharp, substantial widening of credit spreads provoked by an unanticipated default or two or just a general reassessment of risk at current prices. A very large amount of LBO financing that is yet to be closed, distributed, and placed is still working its way through the system. As in the past, we could see a deal or two get hung, the music stop, and that force some broader repricing. People get stuck with stuff they don’t want to hold or did not expect to hold. I think we now see more sensitivity in markets about the prospect of a diminished appetite among the world’s savers and central banks to increase their exposure to the United States, or at least we see more sensitivity to the perception out there that the dynamic might be unfolding. You can see a bit of all this in some spreads, in some reports of resistance to further erosion in covenants, in some reduced appetite for new bridge book exposure to leveraged lending. You can see it in some changes in margin terms in some instruments vis- à-vis some counterparties. For now I think it is a relatively healthy, still pretty modest, and quite contained shift toward a more cautious assessment of risk, but these things generally don’t tend to unfold gradually. On balance, though, I think we are in a pretty good place in terms of policy, in terms of the market’s expectations about policy now, and in terms of how we have been framing the balance of risks to the outlook." CHRG-109shrg24852--117 PREPARED STATEMENT OF ALAN GREENSPAN Chairman, Board of Governors of the Federal Reserve System July 21, 2005 Mr. Chairman and Members of the Committee, I am pleased to be here to present the Federal Reserve's Monetary Policy Report to the Congress. In mid-February, when I presented our last report to the Congress, the economy, supported by strong underlying fundamentals, appeared to be on a solid growth path, and those circumstances prevailed through March. Accordingly, the Federal Open Market Committee (FOMC) continued the process of a measured removal of monetary accommodation, which it had begun in June 2004, by raising the Federal funds rate 1/4 percentage point at both the February and the March meetings. The upbeat picture became cloudier this spring, when data on economic activity proved to be weaker than most market participants had anticipated and inflation moved up in response to the jump in world oil prices. By the time of the May FOMC meeting, some evidence suggested that the economy might have been entering a soft patch reminiscent of the middle of last year, perhaps as a result of higher energy costs worldwide. In particular, employment gains had slowed from the strong pace of the end of 2004, consumer sentiment had weakened, and the momentum in household and business spending appeared to have dissipated somewhat. At the May meeting, the Committee had to weigh the extent to which this weakness was likely to be temporary--perhaps simply the product of the normal ebb and flow of a business expansion--and the extent to which it reflected some influence that might prove more persistent, such as the further run-up in crude oil prices. While the incoming data highlighted some downside risks to the outlook for economic growth, the FOMC judged the balance of information as suggesting that the economy had not weakened fundamentally. Moreover, core inflation had moved higher again through the first quarter. The rising prices of energy and other commodities continued to place upward pressures on costs, and reports of greater pricing power of firms indicated that they might be more able to pass those higher costs on to their customers. Given these considerations, the Committee continued the process of gradually removing monetary accommodation in May. The data released over the past 2 months or so accord with the view that the earlier soft readings on the economy were not presaging a more serious slowdown in the pace of activity. Employment has remained on an upward trend, retail spending has posted appreciable gains, inventory levels are modest, and business investment appears to have firmed. At the same time, low long-term interest rates have continued to provide a lift to housing activity. Although both overall and core consumer price inflation have eased of late, the prices of oil and natural gas have moved up again on balance since May and are likely to place some upward pressure on consumer prices, at least over the near-term. Slack in labor and product markets has continued to decline. In light of these developments, the FOMC raised the Federal funds rate at its June meeting to further reduce monetary policy accommodation. That action brought the cumulative increase in the funds rate over the past year to 2\1/4\ percentage points. Should the prices of crude oil and natural gas flatten out after their recent run-up--the forecast currently embedded in futures markets--the prospects for aggregate demand appear favorable. Household spending--buoyed by past gains in wealth, ongoing increases in employment and income, and relatively low interest rates--is likely to continue to expand. Business investment in equipment and software seems to be on a solid upward trajectory in response to supportive conditions in financial markets and the ongoing need to replace or upgrade aging high-tech and other equipment. Moreover, some recovery in nonresidential construction appears in the offing, spurred partly by lower vacancy rates and rising prices for commercial properties. However, given the comparatively less buoyant growth of many foreign economies and the recent increase in the foreign exchange value of the dollar, our external sector does not yet seem poised to contribute steadily to U.S. growth. A flattening out of the prices of crude oil and natural gas, were it to materialize, would also lessen upward pressures on inflation. Overall inflation would probably drop back noticeably from the rates experienced in 2004 and early 2005, and core inflation could hold steady or edge lower. Prices of crude materials and intermediate goods have softened of late, and the slower rise in import prices that should result from the recent strength in the foreign exchange value of the dollar could also relieve some pressure on inflation. Thus, our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation. This generally favorable outlook, however, is attended by some significant uncertainties that warrant careful scrutiny. With regard to the outlook for inflation, future price performance will be influenced importantly by the trend in unit labor costs, or its equivalent, the ratio of hourly labor compensation to output per hour. Over most of the past several years, the behavior of unit labor costs has been quite subdued. But those costs have turned up of late, and whether the favorable trends of the past few years will be maintained is unclear. Hourly labor compensation as measured from the national income and product accounts increased sharply near the end of 2004. However, that measure appears to have been boosted significantly by temporary factors. Other broad measures suggest hourly labor compensation continues to rise at a moderate rate. The evolution of unit labor costs will also reflect the growth of output per hour. Over the past decade, the U.S. economy has benefited from a remarkable acceleration of productivity: Strong gains in efficiency have buoyed real incomes and restrained inflation. But experience suggests that such rapid advances are unlikely to be maintained in an economy that has reached the cutting edge of technology. Over the past 2 years, growth in output per hour seems to have moved off the peak that it reached in 2003. However, the cause, extent, and duration of that slowdown are not yet clear. The traditional measure of the growth in output per hour, which is based on output as measured from the product side of the national accounts, has slowed sharply in recent quarters. But a conceptually equivalent measure that uses output measured from the income side has slowed far less. Given the divergence between these two readings, a reasonably accurate determination of the extent of the recent slowing in productivity growth and its parsing into cyclical and secular influences will require the accumulation of more evidence. Energy prices represent a second major uncertainty in the economic outlook. A further rise could cut materially into private spending and thus damp the rate of economic expansion. In recent weeks, spot prices for crude oil and natural gas have been both high and volatile. Prices for far-future delivery of oil and gas have risen even more markedly than spot prices over the past year. Apparently, market participants now see little prospect of appreciable relief from elevated energy prices for years to come. Global demand for energy apparently is expected to remain strong, and market participants are evidencing increased concerns about the potential for supply disruptions in various oil-producing regions. To be sure, the capacity to tap and utilize the world's supply of oil continues to expand. Major advances in recovery rates from existing reservoirs have enhanced proved reserves despite ever fewer discoveries of major oil fields. But, going forward, because of the geographic location of proved reserves, the great majority of the investment required to convert reserves into new crude oil productive capacity will need to be made in countries where foreign investment is currently prohibited or restricted or faces considerable political risk. Moreover, the preponderance of oil and gas revenues of the dominant national oil companies is perceived as necessary to meet the domestic needs of growing populations. These factors have the potential to constrain the ability of producers to expand capacity to keep up with the projected growth of world demand, which has been propelled to an unexpected extent by burgeoning demand in emerging Asia. More favorably, the current and prospective expansion of U.S. capability to import liquefied natural gas will help ease longer-term natural gas stringencies and perhaps bring natural gas prices in the United States down to world levels. The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates. The yield on 10-year Treasury notes, currently near 4\1/4\ percent, is about 50 basis points below its level of late spring 2004. Moreover, even after the recent widening of credit risk spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than those on Treasury notes over the same period. This decline in long-term rates has occurred against the backdrop of generally firm U.S. economic growth, a continued boost to inflation from higher energy prices, and fiscal pressures associated with the fast approaching retirement of the baby-boom generation.\1\ The drop in long-term rates is especially surprising given the increase in the Federal funds rate over the same period. Such a pattern is clearly without precedent in our recent experience.--------------------------------------------------------------------------- \1\ Under current law, those longer-run pressures on the Federal budget threaten to place the economy on an unsustainable path. Large deficits could result in rising interest rates and ever-growing interest payments on the accumulating stock of debt, which in turn would further augment deficits in future years. That process could result in deficits as a percentage of gross domestic product rising without limit. Unless such a development were headed off, these deficits could cause the economy to stagnate or worse at some point over the next couple of decades.--------------------------------------------------------------------------- The unusual behavior of long-term interest rates first became apparent last year. In May and June 2004, with a tightening of monetary policy by the Federal Reserve widely expected, market participants built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with an initial rise in the Federal funds rate. Accordingly, yields on 10-year Treasury notes rose during the spring of last year about 1 percentage point. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In March of this year, long-term rates once again began to rise, but like last year, market forces came into play to make those increases short lived. Considerable debate remains among analysts as to the nature of those market forces. Whatever those forces are, they are surely global, because the decline in long-term interest rates in the past year is even more pronounced in major foreign financial markets than in the United States. Two distinct but overlapping developments appear to be at work: A longer-term trend decline in bond yields and an acceleration of that trend of late. Both developments are particularly evident in the interest rate applying to the 1 year period ending 10 years from today that can be inferred from the U.S. Treasury yield curve. In 1994, that so-called forward rate exceeded 8 percent. By mid-2004, it had declined to about 6\1/2\ percent--an easing of about 15 basis points per year on average.\2\ Over the past year, that drop steepened, and the forward rate fell 130 basis points to less than 5 percent.--------------------------------------------------------------------------- \2\ Dollar interest rate swaps 5 years forward and maturing in 10 years declined 19 basis points per year on average over the same period. Comparable euro (pre-1999, Deutschemark) swaps declined 27 basis points, sterling swaps 35 basis points, and yen swaps 23 basis points.--------------------------------------------------------------------------- Some, but not all, of the decade-long trend decline in that forward yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real term premium that seems due to a moderation of the business cycle over the past few decades.\3\ This decline in inflation expectations and risk premiums is a signal development. As I noted in my testimony before this Committee in February, the effective productive capacity of the global economy has substantially increased, in part because of the breakup of the Soviet Union and the integration of China and India into the global marketplace. And this increase in capacity, in turn, has doubtless contributed to expectations of lower inflation and lower inflation-risk premiums.--------------------------------------------------------------------------- \3\ Term premiums measure the extent to which current prices of bonds discount future uncertainties.--------------------------------------------------------------------------- In addition to these factors, the trend reduction worldwide in long-term yields surely reflects an excess of intended saving over intended investment. This configuration is equivalent to an excess of the supply of funds relative to the demand for investment. What is unclear is whether the excess is due to a glut of saving or a shortfall of investment. Because intended capital investment is to some extent driven by forces independent of those governing intended saving, the gap between intended saving and investment can be quite wide and variable. It is real interest rates that bring actual capital investment worldwide and its means of financing, global saving, into equality. We can directly observe only the actual flows, not the saving and investment tendencies. Nonetheless, as best we can judge, both high levels of intended saving and low levels of intended investment have combined to lower real long-term interest rates over the past decade. Since the mid-1990's, a significant increase in the share of world gross domestic product (GDP) produced by economies with persistently above-average saving--prominently the emerging economies of Asia--has put upward pressure on world saving. These pressures have been supplemented by shifts in income toward the oil-exporting countries, which more recently have built surpluses because of steep increases in oil prices. The changes in shares of world GDP, however, have had little effect on actual world capital investment as a percentage of GDP. The fact that investment as a percentage of GDP apparently changed little when real interest rates were falling, even adjusting for the shift in the shares of world GDP, suggests that, on average, countries' investment propensities had been declining.\4\--------------------------------------------------------------------------- \4\ Nominal GDP figures by country are estimated in dollars by the International Monetary Fund using purchasing power parities (PPP) of currencies. These GDP figures are used to calculate weights applied to national saving and investment rates to form global measures. When the GDP figures are instead measured at market exchange rates, the results are similar. The PPP estimates emphasize the economic factors generating investment and the use of saving. Exchange rates emphasize the financial forces governing the financing of investment across borders. Both approaches are useful.--------------------------------------------------------------------------- Softness in intended investment is also evident in corporate behavior. Although corporate capital investment in the major industrial countries rose in recent years, it apparently failed to match increases in corporate cashflow.\5\ In the United States, for example, capital expenditures were below the very substantial level of corporate cashflow in 2003, the first shortfall since the severe recession of 1975. That development was likely a result of the business caution that was apparent in the wake of the stock market decline and the corporate scandals early this decade. (Capital investment in the United States has only recently shown signs of shedding at least some of that caution.) Japanese investment exhibited prolonged restraint following the bursting of their speculative bubble in the early 1990's. And investment in emerging Asia excluding China fell appreciably after the Asian financial crisis in the late 1990's. Moreover, only a modest part of the large revenue surpluses of oil-producing nations has been reinvested in physical assets. In fact, capital investment in the Middle East in 2004, at 25 percent of the region's GDP, was the same as in 1998. National saving, however, rose from 21 percent to 32 percent of GDP. The unused saving of this region was invested in world markets.--------------------------------------------------------------------------- \5\ A significant part of the surge in cashflow of U.S. corporations was accrued by those financial intermediaries that invest only a small part in capital assets. It appears that the value added of intermediation has increased materially over the past decade because of major advances in financial product innovation.--------------------------------------------------------------------------- Whether the excess of global intended saving over intended investment has been caused by weak investment or excessive saving--that is, by weak consumption--or, more likely, a combination of both does not much affect the intermediate-term outlook for world GDP or, for that matter, U.S. monetary policy. What have mattered in recent years are the sign and the size of the gap of intentions and the implications for interest rates, not whether the gap results from a saving glut or an investment shortfall. That said, saving and investment propensities do matter over the longer-run. Higher levels of investment relative to consumption build up the capital stock and thus add to the productive potential of an economy. The economic forces driving the global saving-investment balance have been unfolding over the course of the past decade, so the steepness of the recent decline in long-term dollar yields and the associated distant forward rates suggests that something more may have been at work over the past year.\6\ Inflation premiums in forward rates 10 years ahead have apparently continued to decline, but real yields have also fallen markedly over the past year. It is possible that the factors that have tended to depress real yields over the past decade have accelerated recently, though that notion seems implausible.--------------------------------------------------------------------------- \6\ The decline of euro, sterling, and yen forward swap rates also steepened.--------------------------------------------------------------------------- According to estimates prepared by the Federal Reserve Board staff, a significant portion of the sharp decline in the 10-year forward 1 year rate over the past year appears to have resulted from a fall in term premiums. Such estimates are subject to considerable uncertainty. Nevertheless, they suggest that risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. These actions have been accompanied by significant declines in measures of expected volatility in equity and credit markets inferred from prices of stock and bond options and narrow credit risk premiums. History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress. Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks. And, certainly, the exceptionally low interest rates on 10-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding, home turnover, and particularly in the steep climb in home prices. Whether home prices on average for the Nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor. The apparent froth in housing markets appears to have interacted with evolving practices in mortgage markets. The increase in the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But some households may be employing these instruments to purchase homes that would otherwise be unaffordable, and consequently their use could be adding to pressures in the housing market. Moreover, these contracts may leave some mortgagors vulnerable to adverse events. It is important that lenders fully appreciate the risk that some households may have trouble meeting monthly payments as interest rates and the macroeconomic climate change. The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Nationwide banking and widespread securitization of mortgages make financial intermediation less likely to be impaired than it was in some previous episodes of regional house-price correction. Moreover, a decline in the national housing price level would need to be substantial to trigger a significant rise in foreclosures, because the vast majority of homeowners have built up substantial equity in their homes despite large mortgage-market-financed withdrawals of home equity in recent years. Historically, it has been rising real long-term interest rates that have restrained the pace of residential building and have suppressed existing home sales, high levels of which have been the major contributor to the home equity extraction that arguably has financed a noticeable share of personal consumption expenditures and home modernization outlays. The trend of mortgage rates, or long-term interest rates more generally, is likely to be influenced importantly by the worldwide evolution of intended saving and intended investment. We at the Federal Reserve will be closely monitoring the path of this global development few, if any, have previously experienced. As I indicated earlier, the capital investment climate in the United States appears to be improving following significant headwinds since late 2000, as is that in Japan. Capital investment in Europe, however, remains tepid. A broad worldwide expansion of capital investment not offset by a rising worldwide propensity to save would presumably move real long-term interest rates higher. Moreover, with term premiums at historical lows, further downward pressure on long-term rates from this source is unlikely. We collectively confront many risks beyond those that I have just mentioned. As was tragically evidenced again by the bombings in London earlier this month, terrorism and geopolitical risk have become enduring features of the global landscape. Another prominent concern is the growing evidence of antiglobalization sentiment and protectionist initiatives, which, if implemented, would significantly threaten the flexibility and resilience of many economies. This situation is especially troubling for the United States, where openness and flexibility have allowed us to absorb a succession of large shocks in recent years with only minimal economic disruption. That flexibility is, in large measure, a testament to the industry and resourcefulness of our workers and businesses. But our success in this dimension has also been aided importantly by more than two and a half decades of bipartisan effort aimed at reducing unnecessary regulation and promoting the openness of our market economy. Going forward, policymakers will need to be vigilant to preserve this flexibility, which has contributed so constructively to our economic performance in recent years. In conclusion, Mr. Chairman, despite the challenges that I have highlighted and the many I have not, the U.S. economy has remained on a firm footing, and inflation continues to be well contained. Moreover, the prospects are favorable for a continuation of those trends. Accordingly, the Federal Open Market Committee in its June meeting reaffirmed that it ``. . . believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.'' FOMC20071031meeting--41 39,MR. ROSENGREN.," Thank you, Mr. Chairman. The Boston forecast is very close to that of the Greenbook. With the constant federal funds rate assumption, the economy is very close to full employment, and core inflation is close to 2 percent at the end of 2008. Such an outcome is consistent with what I would hope to achieve with appropriate monetary policy. However, while this is an expected path that seems quite reasonable, the distribution of risks around that outcome for growth remains skewed to the downside. Our forecast, like that of the Greenbook, expects particularly weak residential investment. Problems in financing mortgages, expectations of falling housing prices, and more-severe financial stress for homebuilders are likely to weigh heavily over the next two quarters. In fact, our forecast for residential investment has become sufficiently bleak that there may actually be some upside risk to it. [Laughter] Somewhat surprising to me has been the lack of spillover to the rest of the economy from the problems in residential investment. I remain concerned that falling housing prices will further sap consumer confidence and cause a pullback in consumption, though to date there is little evidence of a significant effect of the housing problems on consumer spending. Similarly, I would have expected the financing problems that have aggravated the housing situation to have caused a sharper reduction in investment in general and in nonresidential structures in particular. However, so far these remain risks rather than outcomes. Thus, while I am worried about the downside risks, I am reminded that forecasters have frequently overestimated the consequences of liquidity problems in the past. On the financial side, there have definitely been improvements in market conditions, though markets remain fragile. Particularly worrisome has been the announcement of significant downgrades of tranches of CDOs and mortgage-backed securities with large exposure to the subprime mortgage market. Not only have the lower tranches experienced significant downgrades, but a number of the AAA and AA tranches have been downgraded to below investment grade. Some investors cannot retain below-investment-grade securities and are forced to sell these securities in an already depressed market. The number of the downgrades, the magnitude of the downgrades, and the piecemeal ratings announcements all are likely to call into further question the reliability of the ratings process. If many high-grade securities tied to mortgages are downgraded to below investment grade, some investors may conclude that repricing of even high-graded tranches does not reflect a liquidity problem but rather a substantial reevaluation of credit risk. Thus, I am concerned that continued widespread downgrades may make recovery in the securitization market more difficult, particularly for nonconforming mortgages, with a consequent increase in the financing cost of these assets. I also remain concerned that the asset-backed commercial paper market remains fragile. While investors seem to be distinguishing between conduits whose structure or underlying assets are quite risky, my sense is that money managers are watching the market quite closely. I continue to hear concerns over the possibility that some money market funds will experience losses that will not be supported by their parents, resulting in increased investor concern with the safety of money market funds more generally. On balance, the data both on the real economy and on financial markets have improved since our September meeting. That improvement makes it more likely that the economy will continue to recover gradually from the financial turmoil. However, both the real and the financial risks remain skewed to the downside." FOMC20080318meeting--59 57,MS. PIANALTO.," Thank you, Mr. Chairman. Through my conversations with people in the Fourth District financial community, I get the clear impression that some credit channels are closing down. Given the uncertainties in financial markets, some of the large banks in my District are finding it challenging to ascertain potential loss exposures in certain asset categories, especially to residential real estate developers. Two large banks in the District have seen their asset quality deteriorate more quickly than they had projected in January. Clearly, banks and other financial institutions are getting squeezed from both sides of their balance sheets, and the most highly leveraged institutions are getting squeezed the hardest. Many of the large banks in my District are going to considerable lengths to stay liquid and to conserve capital. The largest and most complex institutions are attempting to raise more capital. The deteriorating environment in the financial markets is clearly affecting business conditions. Most manufacturers in the District have seen a slowing in business activity. Those that are doing better are doing so because they are being helped some by stronger export demand. Pessimism over economic prospects is now prevalent among the CEOs that I talked with, and many are scaling back their business plans for 2008 by a considerable amount. The faltering business prospects are making the financial environment even more uncertain--a pattern that conforms to the adverse feedback loop that Governor Mishkin and others have been warning about. Like others, I have once more cut my growth projections for 2008 and, again, by a relatively large margin. As in the Greenbook, I have factored into my projection the weaker than previously expected estimates of spending and employment as well as the sharp run-up in energy costs. An especially important element in my current thinking is the future path of housing values. Many of my contacts have told me that they don't see how financial market conditions can stabilize without more confidence about where the bottom of the housing market lies and, as a corollary, where the bottom of the residential-mortgage-backed security prices might lie. Unfortunately, I haven't seen evidence that we are seeing a leveling out in housing prices. The Greenbook baseline projection carries with it nominal house-price declines of about 5 percent this year and next. A month ago that may have seemed like a reasonably good assumption to me, but today I fear that projection may be too optimistic. Certainly, the decline in house values that one sees in futures markets for the markets that are covered by the Case-Shiller index indicates a decline of twice that magnitude. My own baseline projection is closer to the ""greater housing correction"" alternative than the Greenbook's baseline projection. Even the ""greater housing correction with more financial fallout"" alternative seems somewhat plausible to me. Turning to the inflation outlook, at our January meeting my modal outlook was one in which the inflation trend declined to just below 2 percent in 2010. At the same time, I was one of the few participants who said that the inflation risk had shifted to the upside. I still hold to those views--that is, I still expect the trend of inflation to fall below 2 percent by 2010, but I still worry that we are going to continue to experience upside surprises to that inflation outlook. Indeed, I can't recall a single conversation that I have had with my business contacts recently that hasn't touched on the increasing cost pressures that they are facing. In most cases, they are now successfully passing along price increases to their customers. Nevertheless, as I assess the economic environment this morning relative to where I was in January, particularly given the prospects of yet larger wealth losses stemming from the real estate market and certainly the chance for even greater impairment to the functioning of our credit markets, I think the downside risks to economic growth continue to outweigh the upside risks to inflation. Thank you, Mr. Chairman. " FOMC20050630meeting--45 43,MR. PEACH.," I have just three comments. First, I’m not disputing that land prices where houses are being built would be lower than land prices closer to the center of a metropolitan area. The issue is the rate of increase of those land prices. And we don’t really know what’s happening to the rate of increase of land prices at different points along the continuum." CHRG-109shrg30354--46 Chairman Bernanke," Senator, so far the credit quality looks to be good. We see that mortgages are, for the most part, fixed-rate despite the fact that we have seen more nontraditional mortgages and ARM's issued recently. We only see about 10 percent of all mortgages being repriced during 2006. Because of these rapid increases in house prices, a lot of homeowners do have a lot of equity. And, therefore, they are able to make the payments on their homes. So we do not see any near-term significant increase in mortgage delinquencies or credit risk. The one area that we are watching very carefully is low and moderate-income subprime mortgage lending. That area, more than the broader market, has seen adjustable-rate mortgage lending. And therefore, there is more susceptibility, I think, there to increases in interest rates affecting the monthly cost of mortgages. " FOMC20080625meeting--256 254,MR. ROSENGREN.," One last question. Sorry for so many questions. The situation of Lehman was kind of interesting because you saw their stock price go down. Talking to financial institutions, both regulated and unregulated, in Boston, a lot of people were evaluating counterparty risk and deciding whether or not they were going to start running before the capital issue. Did your measures of liquidity pick up the amount of stress that was going on in the counterparty analysis being done, I assume, all over the country? One of the conditions for an institution's access to the discount window at a primary credit rate is that it not be rated a 4 or a 5. I know we're not doing bank exams, and I know we're not looking at all the elements of the bank exam. How confident are we, if we were to do something like that for Lehman or for Merrill Lynch, that we wouldn't rate them a 4 or a 5? " CHRG-110hhrg38392--187 Mr. Bernanke," The best guess is that food and energy prices, or at least energy prices, will stay high. The question, though, is whether they will keep rising at the pace that they have been rising. As best we can tell, as best as futures markets suggest, while they may remain high, they will not continue to rise at the same pace. Now, that is a very uncertain judgment. I discussed in my testimony that this is one of the risks that we are examining. One of the things that could happen to make inflation more of a problem would be if energy prices in fact did continue to rise at the pace they have in recent years. Mr. Miller of North Carolina. I have more questions, but I want to move on to subprime lending. Many people have asked about subprime lending. When I have asked in the past about subprime lending, it has been a pretty lonely effort. The concerns about subprime lending are not new for many of us. I introduced a predatory mortgage lending bill 4 years ago, 4\1/2\ years ago, when I first came to Congress, and I dearly wish that Congress had enacted that legislation because we would not have seen the spike, the disastrous spike in foreclosure rates and the default rates that we have. There has been more discussion in the press about the spike in foreclosures in the subprime market has affected the stability, what it has done to hedge funds that hold portfolios than there has to how it affects the families who have lost their homes. You have talked some about the importance of homeownership, equity in homes, to the wealth of no class families. The information I have: there were about 900,000 residential foreclosures in 2005; 1.2 million foreclosures last year; and there will be 1.5 million foreclosures this year. As you have said, based upon the change in underwriting last year, it is going to explode the year after that and the year after that. What is that doing to the wealth, to the life savings of families who are now facing foreclosure? " CHRG-111shrg57319--6 Mr. Cathcart," Chairman Levin, Ranking Member Coburn, and Members of the Committee, thank you for the opportunity to comment on my history with Washington Mutual Bank and to provide a risk management perspective on some root causes of the U.S. financial services crisis.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Cathcart appears in the Appendix on page 138.--------------------------------------------------------------------------- Before leading the Enterprise Risk Management Group at WaMu, I spent more than 20 years working in risk management positions at World Bank of Canada, Bank One, and CIBC. I joined WaMu's management team in December 2005 and served as the Chief Enterprise Risk Officer through April 2008. When I arrived at WaMu, I inherited a Risk Department that was isolated from the rest of the bank and was struggling to be effective at a time when the mortgage industry was experiencing unprecedented demand for residential mortgage assets. I understood that the regulatory agencies and WaMu's Board of Directors were interested in expanding risk management functions within the company to meet this demand. The general function of risk management is to measure, monitor, and establish parameters to control risk so that the company is prepared for potential loss. In order to meet this objective, during my first few months, I reorganized the department in order to align risk management with the company's business lines and to embed risk managers in each of the four business units. The company's strategic plan to shift its portfolios towards higher margin products was already underway when I arrived at WaMu. Basically, this strategy involved moving away from traditional mortgage lending into alternative lending programs involving adjustable-rate mortgages as well as into subprime products. The strategic shift to higher-margin products resulted in the bank taking on a higher degree of credit risk because there was a greater chance that borrowers would default. In hindsight, the shift to both adjustable-rate Option ARM loans and subprime products was a significant factor in the failure of WaMu and contributed to the financial crisis generally. These products depended on house price appreciation to be viable. When housing prices decelerated, they became problem assets. In early 2006, a high volume of Option ARM loans was being originated and securitized at WaMu and throughout the West Coast mortgage industry. Wall Street had a huge appetite for Option ARMs and WaMu could sell these loans as quickly as it could originate them. With an incentive to bundle and sell large quantities of loans as quickly as possible, banks all over the country, including WaMu, became conduits for the securitization and sale of loans to Wall Street. The banking industry began to move away from the traditional model, where banks held the loans they originated, towards a new model where banks acted as conduits. The demand for securitized mortgage products encouraged poor underwriting, and guidelines which had been established to mitigate and control risk were often ignored. The source of repayment for each mortgage shifted away from the individual and their credit profile to the value of the home. This approach of focusing on the asset rather than on the customer ignores the reality that portfolio performance is ultimately determined by customer selection and credit evaluation. Even the most rigorous efforts to measure, monitor, and control risk cannot overcome poor product design and weak underwriting and organizational practices. Another key component of WaMu's higher-risk strategy involved efforts to increase the company's exposure to the subprime market. These efforts focused on lending to customers who did not meet the credit qualifications to obtain traditional mortgages. In order to be successful, any bank offering subprime products must operate with a high degree of credit discipline. However, the credit performance of Long Beach-originated loans did not meet acceptable risk standards and the high level of early payment defaults suggested poor customer selection and underwriting practices. Risk management, therefore, determined that Long Beach had outsized risk parameters and we implemented standards to tighten them. In the end, WaMu's subprime exposure never reached the levels envisaged in the 2005 strategy. In fact, thanks in part to tightening of controls and risk parameters, these were reduced. Financial conditions in late 2007 and early 2008 deteriorated further in 2007 and 2008. As head of risk, I began to be excluded from key management decisions. By February 2008, I had been so fully isolated that I initiated a meeting with the director, where I advised that I was being marginalized by senior management to the point that I was no longer able to discharge my responsibilities as Chief Enterprise Risk Officer of WaMu. Within several weeks, I was terminated by the chairman. In conclusion, let me identify some of the factors which contributed to the decline of the U.S. financial market. A confluence of factors came together to create unprecedented financial conditions which the market was not equipped to handle. Due to a lack of regulation and lax lending standards, mortgage brokers operated without oversight and underwriting quality suffered as a result. The banking industry's focus shifted from customer selection to asset-based lending as banks became conduits for Wall Street, which could and would securitize whatever mortgage pool the bank originated. Rating agencies and regulators seemed to be lulled into a sense of complacency, and the Government-Sponsored Enterprises opened their risk envelopes and guaranteed and warehoused increasingly risky products. Thank you for the opportunity to share my thoughts and experiences. I look forward to the Subcommittee's review of this matter and I am prepared to answer any questions. Senator Levin. Thank you very much, Mr. Cathcart. We thank you all for your statements, which we have had an opportunity to read. " Mr. Melby,"TESTIMONY OF RANDY MELBY,\1\ FORMER GENERAL AUDITOR, WASHINGTON FOMC20060510meeting--91 89,MR. MOSKOW.," Thank you, Mr. Chairman. Most of my business contacts indicated that overall economic activity remains on a solid footing and that resource utilization has tightened further. Both of the major temporary-help firms headquartered in our District said that hiring remains strong nationwide. They continued to say that skilled workers are in short supply. This topic was also on the minds of our contacts in manufacturing and construction. As I’ve noted previously, we’ve heard a few reports from manufacturers that labor shortages were causing delays in supplier deliveries. Strengthened labor demand, however, has not yet spread to lower-skilled workers. So while wages for skilled individuals continue to increase briskly, pay rates for other workers are up only modestly. We’re also seeing signs of pressure on nonlabor resources. Some of our contacts have run into problems with the costs and availability of trucking and rail shipping capacity, and a manufacturer of drilling equipment reported supply disruptions because its vendors were heavily backlogged. Several contacts noted that price pressures have intensified for many commodities, as we’ve discussed before. Of course, everyone was talking about the surge in energy costs. Some retailers noted that sales had slowed, and they attributed the softness to higher energy prices. Others were concerned about the impact of energy going forward. In contrast, our manufacturing contacts reported that they generally have no plans to scale back production in response to the recent increases. There is not much new to report on the Delphi negotiations. The period for Delphi workers to sign up for early retirement is just starting. Delphi, General Motors, and the UAW hope that many will accept the buyout. This would leave fewer union workers vulnerable to being laid off as Delphi downsizes, which would make the negotiations easier for all the parties involved. On a final note, several of my directors continue to be concerned about the amount of liquidity in financial markets. They say prices and terms for more and more deals are bordering on speculative. Turning to the outlook, we’ve had quite a bit of news since our last meeting. Much of it suggests increased risks on the inflation front. Of course, the March reading on core inflation was just one month, but the twelve-month change in core PCE inflation is now back up to 2 percent. And as President Lacker said, the six-month change is now up to 2.4 percent. Moreover, energy prices have jumped again. The dollar has weakened a bit more, and inflation expectations have risen. In response to the latest data, the forecasts from our indicator models of inflation have moved up some. Currently, these project 2007 core PCE inflation between 2 percent and 2.4 percent. To be sure, things are far from getting out of hand: Resource utilization measures currently are only modestly on the tight side, and we are all well aware of the uncertainty surrounding those measures. Furthermore, the recent ECI data suggest that wage pressures remain muted. That said, other measures of wage growth have been rising. Looking at the markup of prices over labor costs, one would think that there’s plenty of room for profit margins to absorb higher wages. But as Bill Poole suggested in the issue we discussed before, the business people I talked to haven’t gotten that message. Their attempts to maintain margins in the face of increasing costs represent an upside risk to the inflation outlook. So I agree with the upward nudge to the Greenbook inflation forecast, but I’d go a bit further. Given the Greenbook path for the funds rate, I think core inflation of 2¼ percent is a more reasonable point forecast for 2007. In terms of growth, the expansion still appears solid. The softening in housing that we have been anticipating is more obvious now. There’s a possibility that moderation might turn to something bigger, but I don’t see this as a large risk. Of course, $3-a-gallon gasoline should restrain demand somewhat, and we’ll need to keep a close eye on how consumers respond to yet another hit to their purchasing power. But employment continues to rise at a good pace, generating healthy increases in income, which should support household demand. Businesses are supporting spending on capital goods, and growth prospects abroad continue to suggest some optimism on export demand. So I think growth will average around potential over the course of the projection period." FOMC20050202meeting--92 90,MR. SLIFMAN.,"3 Thank you, Mr. Chairman. We’ll be referring to the package of materials entitled “Staff Presentation on the Economic Outlook.” As you know from reading the Greenbook, the only material change in our forecast since the December FOMC meeting concerns prospects for the near term. So, after briefly reviewing some of the recent high-frequency indicators, I’ll focus my discussion on the fundamental forces that we see driving economic activity over the next two years. With regard to the very near-term outlook, your first chart shows a variety of data series that have informed our judgments. The upper panels highlight two “production side” indicators. As illustrated in the upper left, private nonfarm payroll employment rose 181,000 per month, on average, in the fourth quarter, a noticeable pickup from the third-quarter pace. In addition, the Board’s index of industrial production continued to show above-trend gains in manufacturing sector activity. Most forward-looking indicators of production, such as the regional business surveys conducted by the Reserve Banks and the ISM [Institute for Supply Management] manufacturing report that was released yesterday, also point to continued near-term gains, although perhaps not as robust as late last year. The data on private final sales also look quite favorable. Real PCE excluding motor vehicles (the middle left panel) rose rapidly in the fourth quarter, and motor vehicles (the panel to the right) continue to sell at a brisk pace. After the Greenbook was published, we received information on orders and shipments for nondefense capital goods. As shown by the inset box in the lower left panel, shipments excluding aircraft rose 2.2 percent and orders advanced 1.8 percent in December. These figures were about in line with our expectations. All told, our estimate of fourth-quarter real GDP growth, shown on line 1 of the table, was fairly close to BEA’s [Bureau of Economic Analysis]—especially after BEA factors in an error in the Canadian trade statistics that apparently depressed estimated U.S. exports. Karen will have more to say about the Canadian numbers shortly. In any event, we see no reason to alter our first-quarter forecast as a result of the BEA’s fourth-quarter GDP estimate. Your next chart presents an overview of the forecast. As described in the first bullet of the upper panel, our forecast is predicated on a continuing withdrawal February 1-2, 2005 69 of 177 of monetary accommodation over the next two years, with the federal funds rate reaching 3 percent in the fourth quarter of this year and 3½ percent in the latter part of 2006—a path quite similar to that implied by futures quotes. Regarding fiscal policy, we’ve reduced our deficit projection for fiscal year 2005 more than $20 billion, primarily reflecting stronger incoming data on corporate tax receipts; the deficit in 2006 is unchanged from the previous Greenbook. But the change to our deficit estimate has virtually no effect on our preferred indicator of fiscal stimulus, FI, which is designed to capture the macroeconomic effects of exogenous policy changes. FI is expected to be neutral in 2005 and to provide only a small positive impetus to GDP growth in 2006. Although oil prices have moved higher in recent weeks, the futures market continues to see the likely path as pointing downward from here forward, and, as usual, we have conditioned the forecast on their views. Karen and I will both have more to say about oil prices. And, as Karen will discuss, the staff expects the foreign exchange value of the dollar to drift down. As for asset values, stock prices are assumed to rise 6½ percent this year and next, which would roughly maintain risk- adjusted parity with the yield on long-term bonds, while the rate of increase in house prices is expected to slow considerably from last year’s torrid pace. As shown in the bottom panel, real GDP is projected to rise at a 3¾ percent rate, on average, over the projection period, about half a percentage point faster than our estimate of potential GDP growth. Spending on private consumption and fixed investment (line 2) is the main contributor to GDP growth, although some of the growth in that demand is expected to be satisfied by foreign producers (line 3). Domestic production is also boosted by export demand and government purchases (lines 4 and 5), while inventory investment is roughly neutral. Exhibit 3 examines the forces that we think will be working to produce two more years of above-potential growth. Monetary policy continues to be an important factor. As shown in the middle left panel, even with the assumed policy tightening over the next two years, the real funds rate is projected to remain below its long-run average and on the stimulative side of the short-run measures of r* shown in the Bluebook. February 1-2, 2005 70 of 177 As I noted earlier, after the rapid run-up last year, we expect oil prices to drift down over the next two years, which should be a small plus for domestic spending power and GDP growth. Turning to the final bullet in the upper panel, we estimate that the higher oil prices in 2004 reduced GDP growth by three-fourths of a percentage point last year. In our forecast, the negative effects wane to a quarter of a percentage point in 2005 as oil prices begin to recede; the projected decline in oil prices then boosts GDP growth a couple of tenths in 2006. Exhibit 4 focuses on the household sector. Consumption outlays (the blue bars in the upper left panel) grow at a 3¾ percent rate this year and next, a shade less than in 2004. We expect income growth (the red bars) to step up as the labor market strengthens. Moreover, household financial positions—as summarized by the financial obligations ratio, to the right—seem solid. However, the downdrift in household net worth relative to income that we project in the baseline forecast, and depicted by the black line in the middle left panel, imparts a slight drag on spending. In addition, the strength of consumer spending last year pushed the saving rate (not shown) to an unusually low level, and, as a consequence, consumer spending also is expected to be restrained a bit during the forecast period by a desire on the part of households to rebuild savings. One risk to the forecast that we discussed in the Greenbook is the possibility of a real estate slump. In the Greenbook alternative simulation, depicted by the red line in the middle right panel, we assumed that house prices fall a little more than 10 percent cumulatively over the next two years, leaving the level 20 percent below the baseline. Such an outcome, especially if accompanied by a drop in consumer confidence, would restrain PCE and GDP growth appreciably over the next two years. But, even with the implied loss of household wealth, the ratio of net worth to income that comes out of the alternative simulation (the red line in the middle left panel) is still quite high by historical standards. Accordingly, we don’t see this scenario as causing a serious debilitation of household sector financial health, on the whole. In the housing market, the lower panels, annual single-family starts are projected to remain close to the 1.6 million unit mark over the next two years. Favorable mortgage rates are expected to provide ongoing support to housing activity in our forecast. And, as with consumer spending, solid income gains also support housing demand. February 1-2, 2005 71 of 177 longer-run average. Demand is supported, in part, by a shrinking margin of unused capacity over the next two years, as depicted in the panel to the right. However, as shown in the middle left panel, the rate of return on capital is projected to ebb over the next two years, which tempers our forecast slightly. We interpret the results of the special questions on capital spending asked by the staffs at the Reserve Banks—summarized in the table to the right—as being broadly consistent with our view that this will be a pretty good year, on balance, for business equipment investment, although probably not quite as brisk as in 2004. The usual accelerator effects were the primary reason given by survey respondents for boosting capital spending this year; additionally, a sizable fraction of respondents pointed to replacement needs as an important consideration. The remainder of the chart highlights two of the risks to the forecast for equipment spending. An upside risk that we highlighted in the Greenbook is the possibility that we have been wrong about the effects of partial expensing. If so, the alternative simulation of FRB/US, shown by the blue bars in the lower left panel, suggests that equipment and software spending could increase considerably faster than in the baseline. One downside risk to the forecast for high-tech equipment, which Governor Ferguson noted in a speech recently, is the possibility that the pace of technical advancement in computers is slowing. As you know, the speed at which quality- adjusted computer prices fall is a rough indicator of the pace of technological progress for that equipment. The constant-quality price index for desktop computers that we use for constructing industrial production is shown in the lower right panel. The price declines are decomposed into declines that we attribute to improvements in production processes—for example, Michael Dell figuring out better ways to assemble boxes—and the price declines that we attribute to technological improvements—for instance, Intel designing better chips to go inside the boxes. As you can see from the red portion of the bars, this decomposition suggests that the rate of technological improvement for computers has slowed appreciably. A further slowing in the pace of innovation going forward would imply less spending for upgrades than is implicit in our forecast. However, recent announcements by Intel and AMD regarding introduction schedules for their next-generation chips give a hint that a return to a faster pace of technological improvements may be in train. If this speed-up in planned improvements to semiconductors is, in fact, realized, that should translate into faster technological progress for computers. Sandy will now continue our presentation. February 1-2, 2005 72 of 177 job creation last year. Businesses reportedly have become convinced that the economic expansion is on a solid footing, and we are anticipating that they will be hiring more aggressively. That said, we do not think firms are abandoning their focus on boosting efficiency. As shown in the upper right panel, we expect structural labor productivity to continue to rise at a brisk pace over the forecast period, albeit below that experienced from 2001 to 2003. Given our investment forecast, we expect a rising contribution from capital deepening (the blue shaded area), while the rate of multifactor productivity [MFP] growth slows from the extraordinary pace witnessed in recent years. We think a good part of the 2001-2003 acceleration reflected one­ time changes in the level of productivity, as firms implemented managerial and organizational changes, rather than a speed-up in the underlying rate of technological progress. Such organizational changes are expected to diminish in importance as the upswing proceeds, and we are forecasting structural MFP growth to move back towards its longer-run average. With this slightly slower rate of structural productivity growth and the pickup in hiring, we are projecting the level of actual labor productivity (the black line in the middle left panel) to move back into line with the level of structural productivity by the end of next year. We also are anticipating that the more favorable labor market conditions will begin to attract workers back into the labor force. As shown in the middle right panel, the labor force participation rate is projected to move up over the projection period after the large declines of recent years. However, the progress here is only modest, and the participation rate remains below its estimated trend. The combination of above-trend economic growth and rising participation rates is sufficient in our forecast to keep the unemployment rate (shown in the lower left panel) on a gradual downtrend, reaching 5 percent—our estimate of the NAIRU—by the end of next year. The ratio of employment to population—a measure of slack that combines movements in both the unemployment rate and the labor force participation rate—increases slightly over the projection period. February 1-2, 2005 73 of 177 middle left) have drifted upward slightly in response to the increases in energy prices, and we expect this to be reflected in wage demands this year. In addition, the lagged effects of the acceleration in structural labor productivity also should result in somewhat larger gains in compensation. Moreover, the depressing effect of labor market slack (shown in the middle right panel) is projected to diminish over the projection period. These forces are manifest in our projection of a somewhat faster rate of increase in the growth of wages (shown on the lower left), but this is offset by slower growth in benefits. This slowdown reflects smaller increases in employer contributions to retirement and saving plans, after these payments surged in 2004. Your next chart reviews recent price developments. As shown in the upper left panel, the 12-month change in consumer prices moved up sharply last year, mainly in response to higher energy prices (shown in the upper right panel). As you know, higher world crude oil prices and supply-driven fluctuations in domestic refining margins were responsible for the swings. Increases in food prices (the middle left panel) were relatively stable. As indicated in the middle right panel, the rate of increase in core consumer prices moved up to about a 1½ percent rate in early 2004 and held at about that pace for the remainder of the year. As indicated in the table on the lower left, all of this acceleration occurred in goods prices, where, in addition to a large, idiosyncratic swing in used cars, price increases were broad- based. In our view, the underlying acceleration in goods prices reflects the run-up in intermediate materials prices shown on the right, the pass-through to the retail level of higher energy costs, and the weaker foreign exchange value of the dollar. Your next chart presents the outlook for inflation. The rate of increase in total PCE prices (shown on the upper left) is expected to slow to a 1¼ percent pace in 2005 and 2006. Energy prices (shown on the upper right) are expected to retrace part of last year’s run-up over the projection period, while the rate of increase in food prices (not shown) slows by about ¾ percentage point. Core inflation (shown on the middle left) is projected to remain at a 1½ percent rate. This projected stability of core inflation reflects several offsetting factors. The slower pace of structural labor productivity is expected to result in somewhat faster growth in trend unit labor costs, and the declining margin of slack in labor and product markets is projected to exert less downward pressure on wages and prices. Offsetting these influences, the rate of increase in core, nonfuel import prices (shown on the middle right) is forecasted to fall back to zero in 2006, and the indirect effects of lower energy prices are expected to put downward pressure on retail prices. February 1-2, 2005 74 of 177 markup (shown on the lower left) at its present level. Under these circumstances, core PCE inflation (shown as the red line in the lower right panel) rises to almost 2½ percent in 2006. In the lower-inflation alternative, we assume that the rate of increase in structural multifactor productivity growth does not slow as in the baseline forecast but holds at a 2¼ percent rate over the 2004-2006 period. In implementing this simulation, we have assumed that financial markets have already incorporated this expectation, and thus there is no additional effect on asset prices. With the faster rate of structural MFP growth boosting aggregate supply, core PCE inflation slows to 1 percent in 2006. Karen Johnson will now continue our presentation." FOMC20050809meeting--155 153,MR. HOENIG.," Mr. Chairman, let me start with some thoughts on the national economy. I do expect growth in real GDP to average about 3¾ percent this year and 3½ percent next year. While this is somewhat slower than last year, it remains above trend. And the monetary policy and financial conditions currently in place I think are poised to support continued above-trend growth. With growth above trend, the output gap and labor market slack will further diminish. In fact, the economy appears to be at or near full employment now, which is all the more reason to have the federal funds rate above its current level. I’d like to turn for a bit to developments in our region, because the evidence from the Tenth District is consistent with this strong outlook. For example, economic growth has strengthened rather noticeably since our last meeting. Employment continued to expand, and in the intermeeting period businesses announced substantially more new hires than layoffs in our August 9, 2005 58 of 110 rebounded, and tourist activity showed no effect that we could notice from higher gasoline prices. In addition, energy held steady in terms of high levels of demand. Drilling has slowed in the mature oil and gas fields of Oklahoma but has continued to grow strongly in newer fields in the Rocky Mountain region. Drilling in those areas continued to be constrained by a shortage of equipment and labor. As a result—and I’ll repeat what Richard said—one Denver-based energy company has ordered two Chinese rigs and rig crews for delivery this fall as well as several additional rigs for the coming couple of years. While manufacturing activity expanded at a slower pace than in the spring, most firms are optimistic about future sales and plan more hiring and investment to meet the increased demand. A wide range of District businesses also reported sharply improved earnings due to strong revenue growth systematically in our region. The only negative news on this level was that commercial real estate markets continued to show only modest improvement and that inventories of unsold homes were up noticeably in some of our cities. I think it is worth noting that a sizable area of extreme drought has developed throughout the central Corn Belt states. The drought affects much of Missouri and Illinois and parts of Wisconsin and Indiana. Markets currently expect the nation’s corn crop to drop 10 percent and the soybean crop to drop 4 percent. As a result, corn and soybean prices have both risen about 13 percent since their planting. The USDA crop report that will come out later this week, on August 12th, could trigger a further rally in prices if drought damage is greater than the market currently expects. Turning to inflation, I think it is worth noting that core PCE inflation, as we discussed August 9, 2005 59 of 110 at that pace next year. While we continue to talk about this as being moderate, I think it is important to recognize that it represents a continued upward adjustment of the inflation outlook and is at the higher end of what most of us have indicated we are comfortable with. I also remain concerned about the upward pressure on inflation. First, there is an upside risk from higher energy prices and dollar depreciation. In addition, the real fed funds rate, using the core PCE inflation, is only 1.2 percent. These factors, I think, pose an upside risk to inflation, especially when combined with growth that remains above trend and an output gap that is small and approaching zero. I believe we are now at a point where the upside risk to the economy is greater than the downside risk. And while we appear committed to moving only 25 basis points today, and I think the market would be surprised if we did otherwise, we ought to at least seriously consider eliminating any reference to “measured pace” in our statement. To me it was noticeable in listening to David today that, as we talk about the economy, potential is less than we expected, demand is greater than expected, inflation is greater than we anticipated, and monetary policy is probably 100 basis points below what most people think it should be. In my view, it’s time to think about changing our statement. Thank you." FOMC20050630meeting--315 313,MS. JOHNSON.," One issue is the fact that some of these countries subsidize. That is, the price run-up to date has been passed through only partially to consumer demand in many of the emerging Asia countries. And as a consequence, some of these governments have had a big hit to their budget deficits because of these subsidies. Now, if you think about 2004 versus 2005, the run-up in oil prices last year proved to be a transitory phenomenon, and I think they believe that that policy worked well. They buffered their populations a bit, and they didn’t take the political heat about higher oil prices. And they were right; the oil price came down and all was well. They tried it again this year, and they are now confronting these high futures prices that Mike was emphasizing. So some of them are now relenting and are proposing to pass through into consumer prices, over some staggered path, the price increases that we’ve seen. I would assume that will have a measurable effect." FOMC20070628meeting--117 115,MR. HOENIG.," Thank you. I will spend just a couple of minutes extra on the District this time because, generally speaking, our District economy continues to perform very well despite the weakness in the housing sector. Energy and agriculture remain very strong, and manufacturing remains generally strong although we have seen some leveling-off of that in the past month. The strength in these three sectors has helped spur broad-based job growth throughout the District and a significant tightening of our labor markets and their conditions. Many of our contacts report labor shortages and higher wage pressures. Demand for skilled labor remains very strong, and some firms have limited hiring plans because of the unavailability of qualified workers. To bolster recruiting, a few companies have partnered with vocational schools to offer industry- specific training programs to try to fill the gap. Since our last meeting, hiring announcements, which we try to track, have outpaced layoff announcements by a margin of 6 to 1. One anecdotal piece of information—we have some fairly large engineering firms in Kansas City that build power plants globally, including in China, and also ethanol plants. Last year, one CEO told me that they hired 2,100 engineers and were unable to fill 900 positions on a global basis. So there is a lot of activity going on out there. Construction activity remains mixed, with weakness in residential construction balanced by strength in commercial construction. On the residential side, we have seen some pickup in sales, but high inventories have limited new construction. For us, problems with subprime loans are concentrated in Colorado and in a few other areas. But because of the strength in energy and agriculture, some parts of the region are actually experiencing a housing boom, with strong home-price appreciation. Relative to the total market, that is small, but it is a rather sharp contrast. Conditions in agriculture are the best in recent years. Spring rains have alleviated drought conditions in much of our region. Strong demand and limited supplies continue to boost farm commodity prices and farm incomes. However, we are also beginning to see the effects of higher livestock and crop prices on retail food prices themselves. An additional concern is the sharp rise in land prices throughout much of our District. First-quarter cropland values in the District rose roughly 12 percent above year-ago levels, and ranchland values have strengthened as well, that much or perhaps a little more. Our contacts in the real estate industry indicate that some of the recent surge in land prices is speculative in nature, and some District bankers have expressed concern about the bubble in farmland values driven in part by the ethanol boom that we have heard about. In recent examination reports, our supervision staff have begun to see some increases in nonperforming real estate loans, and that includes some pickup in other real estate owned as well. These developments are very preliminary, but they are reminiscent of an earlier time, and we are trying to pay a little more attention to that. On the national outlook, data released since the last meeting support the view that growth will pick up over the year. I have been encouraged by the recent pickup in retail sales and by positive news on employment and personal income. At the same time, the recent increase in longer-term interest rates, if sustained, is likely to damp growth somewhat in the period ahead. In particular, the rise in the thirty-year fixed mortgage rate may deepen and prolong the ongoing housing slump. The combined effects of weaker growth in the first quarter and the rise of long-term rates have led me to lower my estimate of growth in 2007 to about 2.3 percent. I expect growth of 2.7 in ’08 and 2.8 in ’09. I now think the risks, perhaps, are roughly balanced. While the downside risk from housing remains, the outlook for other sectors, as others have reported, has appeared to improve. Markets seem to have adopted this view as well, as removal of the expected policy easing has contributed to the flattening of the yield curve at this point. In terms of the inflation outlook, recent data have been favorable, with core CPI on a twelve-month basis down to 2¼ percent. I expect continued moderation over the year. In particular, if owners’ equivalent rent continues at the slower pace of the past three months, it will help bring down the twelve-month core inflation number over time. Despite these recent improvements, I continue to believe that upside risks to inflation remain. The possible pass-through of recent energy and food price inflation to core inflation may slow progress toward lower inflation. In addition, pressures from resource utilization and slow productivity growth, if that happens to be the case, could affect that outlook as well. Finally, I am somewhat concerned with the recent uptick in longer-term inflation expectations. We have talked about the TIPS five-year, five-year-ahead breakeven inflation rate; as mentioned in the earlier briefing, it has increased about 20 basis points over the past month. So in light of these factors, I believe it is important that we continue to signal to the markets that current inflation rates are not acceptable over the longer term. Thank you." FOMC20060328meeting--146 144,MR. KOHN.," Thank you, Mr. Chairman. Since the last meeting, as many of us have remarked, we have seen stronger domestic demand and a little less core inflation than expected. To a degree, this extends a pattern. In looking at the Greenbook chart on the evolution of the staff forecast, I was struck by the steady upward drift since last fall of projected growth in 2006 and 2007, coupled with flat to downward movement in projected inflation for those years. Now, much of the 2006 growth was shifted from 2005, but the unemployment rate at the end of this year and next is lower than it was projected last fall—without any more, and maybe even a little less, price pressure projected. One possibility is that we are seeing a smaller effect from higher energy prices than anticipated, at least on inflation and perhaps on demand as well. Since we expected the effect of energy prices on growth rates of output and core prices to be temporary in any case, this sort of information should not deflect us from our underlying view that growth is in the process of slowing to trend, holding underlying inflation roughly stable. The cooling of the housing market is the main impetus for a slight moderation in growth. In this regard, although the incoming data on housing have been distorted by unusual weather and subject to considerable noise, I judge them on balance to lend added support to the sense that activity and price increases are softening, albeit to an unknown extent. I agree with President Stern that an orderly cooling of these markets with moderate effects on growth is the most likely outcome, but we just do not know yet. Rising inventories, declining new home sales, downward movement in building permits, and a drop in mortgage applications—all point to an appreciable drop-off in the demand for housing. In the staff forecast, residential construction flattens out this year and next, after contributing nearly half a point to GDP growth last year. Logically, softer demand should also be reflected in prices. Unfortunately, data for prices are even harder to read than those for activity, but the recent monthly information on existing and new home prices seems consistent with the March slowdown in the rate of increase of these prices, which should feed through to wealth and consumption. And we probably haven’t seen the full effect of the rise in short-term interest rates on housing demand, particularly for those who are liquidity or income constrained. Mortgage rates have also picked up somewhat this year, and they are at the upper end of the range they have been in for the past several years. So we could see some of the long-term mortgage rate effects as well. It is possible, of course, that the damping influence of the housing market could be offset by greater strength elsewhere, and two logical contenders are exports sparked by stronger growth abroad and business investment. We have seen another in the series of upward revisions to foreign growth in the current Greenbook, but we have also seen greater tightening of monetary policy get built into financial markets, offsetting some of the increase in the strength of demand abroad. Moreover, the dollar has risen on balance, reducing the feed-through of higher demand abroad to purchases from U.S. producers. Business investment looks robust, albeit a little less so after Friday’s data on orders and shipments. If housing takes something out of consumption, however, prospective sales growth will not be quite so strong, and this will constrain the increase in investment demand. So, on balance, I see a moderation of growth to around the rate of increase in potential as a reasonable expectation, given the structure of interest rates built into markets. The key question is whether such a path for output will be consistent with low, stable inflation. I think we can be encouraged by the recent data on prices and compensation. Core consumer and inflation measures have been flat or declining on a twelve-month basis over the last six months or so, despite the uptrend in energy prices. And inflation expectations have remained quite stable on balance. Compensation measures are a bit more mixed. The broadest measures, ECI and total compensation, have not picked up despite the erosion of purchasing power implied by higher energy prices and despite good trend productivity growth. In this regard, Mr. Chairman, we do see an increase in average hourly earnings of nonsupervisory workers. Maybe we are beginning to see some of this feed-through to workers on the lower end of those wages. But, overall, I think compensation growth has been very well behaved. To be sure, we have not yet seen the effects of the recent increases in resource utilization, decline in the unemployment rate, or rise in capacity utilization—and these feed through to inflation pressures with pretty long lives. Given the flatness of the Phillips curve, it could take some time to perceive the inflationary effects if, indeed, the economy is operating beyond its sustainable potential. Moreover, the staff is looking for a notable pickup in compensation. The unit labor costs this year and next are partly absorbed by smaller markups. At this point, however, given the recent data, I would judge these potential developments to weigh on the side of upside risks to inflation rather than tilting the most likely outcome. Both compensation and price increases have fallen short of model projections in recent quarters. While the less-than-expected effects of energy prices could explain this more favorable relationship of output and inflation, we can’t reject the hypothesis that we are seeing something more fundamental developing, especially on the supply side of the economy. Recent data suggest it is not an unexpected increase in productivity. Some combination of the lower NAIRU and the anchored inflation expectations alternative simulations in the Greenbook or other factors could be holding down wages and prices. It is far too soon to say whether anything is going on or to tease out the policy implications, but we would do well to remember just how wide those confidence intervals are, how little we know about price and output determination, and especially how little we know about the level and growth rate of potential GDP. Thank you, Mr. Chairman." FOMC20080318meeting--61 59,MR. EVANS.," Thank you, Mr. Chairman. Clearly, the incoming data on activity have been weaker than we expected. I think they point to a downturn in GDP in the first half of the year similar to that in the Greenbook. While the February CPI report was welcome news, on balance I think the inflation picture continues to be troubling. I noticed a marked change in the sentiment of my business contacts this round. Many more are now telling me that the problems on Wall Street are affecting their financing. Credit availability is now an issue. With regard to borrowing from banks, these reports seem consistent with the Senior Loan Officer Opinion Survey. Credit is an issue for those tapping nonbank sources as well, as in the comments that President Yellen made. As an example, back in December a major shopping center developer indicated that, even though the commercial-mortgage-backed security market had dried up, he was still able to obtain financing on reasonable terms from other sources, such as life insurance companies. Last week he told me that these sources had dried up, too. He's now trying to raise equity funding, which he considers very costly and an unappealing alternative. Many contacts also expressed increased nervousness over the economic situation and its likely impact on demand for their products. Manpower's CEO told me that their business had deteriorated in recent weeks. Some of his clients were trimming staff because of a lower current demand, and many others were being cautious and cutting back in expectation of future weakening. Still, even though restrictive financing and heightened caution are weighing on households and businesses, there is a sense from my contacts that spending is not collapsing at this point, and exports of capital equipment in the agricultural sector continue to do well, similar to President Hoenig's comments. Another common theme I heard from my contacts is that, while the Fed's innovative response has helped, they do not expect that these measures will do a lot to solve the financial sector's fundamental problems. I doubt that any of us disagree with that. As one of my directors put it, ""Monetary policy is not enough. We need a solution to the subprime mess. Once that happens, the contagion will run in reverse."" I believe our innovative policies are helpful for facilitating market functioning, but they don't address the root problem. Markets want a firmer sense of where prices for stressed assets will bottom out and of the magnitude of the portfolio losses that will be taken by major financial players. Unfortunately, it will take a good deal of time before these uncertainties will be resolved, and I'm not sure what we can do to speed the process. After all, a number of these losses are going to stem from mortgage delinquencies that have not yet occurred and perhaps from homeowners who have not even contemplated that outcome. This means that financial headwinds likely will be weighing on the real economy for some time, as President Stern said. I agree with his comments there. The substantial uncertainty over the length and breadth of this process adds uncertainty to the medium-term outlook for growth. So while I am hopeful that the economy will begin to recover in the second half of the year, I'm a lot less confident of that outcome than I'd like to be. Turning to inflation, Friday's CPI report was about the only good news I heard during the intermeeting period (I think last time the reports weren't very good either, President Yellen), although as the Greenbook Supplement points out, the less favorable translation to PCE prices takes out some of the luster. It's no surprise that many of my contacts pointed to increasing pressures from higher costs for food, energy, and other commodity inputs. I also heard numerous reports of higher costs being passed downstream. One notable case was for wallboard. Even though demand is weak and the industry had plenty of excess capacity, higher costs for energy inputs were resulting in the first increase in wallboard prices in 20 months. The director who reported this was concerned that pricing behavior is moving toward a cost-plus mentality. This is, after all, his industry. If so, this would have negative implications for inflation expectations. However, I see this as a risk and not a base case scenario because the resource gaps opening up in the economy should bring inflation down. Firms will find it difficult to pass through cost increases in an environment of weak demand. Businesses and financial market participants will be aware of this difficulty in passing through costs, which should help keep down their inflation expectations. That said, even in a weak economy, firms will have only so much room to absorb costs, and pressures from higher prices for energy and other commodities and for imported goods pose a risk to the outlook. In addition, while I expect inflation expectations to be contained, there are risks on this front, too. Some can see a low fed funds rate path, such as that assumed by the Greenbook, as an indication of a lack of resolve on inflation. I don't agree with that assessment, but it's an increasing risk that we will be running, particularly if the inflation news breaks in the wrong way. Thank you, Mr. Chairman. " FOMC20050322meeting--107 105,MS. MINEHAN.," Thank you, Mr. Chairman. Economic activity seems definitely on the upswing in New England. As we discussed conditions with our Beige Book contacts, met with our small business advisory group, and talked in some depth with local temporary-help agencies and software developers—as we did our usual round of contacts—the themes of solid growth and increasing confidence were repeated with some frequency. Manufacturers, especially those that have some defense business, report very good sales, and, at least in the case of one large manufacturer, an inability to keep up with demand. Labor markets have strengthened as well, and benchmark revisions to employment data indicate that 2004 was a better period for job growth in New England than previously thought. Temporary help agencies report good demand for labor, and help-wanted is stronger, as judged by both traditional measures and the indexed data on the region that are available from Monster.com. Housing remains strong, though we don’t see much sign of speculation and there is some softness at the upper end of the price range. Retail business is reported to be good, and both business and consumer confidence has increased. Contacts in the regional economy appear to be moving from a focus on concerns about March 22, 2005 45 of 116 of small businesses in the period since our February meeting, and they almost uniformly report rising costs of raw materials and labor that are starting to impact their prices. In a growing number of cases, these firms have been able to make price increases stick, even to big buyers like Wal-Mart, though, largely, the price increases have been in the form of surcharges. Skilled workers are becoming difficult to find. Businesses report that they’re in a hiring mode and have to pay up to get the people they need. Some companies have begun to hire in advance of need, simply to have a pool of available workers. Capital spending plans seem quite solid, and now there is a mixture of firms spending not only to further increase productivity but also to expand to handle increased business. Two areas of concern emerged beyond those related to rising costs. The first involves tourism in northern New England. Evidently, while this was a snowy year in the southern part of our region, the northern areas have suffered from both too little snow and the timing of storms, which created weekend travel problems. The second is a continued sluggishness in commercial real estate markets. Given the number of large mergers affecting the region, both in the financial services industry and elsewhere, and the reduction of headquarters staff that has resulted, commercial vacancy rates remain high and rents low—especially in downtown and suburban Boston. I should say the rents are relatively low, since Boston rents tend to be high anyway. This has not, however, seemed to put much of a crimp in the market for purchasing commercial buildings, which continues to be quite strong. Turning to the national scene, I’ve been struck by the strength of the incoming economic data, as has everyone else. We in Boston have adjusted our forecast upward, especially in the near March 22, 2005 46 of 116 Greenbook over the forecast horizon, though our calculations suggest some greater economic capacity and less downward pressure on the unemployment rate. However, there is not a lot to argue about here, given the continuing upside surprises in overall economic growth and in price pressures. Indeed, it seems clear to me that the underlying rationale we have used in moving policy slowly and gradually to a less accommodative place is becoming questionable. Unlike last year when growth seemed fragile and uncertain, economic growth now seems solid and resilient and in less need of policy accommodation. Overall credit and financial conditions are supportive, if not encouraging, to spending and growth. Business investment is not taking a breather with the ending of the tax incentive, and consumers aren’t either, except in their post-holiday purchases of autos. Surely it is possible to see downside risks from a rise in the saving rate, from an untoward increase in oil prices that impacts demand, or from an impact arising out of the external deficit. But I think it’s even easier to imagine upside inflation surprises as rising energy, raw material, import, and labor costs get embedded into economic activity. In that regard, I found the Greenbook alternatives focused on a spending boom and on a boom with rising inflation expectations very interesting. I should also note that while my admiration for the FRB/US model is enormous, I think it’s difficult for any model to correctly anticipate the full interplay of economic factors once the unexpected happens. The baseline, I think, is still pretty much a good, solid forecast. Continued solid productivity growth will keep nascent cost pressures and inflation expectations under control. However, the risks that this will not happen seem to me to have grown and to have become a bit more one-sided. That is, I think we need to be more focused on the risks that rising cost pressures will get out of hand. March 22, 2005 47 of 116 case could be made for moving faster rather than slower toward that so-called neutral place. Taking larger steps now would have the benefit of affecting market attitudes toward risk in a positive way, largely because it is not what markets expect us to do. That option has some attraction to me. But it could be too much of a surprise and indicate too much concern about future prospects than perhaps is necessary. However, we could take advantage of this point in time by preparing the markets for greater policy flexibility. That is, we could change the language of the announcement by following the Chairman’s example in taking out the reference to a measured pace. In my view, anyway, that would have two benefits. It would continue the process of removing policy accommodation, and it would focus markets better on the uncertainties of the future." FOMC20050630meeting--280 278,MR. WILCOX.," No, that’s correct. In terms of the factors contributing to the deceleration in core PCE price inflation between 2005 and 2006, what I’ve shown here—energy prices, import prices, and these other relative prices that I’ve chosen to proxy by the intermediate materials prices—are taking off somewhere between ¼ and ½ percentage point from core PCE inflation, in June 29-30, 2005 95 of 234 gotten built into the structure of inflation a bit. Whether one labels that “inflation expectations” or “inflation momentum,” it is awfully hard to disentangle. As for productivity, we think that it’s mainly structural productivity that matters for firms’ pricing decisions, not fluctuations in actual quarter-by-quarter productivity. So we have that as essentially a neutral influence on inflation over the projection period. The fact that we tie pricing decisions to structural productivity developments rather than actual productivity may be what is colliding with your intuition." CHRG-110shrg50369--55 Mr. Bernanke," Senator, one thing that is certainly true is that a lot of the big house price declines are taking place in high-priced areas like California and Florida, Nevada, Arizona, where prices went up a lot before, and now they are coming back down. Senator Bennett. That is the price range that it is hitting in Utah as well. Thank you, Mr. Chairman. " FOMC20080625meeting--31 29,MR. WASCHER.," Exhibit 10 reviews our assumptions about aggregate supply. As you can see from the first two rows of the table at the top, we now assume that potential output growth will hold steady at about 2� percent per year over the forecast period, about � percentage point per year higher from 2007 to 2009 than we had assumed in the April Greenbook. This upward revision is split roughly equally between structural productivity growth (lines 3 and 4) and trend hours (lines 5 and 6). The middle two panels provide the reasoning for our change. The left panel shows the difference between actual productivity growth (the black line) and a simulation from our standard model (the green line) using the pace of structural productivity growth that we had assumed in April. As you can see, labor productivity growth in recent quarters has been stronger than the model would have expected given the deceleration in economic activity. As shown in the inset box, a purely statistical model based on a Kalman filter would have responded to the recent data by raising its estimate of structural productivity growth 0.2 percentage point. Because we place less weight on data that have not yet been through an annual revision, we generally tend to revise our own estimate by less than the amount suggested by such models; moreover, the Kalman filter model does not take into account the steep rise in energy prices, which we think might subtract a bit from structural productivity growth in coming years. Nevertheless, we did think it appropriate to nudge up our productivity growth trend a little. The green line in the middle right panel shows a similar model simulation for the labor force participation rate, again using our previously estimated trend. Here, too, the incoming data have been a little higher than the model would have expected. One can think of potential explanations for this--for example, it may be that strains on household budgets associated with rising costs of food and energy have increased labor force participation among secondary earners, an influence not captured by the model. We are not ready to back away from our basic story that demographics will continue to put downward pressure on the participation rate over time, but we did slightly raise our assumed trend in response to the recent data. The key elements of the labor market forecast are shown in the bottom panels. As indicated to the left, nonfarm payroll employment (the black line) is projected to decline about 40,000 per month through the rest of this year. As the economy improves in 2009, we expect payrolls to start rising again, although at a pace below our estimate of trend employment growth (the green line) for most of the year. As shown in the inset box in the bottom right panel, we expect the unemployment rate to drop back in June from its suspiciously high May reading, which would leave the average jobless rate in the second quarter at 5.3 percent. However, with employment declines projected to continue for a while longer, we expect the unemployment rate to drift up to 5.7 percent by early next year and remain near that level through the end of 2009. Exhibit 11 presents the near-term inflation outlook. As you can see in the top left panel, the recent data on consumer prices have come in a little lower than we had expected at the time of the April Greenbook. As shown on line 3, core PCE prices rose only 0.1 percent in April, and based on the latest CPI and PPI readings, we expect an increase of 0.2 percent in May. As a result, we have marked down our estimate of core PCE inflation in the second quarter by 0.3 percentage point, to an annual rate of 2 percent. Total PCE prices (line 1) have risen at a substantially faster pace than core prices; but here, too, the current-quarter forecast is a little lower than in our previous projection, both because of the lower core inflation and because the sharp increases in oil prices have been slow to feed through to finished energy prices. Despite this recent news, we expect inflation to rise sharply over the next few months. In part, this reflects our judgment that core prices were held down in the first half by some factors that will not persist into the second half. In addition, as shown to the right, we expect increases in food and energy prices to push up the twelve-month change in the total PCE price index more than 1 percentage point over the next several months, to about 4� percent. The remaining panels of the exhibit focus on the projection for energy and food prices. As shown by the black line in the middle left panel, rising crude oil prices have pushed up retail gasoline prices sharply so far this year. Even so, margins are still relatively low, and we expect further sizable increases in pump prices in coming months. Spot prices for natural gas (the red line) have also risen noticeably, reflecting its substitutability with crude oil. Meanwhile, prices for crops, plotted in black at the right, have moved well above the levels at the time of the April Greenbook, mainly in response to the severe flooding in the Midwest. The higher prices for grains have also pushed up livestock prices (the blue line), although recent increases in supply have tempered this rise somewhat. In both cases, futures prices indicate that market participants expect these prices to flatten out at about their current levels. The bottom two panels show our forecast for overall consumer food and energy prices. Based on current futures prices, we expect energy price inflation to move yet higher next quarter before slowing to a pace close to zero in 2009. We expect food prices to show a similar--albeit less pronounced--pattern, with the fourquarter change peaking at about 5 percent this quarter and then decelerating to a pace of 2� percent next year. The upper panels of your next exhibit examine the implications of the recent increases in energy and other commodity prices for core inflation. The first thing to note is that these increases are showing through to producers' costs. As indicated in the top left panel, the producer price index for core intermediate materials (the black line) has accelerated yet again and was up more than 7 percent over the past twelve months, with especially large increases for metal products and energy-intensive materials. Likewise, the diffusion index for prices paid from the Institute for Supply Management's manufacturing survey (the red line) has climbed steadily since late last year. As Nathan noted, rising commodity prices have been an important source of the sizable increases in import prices shown to the right. In addition, higher energy prices have boosted the costs of shipping goods from manufacturers to wholesalers and retailers. As you can see in the middle left panel, the PPIs for both trucking and rail transport have accelerated sharply over the past year or so. Obviously, a key question is the extent to which these higher costs will be passed through to core consumer prices. The panel to the right provides rough estimates of the size of these pass-throughs from our suite of econometric models, with the effect of energy prices on core PCE inflation shown by the blue bars and the combined effects of import prices and other commodity prices indicated by the red bars. As you can see, these effects add more than 0.6 percentage point to our forecast of core inflation this year. With energy and import prices expected to decelerate, the contribution of these factors to core inflation steps down to � percentage point next year. In contrast to the evidence of greater cost pressures from commodity prices, we've seen no signs of acceleration in labor costs. The bottom left panel plots the three main measures of labor compensation that we follow. None of them suggests that employers have experienced a step-up in the pace of compensation growth; and given the weaker labor market in our projection, we don't think that workers will do much better over the next year and a half either. Accordingly, we expect the rise in trend unit labor costs, shown in the table to the right, to hold steady at about 2 percent per year over the projection period. In putting together our forecast, we've also had to make some decisions about how to interpret the recent data on inflation expectations--the subject of your final exhibit. As shown in the top left panel, some measures of short-run inflation expectations have jumped sharply in response to the run-up in energy and food prices this year. In particular, the Reuters-Michigan measure of one-year-ahead expectations (the blue line) rose above 5 percent in May and remained high in the preliminary June survey. Meanwhile, as shown to the right, indicators of long-run inflation expectations have ranged from roughly unchanged to higher since late April. As I already noted, the recent compensation data do not suggest that higher inflation expectations have started to push up wage increases. However, on balance, we view the data as consistent with a slight updrift in the underlying long-run inflation expectations that drive actual inflation, and we have carried this updrift into the projection period. All told, we expect core PCE inflation (line 3 of the middle left table) to step up to a 2� percent annual rate in the second half of this year, pushed up by the effects of higher input costs and the increase in inflation expectations. In 2009, core inflation is projected to step back down to 2� percent, as the effects of decelerating energy and import prices and a wider unemployment gap offset a small further updrift in expected inflation. We have taken only a small signal from the apparent deterioration in expected inflation, but we view the possibility that inflation expectations will become unmoored in response to the persistently high rate of headline inflation as a risk to our forecast. Accordingly, as indicated in the box to the right, we included in the Greenbook an alternative simulation that assumes that long-run inflation expectations move up � percentage point relative to baseline in the third quarter. Consistent with our usual practice, monetary policy in this simulation is assumed to respond according to the estimated Taylor rule. Both wages and prices are affected by these higher inflation expectations, and as you can see by the green line in the middle panel at the bottom, core inflation rises to 2.6 percent in 2009, almost � percentage point higher than baseline. Monetary policy responds in this simulation by raising the federal funds rate more than in the baseline forecast. As a result of this additional tightening, the unemployment rate declines a bit more slowly, and core inflation moderates to about 2� percent in 2012. Brian will now continue the presentation. " CHRG-110shrg50417--126 Mr. Campbell," This is a very fragile market, and, frankly, one of the things that we have to consider is we have a very large inventory of foreclosed and unsold property. And so to potentially throw a curve into this segment of the market where potentially one of the outcomes, the likely outcomes to cramdowns, would be that the markets would--since there is less predictability in the market, it is likely that two things are going to happen; investors are going to require two things to happen to try and offset the uncertainties: one, downpayment sum will probably be increased, and, logically, prices would be increased to try and offset some of the uncertainties that exist by contracts being able to be just crammed down. And so while we have got this inventory and we need to find a way to stimulate the housing market, do we want to put at risk that market by taking that step? is the question I think we all have to step back and carefully and thoughtfully think through. " FOMC20051101meeting--121 119,MS. MINEHAN.," Thank you, Mr. Chairman. Economic conditions in New England have bounced around a little bit over the last year or so. Right now they show a few signs of flattening out. Surveys of both consumer and business confidence show some current strength, but opinions about activity six months from now either remain at a low level in the case of consumers or, for businesses, turned negative for the first time in the last five years. Worries about fuel and benefits costs, interest rate increases, and the war in Iraq are most often mentioned by contacts as shaping a less-than-rosy outlook. And when you talk to them about big profit margins, they look at you with a puzzled expression, wondering what business you are talking about because that’s certainly not the case for their business. I think there’s some difference of opinion when looking at your own numbers versus the numbers in the aggregate. Anyway, for the present, most firms do report profits, with those serving the defense industry making notable headway. Consumers are spending, if not on cars then on housing, though at least according to one survey they perceive rising pressures on their personal finances. And core inflation in the Boston area is surprisingly low relative to the nation. It’s usually higher. Thus, there’s a sense in which the region may be experiencing a period of calm before a possible storm of negative trends. Employment in the region dropped in September, and the unemployment rate rose. The employment decline was widespread by state and involved, in part, the usual suspects of trade and manufacturing, but about half reflected government workers in Maine. September government employment can move around a lot, depending on the hiring of teachers for kindergarten through November 1, 2005 42 of 114 report that skilled labor is hard to find and expensive. There are continuing references to caution in hiring and a desire not to add a single new employee until it’s necessary to do so. Both businesses and consumers are concerned about the impact of high heating oil, natural gas, and gasoline prices. Local heating oil companies that have provided lock-in rates for the winter in the past will not do so now, likely feeding into concerns. Despite many fervent prayers for the opposite, the winter is expected to be a bad one. And that forecast was underlined by the early snowfalls in northern New England a couple weeks ago and by the flurries in Massachusetts over the weekend. Certainly this is good in terms of prospects for skiing revenues, but not so good for general optimism, given concerns about energy. Finally, let me say a word about residential real estate markets. The Boston area is often mentioned as having bubble-like characteristics. This is an obvious concern, given the problems the region experienced with falling prices and related banking failures in the early ’90s. However, there’s good reason to assume that recent rising prices in New England reflect a lack of supply and an older, wealthier population capable of supporting both a primary and a secondary residence, rather than a fundamentally unstable situation. And some of the froth is fading. Home prices continue to escalate but are currently increasing at about the same pace as in the nation as a whole rather than leading it. Four out of the eight other regions of the country are now experiencing more rapid escalation. Contacts in the real estate industry report two trends. First, there was a rather abrupt softening in the high-end suburban markets this summer, with escalating supply and the advent of a buyer’s market—something not seen in several years. The other trend is an increase in the supply of multifamily units, particularly condominiums, and a marked upturn in condo inventory. Thus, most November 1, 2005 43 of 114 much of the change at the high end. This could feed into some concerns about spending in the future and could certainly make people feel less wealthy. But given where it seems to be centered, it doesn’t appear likely to do a lot of near-term damage. Turning to the national scene, incoming data appear to confirm the underlying strength of the U.S. economy. Separating out the impact of several hurricanes is not easy. Readings on unemployment and business spending net of hurricane effects seem consistent with the continuation of solid growth through the remainder of 2005. The strength of consumer outlays remains a question, given the now 2-month downturn in confidence and the fact that the outsized motor vehicle purchases that had supported such outlays in the third quarter are falling off their highs. However, labor market data seem consistent with continued strength in hiring. One would suppose that, at least in the near term, working consumers will be spending consumers, especially if confidence improves in the face of waning energy prices—or at least prices for gasoline. Finally, I take the continued strength in housing as a sign that, under it all, consumers still have the confidence to make rather long-term investments. Our forecast in Boston for the next year and into ’07 differs little from the Greenbook’s. Assuming energy prices subside, or at a minimum that we don’t have any new shocks, growth should pick up in the spring, as the impact of the energy tax on consumers eases and as rebuilding in hurricane-ravaged areas accelerates. Over the same 6-month or so period through the winter into spring, low inventory levels are likely to be replenished, feeding factory activity. Growth outside the United States is, on balance, expected to be positive as well. Employment growth should return to its pre-Katrina monthly pace, and the remaining slack in the U.S. economy should wane. The post-Katrina “throw money at it” attitude in Washington seems to have moderated, but a fiscal November 1, 2005 44 of 114 The worrisome headline numbers on both the CPI and the PCE moderate; the feed-through to core inflation ticks up but then moderates through the year; and this process pulls in on the upward trajectory of near-term inflation expectations. There are obvious risks here. Energy-based headline inflation could feed more strongly into the core, and inflation expectations could remain elevated. We could see the moderate trends in wage and salary growth, as measured by the ECI, begin to take off. However, I’m hopeful, along the same lines that President Yellen is, that inflation expectations will moderate, as gasoline prices have, and that we won’t see even as big a feed-through to the ECI data as the Greenbook projects. However, if a big rise in wages were to occur, it would set red lights flashing on everybody’s economic dashboard. If we are lucky, our rather benign forecast for the next year will work out. If we’re not, we could be looking at both rising inflation and falling growth, as one of the alternative scenarios highlights. In that regard, we need to pay careful attention to incoming data on expectations, compensation, and core inflation. If they’re blinking yellow or green, we may be on track. If red predominates, the risks have clearly escalated. It certainly seems clear that managing such risks in the near term involves placing a premium on remaining credible regarding inflation. Doing so should moderate price growth by tightening financial conditions and should result in better pricing of risk. It should also convince consumers that inflation will not continue to exacerbate the growing strain on their pocketbooks. It should moderate inflation expectations and limit the feed-through into wage and salary growth. But we also need to take care not to overdo. There are downside risks. With a small amount of additional tightening in the mix, the Greenbook sees growth at below potential in late ’06, a November 1, 2005 45 of 114 slowing in real estate markets and a decline in relative household wealth. The related expected rise in personal saving may be just what the doctor ordered to start the process of reining in the excesses in the U.S. economy, but I think we do need to take care about dispensing excessive amounts of inflation medicine. In my view, we’re not at a tipping point as yet. Our process of measured steps toward removing the remaining accommodation should continue for a time, taking us closer to the middle of the range of equilibrium rates. But we should also begin to consider when we might have moved enough and how we might prepare markets for that. In that regard, I was interested in the proposal that President Yellen had for an evolution in our statement. I think it’s going to take some time to absorb what she has recommended. Maybe this meeting is not the meeting to make a change. I’m probably comfortable with alternative B. A couple of meetings ago, the Chairman suggested that I take on the task—because I was opening my mouth at the time—of putting some proposals on the table, and I’ve been dragging my heels. I’m more than happy to work with President Yellen on the direction she’s trying to take the statement. Thank you." FOMC20070918meeting--130 128,MR. MISHKIN.," Thank you, Mr. Chairman. Clearly, the key issue in thinking about where the economy is and what we need to do about policy is the financial destruction that is going on right now. When I look at it, I think about the different episodes that we’ve had in the post-World War II period and separate them into two sets of episodes. There’s the episode of 1970 with the Penn Central crisis, there’s the 1987 stock market crash, there’s the 1998 LTCM episode, and then, of course, the World Trade Center terrorist tragedy in 2001. That’s one group. In those contexts, there was a lender-of-last-resort operation. It was active policy on our part, and it did resolve the situation in the financial markets very quickly. The other episode is the early 1990s, when there was much more of a severe structural problem in which the banks got into trouble. Therefore, it took quite a long time for them to fix their balance sheets in order to get players back into the financial markets to make loans to people who had good investment opportunities. When I look at the current episode, I see something in-between. I do not think that in this case the situation can be resolved quickly because I think that the price discovery issues are severe. In particular, we’ve gone to an originate-to-distribute model, which Governor Kroszner mentioned, and we have found some serious flaws in it. The expectation is that we will have new models coming out. In fact, I think that this is actually going to be a long-run profit opportunity for the banks. So if we were allowed to buy bank stocks, I think it would be a good idea. [Laughter] But the key problem is that this is going to take a substantial amount of time, even if things go very well; in that context, there is a substantial negative shock to aggregate demand and, therefore, a substantially weaker economy. However, the issue that most concerns me here is that, even though I think the modal forecast is that growth will be slower than we expected, the downside risk is actually very, very substantial. Though we may not be allowed to mention it in public, we have to mention the “R” word because there is now a significant probability of recession. The problem here is really the interaction of the financial side with the real side. I’m worried that, as the economy becomes more nonlinear, we have the potential for a vicious circle or a downward spiral, whatever phrase you want to use—that, in particular, we have a financial disruption, which means that it’s harder to allocate capital to people with productive investment opportunities and, as a result, you get a contraction in economic activity. A contraction in economic activity makes information revelation or price discovery harder to do. That can then lead to more financial disruption, which leads to a downward spiral in terms of economic activity. So the big issue here for me is that this nonlinear element is very real right now. The question is what to do about it, and that’s what we will be discussing shortly. However, I think it is also important to recognize that inflation risks are just not that severe right now. That’s the good news because it will allow us flexibility to deal with the situation. In particular, we see inflation expectations that are very grounded, something that everybody has mentioned. Also, even in the modal forecast and not worrying about the downside risks, the expected future output gaps are more negative, so we have less pressure going forward there. I was happy that the staff slightly lowered the NAIRU estimate, which was consistent with my views in the past couple of cycles, when I thought that it might be a smidgeon under 5 percent. I think their revision makes sense, and, again, it means that there’s a bit less likelihood of upside risk to inflation. Then, also, there are the downside risks to real growth. When I look at the inflation situation, I do think that inflation expectations are grounded around 2 percent right now. By the way, that’s not necessarily written in stone because things that we might do could actually change inflation expectations; but I think that we have to take inflation expectations as given right now. However, I see that the risks are slightly to the downside from that 2 percent level because of the things that I’ve just mentioned. The key point here is that we have a situation of potential nonlinearities, big tail risk, that could actually get very nasty, and in fact there is a potential for recession. On the other hand, I don’t see that inflation risk is the big problem right now. Thank you." FOMC20080109confcall--21 19,CHAIRMAN BERNANKE.," Are there other questions for Dave? If not, if I could kick off the general discussion, I will talk a bit about how I see the economy. I have two main points to make. First, I think the downside risks to the economy are quite significant and larger than they were. Speaking as a former member of the NBER Business Cycle Dating Committee, I think there are a lot of indications that we may soon be in a recession. I think a garden variety recession is an acceptable risk, but I am also concerned that such a downturn might morph into something more serious, and I will talk about that in a moment. My second point is that I think that 100 basis points of easing may or may not be a rough offset, in terms of expectations, to the decline in demand that we have seen, but I don't think that we have done really very much at all in terms of taking out insurance against what I perceive to be the greater risk at this point. So let me address those questions just a bit. President Lacker already anticipated me in mentioning the regime-switching models of recession. Those suggest a nonlinear process: There are two states of the world--a growth state and a recession state--and the behavior of the economy is different in those two states. Those models fit pretty well, although, of course, like many econometric models they are mostly retrospective. But some of the indicators suggesting a switch are things like falling equity prices, slower manufacturing growth, rising credit spreads, and--an often very effective indicator--the fact that the federal funds rate is so far above twoyear interest rates at this point. Those would all be indications that the regime is about to switch, if it hasn't already. President Lacker also mentioned the idea of a stall speed. I presented some figures on that in a meeting in 2006. There have been situations of a 0.3 percentage point increase in the unemployment rate in a month that have been reversed, but there has never been in our case a 0.6 increase over a period of time that didn't translate into a recession and a much greater increase in unemployment. Similarly, there has never been a sustained GDP growth rate below 2 percent-- and we have a 1 percent forecast for 2008--that has not turned into a recession. Indicative of the kind of behavior that we have seen in the past, let me just refer to the last two recessions. Unemployment was 5.2 percent in June 1990, having been there for about two years. It jumped to 5.5 percent in July, by the next June it was 6.9, and the following June it was 7.8. In December 2000, unemployment was 3.9, it was 4.3 at the cyclical peak in March 2001, and ultimately it hit 6.3 in June 2003. So there is some tendency, once a stall speed is reached, for the economy to slow quite considerably. Again, like David, I don't know if we're there yet. Obviously, ex ante it's extremely hard to tell, but I do think the risks are at least 50 percent at this point that we will see an NBER recession this year. Now, as I said, the concern I have is not just a slowdown but the possibility that it might become a much nastier episode. The main mechanism I have in mind--there are several possibilities, but I think the financial markets are the main risk. Let me talk a bit about banks, which are at the center of this set of issues. I'm going to talk a bit about the 21 large, complex banking organizations (LCBOs). I have had some data worked up for me by the supervisory staff. Since August these 21 LCBOs have announced $75 billion in extraordinary markdowns associated with various credit issues. They have, on the other hand, either raised or plan to raise $50 billion in capital. Therefore, one might say, ""Well, that looks pretty good."" I think, though, on net that there is really actually quite a fragility here. Several factors are going to put pressure on bank capital going forward. First, they have been taking assets on the balance sheet, as you know--about $250 billion so far of semi-voluntary additions coming from off-balance-sheet conduits and others. It is hard to say how much contingent additional exposure they have. There are a lot of different estimates. For these 21 banks, the Board supervisory staff identified between $250 billion and $300 billion more of potential exposures to bring back on the balance sheet. The BIS, at the meeting I attended over the weekend, looking at the 20 largest international banks, estimated $600 billion. We don't know how much it is going to be, but the banks themselves are somewhat unsure about potential exposures. Loan-loss reserves are quite low for this stage in the cycle, about 1.4 percent, compared with, say, 2.5 percent during the headwinds period of the early 1990s, and that is partly a result of the SEC regulations, which have forced banks to keep their reserves low. There is a lot of concern in banks about additional credit losses and downgrades, concern about financial guarantors, and, of course, macro concerns. Finally--and I think this is one of the most worrisome things to me--we are beginning to see some credit issues outside of housing and mortgages. Credit card delinquencies have jumped in a few banks' home equity lines. There are concerns in commercial real estate, particularly in some regions like Florida and California. And with fair value accounting, as pricing goes down, even if you don't yet see a cashflow effect, you get immediate effects on capitalization. The implications of this, even if the economy continues along, say, the Greenbook's estimates, are that lending is going to be quite tight. Banks are reluctant to take loans onto their balance sheets because of the capital constraints. They are, in fact, raising their internal capital targets because of their concerns about credit losses and about additional off-balance-sheet responsibilities. We have seen contraction not only in the primary mortgage market but also in home equity lines of credit, and I suspect we will see tighter conditions for credit cards, CRE lending, and non-investment-grade corporates. A question is high-grade corporates. There has even been some deterioration in, say, A-rated corporations. I have had a lot of opportunities to talk to bankers. We had a meeting over the weekend in Basel between the central bankers and about 50 private-sector representatives. The thrust that I got was that things are going to be pretty tight. ""We are going to meet our regular customers' needs, but all of this is conditioned on no recession."" As one banker put it in our meeting, ""There is no Plan B."" So a concern that is evident is that, if economic conditions worsen notably, the effects on bank capital, on credit risk, and so on will create a more severe credit situation, which could turn a garden variety downturn into something more persistent. The other issue, of course, is housing. Credit markets and housing are interacting very closely. I think that residential construction is going to stop subtracting so much from GDP growth because there is a non-negativity constraint. Eventually, the declines in residential construction will have to stop, but we are pretty far from the non-negativity constraint on prices, and I think that is where the issue is. I have reviewed the staff's analysis of house prices. They make perfectly reasonable guesses about what house prices will do. But it is inherently very difficult, and there is a very wide range of possible outcomes. If the housing market continues to be weak and if credit continues to be tight, then the possibility of a much more significant decline in house prices, particularly in some regions, is certainly there; and that, in turn, would have significant effects on credit markets and on the economy. So I have tried to be quick; I don't want to take too much time; but I see a lot of indications that a recession may well happen. Given the additional considerations of credit markets and housing markets, I am concerned that we might get something worse than, say, 2001. The other question I raised was, Have we done enough? We have done 100 basis points. Of course, it is hard to know. A few indicators: The Greenbook-consistent medium-term r*, which is an indicator of the real funds rate that leads to full employment in three years, was 3.3 percent in August 2007. It is currently about 1.8 percent, so that is a decline of 150 basis points. That is just one rough indicator of the decline in aggregate demand. I have not redone the Taylor rules, but for December the estimated forecast- and outcome-based Taylor rules showed a rate of about 4.0 to 4.1. Again, that would not include any risk-management considerations. That is just sort of an average over periods of both inflation risk and growth risk. I guess I would also mention the 2001 pattern, the most recent episode. The FOMC--many of you were there, I was not--dropped the rate 250 basis points in a little over four months in early 2001. Obviously, that was a much more aggressive episode. What about inflation? The fact is that we are in a tough bind here, and we don't have any easy, simple solution. We are going to have to balance risks against each other. We are going to have to do it in a forward-looking way, and we are going to have to try to make some judgments. I'll make a couple of comments. First, even assuming no recession, as the staff does, the staff has core and total inflation back into a reasonable approximation of price stability by 2009. As they note, wage growth has slowed; that doesn't seem to be incorporating any inflation pressures. The other thing I would say is that, if we do have a recession, inflation during recession periods does tend to fall fairly quickly. In the 1990 episode I mentioned before, between June 1990 and June 1993, core PCE inflation fell from 4.4 to 2.7 percent. Of course, in the 2001 episode, despite 550 basis points of easing, we went from 2.2 percent in the fall of 2001 to unwelcome disinflation in 2003. So should there be a recession, the inflation problem would probably take care of itself. Now, there is an argument--and Governor Mishkin's speech on Friday makes the case pretty well--that, when you have these kinds of risks, the best way to balance the growth and inflation risks is to be aggressive in the short run but to take back the accommodation in a timely way when the economy begins to stabilize. I realize this is not easy to communicate, but I think if we attempt to do so we can make some progress on that front. So, to summarize, we have a very difficult situation, but I do think the downside risks have increased and are quite significant. I don't think that our policy thus far has gotten ahead of the curve, so to speak, in terms of taking out insurance. Although, again, I'm not recommending any action today, I think we need to be cognizant of this issue as we go into the January and subsequent meetings. So let me stop there and open the floor for your reactions and comments. I'd like to know if you are comfortable not acting today--waiting until the January meeting. On the other hand, I am also interested in knowing if you share my assessments or if you don't. Let me be clear: I am not asking now for a commitment to any particular action in January. I am not asking for carte blanche. I am simply trying to see if we are all on the same page, or more or less on the same page, so that we can collectively communicate more effectively and I hope take the right actions when the time comes. So let me stop there, and Debbie will call on members. President Lacker. " FinancialCrisisReport--113 So we come down to the basic question, is this the time to expand beyond the ’05 Plan and/or to expand into new categories of higher risk assets? For my part I think not. We still need to complete EDE [Enterprise Decision Engine, an automated underwriting system], reduce policy exception levels, improve the pricing models, build our sub-prime collection capability, improve our modeling etc. We need to listen to our instincts about the overheated housing market and the likely outcome in our primary markets. We need to build further credibility with the regulators about the control exercised over our SFR underwriting and sub-prime underwriting particularly in LBMC.” 393 Mr. Vanasek retired in December 2005, in part, because the management support for his risk policies and culture was lacking. 394 When Mr. Vanasek left WaMu, the company lost one of the few senior officers urging caution regarding the high risk lending that came to dominate the bank. After his departure, many of his risk management policies were ignored or discarded. For example, by the end of 2007, stated income loans represented 73% of WaMu’s Option ARMs, 50% of its subprime loans, and 90% of its home equity loans. 395 Ronald Cathcart was hired in December 2005 to replace Mr. Vanasek, and became the Chief Enterprise Risk Officer. He had most recently been the Chief Risk Officer for Canadian Imperial Bank of Commerce’s retail bank. 396 Although the High Risk Lending Strategy was well underway, after Mr. Vanasek’s departure, risk management was in turmoil. Mr. Cathcart testified at the Subcommittee hearing: “When I arrived at WaMu, I inherited a Risk Department that was isolated from the rest of the bank and was struggling to be effective at a time when the mortgage industry was experiencing unprecedented demand for residential mortgage assets.” In early 2006, the bank reorganized WaMu’s risk management. 397 Under the new system, much of the risk management was subordinated to the WaMu business divisions, with each business division’s Chief Risk Officer reporting to two bosses, Mr. Cathcart and the head of the business unit to which the division’s Chief Risk Officer was assigned. WaMu referred to this system of reporting as a “Double-Double.” 398 393 2/24/2005 Washington Mutual memorandum from Jim Vanasek to the Executive Committee, “Critical Pending Decisions,” JPM_WM01265462-64. 394 Subcommittee interview of Jim Vanasek (12/18/2009 and 1/19/2010). 395 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82. 396 Subcommittee interview of Ronald Cathcart (2/23/2010). 397 Id. 398 Id.; Subcommittee interviews of David Schneider (2/17/2010) and Cheryl Feltgen (2/6/2010). CHRG-111hhrg48868--628 Mr. Liddy," No. I don't believe it is. And I think as I listened to the individual from the GAO, I think what she said was as of her testimony today, they had seen--and Joel Ario said the same thing--they had seen no evidence of irresponsible price cutting on the part of AIG. I will tell you what is happening. What AIG does is we write really big risks for oil rigs and large apartment buildings and new hotels and tunnels and things of that nature. That has all ground to a halt. So there is no new business that you can write insurance on. So to the extent you lose an account, there's not fertile ground that you can apply to replace that account. That is happening in spades. The point you make is a good one. Over time, people just get AIG fatigue. A buyer of insurance just doesn't want to deal with, ``Is AIG bankrupt? Are they solvent? Are they going to be around? Why did they pay those bonuses?'' You just get AIG fatigue. And if I can't turn this situation around, we run the risk that the business does atrophy. We're trying very hard not to do that. We have a plan. We're going to sell a minority interest in that business, maybe take it public, maybe get it out entirely from underneath the AIG umbrella. We brand it and give it a chance so we can realize some value and pay it back to the Federal Government. " FOMC20080130meeting--194 192,VICE CHAIRMAN GEITHNER.," I'm going to end dark, but it's not all dark. The world still seems likely to be a source of strength. You know, we have the implausible kind of Goldilocks view of the world, which is it's going to be a little slower, taking some of the edge off inflation risk, without being so slow that it's going to amplify downside risks to growth in the United States. That may be too optimistic, but the world still is looking pretty good. Central banks in a lot of places are starting to soften their link to the dollar so that they can get more freedom to direct monetary policy to respond to inflation pressure. That's a good thing. U.S. external imbalances are adjusting at a pace well ahead of expectations. That's all good, I think. As many people pointed out, the fact that we don't have a lot of imbalances outside of housing coming into this slowdown is helpful. There's a little sign of incipient optimism on the productivity outlook or maybe a little less pessimism that we're in a much slower structural productivity growth outlook than before. The market is building an expectation for housing prices that is very, very steep. That could be a source of darkness or strength, but some people are starting to call the bottom ahead, and that's the first time. It has been a long time since we've seen any sense that maybe the turn is ahead. It seems unlikely, but maybe they're right. In the financial markets, I think it is true that there is some sign that the process of repair is starting. We have seen very, very substantial adjustment by the major financial institutions; very, very substantial de-leveraging ahead as the institutions adjust to this much, much greater increase in macroeconomic uncertainty and downside risk; very, very substantial early equity raising by major firms; pretty substantial improvement in market functioning; and easing of liquidity pressure. Those are useful, encouraging things. There is a huge amount of uncertainty about the size and the location of remaining credit losses across the system. But based on what we know, I think it's still true that the capital positions of the major U.S. institutions coming into this look pretty good relative to how they did in the early 1990s. Of course, as many people have said many times, there's a fair amount of money in the world willing and able to come in when investors see prices at sufficiently distressed levels. One more encouraging sign, of course, is that the timing, content, and design of the stimulus package look as though the package will be a modest positive. It could have been a worse balance of lateness and poor design, but I think it looks to be above expectations on both timing and design, and it will help a little on the downside and take out some of the downside risk. Having said that, though, I think it is quite dark still out there. Like everyone else, we have revised down our growth forecast. We expect very little growth, if any, in the first half of the year before policy starts to bring growth back up to potential. The main risk, as has been true since August, is the dangerous self-reinforcing cycle, in which tighter financial conditions hurt confidence and raise recession probability, causing people to behave on the expectation that recession probably is higher, reinforcing the financial headwinds, et cetera. The dominant challenge to policy is still to arrest that dynamic and reduce the probability of the very adverse outcome on the growth side. Of course, we have to do that without risking too much damage to our inflation credibility and too much damage to future incentives and future resource allocation. Like many of you, I think the inflation outlook for the reasons laid out in the Greenbook is better than it was. It's not terrific, but it's better. The risks are probably balanced around the inflation outlook. Our inflation forecast still has core PCE coming down below 2 percent over the forecast period. There's obviously a lot of uncertainty around that, but I really think that you can look at inflation expectations in the markets as somewhat reassuring on the credibility front to date. So again, I think the key question for policy is how low we should get real short-term rates relative to equilibrium, and our best judgment is that we're going to have to get them lower even with another 50 basis points tomorrow. We're still going to need to try to reinforce the signal that we're going to provide an adequate degree of accommodation or insurance against this very dangerous risk of a self-reinforcing cycle in which financial weakness headwinds reinforce the risk of a much deeper and prolonged decline in economic activity. " CHRG-111shrg54589--147 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM KENNETH C. GRIFFINQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. No. There are many legitimate derivative instruments that serve important economic functions that have no ``cash'' market. Examples of these include: weather derivatives, which, for example, can be used by farmers to manage exposure to adverse climate changes; reinsurance derivatives, which allow a broad array of market participants to mitigate the risk of natural catastrophes; and macroeconomic derivatives on measures of inflation, GDP growth and unemployment which give a wide range of firms important tools to manage their risk exposure to changes in the broad economy.Q.1.b. If not, what specific, objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. The value of many derivatives is determined solely by observed values of indices, such as measures of inflation, weather observations and other objectively determined variables.Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative, and the model is effectively the basis, why should the models not be public?A.2. The models and principals used in the pricing of OTC derivatives are widely available. For example, the University of Chicago's Master of Science in Financial Mathematics describes its program as (http://finmath.uchicago.edu/new/msfm/prospective/ourprogram_program.php): Theory Applied to the Real World This program teaches applied mathematics and its applications in the financial industry. Students learn the theoretical background for pricing derivatives and for managing assets, but also attain a real understanding of the underlying assumptions and an ability to critically ascertain the applicability and limitations of the various models. Courses are taught by faculty of the University of Chicago and by professionals from the financial industry.In the CDS market, participants historically have used arbitrage-free pricing models based on spreads, default probabilities and recovery rates. ISDA has published a spread-based model with standardized inputs that is widely used to drive consistency in calculating trade settlement amounts. Of course, many firms have spent considerable resources developing models superior to the general market models and these models appropriately constitute trade secrets. No end user of derivatives should use derivative instruments without an understanding of the risks involved in the use of the instrument. Note finally that, apart from the uses of models in pricing derivatives and managing risk, over the life of the derivative instrument, realization in value based upon the observed underlying variables will ultimately take place.Q.3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?A.3. Restricting the use of OTC derivatives to ``legitimate hedges'' will significantly impair the valuable economic function that such markets perform in allowing participants to hedge and transfer risk. It would be a very unlikely and a costly undertaking for a dealer to find a willing buyer and willing seller of the same risk exposure at the same time if trading were limited to those only with ``legitimate'' hedges. Investors (which here, though being characterized as ``speculators,'' really represent all those who are willing to take risk in seeking return on investment capital) and market makers serve an important role in absorbing risk from hedgers. Furthermore, the price discovery of the derivatives markets send important signals to producers and consumers about the future prices of goods, encouraging investment where appropriate and conservation where appropriate. In the CDS market, there are a tremendous number of ``natural'' or hedged buyers of credit protection (all those who own bonds), but there are virtually no natural sellers of protection who are doing so solely to hedge a specific credit risk. As such, the CDS market would not exist if the only users of the product would be those market participants who owned the underlying cash bonds. Liquidity of CDS, one of the most important financial innovations of the past two decades, would disappear, undermining the ability to hedge risks and likely materially raising the cost of capital for corporate America, which could lead to additional job losses In addition to the near impossibility of a market structure as described above, it also is quite difficult to determine and enforce an appropriate definition of ``legitimate'' hedging. Consider a firm that does not own a bond of one of its suppliers or clients. It may be a wise business decision for that firm to buy protection against a possible bankruptcy of that supplier or client. But what would the extent of the ``insurable interest'' have to be to qualify to trade in the market? What if CDS offers the best way of hedging against the credit risks posed by a given sector to which a firm is particularly exposed through a range of commercial relationships? How again could the extent of ``insurable interest'' be defined here?Q.4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?A.4. Regulatory arbitrage is a very real issue in a global economy where capital can flow freely. The U.S. should take the lead and act while working with and through international bodies such as the Financial Stability Board, the Basel Committee on Banking Supervision, the European Union and the G20 to ensure safe and sound markets that do not disadvantage U.S. firms. Regulating only contracts written in the U.S. and allowing American firms to only buy and sell regulated contracts will not solve the problem when U.S. firms can operate subsidiaries or affiliates offshore free of such restrictions. Also, this could invite a retaliatory response from non-U.S. regulators that would put U.S. firms at a disadvantage if they, but not their international competitors, are excluded from financial markets and products abroad. International coordination is essential.Q.5. Do over-the-counter or custom derivatives have any favorable accounting or tax treatments versus exchange traded derivatives?A.5. From an accounting perspective, many financial participants follow mark-to-market accounting and therefore recognize gains and losses on their derivative contracts in current earnings, irrespective of whether such contracts are exchange-traded or not. For firms that do not follow mark-to-market accounting, however, certain accounting provisions, such as FAS 133, may favor customization of certain derivative instruments for certain users. A clearinghouse for derivatives should be able to provide the level of customization needed--for example in notional amount or maturity date--to meet the needs of the significant portion of the users who require FAS 133 accounting treatment. From a tax perspective, exchange-traded derivatives are generally subject to mark-to-market treatment, whereas OTC derivatives are governed by rules, depending on how they are structured, for notional principle contracts, forwards or options. Contingent swap contracts such as CDS present a different case. Specifically, there is substantial uncertainty as to how contingent swap contracts should be treated for tax purposes.Q.6. In addition to the Administration's proposed changes to gain on sale accounting for derivatives, what other changes need to be made to accounting and tax rules to reflect the actual risks and benefits of derivatives?A.6. As noted, certain hedge accounting rules have the effect of discouraging the use of standardized derivatives as compared to more customized solutions, even when the risk profile and economic considerations of the standardized derivatives are equal to or better than the customized instrument. FAS 133, and any other hedge accounting rules, should be broadened to permit corporate users to use the standardized products, if the hedging basis risk is minimal. The societal benefits of deeply liquid and transparent markets, driven largely through increased use of standardized products and CCPs, justify the absorption of a higher level of basis risk under FAS 133. The tax treatment of contingent swap contracts (which may encompass CDS) should be clarified and legislators and regulators should work with industry groups such as ISDA which has already proposed clarifications to the tax code on this issue.Q.7. Is there any reason standardized derivatives should not be traded on an exchange?A.7. Exchanges are an important step in the evolution of the CDS market. Moving from the current bilateral market to a CCP will dramatically reduce systemic risk and increase the stability of the financial markets. The enhanced liquidity and standardization brought about by clearing will further facilitate an exchange-trading mechanism. Exchanges work best when there is a concurrency in interest between natural buyers and sellers. For the liquid index CDS product, which accounts for approximately 70 percent of all CDS trading volume, and for the most liquid single name CDS, the introduction of exchange trading will facilitate a more efficient and transparent market. However, for the less liquid single name CDS products, it will be necessary to allow market makers to continue to play a vital role in providing liquidity outside the exchange model, at least until the markets for these products evolve to the stage where there is sufficient concurrency of interest for exchange trading.Q.8. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than renegotiate the debt?A.8. In today's market, holders of a corporate debt security utilize a variety of investment products that may alter debt holders' payoffs to make bankruptcy preferable to debt restructuring. Examples include shorting junior debt instruments in the capital structure, shorting the underlying stock, buying equity default swaps and buying puts or selling call options on the stock. CDS are no different than these other instruments in their ability to alter the economic preference of a debt holder with respect to a bankruptcy or a restructuring. Although beyond the scope of this question, research suggests that under current rules bankruptcy itself is quite costly and reduces a firm's value, independent of and in addition to the financial and operational problems that brought the firm to distress. Accordingly, streamlining of the bankruptcy process to minimize the deadweight loss incurred in a bankruptcy proceeding would potentially more directly address the concern raised with this question.Q.9. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?A.9. As there are always two sides of every trade, even if a specific investor chooses not to perform credit research on a particular issuer, the seller of credit protection for the debt securities of such issuer will have a strong economic incentive to perform extensive credit research. Where the risks of CDS are properly managed by a central counterparty and when a diverse set of participants create a liquid, transparent market, CDS can also provide a benchmark for pricing the probability of default of a firm or index of firms. By aggregating market participants' views on creditworthiness, CDS performs an important role in the pricing of a wide range of vital credit instruments.Q.10. Do net sellers of credit protection carry that exposure on their balance sheet as an asset? If not, why shouldn't they?A.10. Sellers of credit protection record their exposure on their balance sheet under their applicable accounting rules. Generally, for CDS contracts, the net seller's economic exposure is better described as the fair market value of the open contracts and not the notional amount. This is similar to a wide range of traded derivatives, such as options, where the relevant valuation for balance sheet purposes is the fair market value of the contract, not the notional value of the option. For financial reporting purposes, the fair market value of the open contracts is presented in the financial statements, often along with additional information in the financial footnotes. GAAP accounting rules typically require disclosure of the gross and net notional exposure for off balance sheet derivatives.Q.11. In her testimony Chairman Schapiro mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.11. ``Synthetic exposure'' through derivatives is a cornerstone of our modern financial markets, enabling investors to secure an economic exposure without needing to own the underlying asset. For example, a retiree may want to hedge against the risk of inflation by buying gold futures. It is far more efficient to purchase a gold future than to acquire gold. The leverage created by derivatives is a function of margin and capital requirements. A central clearing solution for CDS would establish appropriate margin and capital requirements for the instruments, helping to reduce systemic risk.Q.12. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn't the economic benefit of that demand--higher value--flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?A.12. One of the central tenets of our economy is that supply and demand are largely balanced through free market forces. The same can be said of supply and demand for financial products; that is, free market forces bring equilibrium to supply and demand. Synthetic exposures created through derivatives are an important means by which the market arrives at a more stable equilibrium. Without derivatives instruments, we would be likely to see markets characterized by much higher levels of volatility and far lower levels of liquidity. In addition, if there is increased demand for credit exposure, for example, the net effects of trading in the synthetic exposure will flow through to the owner of related assets and the issuer of that asset. For instance, if the market perceives a company to have a low probability of default and the supply of credit protection outweighs the demand for the bonds, then the cost CDS protection will decrease. When the cost of CDS protection decreases, it is easier for investors manage their bond credit risks, leading to an increase in demand for the bond, resulting in a decrease in borrowing costs for the issuer and higher bond prices for owners of the bonds.Q.13. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn't that demand lead to a greater supply and thus more liquidity?A.13. With respect to the credit markets, it is fundamental to emphasize that corporations focus on achieving the capital structure that meets the needs of their stakeholders, as opposed to meeting ``the demand for debt securities'' of investors. Corporate CEOs and CFOs have a fiduciary duty to limit issuance of debt that, although potentially satisfying investor demand, would leave the company dangerously over-leveraged and at risk of bankruptcy. Synthetic exposure to corporate credit through CDS thus helps to satisfy investor and hedging demand for such risks without distorting corporate balance sheets. The CDS market allows investors with a viewpoint on the price of risk for a given issuer to actively express their view by use of CDS contracts. Such trading increases liquidity and encourages more investors to focus on the merits of any given issuer's creditworthiness. As noted in the response to the preceding question, the increase in liquidity and the broadening of investor participation works to reduce the cost of capital for corporations. Conversely, if CDS trading was restricted or eliminated, liquidity in the bonds would almost certainly be reduced, leading to a higher cost of capital for American corporations.Q.14. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?A.14. There are numerous well-functioning markets where derivative exposure exceeds the value of underlying assets; certain equity options and commodity futures are two such examples. The presence of this alone does not cause any systemic risk to the economy. In fact, it very well can be a sign of a healthy and robust marketplace where many participants come together to provide consensus pricing. Moreover, as noted above, there are many circumstances in which one party may not own the reference asset but have a legitimate demand to hedge, e.g., a firm that wants to buy protection against the possibility of bankruptcy of a major customer or supplier. As stated previously, CDS in particular serve several critical market functions that lead to stronger economic growth by lowering the cost of capital for America's corporations. Examples of these critical market functions include: (a) the ability to efficiently and effectively manage credit risk, which (i) permits investors (including financial institutions) to diversify their holdings, and (ii) increases liquidity in the marketplace; (b) balancing of the supply and demand for credit risk, which helps to moderate asset prices to reflect appropriate risk-based returns; and (c) providing credit risk price transparency, which increases investor confidence and market liquidity. Events of 2008 have highlighted weaknesses in the market structure for CDS, and underscore the valuable role of a CCP for users of CDS. By swiftly introducing and promoting CCP clearing of CDS, the important societal benefits of CDS can be maintained while at the same dramatically reducing the systemic risk inherent in noncleared derivative products.Q.15. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?A.15. Futures are highly standardized contracts that are traded on exchanges and centrally cleared by a clearinghouse. Futures offer a proven template for operational and risk management of standardized derivatives, providing for efficient and well-understood processing, margining, netting and default management. Swaps, historically, are more customized, bespoke trades that are individually negotiated in the OTC market. However, with the significant progress towards standardization over the last several years, many bespoke, customized swaps have become standardized. Examples include the CDS market where 90-95 percent of trading volume is now in ``standardized'' contracts. All the terms of such contracts are fixed by convention, and the contracts trade purely on price and volume. Such ``standardized'' CDS contracts can be centrally cleared in a futures-like framework, subject to the standard rules of the central counterparty and provide similar risk management and customer segregation protection and portability. Individually negotiated swaps may still be utilized to meet the limited need for customized CDS contracts. With central clearing of standardized CDS in a futures-like framework, most market participants agree that electronic trading, at least of the leading CDS indices and most highly liquid single names, will shortly follow. If it does not, then regulators should intervene to remove any artificial barriers to such market evolution.Q.16. One of the arguments for keeping over-the-counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?A.16. The most liquid of the OTC derivatives markets, such as the interest rate swap markets and CDS markets, have already embraced standardization as a means of increasing liquidity, reducing operational risk and reducing costs. In both the interest rate swap markets and the CDS markets, the vast majority of contracts are traded according to standardized market conventions. What has not evolved is a central clearinghouse readily available to the end users of such products. Such a central clearinghouse would reduce the banks' privileged role as the providers of credit intermediation (and undermine the economic rents associated with such concentrated power). Depending upon the OTC market, customization may be desirable to reflect specific underlying commodities or instruments, delivery locations, quantity, quality or grade, payment dates, maturity dates, cash flows or other payment terms, any or all of which may or may not be reflected in standardized agreements. It is a fallacy that standardized and cleared contracts are more costly than customized, noncleared OTC contracts. There are three primary economic costs in trading contracts: (i) operational costs of managing and processing such contracts; (ii) trading costs, as measured by the bid-offer spread; and (iii) capital and margin costs for investing in such contracts. Standardization and clearing significantly reduces the first two costs and can be expected to reduce the third. Numerous studies have documented the economies of scale that are gained by centrally processing and managing contracts through a central counterparty. Moreover, standardized contracts also enable standardized processes that reduce costs. Additionally, as contracts are standardized and move to a CCP (increasing price transparency and making it easier to transact in such instruments), liquidity increases and the bid-offer spread decreases--reducing the cost for all investors, including corporations, pension funds, insurance companies and hedge funds. The posting of collateral for standardized cleared contracts does not necessarily increase costs compared to noncleared OTC contracts. Central clearing provides significant capital efficiency through multilateral netting and the elimination of counterparty risk. Of greatest importance, a clearinghouse will all but eliminate the externalities inherent in today's market structure--externalities that are borne by taxpayers. A clearinghouse will roll back the emergent paradigm of ``too interconnected to fail'' and dramatically reduce the probability of a future AIG-like financial black hole.Q.17. Who is a natural seller of credit protection?A.17. The natural sellers of credit protection would be best described as the broad array of investors who generally invest in the cash corporate bond markets. These investors generally have demonstrated credit analysis capabilities and strong balance sheets with which to underwrite risk.Q.18. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.18. Cleared derivative transactions are, of course, recorded on the books and records of the clearinghouses and details of these transactions are readily available to regulators. Noncleared derivative transactions should be reported to a non-CCP based central warehouse such as DTCC to ensure that the details of these transaction are readily available to regulators. In addition to facilitating the appropriate monitoring of systemic risk in the financial system, an accurate and readily accessible warehouse of transaction details is important to facilitate the dissolution of a financial institution that is in financial distress. Regulators and others, however, need to closely guard the information at both the CCPs and trade warehouses such that no information that would compromise the identity or specific positions of institutions is publicly divulged. The public disclosure of such information could have significant negative effects on liquidity in the market. CCPs' publishing of end of day settlement prices, and the progressive publishing of transaction prices for liquid traded CDS, will bring highly beneficial transparency to the CDS market. However, for certain less-liquid contracts, immediately releasing the details of a trade could serve to reduce liquidity. In relatively illiquid markets, or where an individual trade may be large relative to daily trading volume, dealers or others may be reluctant to commit large amounts of capital if their actions become immediately known to other market participants. In this case, requiring such information to be immediately disclosed could discourage trading and thus impair liquidity. In these circumstances, such information should be made available to the public only on a lagged basis, and, depending on the circumstances, potentially also only on an aggregated basis.Q.19. What is insufficient about the clearinghouse proposed by the dealers and New York Fed?A.19. Well-functioning markets are efficient, open, and transparent. Well-functioning standardized derivatives markets utilize a CCP to significantly reduce counterparty risk exposure, facilitate liquidity, protect customer collateral, and facilitate multilateral netting and monitoring of positions. ICE U.S. Trust (ICE), the first U.S.-based clearinghouse to be sponsored by the dealers does, to some extent, improve upon the current market by reducing counterparty risk and facilitating multilateral netting and the monitoring of positions among and for the select group of 10 ICE clearing members. At the same time, certain elements of the ICE model do not help as much as they could to improve the CDS market structure, because of: Lack of regulatory and legal clarity on the protection of customer margins and positions in the case of a clearing member default, which dramatically limits the value of such clearinghouse for customers; Inability to process trades directly into clearing without any daylight counterparty exposure post execution; Reliance upon bilaterally negotiated ISDA agreements that limit the ability of one firm to trade with another firm; and Inability of nonbank CDS dealers to directly face ICE as a clearing member and receive the benefits of such clearing membership. ICE's structural lack of straight through processing and immediate review and acceptance for clearing creates a very significant barrier to the evolution of electronic matching. Additionally, ICE's clearing solution lacks buy-side stakeholders and participation in governance. This general lack of inclusion of buy-side firms has lead to the development of a solution that does not currently meet the needs of most buy-side firms, whose positions and trading volume comprise a substantial portion of the CDS market and the vast majority of the aggregate net risk held in the market place. It is important for any clearinghouse or any other central industry facility to include the voice of all market participants--buy-side and sell-side alike.Q.20. How do we prevent a clearinghouse or exchange from being too big to fail? And should they have access to Fed borrowing?A.20. CCPs have a very long track record of surviving wars, depressions, recessions and failures of major members. In fact, there has never been a clearinghouse failure in the U.S. in the over 100-year history of U.S. clearing organizations. When Lehman's default was declared, the CME as central counterparty to Lehman's futures positions moved all futures customer positions to other clearing members and auctioned Lehman's positions quickly and efficiently. As a result of these actions there was no disruption in the market and no loss to any customer or CME clearing member or to the CME's pool of security deposits and other assets that stand as a backstop to protect the clearinghouse and its members against loss in extreme scenarios. By contrast, Lehman's bilateral, interconnected derivatives positions and counterparty margin a year later are still locked up in bankruptcy and Lehman's customers suffered significant losses. This is why a clearinghouse is critical to these markets and reduces systemic risk. The robustness of CCPs is a testament to their independence and incentives to be expert in managing risks. The clearinghouse imposes a consistent, neutral margin and risk management discipline on each counterparty, and will work very proactively to prevent default. The clearinghouse has its own capital at stake if the margin is insufficient. The clearinghouse continually assesses its clearing members, and can at any time reduce trading limits or take other measures to reduce risk. This is not always the case in the bilateral world, where commercial relationships, historical agreements and other factors have been proven to lead to inconsistent margining or credit assessment practices, as was the case with AIG. AIG was not required by its counterparties in many instances to post any margin, including mark-to-market margin. While clearinghouses have grown considerably in size as markets have flourished, their maintenance of proportionate capital and margin has ensured their survival. The right way to keep this track record of success unbroken is to ensure the close regulatory supervision of clearinghouses, and the maintenance of their independence so that their incentives remain to be proactive and conservative. Clearinghouses have not required the ability to borrow from the Fed and, if they were, we believe that this would introduce a moral hazard problem. If the CCP believed that the government would bail out any defaults, there is the risk that clearing members would seek to reduce their capital and ease risk-management standards and the CCP would lose its neutral discipline. This is exactly the opposite of what regulators and taxpayers would call for.Q.21. What price discovery information do credit default swaps provide, when the market is functioning properly, that cannot be found somewhere else?A.21. CDS are the most accurate indicators of corporate credit risk and provide capital market participants with robust, real-time, and consensus-driven estimates of corporate default probabilities and recovery rates. No other market, including the bond market, or research institutions such as rating agencies, can provide a similar depth of information that is so critical to debt issuance and economic growth. This is largely because: CDS are in many instances far more liquid than individual bonds, due, in part, to the fact that the CDS represent the credit risk of the underlying entity, whereas that entity may have many distinct bond issuances. IBM, for example, has over 20 different bond issuances. The vast majority of CDS are standardized instruments. Valuation of the CDS are not complicated by specific market technical factors or unique contractual features or rights that are associated with a specific bond issue. In addition, CDS represent the price of credit risk bifurcated from the compensation demanded by investors for committing cash to the acquisition of a debt security. Rating agencies' analytics are driven by analysts that cover the specific corporate bonds. The market price of CDS, on the other had, reflect the market's consensus view of real-time credit risk as determined by investors with financial capital at risk.Q.22. Selling credit default swaps is often said to be the same as being long in bonds. However, when buying bonds, you have to provide real capital up front and there is a limit to the lending. So it sounds like selling swaps may be a bet in the same direction as buying bonds, but is essentially a highly leveraged bet. Is that the case, and if so, should it be treated that way for accounting purposes?A.22. Please see the answer to questions #11, which is restated below for reference. ``Synthetic exposure'' through derivatives is a cornerstone of our modern financial markets, enabling investors to secure an economic exposure without needing to own the underlying asset. For example, a retiree may want to hedge against the risk of inflation by buying gold futures. It is far more efficient to purchase a gold future rather than to acquire gold. The leverage created by derivatives is a function of margin and capital requirements. A central clearing solution for CDS would establish appropriate margin and capital requirements for the instruments, helping to reduce systemic risk.Q.23. Why should we have two regulators of derivatives, with two interpretations of the laws and regulations? Doesn't that just lead to regulation shopping and avoidance?A.23. If we were starting with a clean sheet of paper, we might agree to have a single regulator of derivatives. This is not the case, however. The SEC and CFTC are two large and well-established regulatory bodies that would be difficult and time-consuming to combine. More could be accomplished sooner by focusing on fixing the regulatory gaps--such as exclusion of certain derivatives from oversight and allowing participants to transact in markets without holding or putting up sufficient capital and/or collateral--that contributed to the problems seen in the markets over the past 18 months. We believe the necessary regulatory infrastructure and tools are in place, with support of appropriate legislation, to rapidly implement the reforms needed. In this context, please see the answer to Senator Reed's question #1, with an excerpt of relevant material from that answer below, affirming the immediate value to the market of building from the CFTC's proven account segregation framework: A critical feature of any central clearing structure from the perspective of the buy-side--asset managers, corporations, pension funds, hedge funds, and all other end users--is proven account segregation. Buy-side accounts represent a substantial portion of any derivative's systemic exposure. With proper account segregation for cleared products, the buy-side's positions and margins are protected from the bankruptcy of a defaulting clearing member and transferred to other clearing members, securing the orderly functioning of the markets. The buy-side has confidence in the time-tested CFTC account segregation rules, which were amply proven in the case of the rapid workout, without market disruption, of Lehman's CFTC-regulated futures positions. This was in stark contrast to the losses suffered by end users who faced Lehman in bilateral, noncleared positions that were trapped in Lehman's bankruptcy.Q.24. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.24. Please see answer to question #11, which is restated below for reference. ``Synthetic exposure'' through derivatives is a cornerstone of our modern financial markets, enabling investors to secure an economic exposure without needing to own the underlying asset. For example, a retiree may want to hedge against the risk of inflation by buying gold futures. It is far more efficient to purchase a gold future rather than to acquire gold. The leverage created by derivatives is a function of margin and capital requirements. A central clearing solution for CDS would establish appropriate margin and capital requirements for the instruments, helping to reduce systemic risk.Q.25. What is good about the Administration proposal?A.25. We support the broad principles articulated in the Administration proposal, which include moving towards more efficient and transparent markets, enacting necessary regulatory oversight to prevent market manipulation and fraud, and reducing the concentrated systemic risk that exists today. Specifically, with regard to regulation of the OTC derivative market, we support: The aggressive promotion of clearing of all standardized transactions through capital and other incentives, with higher risk-based capital charges for noncleared derivatives; The need to regulate all significant OTC derivative market participants to prevent systemic risks, while making such regulation transparent and fair to all market participants; The need for greater market transparency, openness and efficiency; and The facilitation of exchange trading for derivatives, where appropriate, and the removal of any artificial barriers to market evolution towards exchange trading if such trading has not naturally evolved.Q.26. Is the Administration proposal enough?A.26. We believe the critical question is not whether the Administration proposal is enough, but whether legislators and regulators can quickly implement key aspects of the proposal (as articulated in the answer to question #25 above) across a broad OTC product set (e.g, credit default swaps, interest rate swaps, and foreign exchange swaps). Unfortunately, certain incumbent market participants seek to delay the movement of noncleared products to clearing, for reasons driven by profitability irrespective of the systemic risks created. These interests should not drive legislative outcomes. Legislators and regulators should not exempt certain market participants from having to post margin or collateral. There is no principled basis for such carve-outs. No market participant should be exempt from posting risk-based capital and/or margin sufficient to protect its counterparties and the market from the risk it incurs. No counterparty should be exempt from the requirement to clear transactions when they can be cleared. But also no qualifying counterparty who meets these requirements should be excluded from the benefits of CDS. Separately, as discussed in more detail in response to Senator Reed's question #6, because dealers today do not post margin for noncleared trades, and buy-side participants do, dealers should be obliged to set aside sufficient capital to secure the exposure they take on, while buy-side participants already meet this requirement through margin. Imposing capital or other requirements on these buy-side firms, would therefore only serve to create impediments to investment, increase the cost of hedging, and reduce liquidity. Please note answers to questions #6 and #16 above that discuss the significant benefits of using standardized contracts and CCPs, such as lower costs of trading and deeper, more liquid markets. The Administration and Congress should work closely to define the most inclusive practical standards for trades to be subject to mandatory clearing, driven primarily by the clearinghouses' independent willingness to accept such trades, on reasonable commercial margining terms. Regulatory carve outs and differential treatment of certain participants, such as exclusion of certain derivatives from regulatory oversight and inconsistent collateral policies, greatly contributed to the problems seen in the derivatives market over the past 18 months and cannot be allowed to continue.Q.27. Mr. Whalen suggests that Congress should subject all derivatives to the Commodity Exchange Act, at least as an interim step. Is there any reason we should not do so?A.27. It is most important that all OTC derivatives be subject to some form of robust regulation that ensures proper transparency, adequate capital and collateral requirements, and clearing by a strong CCP. We support whichever regulatory regime can best and most rapidly achieve these imperatives, provided it recognize the needs of all market participants, including buy-side investors. Please also see the answer to Senator Reed's question #1, from which relevant material is restated below for reference. A critical feature of any central clearing structure from the perspective of the buy-side--asset managers, corporations, pension funds, hedge funds, and all other end users--is proven account segregation. Buy-side accounts represent a substantial portion of any derivative's systemic exposure. With proper account segregation for cleared products, the buy-side's positions and margins are protected from the bankruptcy of a defaulting clearing member and transferred to other clearing members, securing the orderly functioning of the markets. The buy-side has confidence in the time-tested CFTC account segregation rules, which were amply proven in the case of the rapid workout, without market disruption, of Lehman's CFTC-regulated futures positions. This was in stark contrast to the losses suffered by end users who faced Lehman in bilateral, noncleared positions that were (and remain) trapped in Lehman's bankruptcy.Q.28. Is there anything else you would like to say for the record?A.28. The time to act is now. The experience of the current crisis provides us with a tremendous opportunity to learn from past mistakes and correct the fundamental flaws in the financial system. What we saw was that participants in free markets were subsidized, perhaps unjustly, by public resources and investors lost substantial sums of money, not because of their investment strategies, but because of the bankruptcy of their counterparties. It is well established that CCPs will mitigate or eliminate many of the weaknesses inherent in the bilateral trading of derivatives, reducing systemic risk and placing the ``too interconnected to fail'' genie back into the bottle. CCPs can best meet the needs of our society and our capital markets, and can do so now. ------ FOMC20050630meeting--372 370,MR. LACKER.," Thank you, Mr. Chairman. Economic activity in the Fifth District advanced moderately in May and June. The survey results we released earlier this week showed that manufacturing shipments edged higher and that revenues of service firms grew somewhat more quickly this month. New orders in manufacturing seemed to slip this month, however. Growth in retail sales moderated in June, as our big ticket sales index contracted slightly after having moved sharply higher in May. District housing markets remained fairly hot—maybe not as hot as Miami, but fairly hot. Home sales continued at high levels. Bids above asking prices were common in popular locations. Markets for beach properties and for condos in downtown areas are especially June 29-30, 2005 136 of 234 growth to pick up over the next six months. Our contacts also expect an upturn in capital spending growth over that period, and price pressures in the District remain contained. Indications are that the national economy continues to perform well, although concerns about the housing market and energy prices are causing jitters in some quarters about the sustainability of the expansion. Average net job growth for the three months ending in May exceeded 150,000 per month—a rate sufficient to keep up the steady improvement in labor markets we’ve seen since last year. And the Greenbook expects real GDP to average above 3½ percent through the end of 2006, slightly faster than potential. To me, the most striking revision in the June Greenbook was the 0.2 increase in the projected path for core PCE inflation through 2006. Expected inflation is now 2.1 percent for ’05 and 1.9 percent for ’06. I found this revision striking, because 2 percent is the upper limit of my own comfort zone for core PCE inflation. Moreover, market participants are aware that the core PCE index is the Fed’s preferred inflation measure. And if we allow it to drift much above 2 percent, we run the risk of unhinging longer-run inflation expectations, especially if energy prices spike up further as well. Having said that, I take heart from the fact that inflation expectations have fallen somewhat in the past couple of months. TIPS inflation compensation, both near-term and longer-run, has continued to decline even in the face of climbing oil prices. Of course, inflation expectations build in beliefs about our future behavior. I read declining inflation compensation, along with the apparent fall in inflation uncertainty for which Vincent’s staff apparently finds evidence, as implying that markets expect us to do whatever is necessary to hold the line on inflation. I see three main risks to the outlook. First, with oil markets as tight as they are, the world June 29-30, 2005 137 of 234 Second, we’ve been anticipating a handoff from housing investment to business investment over the course of this recovery. While business investment has continued to pick up, the demand for new capital appears to be limited now by the rate at which firms expect their output to grow. So the potential problem is that businesses may be reluctant to pick up more slack before they see that housing is headed for a soft landing. Yet that reluctance would interfere with or impede a smooth handoff, making it more difficult to achieve. Third, I find myself worrying about the possibility of an inflation scare in the bond market, despite the recent decline in TIPS spreads. It’s not clear how likely this is, but if it happened, it would be very costly. A spike in long-term yields could be particularly harmful today for elevated housing prices. It would raise long-term mortgage rates directly, obviously. Moreover, it would force us to raise short-term real rates. And in such circumstances I think it would be even harder for us to facilitate this handoff of investment from the housing sector to the business sector without an intervening recession. Thank you." FOMC20080625meeting--164 162,MR. MISHKIN.," Before the python gets it. I think another consideration is very important. I have to commend you on the Bluebook this time--it just had some great boxes. [Laughter] It would be nicer if they had a little color to them. As a textbook author, I think they could have been a little ritzier and have had a little color, but they were great boxes. In particular, a very important box was the one on the optimal reaction to oil price shocks. One thing that comes out very strongly from that box is that if your credibility is weak on commitment to price stability and containing inflation expectations, you would have to tighten more to restore that credibility and get to a policy that would produce better outcomes. So here is an issue that, with these supply shocks potentially causing a problem for long-run inflation expectations, we actually may have to react more quickly and more aggressively than we otherwise would. This is an issue that I have been concerned about in terms of communication strategy--about how we better anchor long-run inflation expectations. So my bottom line is that I support alternative B. I would like to keep the language the way it is currently, which I think works quite well. But I do think that, going forward, we should not lock ourselves into what our policy is going to be, in either direction. We need to preserve flexibility because we could be very surprised, although I think that the signal we have made that we are more concerned about inflation risks is absolutely appropriate. We have to make clear that we will do whatever it takes, including raising interest rates when unemployment is rising, if we feel that long-run inflation expectations and inflation are not remaining under control. " FOMC20080430meeting--172 170,MR. EVANS.," Thank you, Mr. Chairman. I, too, favor maintaining the federal funds rate at 2� percent today. The current real interest rate provides accommodative monetary conditions for an economy that is struggling near recession or is in mild recession. Our lending facilities are probably doing as much as can be expected to mitigate the serious and necessary financial adjustments that must be accomplished by the private markets. If the economy takes another serious leg down, our current funds rate setting is well positioned for us to respond promptly, appropriately, and aggressively, if circumstances warrant. A pause today affords us a unique opportunity to wait and see how our recent aggressive actions are influencing the trajectory of real activity. Since markets are putting substantial weight on a 25 basis point easing today, a pause will be a relatively small disappointment. As President Plosser pointed out, that was similar to our March disappointment, which seemed to be all right. I think it is important for us to understand how the economy will respond to a pause in rate-cutting when it does occur. With high food, energy, and commodity prices, the extended positive differential of headline inflation over core measures risks an increase in the public's inflation expectations. I agree with President Plosser's discussion of relative prices on that front. From a longer-term perspective, which we don't really talk about very often, I worry about the asymmetric response of policy to high inflation as opposed to when it is low. When headline inflation is above core inflation, we take on board the relative price adjustment, and then we are content, I would guess, to bring inflation down to our perceived inflation targets. But on the downside, when inflation gets low, we become uncomfortable with certain low inflation settings, and so I fear that we would respond more aggressively, as we did in 2003, which really was a positive productivity environment. If you have an asymmetric type of response, you are going to take on board increases in the price level because of that asymmetry. That's one reason that I am concerned about these types of behaviors. Although I expect emerging resource slack to temper any adverse inflation developments, the risk is simply growing in importance with every additional policy easing, compared with the economic risks, which presumably are abating as we respond to them with such easings. Calibrating the current policy stance against these divergent economic and inflation risks is important and challenging, as you pointed out yesterday, Mr. Chairman. I think that comparisons to the rate troughs in the previous cycles of recession policy are instructive. The current real fed funds rate is somewhere in the neighborhood of zero, or it could be lower if you choose a different way to deflate the funds rate by total inflation. I was very impressed with Dave Stockton's response to my question about what types of factors from financial market stress are embodied in the Greenbook-consistent real interest rate. It seems as though a tremendous amount of care has been taken to introduce some of these special factors in innovative ways, and while they may not capture all facets of that, I thought that they did quite a good job. So I feel a bit more comfortable in making those comparisons, but I do recognize that it is a treacherous period. That said, this is about the same place the real funds rate bottomed out during the jobless recovery with financial headwinds in the 1990�91 recession, and with the data we had in hand at the time during the disinflation concerns in 2003. Both periods were unique in suggesting a high degree of accommodation, and the factors that were at work in each of those episodes were unique. Our attempt to incorporate these factors has been quite useful, and so it's a reasonable, if not definitive, comparison. With our current lending facilities addressing financial stress, I think our current policy accommodation, now at 2� percent, is appropriately similar to those episodes. My final observation has to do with these end-of-cycle expectations and what they might mean for long-term interest rates. If 25 basis points is viewed as additional insurance against downside risks, I just don't think this action is significant enough to have much of an effect. We expect to take back some portion of the aggressive cuts, especially the ones that have been an attempt to respond to the financial stress. If the financial stress is mitigated to some extent, we should be expected to take that back. Expectations, as in the fed funds futures market, should limit the effect of those actions on long-term interest rates. After all, by the expectations hypothesis, you are going to be averaging these short-term paths into long-term rates. That is one reason that the Committee injected the language ""considerable period"" back in 2003, to try to convince people that we would do this for a longer period of time and affect long-term rates. So if there is an expectation of some type of rebound, these last insurance cuts might not have that large an effect. Again, I think our lending facilities are better geared for the financial stress. I think we have clearly demonstrated our willingness to provide appropriately accommodative policies in a timely fashion when the economic situation demanded it. For me, the public's expectation of these actions in that event argues against one further small insurance move. Because we are concerned about inflation risks and have indicated that we must flexibly move toward more-neutral policy stances once the economy and financial markets improve, a pause today is a small down payment on those difficult future actions. In terms of language, if it came to that, I would be comfortable with the language of alternative B with this particular rate action. Thank you, Mr. Chairman. " FOMC20070131meeting--55 53,MR. GAGNON.," Your first international exhibit (exhibit 9) covers recent market developments. As shown by the green line in the top left panel, oil prices dropped further this month, bringing the West Texas intermediate spot price back to pre- Katrina levels. The IMF index of nonfuel commodity prices (the red line) was little changed this month after a year of remarkable increases. Readings from futures markets imply a flattening out of nonfuel commodity prices and only a moderate increase in oil prices going forward. The top right panel shows that our real trade- weighted dollar indexes declined on balance last year. In recent weeks the dollar rebounded modestly against the major industrial-country currencies (the red line), but we estimate that it continued to decline in real terms against the currencies of our other important trading partners (the green line). As usual, our forecast calls for a small downward trend from current levels, reflecting our belief that the risk of significant depreciation is slightly greater than the risk of significant appreciation, owing to the unsustainably large U.S. trade deficit. The bottom panels report equity market indexes, with industrial countries shown on the left. The lines are set to equal 100 in March 2000, the previous peak month for the Wilshire 5000. Equity prices have risen broadly across the industrial countries over the past two years and are now just above their March 2000 levels in the United States, the United Kingdom, and Japan, but not in the euro area (the red line). For major emerging markets, on the right, equity indexes are well above March 2000 levels. In Mexico (the blue line), equity prices have more than tripled over this period. In Thailand (the green line), the government’s recent attempts to slow capital inflows and relieve upward pressure on the currency have taken their toll on equity prices, but contagion to other emerging equity markets has been minimal. Overall, commodity and financial market developments are consistent with expectations of strong global growth. Exhibit 10 focuses on financial flows between emerging markets and industrial countries. As shown in the top left panel, the major developing regions have continued the downward trend in their reliance on external borrowing. Fiscal deficits have declined in most countries, and many governments have turned increasingly to local, rather than external, borrowing. The panel to the right shows that yield spreads on dollar-denominated sovereign debt of emerging market countries have dropped to historically low levels. But emerging markets, in the aggregate, have gone much further than just reducing their borrowing. In recent years, emerging markets have experienced record outflows of official capital (the gold bars in the middle panel). These official outflows are composed of the accumulation of foreign exchange reserves, the servicing and paying down of sovereign debt, and the purchase of foreign assets by government-run investment funds such as the Kuwait Investment Authority. In all the emerging market regions, official capital outflows have recently exceeded current account surpluses (the blue bars), which are themselves at record levels. For example, the IMF estimates that in 2006, governments in emerging Asia invested on balance $270 billion outside their borders, a sum that greatly exceeds their combined current account surplus of $185 billion. Most of these official flows have taken the form of additions to foreign exchange reserves, as governments have built up war chests against future financial crises and sought to counter upward pressures on their currencies. The bottom panel looks at these flows from the point of view of the industrial countries, plotting aggregate emerging market net official flows (the gold bars) relative to industrial-country GDP, with negative values denoting net flows into the industrial countries. The statistical accounts do not report the destinations of all these flows, but the available evidence suggests that the overwhelming majority is destined for the industrial countries. Before 2003, net official inflows or outflows from the emerging markets had never exceeded 1 percent of industrial-country GDP. But since 2003, things have changed. Net official outflows from emerging markets are now estimated to equal 2½ percent of the combined GDP of the industrial countries. As shown in the panel, the timing of this unprecedented increase in net official flows corresponds well with the puzzling decline in real short-term interest rates in the industrial countries (the green line) that persisted long after industrial-country GDP growth (the purple line) rebounded from the slowdown early in this decade. The evidence suggests that aggregate policy-driven capital flows from the emerging markets may be an important factor behind low real interest rates in the industrial countries. Moreover, low real rates are not limited to short-maturity instruments. The top panels of exhibit 11 show that ten-year indexed bond yields are also low and have been for several years in the major industrial countries. These rates have ticked up over the past month or two, but only by a small amount. Long-term inflation compensation (shown in the middle row of panels) remains contained. Indeed, in Japan and Canada (the two panels on the right) inflation compensation has moved down in recent months. In the euro area and the United Kingdom (the two panels on the left), where inflation compensation lingers above policymakers’ targets, we project modest additional policy tightening early this year, shown in the bottom row of panels. Despite recent and expected future inflation rates close to zero, the Bank of Japan seems poised to tighten gradually over the next two years. In Canada, policy is expected to remain on hold. If these projections prove to be the peak policy rates for this cycle, they will be the lowest cyclical peaks for short-term interest rates in these countries for at least forty years. Nevertheless, we judge that these policy stances are likely to be consistent with low and stable inflation this year and next. The large capital inflows and low real interest rates in the industrial countries have contributed to rising housing prices in many of these countries. Higher home prices in turn have stimulated housing construction. The top panel of exhibit 12 shows that the extent and timing of the house-price boom differs markedly across countries. The Netherlands (the blue line) was one of the leaders of the global housing boom, with prices rising continuously since the early 1990s, though at much slower rates in recent years. Japan (the green line), on the other hand, is a notable exception to the trend of rising house prices in recent years, reflecting the lingering effects of the bursting of the 1980s asset bubble and Japan’s extended economic slump. The middle panels focus on two countries that experienced strong house-price increases (the purple lines) early in this decade but where house-price increases subsequently halted, at least temporarily. In both Australia and the United Kingdom, as in the United States, residential investment (the green lines) responded positively to higher house prices. In Australia, on the left, real house prices have been flat for the past three years, and residential investment has declined gradually about 1 percentage point of GDP, though it remains above its historical average. In the United Kingdom, on the right, house prices stabilized in 2005 and picked up again modestly last year. Despite lower house-price inflation, residential investment has continued to rise toward historically high levels. The relevance of these foreign experiences for the United States is difficult to gauge, but they provide some support for Larry’s forecast that the downturn in U.S. housing is nearly over. In light of the signals from financial and commodity markets, as well as other real-side indicators, we project continued solid growth in the foreign economies at rates that are not likely to strain resources or to put upward pressure on inflation. As shown in the bottom panel, total foreign growth (line 1) is estimated to have stepped down last year from 4½ percent in the first half to about 3½ percent in the second half, and it is projected to remain around 3½ percent over the forecast period. This projection is about 1 percentage point stronger than the staff’s projection for U.S. growth, shown at the bottom of the panel. The foreign industrial economies (line 2) overall are projected to grow at about the same rate as the United States, Japan a bit slower (line 4), and Canada a bit faster (line 5). The emerging market economies (line 6) are projected to grow at nearly twice the pace of the industrial economies over the forecast period. We expect that emerging Asia (line 7) will continue to grow very rapidly and that Latin America (line 8) will grow at a solid, though not exceptional, rate. Our forecast assumes that the Chinese government will take additional measures if necessary to reduce the growth rate of investment, and we project that Chinese GDP growth will be slower this year than last. But the risks to our growth forecast for China are probably greater on the upside. Exhibit 13 provides an assessment of what all these foreign influences mean for the U.S. economy. Overall import prices, the black line in the top left panel, fell sharply last quarter and are projected to continue to fall in the current quarter, primarily owing to the drop in the price of imported oil. As oil prices stop falling and begin to move gradually back up, overall import price inflation should turn positive. Prices of imported core goods (the red line), which exclude oil, gas, computers, and semiconductors, rose at a rate of nearly 4 percent in the middle of last year, primarily owing to sharply higher prices of nonfuel commodities. With commodity prices projected to stabilize and with only a small depreciation of the dollar in our forecast, prices of imported core goods should increase at a subdued pace over the next two years. The contributions of exports and imports to U.S. GDP growth are shown in the lower panel. We now estimate that the external sector made a positive arithmetic contribution to growth last year, the first positive annual contribution since 1995. Import growth stepped down from previous years as U.S. GDP grew more slowly. Export growth benefited from robust foreign economic activity, but exports turned out even stronger than our models project. Line 1 in the top right panel shows that, for the first eleven months of last year at an annual rate, exports of goods grew 10½ percent from the previous year in real terms. Lines 2 through 4 show that three categories of capital goods—aircraft, machinery, and semiconductors—contributed nearly half of total export growth. Although it is possible that blistering growth rates in exports of these goods may continue, we base our forecast on a return of export growth to a rate more consistent with historical relationships. With the vast majority of aircraft production being exported in recent months and with aircraft factories running at high utilization rates, further large increases in exports from this sector, at least, do not seem likely. Returning to the bottom panel, we project that the negative arithmetic contribution of imports (the red bars) to GDP growth will outweigh the export contribution (the blue bars) in 2007 and 2008 by about ¼ percentage point (the black line). This projection is driven by the historical tendency of U.S. imports to grow at a much faster rate than U.S. GDP. In addition, the larger value of imports relative to exports means that, even if imports and exports were to grow at the same rate, the negative contribution of imports would be greater than the positive contribution of exports. The projected strong growth rates of foreign GDP, discussed in your previous exhibit, are not large enough to outweigh these factors over the next two years. On balance, relative prices have little effect on net exports over the forecast period, as the real trade-weighted dollar has moved in a relatively narrow range over the past couple years and is not projected to move substantially over the forecast period. And now Larry will complete our presentation." CHRG-111shrg57322--722 Mr. Viniar," And you make the assessment of--is the price where you would have to sell that security versus the price you pay to put on the offsetting? If it is a lower price, is it enough lower that it is still worth it or not. And you make that judgment at the time. And markets at the time, if you remember, for the securities that were long, were quite illiquid, and so we made judgments that in some cases we did sell, and I think you see that over the year, we did sell some. But in some cases, we thought it was more prudent to put it on offsetting positions. Senator Kaufman. Right. But illiquid really, in this case, means you didn't like the prices that things were being sold for. It is not that you couldn't go into a market. I mean, illiquid to me means I go into the market and nobody is--like happened on certain days, bad dice, in our history, we just couldn't sell it at any price. You are basically saying, I didn't want to sell it because the price was so low---- " FOMC20070807meeting--126 124,MR. PLOSSER.," Thank you, Mr. Chairman. I am certainly comfortable with maintaining the fed funds rate where it is, so I’m supportive of that. I think the real key here is language. What are we trying to convey to the markets? How far can we go, acknowledging what many people share—a sense of some increased risk—without creating another set of concerns in the marketplace? So the language is the tricky piece here. I’ve waffled a bit in my feelings about this. I’m inclined to be about where I think Bill Poole and Janet Yellen are—moving the downside risks into paragraph 2 as opposed to putting them in the assessment of risk. I would be supportive of that tone. Also, in response to some of Jeff’s comments in his earlier memo on this, I actually prefer the language of repricing of risk rather than of tightening credit conditions simply because it emphasizes that this is partly a relative price adjustment that is going on. But I don’t want to take a strong stand on that. Only one other word concerns me, and I’d like to raise the issue here. In paragraph 3, which nobody has talked about yet, in the first sentence, “readings on core inflation have been relatively subdued in recent months” is a change in the language from our previous statement, which says, “improved modestly recent months.” I worry a little about the word “subdued” because I think it becomes very close to making some kind of normative judgment about the level of inflation that we are happy with. I’m uncomfortable about that particular change in the language because it, again, might imply some normative statement without the Committee’s agreeing on what we view as being subdued or not. So I’d like to suggest that we change that back to what it was before because, if we want to convey stability and some continuity here, there are places to change, there are places not to change, and I would rather change fewer words than more words going forward. That would be the only additional suggestion I would make. Thank you, Mr. Chairman." FOMC20050503meeting--163 161,MS. BIES.," Thank you, Mr. Chairman. I support the recommendation to raise rates 25 basis points, and I’ll support alternative B. As the Governors know, I’ve been frustrated with the whole “assessment of risk” piece of this, but yesterday, after thinking about it, I realized that it isn’t so simple to craft the alternatives. One of the things that I’m struck by is that sentences 3 and 4 are really the meat of the release each time. They tell how we’re looking at the real economy and at inflation, which are our two major mandates. But if we didn’t have something tying them together—to convey some conclusion about the risks—that would leave the markets hanging. To me, that’s what would happen if we got rid of lines 5 and 6 entirely. So, I think we do need something to anchor that. At first I was leaning toward alternative C, line 6, thinking that would do it. Then the more I read it, I thought: These references to fostering the attainment of sustainable economic growth and price stability are like motherhood and apple pie. Obviously, this is what the Fed is supposed to do. So, is it really saying anything? We could have that sentence in there no matter what—if the rate of inflation were 12 percent or if unemployment were down to 3½ percent. So the question is: What do we need there? I think we need something beyond just the rationale for our decision today. Right now, I think sentence 2 is important because it says that while we get noise in the data, underlying all of this we are still accommodative. And that sets up the notion of a May 3, 2005 101 of 116 So, as we look to replace this, it’s almost as if the longer-run horizon is the important point. Maybe, as President Yellen said, this gets back to the way we set our goals and targets overall. But we need a longer-run anchor, and then we need a short-run signal to the market. So I don’t think we can just eliminate the risk assessment. We have to say something, especially at times such as this where we have risks on both sides." FinancialCrisisReport--74 Home Equity originations were projected to grow from $4 billion in 2005 to $30 billion in 2008. On the other hand, WaMu’s low risk originations were expected to be curtailed dramatically. Government backed loan originations, which totaled $8 billion in 2005, were projected to be eliminated by 2008. Fixed rate loan originations were projected to decline from $69 billion in 2005 to $4 billion in 2008. The 2007 “Strategic Direction” memorandum to the Board is dated June 18, 2007, well after U.S. housing prices had begun to decline, as Mr. Killinger acknowledged: “For the past two years, we have been predicting the bursting of the housing bubble and the likelihood of a slowing housing market. This scenario has now turned into a reality. Housing prices are declining in many areas of the country and sales are rapidly slowing. This is leading to an increase in delinquencies and loan losses. The sub-prime market was especially rocked as many sub-prime borrowers bought houses at the peak of the cycle and now find their houses are worth less and they are having difficulties refinancing their initial low-rate loans.” 192 While the memorandum’s section on home loan strategy no longer focused on overall growth, it continued to push the shift to high risk lending, despite problems in the subprime market: “Home Loans is a large and important business, but at this point in the cycle, it is unprofitable. The key strategy for 2008 is to execute on the revised strategy adopted in 2006. … We need to optimize the sub-prime and prime distribution channels with particular emphasis on growing the retail banking, home loan center and consumer direct channels. We also expect to portfolio more of Home Loans’ originations in 2008, including the new Mortgage Plus product. We will continue to emphasize higher-risk adjusted return products such as home equity, sub-prime first mortgages, Alt A mortgages and proprietary products such as Mortgage Plus.” 193 The testimony of other WaMu executives further confirms the bank’s implementation of its High Risk Lending Strategy. Ronald Cathcart, who joined WaMu in 2006, to become the company’s Chief Risk Officer, testified: “The company’s strategic plan to shift its portfolios towards higher margin products was already underway when I arrived at WaMu. Basically, this strategy involved moving away from traditional mortgage lending into alternative lending programs involving adjustable-rate mortgages as well as into subprime products. The strategic shift to 192 6/18/2007 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic Direction,” JPM_WM03227058-67 at 60, Hearing Exhibit 4/13-6a. 193 Id. at 66 [emphasis in original removed]. See also 1/2007 Washington Mutual presentation, “Subprime Mortgage Program,” JPM_WM02551400, Hearing Exhibit 4/13-5 (informing potential investors in its subprime RMBS securities that: “WaMu is focusing on higher margin products”). higher-margin products resulted in the bank taking on a higher degree of credit risk because there was a greater chance that borrowers would default.” 194 CHRG-109shrg30354--93 Chairman Bernanke," We could try to do an evaluation with our models and the like. I am not sure how accurate it would be. In addition, the interesting thing about the energy price increases is that if you go back for 3 or 4 years and you look at each month at what the futures market was expecting, it was always expecting these things. We have had these increases, the energy prices are going to finally stabilize. And every single month it has been wrong. And so this increase in energy prices and commodity prices certainly has been a significant contributor. And I think that we would not really be talking about this now if energy prices were still $30 or $40 a barrel. Senator Sununu. Thank you, Mr. Chairman. " CHRG-111shrg55278--112 PREPARED STATEMENT OF ALICE M. RIVLIN Senior Fellow, Economic Studies, Brookings Institution July 23, 2009 Mr. Chairman and Members of the Committee, I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. I will focus on changes in our regulatory structure that might prevent another catastrophic financial meltdown and what role the Federal Reserve should play in a new financial regulatory system. It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic well-being and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and overborrowing, excessive risk taking, and outsized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world's economic well-being.Approaches To Reducing Systemic Risk The crisis was a financial ``perfect storm'' with multiple causes. Different explanations of why the system failed--each with some validity--point to at least three different approaches to reducing systemic risk in the future.The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down. This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system charged with spotting perverse incentives, regulatory gaps and market pressures that might destabilize the system and taking steps to fix them. The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities. While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.The system crashed because large interconnected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets. This explanation might lead to policies to restrain the growth of large interconnected financial firms--or even break them up--and to expedited resolution authority for large financial firms (including nonbanks) to lessen the impact of their failure on the rest of the system. Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier 1 Financial Institutions. I believe it would be a mistake to identify specific institutions as too-big-to-fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.The Case for a Macro System Stabilizer One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, antiregulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in. Perverse Incentives. Lax lending standards created the bad mortgages that were securitized into the toxic assets now weighting down the books of financial institutions. Lax lending standards by mortgage originators should have been spotted as a threat to stability by a Macro System Stabilizer--the Fed should have played this role and failed to do so--and corrected by tightening the rules (minimum down payments, documentation, proof that the borrow understands the terms of the loan and other no-brainers). Even more important, a Macro System Stabilizer should have focused on why the lenders had such irresistible incentives to push mortgages on people unlikely to repay. Perverse incentives were inherent in the originate-to-distribute model which left the originator with no incentive to examine the credit worthiness of the borrower. The problem was magnified as mortgage-backed securities were resecuritized into more complex instruments and sold again and again. The Administration proposes fixing that system design flaw by requiring loan originators and securitizers to retain 5 percent of the risk of default. This seems to me too low, especially in a market boom, but it is the right idea. The Macro System Stabilizer should also seek other reasons why securitization of asset-backed loans--long thought to be a benign way to spread the risk of individual loans--became a monster that brought the world financial system to its knees. Was it partly because the immediate fees earned by creating and selling more and more complex collateralized debt instruments were so tempting that this market would have exploded even if the originators retained a significant portion of the risk? If so, we need to change the reward structure for this activity so that fees are paid over a long enough period to reflect actual experience with the securities being created. Other examples, of perverse incentives that contributed to the violence of the recent perfect financial storm include Structured Investment Vehicles (SIV's) that hid risks off balance sheets and had to be either jettisoned or brought back on balance sheet at great cost; incentives of rating agencies to produce excessively high ratings; and compensation structures of corporate executives that incented focus on short-term earnings at the expense the longer run profitability of the company. The case for creating a new role of Macro System Stabilizer is that gaps in regulation and perverse incentives cannot be permanently corrected. Whatever new rules are adopted will become obsolete as financial innovation progresses and market participants find ways around the rules in the pursuit of profit. The Macro System Stabilizer should be constantly searching for gaps, weak links and perverse incentives serious enough to threaten the system. It should make its views public and work with other regulators and Congress to mitigate the problem. The Treasury makes the case for a regulator with a broad mandate to collect information from all financial institutions and ``identify emerging risks.'' It proposes putting that responsibility in a Financial Services Oversight Council, chaired by the Treasury, with its own permanent expert staff. The Council seems to me likely to be cumbersome. Interagency councils are usually rife with turf battles and rarely get much done. I think the Fed should have the clear responsibility for spotting emerging risks and trying to head them off before it has to pump trillions into the system to avert disaster. The Fed should make a periodic report to the Congress on the stability of the financial system and possible threats to it. The Fed should consult regularly with the Treasury and other regulators (perhaps in a Financial Services Oversight Council), but should have the lead responsibility. Spotting emerging risks would fit naturally with the Fed's efforts to monitor the State of the economy and the health of the financial sector in order to set and implement monetary policy. Having explicit responsibility for monitoring systemic risk--and more information on which to base judgments would enhance its effectiveness as a central bank. Controlling Leverage. The biggest challenge to restructuring the incentives is: How to avoid excessive leverage that magnified the upswing and turned the downswing into a rout? The aspect of the recent financial extravaganza that made it truly lethal was the overleveraged superstructure of complex derivatives erected on the shaky foundation of America's housing prices. By itself, the housing boom and bust would have created distress in the residential construction, real estate, and mortgage lending sectors, as well as consumer durables and other housing related markets, but would not have tanked the economy. What did us in was the credit crunch that followed the collapse of the highly leveraged financial superstructure that pumped money into the housing sector and became a bloated monster. One approach to controlling serious asset-price bubbles fueled by leverage would be to give the Fed the responsibility for creating a bubble Threat Warning System that would trigger changes in permissible leverage ratios across financial institutions. The warnings would be public like hurricane or terrorist threat warnings. When the threat was high--as demonstrated by rapid price increases in an important class of assets, such as land, housing, equities, and other securities without an underlying economic justification--the Fed would raise the threat level from, say, Three to Four or Yellow to Orange. Investors and financial institutions would be required to put in more of their own money or sell assets to meet the requirements. As the threat moderated, the Fed would reduce the warning level. The Fed already has the power to set margin requirements--the percentage of his own money that an investor is required to put up to buy a stock if he is borrowing the rest from his broker. Policy makers in the 1930s, seeking to avoid repetition of the stock price bubble that preceded the 1929 crash, perceived that much of the stock market bubble of the late 1920s had been financed with money borrowed on margin from broker dealers and that the Fed needed a tool distinct from monetary policy to control such borrowing in the future. During the stock market bubble of the late 1990s, when I was Vice Chair of the Fed's Board of Governors, we talked briefly about raising the margin requirement, but realized that the whole financial system had changed dramatically since the 1920s. Stock market investors in the 1990s had many sources of funds other than borrowing on margin. While raising the margin requirements would have been primarily symbolic, I believe with hindsight that we should have done it anyway in hopes of showing that we were worried about the bubble. The 1930s legislators were correct: monetary policy is a poor instrument for counteracting asset price bubbles; controlling leverage is likely to be more effective. The Fed has been criticized for not raising interest rates in 1998 and the first half of 1999 to discourage the accelerating tech stock bubble. But it would have had to raise rates dramatically to slow the market's upward momentum--a move that conditions in the general economy did not justify. Productivity growth was increasing, inflation was benign and responding to the Asian financial crisis argued for lowering rates, not raising them. Similarly, the Fed might have raised rates from their extremely low levels in 2003 or raised them earlier and more steeply in 2004-5 to discourage the nascent housing price bubble. But such action would have been regarded as a bizarre attempt to abort the economy's still slow recovery. At the time there was little understanding of the extent to which the highly leveraged financial superstructure was building on the collective delusion that U.S. housing prices could not fall. Even with hindsight, controlling leverage (along with stricter regulation of mortgage lending standards) would have been a more effective response to the housing bubble than raising interest rates. But regulators lacked the tools to control excessive leverage across the financial system. In the wake of the current crisis, financial system reformers have approached the leverage control problem in pieces, which is appropriate since financial institutions play diverse roles. However the Federal Reserve--as Macro System Stabilizer--could be given the power to tie the system together so that various kinds of leverage ratios move in the same direction simultaneously as the threat changes. With respect to large commercial banks and other systemically important financial institutions, for example, there is emerging consensus that higher capital ratios would have helped them weather the recent crisis, that capital requirements should be higher for larger, more interconnected institutions than for smaller, less interconnected ones, and that these requirements should rise as the systemic threat level (often associated with asset price bubbles) goes up. With respect to hedge funds and other private investment funds, there is also emerging consensus that they should be more transparent and that financial derivatives should be traded on regulated exchanges or at least cleared on clearinghouses. But such funds might also be subject to leverage limitations that would move with the perceived threat level and could disappear if the threat were low. One could also tie asset securitization into this system. The percent of risk that the originator or securitizer was required to retain could vary with the perceived threat of an asset price bubble. This percentage could be low most of the time, but rise automatically if Macro System Stabilizer deemed the threat of a major asset price bubble was high. One might even apply the system to rating agencies. In addition to requiring rating agencies to be more transparent about their methods and assumptions, they might be subjected to extra scrutiny or requirements when the bubble threat level was high. Designing and coordinating such a leverage control system would not be an easy thing to do. It would require create thinking and care not to introduce new loopholes and perverse incentives. Nevertheless, it holds hope for avoiding the run away asset price exuberance that leads to financial disaster.Systemically Important Institutions The Obama administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier 1 Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go. It is certainly important to reduce the risk that large interconnected institutions fail as a result of engaging in highly risky behavior and that the contagion of their failure brings down others. However, there are at least three reasons for questioning the wisdom of identifying a specific list of such institutions and giving them their own consolidated regulator and set of regulations. First, as the current crisis has amply illustrated, it is very difficult to identify in advance institutions that pose systemic risk. The regulatory system that failed us was based on the premise that commercial banks and thrift institutions that take deposits and make loans should be subject to prudential regulation because their deposits are insured by the Federal Government and they can borrow from the Federal Reserve if they get into trouble. But in this crisis, not only did the regulators fail to prevent excessive risk taking by depository institutions, especially thrifts, but systemic threats came from other quarters. Bear Stearns and Lehman Brothers had no insured deposits and no claim on the resources of the Federal Reserve. Yet when they made stupid decisions and were on the edge of failure the authorities realized they were just as much a threat to the system as commercial banks and thrifts. So was the insurance giant, AIG, and, in an earlier decade, the large hedge fund, LTCM. It is hard to identify a systemically important institution until it is on the point of bringing the system down and then it may be too late. Second, if we visibly cordon off the systemically important institutions and set stricter rules for them than for other financial institutions, we will drive risky behavior outside the strictly regulated cordon. The next systemic crisis will then likely come from outside the ring, as it came this time from outside the cordon of commercial banks. Third, identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize ``too-big-to-fail'' and create a new set of GSE-like institutions. There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money at risk to prevent such failures. Higher capital requirements and stricter regulations for large interconnected institutions make sense, but I would favor a continuum rather than a defined list of institutions with its own special regulator. Since there is no obvious place to put such a responsibility, I think we should seriously consider creating a new financial regulator. This new institution could be similar to the U.K.'s FSA, but structured to be more effective than the FSA proved in the current crisis. In the U.S. one might start by creating a new consolidated regulator of all financial holding companies. It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies. I don't pretend to have a definitive answer to how the regulatory boxes should best be arranged, but it seems to me a mistake to give the Federal Reserve responsibility for consolidated prudential regulation of Tier 1 Financial Holding Companies, as proposed by the Obama Administration. I believe the skills needed by an effective central bank are quite different from those needed to be an effective financial institution regulator. Moreover, the regulatory responsibility would likely grow with time, distract the Fed from its central banking functions, and invite political interference that would eventually threaten the independence of monetary policy. Especially in recent decades, the Federal Reserve has been a successful and widely respected central bank. It has been led by a series of strong macroeconomists--Paul Volcker, Alan Greenspan, Ben Bernanke--who have been skillful at reading the ups and downs of the economy and steering a monetary policy course that contained inflation and fostered sustainable economic growth. It has played its role as banker to the banks and lender of last resort--including aggressive action with little used tools in the crisis of 2008-9. It has kept the payments system functioning even in crises such as 9/11, and worked effectively with other central banks to coordinate responses to credit crunches, especially the current one. Populist resentment of the Fed's control of monetary policy has faded as understanding of the importance of having an independent institution to contain inflation has grown--and the Fed has been more transparent about its objectives. Although respect for the Fed's monetary policy has grown in recent years, its regulatory role has diminished. As regulator of Bank Holding Companies, it did not distinguish itself in the run up to the current crisis (nor did other regulators). It missed the threat posed by the deterioration of mortgage lending standards and the growth of complex derivatives. If the Fed were to take on the role of consolidated prudential regulator of Tier 1 Financial Holding Companies, it would need strong, committed leadership with regulatory skills--lawyers, not economists. This is not a job for which you would look to a Volcker, Greenspan, or Bernanke. Moreover, the regulatory responsibility would likely grow as it became clear that the number and type of systemically important institutions was increasing. My fear is that a bifurcated Fed would be less effective and less respected in monetary policy. Moreover, the concentration of that much power in an institution would rightly make the Congress nervous unless it exercised more oversight and accountability. The Congress would understandably seek to appropriate the Fed's budget and require more reporting and accounting. This is not necessarily bad, but it could result in more Congressional interference with monetary policy, which could threaten the Fed's effectiveness and credibility in containing inflation. In summary, Mr. Chairman: I believe that we need an agency with specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures that could pose serious threats to the stability of the financial system. I would give the Federal Reserve clear responsibility for Macro System Stability, reporting periodically to Congress and coordinating with a Financial System Oversight Council. I would also give the Fed new powers to control leverage across the system--again in coordination with the Council. I would not create a special regulator for Tier 1 Financial Holding Companies, and I would certainly not give that responsibility to the Fed, lest it become a less effective and less independent central bank. Thank you, Mr. Chairman and Members of the Committee. ______ CHRG-111hhrg51698--305 Mr. Taylor," Thank you. Thank you, Chairman Peterson, Ranking Member Lucas, and Members of the Committee. I am Gary Taylor, CEO of Cargill Cotton in Memphis, Tennessee; and I appear today here representing the members of the National Cotton Council, the American Cotton Shippers and AMCOT, which is a trade association of marketing cooperatives. In the past year, the cotton industry has undergone severe financial strain due to the unpredictable risk caused by a dysfunctional futures market. The March 2008, debacle and the ICE No. 2 Cotton Contract forced a number of first handlers into bankruptcy, while others have announced orderly closures. Traditional merchandising relationships have ceased, because price risks are too great for hedging purposes. Growers continue to be concerned about the financial viability of marketing entities with whom they have previously contracted. To ensure the survival of our marketing structure, the cotton futures market must be returned to its historical function of price discovery and risk management relative to real market conditions. As the cotton industry informed this Committee in 2008, investment funds and over-the-counter operatives flooded our futures markets with record amounts of cash. In our opinion, their presence distorted both the futures and physical markets. We believe the legislation before the Committee, the Derivatives Markets Transparency and Accountability Act of 2009, addresses these concerns raised by our industry and the agriculture sector and restores confidence of the commercial trade and lending institutions. It will facilitate market fundamentals, not speculative activity, resulting in accurate price discovery. The cotton industry acknowledges the importance of market liquidity and the essential function speculative interests perform in our commodity markets. In our view, by requiring full transparency and accountability of speculative trades, the proposed legislation would not discourage speculative participation in the commodity contracts. Market liquidity is essential, but it must be tempered and monitored, and it should not dictate the direction of the market. In the current regulatory structure, Congress's CFTC has imposed speculative position limits in our futures contracts to reduce the potential for market disruption or manipulation. Such limits are no longer effective for three reasons: first, hedge exemptions granted to investment funds allowed them to exceed the limit; second, large traders using swaps exemptions operate outside the regulatory framework altogether; and third, nontraditional trader's speculative limits are only imposed as these contracts go into convergence. The other significant area of concern is the exempt status afforded swaps transactions that are executed off-exchange with each party mutually agreeing to satisfy each other's credit standards, and to remit margins to one another as the underlying market fluctuates. Such transactions pose problems when one of the parties has a hedge exemption that exempts his or her on-exchange futures trading from position size limits. These arrangements, along with billions of dollars invested in index funds, has brought so much cash into our markets that the traditional speculators could not take a short position to match the institutional longs. This left it up to the commercials to offset these positions. But, lacking the necessary capital to meet the huge margin requirements, they could not do so. The result is a market with no economic purpose for the commercial traders. Simply put, the investment funds have negated the real purpose of our futures markets. In order to restore the integrity of the markets, and to ensure they fulfill the basic roles of price discovery risk management and hedging, the cotton industry has developed a number of recommendations that are incorporated into the legislation before the Committee. First, establish trading limits to prevent excessive speculation; second, subject all contract and over-the-counter market participants to speculative position limits; third, subject speculative entities to the same weekly reporting requirements as the trade; and finally, limit hedge exemptions and limit eligibility for hedge margin levels to those actually involved in the physical handling of our commodities. The cotton industry also believes that the lack of transparency and disparate reporting requirements by market participants is appropriately addressed by legislation requiring the CFTC to disaggregate index funds, and publish the number of positions and total value of the index funds and other passive, long-only, short-only investors and data on speculative positions relative to their bona fide physical hedges. And also to establish reporting requirements for index traders and swap traders in designated market contracts, derivative transaction execution facilities and all other trading areas. In addition to these necessary changes, the cotton industry feels strongly that the CFTC should require the IntercontinentalExchange and its clearinghouse members to adhere to the practice of margining futures to futures settlements and options to options settlements. Also, the cotton industry has an important caveat for both the Committee and the CFTC. We submit that no action should be taken to discourage over-the-counter transactions with legitimate commercial purposes, transactions that are transparent and have proven to be beneficial risk management tools. It is essential that we encourage commercial innovation for those producing, merchandising or using physical commodities traded in the futures market. In closing, I would like to stress restoring confidence in the futures markets is of the utmost importance, and we thank you for considering our views. [The prepared statement of Mr. Taylor follows:] Prepared Statement of Gary W. Taylor, CEO, Cargill Cotton Company, Cordova, TN; on Behalf of National Cotton Council; American Cotton Shippers Association; and AMCOT Chairman Peterson, Ranking Member Lucas, and Members of the Committee, I am Gary Taylor, CEO of Cargill Cotton Company in Cordova, Tennessee. Cargill Cotton is a division of Cargill, Incorporated, an international provider of food, agricultural and risk management products and services. We service growers, ginners, buyers and textile mills worldwide through our network of buying, selling and shipping offices and our cotton gins and warehouses. I appear today representing the members of the National Cotton Council, the American Cotton Shippers Association, and AMCOT, a trade association of marketing cooperatives. We appreciate your scheduling this week's hearing and the outstanding leadership you have provided this past year on this subject critical to farmers, marketers, processors and consumers of agricultural and energy products. The involvement of the Committee this past year exemplifies its interest and its willingness to effectively oversee the commodity futures markets and to address issues vitally important to the functioning of the U.S. economy.Impact of Futures Markets on Cotton Industry The sound and effective regulation of a transparent futures market would provide significant benefits to the cotton industry, which is concentrated in 17 cotton-producing states, stretching from Virginia to California with the downstream manufacturers of cotton apparel and home furnishings located in virtually every state. The industry and its suppliers, together with the cotton product manufacturers, account for more than 230,000 jobs in the U.S. The annual economic activity generated by cotton and its products in the U.S. is estimated to be in excess of $100 billion. In the past year, the cotton industry has undergone severe financial strain due to the uncertainty and unpredictable risk caused by a dysfunctional futures market. Coming to light is the damage of the March 2008 debacle in the ICE No. 2 Upland Cotton Contract as a number of first handlers have been forced into bankruptcy, several have announced orderly closures, and most have seen their assets dwindle to a critical level. Traditional merchandising relationships between growers and buyers have ceased because price risks are too great for short hedging purposes. Growers continue to be concerned about the financial viability of marketing entities with whom they have previously contracted crop sales. The inability of merchandisers to hedge their risks translates into a weaker basis and lower prices offered to the cotton producer. Each penny reduction in the price of cotton means that U.S. cotton farmers lose $85 million in revenue. Therefore, to insure the survival of our marketing structure, the cotton futures market must be returned to its historical function of price discovery and risk management relative to real market conditions.The Lesson Learned As the cotton industry and the agricultural complex informed this Committee in 2008, investment funds and over-the-counter (OTC) operatives flooded the futures markets with record amounts of cash, throwing the trading fundamentals out of balance, resulting in a widened basis, and thereby making these markets illiquid for those for whom Congress created these markets. The presence of large speculative funds and index funds in the energy and agricultural futures contracts distorted the futures and the physical or cash markets of these commodities. The abundance of unregulated cash allowed these funds to overwhelm these markets negating their primary purposes. Long before others in the Congress or the regulatory agencies recognized the problem or began to take action, the House Agriculture Committee had hearings underway and appropriate legislation before the Congress. Now, the leaders of the developed and developing world are calling for the U.S. to effectively regulate the commodity markets. We commend the Committee for that bipartisan foresight and believe that the legislation before the Committee, The Derivatives Markets Transparency and Accountability Act of 2009, would address the concerns raised by the cotton industry and the agricultural sector and restore the confidence of the commercial trade and the lending institutions. Above all, it will facilitate market fundamentals, not speculative activity, resulting in accurate price discovery in the futures markets.The Importance of Market Liquidity The cotton industry acknowledges the importance of market liquidity and the essential function the speculative interests perform in the commodity markets. We welcome that participation and do not wish to discourage it. In our view, the legislation before the Committee by requiring full transparency and accountability of speculative trades would not discourage speculative participation in the commodity contracts. Market liquidity is essential, but it must be tempered and monitored--it should not dictate the direction of the market.Speculative Position Limits and the Swaps Exemption In the current regulatory structure of the futures markets, Congress, through the CFTC, has imposed speculative positions limits in the futures contracts to reduce the potential for market disruption or manipulation. But such limits are no longer effective for three reasons: 1. The CFTC has granted Hedge Exemptions to the investment funds allowing them to exceed the limits; 2. Large traders were permitted by Congress, through the Swaps Exemption, to operate outside the regulatory framework altogether; and 3. Non-traditional traders speculative limits are only imposed as contracts go into convergence. The other significant area of concern is the exempt status afforded Swaps transactions that are executed off-exchange with each party mutually agreeing to satisfy each other's credit standards and to remit margins to one another as the underlying market fluctuates. Such transactions, however, pose problems when one of the parties to the Swap has a ``Hedge Exemption'' that exempts his or her on-exchange futures trading from position-size limits.\1\--------------------------------------------------------------------------- \1\ In such situations, the Swaps dealer would take an equal and opposite position in the futures market to the Swaps trade. For example, should a pension fund desire to purchase $20 million in long exposure in a commodity, it can purchase this exposure from a Swaps dealer. The dealer, now short the price of that commodity via the Swap, enters the futures market to hedge his position by buying futures in that commodity. Given that he is a ``hedger,'' the CFTC allows him to trade futures in excess of the normal speculative position-size limits. This has created a situation where such large investors can trade in any contract in any size they desire without regard to position limits. They are not limited by the CFTC. Only a Swaps dealer can limit such trades, and it is unlikely that a Swaps dealer would turn a deaf ear to a financial entity awash in cash.--------------------------------------------------------------------------- These arrangements, along with the billions of dollars invested in index funds, brought so much cash into the market that the traditional speculators could not take a short position to match the institutional longs. This left it up to the commercials to offset these positions. But lacking the necessary capital to meet the huge margin requirements, they could not do so. That has been the situation this past year as the funds continued to purchase futures. Unwilling to assume such margin risks in such a volatile futures market, the commercial traders were forced to remain passive not only in the futures, but in the physical markets as well. The result: markets with no economic purpose for the commercials. Therefore, no business was done. Producers, lacking a price, could not properly plan and processors had to buy hand to mouth. Simply put, the investment funds have negated the real purpose of the futures markets, causing severe disruptions in the marketing process.Cotton Industry Recommendations In order to restore the integrity of the futures and derivatives markets and to ensure that such markets function properly by providing price discovery and hedging thereby allowing producers and manufacturers to lock in prices and merchants and cooperatives to offer forward prices to producers and manufacturers, the U.S. cotton industry has developed a number of recommendations that are incorporated in The Derivatives Markets Transparency and Accountability Act of 2009. Congress should: Establish trading limits to prevent excessive speculation, Subject all contract and over-the-counter market participants to speculative position limits, Subject speculative entities to the same weekly reporting requirements as the trade, and Limit hedge exemptions and limit eligibility for hedge margin levels to those actually involved in the physical handling of the agricultural commodity. The cotton industry also believes that the lack of transparency and disparate reporting requirements by market participants is appropriately addressed by the legislation by requiring the CFTC to: Disaggregate index funds and publish the number of positions and total value of the index funds and other passive, long-only and short-only investors, and data on speculative positions relative to their bona fide physical hedges, and Establish reporting requirements for index traders and swap dealers in designated contract markets (exchanges), derivative transaction execution facilities and all other trading areas. In addition to these necessary changes, the cotton industry feels strongly that the CFTC should require the IntercontinentalExchange and its clearing house members to adhere to the practice of margining futures to futures settlements and options to options settlements. Also, the cotton industry has an important caveat for both the Committee and the CFTC. We submit that no action should be taken to discourage over-the-counter transactions with legitimate commercial purposes--transactions that are transparent and have proven to be beneficial risk management tools utilized by producers, merchants, and manufacturers. It is essential that we encourage commercial innovation for those producing, merchandising, manufacturing, or using the physical commodity traded in the futures markets. In closing, I would like to stress that restoring confidence in the futures market is of the utmost importance to our industry. Thank you for considering our views and recommendations during the development and consideration of this vitally important legislation. " FOMC20080625meeting--131 129,MR. PLOSSER.," Thank you, Mr. Chairman. In my view the economy is evolving in a way that suggests that we need to take back sooner rather than later some of the insurance we put in place against downside tail risk. I base this view on several points. First, economic activity remains weak. I don't dispute that. The data since our last meeting have been better than expected. The Greenbook forecasts as well as most private-sector forecasts have been revised up. So although downside risks remain, the tail risk of a significant recession-like outcome for the economy, though it has not vanished, has certainly diminished. Second, financial market indicators suggest that market functioning, though not back to normal, has certainly improved somewhat in recent months. Demand for Fed liquidity from the primary dealers has fallen. Primary credit borrowing generally is down. Now, although we may wish to keep our liquidity facilities for now as a backstop, the extra accommodation that we have built into monetary policy may no longer be needed or even appropriate at this point. The real economy and financial functioning have improved since our last meeting, but the inflation outlook has worsened, as we have been hearing. Headline inflation is up. Expectations of various kinds are elevated. Upside risk to core inflation has increased, as the Greenbook has said. As I said yesterday, these upside risks stem not only from the potential passthrough of energy prices but also, in my view, from the fact that we're running a very accommodative policy despite rising inflation. In fact, I believe that policy has actually become more accommodative since the meeting at the end of April. First, the nominal funds rate has been at a constant level, but expectations of inflation have risen. So, in fact, the real funds rate has actually declined since our last meeting as inflation has risen. Second, real rates of interest more broadly have been gradually drifting up since late March or early April. The TIPS rates, the real interest rates, have been drifting up by, depending on which term you look at, anywhere from 25 basis points to 35 basis points. So as the real rates on risk-free securities have risen, which may be appropriate given the fact that prospects for the real economy have improved modestly, the real funds rate has been declining. As a consequence, whatever you think about the level of the fed funds rate, we have become more accommodative since the last meeting. As I've argued before in this Committee, optimal monetary policy in a broad class of models suggests that you get Taylor-rule-like rules but that the funds rate follows the real interest rate as it moves around. Optimal policy calls for following the real rates. I argued that was the case and appropriate as real rates fell in the context of a weakening economy. It was important that policy match those declines in the real rates, which I think it did. It's a coherent policy, but it also means that as real rates begin to rise, as we have been seeing, policy needs to adjust to those real rates rising. Now, of course, a lot of judgment is required in this type of policy. There are smoothing issues. Real rates could be quite volatile. There's debate about which real rate you want to be looking at. I understand that. But I don't think there's any question that the objective should be to match those movements in the real rates, and we should be thinking about it in those terms. Long-term inflation expectations have been volatile but have moved within a reasonably defined range over the last period, and I'm comforted somewhat by that. But as I have said, I believe that inflation expectations are fragile. At the very least, the anchor is dragging, and if we continue to maintain a real funds rate well below zero with rising inflation well above our goal, I do not think we can continue to assume and trust that expectations will remain well anchored. We've done a good job with our words so far, but with the shift from downside risk to growth to upside risk to inflation, we need to take action to ensure that price stability remains a credible objective of this Committee. If the economy and financial markets continue to evolve as they have over the last couple of months, that time may be soon. We must take back some of the insurance we put on. Not doing so soon risks having to respond more aggressively later on, which I believe will be much more difficult for the Committee to do. In fact, smaller moves sooner will help with our credibility in the marketplace and will help anchor those expectations as we wait for more data and for the economy to strengthen. In this regard, I think we are fortunate that market participants reacted to the incoming data by appreciably tightening their policy expectations. Thus, a move to raise rates is unlikely to catch them off guard. Moreover, I don't think that we should disabuse them of such policy expectations. Some might argue that an increase in policy expectations is a negative development. I would disagree. I think that it reflects rising expectations of a somewhat stronger economy and concerns about inflation. As the Chairman said, we should resist any erosion, any rise in longer-term inflation expectations. Now, as I said, the timing of such a move is a judgment call, and I expect that my views will differ from those of some of my colleagues, particularly since I had my fed funds rate path rising to 2� percent by the end of '08. So let me turn to language. In the rationale in paragraph 2, I have only one suggestion. I think that we should acknowledge that the functioning of financial markets, while not back to normal, has improved. So instead of saying ""financial markets remain under considerable stress,"" which we have said for some time, perhaps it might be easy to say just that the financial markets remain under stress, leaving out ""considerable."" That acknowledges the fact that there's some improvement but that stress is still there. Finally, in paragraph 4, I am pleased that the revisions make more explicit that the upside risks to inflation and inflation expectations have increased and that the downside risks to growth remain but are diminished. I was going to suggest that we strike ""near-term,"" but Brian beat me to the punch there. So I approve of that change. I think that's very good. In alternative B, I would prefer that we add some of the language from the Chairman's recent speech to paragraph 4. I think it would be a stronger message that the Committee will take actions to ensure that inflation expectations do not become unhinged, and it would also convey that both parts of our dual mandate, price stability and economic growth, are at risk should inflation expectations become unhinged. Thank you, Mr. Chairman. " FOMC20080625meeting--37 35,MR. SHEETS.," In the process of preparing our forecast, we do come up with estimates of slack for the emerging market economies, but we are not inclined to put a whole lot of weight on them. The concept of an output gap is not really a well-defined construct for, say, China. Nevertheless, these economies will be growing a little more slowly than they have in the past, and some of the pressures on resources associated with that growth may abate a bit. I think that is at least a piece of the story of what you see here as the decline. But at the end of the day, it has to be a story about commodity prices. Food prices and energy prices have pushed this up. Depending on exactly which emerging market economy you're in, food prices will range anywhere from 25 percent to 33 percent of their basket. As long as those food prices and energy prices are moving up dramatically, you are going to see rapid increases in inflation. So the decline that you are seeing in this chart really is conditioned first and foremost on commodity prices flattening out. I wish I had a better story. " FOMC20080625meeting--102 100,MR. MADIGAN.," 4 Thank you, Mr. Chairman. I will begin by referring to the draft announcement language in table 1, included in the package labeled ""Material for FOMC Briefing on Monetary Policy Alternatives."" As Chairman Bernanke noted yesterday, this version is only slightly revised from the version discussed in the Bluebook. Rather than keep you in suspense, I will note now that the revision is simply to strike the phrase ""near-term"" from alternative B, paragraph 4. Turning first to alternative A, the Committee would ease policy 25 basis points at this meeting and would issue a statement similar to the one published after the April FOMC meeting. The second paragraph would indicate that economic activity has remained weak in recent months. It would recognize that consumer spending appears to have firmed but would go on to mention other aspects of economic performance that remain weak. The paragraph on inflation would cite the recent further increase in energy prices but would also note the stability of core inflation. It would again express the Committee's expectation for inflation to moderate, partly reflecting a leveling-off of energy prices, but would acknowledge that uncertainty about the inflation outlook remains high. As in April, the final paragraph would be silent on the balance of risks and on the likely path of policy. For most of you, your baseline outlook would seem to provide little support for selection of alternative A at this meeting. As was noted yesterday, most of you conditioned your projections on a path for policy that begins to tilt up either immediately or sometime in the next few quarters. With such a policy path, the central tendency of your projections points to a gradual pickup in economic growth and a fairly prompt drop in total inflation as energy and other commodity prices level out but only a gradual decline in core inflation, which reflects the moderate amount of economic slack that you foresee over the next few years. As was illustrated in one of 4 The materials used by Mr. Madigan are appended to this transcript (appendix 4). the optimal control simulations presented in the Bluebook, a case can be made for alternative A if you agree with the staff baseline outlook and favor aiming for 2 percent inflation over the longer term. One of the estimated policy rules presented in the Bluebook also suggests modest further easing, but again that prescription relies on the staff's forecast rather than on your generally stronger near-term outlook. But given the modal outlooks of most members of the Committee, any case for easing at this meeting would seem to be best motivated by persisting concern about the downside risks to growth that many of you again cited in your forecast submissions. The ""recession"" simulation in the Greenbook provided one plausible scenario for the realization of such risks and suggested that the funds rate might need to be lowered to 1� percent. Under alternative B, the Committee would leave the stance of policy unchanged at this meeting. The statement would note that economic activity continues to expand and, as in alternative A, would mention the firming of consumer spending. It would cite the same factors that could restrain economic growth that were referenced in April and would add the rise in energy prices to the list. The inflation paragraph would again convey the Committee's anticipation that inflation will moderate but would elide the explanation for that expectation and would reference high uncertainty about inflation prospects. The final paragraph would indicate that the downside risks to growth appear to have diminished somewhat and that the upside risks to inflation and inflation expectations have increased. As I noted previously, we have suggested that the phrase ""near-term"" be struck as the Committee's focus presumably is on longer-term inflation. The references to risks to both growth and inflation would be consistent with the concerns that you expressed in your forecast submissions. The statement proposed for alternative B seems generally in line with market expectations, and an announcement along these lines is unlikely to provoke much market reaction. By pointing to reduced risks to growth and increased risks to inflation while not explicitly stating that the inflation risks predominate, the Committee would likely be seen as suggesting that its next policy move could be toward firming but also that such a move probably was not imminent. A policy approach along the lines of alternative B seems generally consistent with the projections that many of you provided for this round. Although most participants conditioned their projections on a steeper policy path than the one in the Greenbook, many also appeared to assume that the firming process would not commence until later this year or in 2009. A decision to stand pat at this meeting might be motivated importantly by your sense that the risks in both directions around your baseline projections are substantial. While staying your hand today might risk a further upcreep in inflation expectations, you might also be concerned that a policy firming now, given that financial markets are still fragile, would risk having outsized market effects with adverse implications for an economy that remains weak. As a result, you may see benefits to allowing more time for financial markets to recuperate and more time for information on the outlook to accumulate before taking policy action. Holding the funds rate at 2 percent at this meeting would be consistent with the Committee's past behavior as captured by the estimated outcome-based rule presented in the Bluebook. Under alternative C, the final column, the Committee would firm policy 25 basis points at this meeting. In the statement, the paragraph on real activity would be identical to that for alternative B. However, the third paragraph would provide the motivation for the action by emphasizing that overall inflation has been elevated, that energy prices have risen further, and that inflation expectations have risen further. No assessment of the balance of risks would be provided in the final paragraph, thus avoiding a suggestion that the firming signaled a sequence of further rate increases. Nonetheless, with market participants currently seeing only a small chance of a rate increase at this meeting, an announcement along the lines of alternative C would likely prompt a considerable jump in short- and intermediate-term market interest rates. Although most of your forecasts appeared to assume that policy firming would begin later this year or early next year, some of you explicitly assumed an earlier start to policy tightening. Members might believe that firming at this meeting is warranted partly by evidence of some reduction in downside risks to growth. Recent spending data suggest that economic activity has a bit more forward momentum than previously perceived, reducing the odds on recession; the modest improvement in financial market conditions points to some reduction in downside risks; and the Federal Reserve's special liquidity facilities appear to have been successful in reducing the odds of negative tail events and severe adverse feedback loops. Thus members might see it as appropriate now to begin to reverse some of the Committee's past policy actions to the extent that those actions were seen as motivated by downside risks that have now diminished. Also, near-term firming might be motivated by the further increases in inflation pressures and risks resulting from the continued upward march of energy and some other commodity prices. Finally, with inflation expectations continuing to show some signs of moving up, a firming of policy at this time might be viewed as a timely shot across the bow that could be helpful in restraining such expectations. I thought that it might be helpful to conclude by reviewing two exhibits from the medium-term strategies section of the Bluebook, starting with the optimal policy simulations that are reproduced in exhibit 2. The simulations underlying these exhibits are based on the FRB/US model after adjusting it to line up with the Greenbook forecast and extension. As usual, these simulations assume that you aim to minimize the sum of squared deviations of inflation from target, squared deviations of the unemployment rate from the NAIRU, and squared changes in the nominal funds rate. Two key points can be drawn from these simulations. First, whether policy firming should begin sooner or later may depend partly on your longer-run inflation objective. As shown by the black line in the top right-hand panel, if your objective for the longer run is to get back to a 2 percent inflation rate, these simulations suggest that you can hold the funds rate steady or even ease slightly further before beginning to firm in 2010. This policy path produces a somewhat faster decline in the output gap and thus somewhat slower disinflation than in the Greenbook and extension. In contrast, the simulations shown in the left-hand column suggest that pursuit of a 1� percent inflation objective would involve policy firming beginning quite soon. In general, the policy paths described by many of you in your forecast submissions seem to fall between these two scenarios, apparently reflecting your sense that aggregate demand growth could be a bit stronger and inflation pressures a bit more intense than projected by the staff as well as your dissatisfaction with a path for inflation that is as shallow as that for the scenario with a 2 percent inflation objective. The second point underscored by these simulations is that, even though the nearterm path for the unemployment rate is a bit lower than in April, reflecting the recent indications of somewhat greater strength in aggregate demand, the medium-term outlook involves larger and more persistent slack than foreseen in April under either inflation goal. Despite that greater slack, as shown in the bottom two panels, core inflation under both inflation objectives runs 0.1 to 0.3 percentage point higher over the next four years than in the April simulations. That, of course, is the fundamental nature of a negative supply shock: Policymakers are forced to accept some combination of greater economic slack and higher inflation during a period of transition to a lower output path and, presumably, to an unchanged long-run inflation rate. That same point was made in a Bluebook box and in a staff paper on this subject. Turning to your final exhibit, I would like to note that, in response to the comments of some members at recent FOMC meetings, the r* exhibit in the Bluebook has been augmented to include two additional measures of the real federal funds rate. Line 11 in the table at the bottom shows a measure of the real federal funds rate that uses lagged headline inflation as a proxy for expected inflation. By contrast, our standard measure, shown on line 10, employs lagged core inflation as the proxy. Line 12 shows a measure based on the staff's projection of headline inflation. Both of these new measures, at minus 1.3 percent, are considerably lower than the current value of the standard measure, minus 0.2 percent. I want to emphasize, first, that these additional measures should not be compared directly with the r* measures shown in lines 1 through 9 of the table because the values of those measures are in part a function of the proxy used for expected inflation. For example, the r* value that would be consistent with the Greenbook projection and the actual real funds rate based on the lagged four-quarter average of headline inflation is minus 0.7 percent. Moreover, even if we redefined the Greenbook-consistent measure of r* to use lagged headline inflation, the implied 0.6 percentage point gap between the actual and the estimated equilibrium real rates would not necessarily imply that you should quickly raise the nominal funds rate by more than � percentage point. If, like the staff, you think it likely that headline inflation will moderate substantially later this year, then it follows that a gradual firming of policy in nominal terms would be consistent with a substantial rise in the real funds rate on this measure over time. Indeed, in the staff's view, the average value of the real federal funds rate over the next few years on any measure is a bit above the corresponding value of r*, and consequently the trajectory of the real funds rate on any measure would be consistent with protracted slack and declining inflation over the next several years. Of course, you may not agree with the staff about underlying trends for prices and real activity and, hence, about the value of r*. Even if you do agree, you may be dissatisfied with the projected trajectories for key variables such as output, employment, and inflation. Such considerations illustrate why no estimate of r* can be a complete guide to policy. That completes my prepared remarks. " CHRG-110hhrg46591--17 Mr. Scott," Thank you, Mr. Chairman. Thank you for the hearing. I think we have to realize that the damage has been done. We have to change our mindset from one of continuing to try to find blame; and, instead, we have to work on real solutions. The number one issue we have before us is that our system is vulnerable. It has been vulnerable because a small quantity of high-risk assets undermined the confidence of investors as well as other market participants across a much broader range; and the combined effect of these factors, without the necessary regulation, caused the system to be vulnerable to self-reinforcing asset price and credit cycles. The issue before us: What are the reforms that will be necessary to reduce the vulnerabilities in our economic system in the future? We have to press hard to make sure that we stop the blame game and understand that the American people are looking to us to provide real solutions. Thank you, Mr. Chairman. " CHRG-111hhrg52261--87 Mr. Robinson," That is correct, Congressman. If there is a common thread that I could recommend that might answer some of these questions, it is, how broad a measure would be needed to cover all kinds of problems. It is answering a simple question like, Who underwrites the risk and who prices it? Because you could have somebody saying, Well, I thought the loan originator was. Well, I thought they were. Well, who is? Whether it is a credit default swap or a mortgage. And I think as we try to solve these issues--and there is no question that there are issues to be solved--that instead of perhaps picking a number to define too-big-to-fail, say, All right, you are big; what are your exposures and how much capital do you have to handle what statisticians would call the tail events--things that you don't think happen? And if they cannot answer those questions clearly and they perhaps have no idea, then that might aim you towards the real root cause of the issue. And that might be a good step, I would recommend. " FOMC20071211meeting--45 43,MR. SHEETS.," Just to underscore what Dave has said, our forecast is driven largely from the quotes from futures markets. So, really, the question boils down to, Why in the world do the futures markets expect the prices of these foodstuffs to decline? I think a key factor is that there are some important temporary developments that have driven up food prices. There have been adverse weather conditions in a number of Asian economies. For example, in China, they had floods earlier this year that have significantly driven up vegetable prices. In addition, there has been a sustained drought in Australia that has driven up wheat prices significantly. It has been several years that we have seen these drought conditions in Australia. It is an open issue as to whether that goes away in 2008 or 2009, but the expectation is that at some point that is going to abate somewhat. So we can point to temporary factors. There has also been a significant imprint on the food prices of a move to ethanol in the United States, and that has driven up the price of corn. At the same time, some acreage that had been in soybeans has shifted to corn, and that has reduced the supply of soybeans and driven up that price as well. But it is our view and I think the view of the futures markets that over time you are going to see some of these effects balanced out, and the acreage production will be distributed in a way that will help bring these prices down. In addition, you could get more acres brought into production of these foodstuffs. The final point that I want to emphasize here is that there are also some important structural factors that are driving up food prices, two that I think are worth mentioning. One is that you have a lot of people in these emerging-market economies who are a lot wealthier than they were ten years ago, and they want to eat better, and the world is going to have to find a way to produce more and higher-quality agricultural goods. It is imaginable that there will be some upward pressure on price through that transition. The second important factor that I think is structural is we have seen a sustained and now an apparently permanent increase in the price of oil. It takes a lot of petroleum to produce these goods, so that is a longer-run factor that may contribute to higher agricultural prices." FOMC20051101meeting--73 71,MS. JOHNSON.," The staff forecast for real GDP growth and inflation abroad is little changed this time from the forecast in the September Greenbook. This is the case despite additional hurricanes, volatile energy prices, and a notable rise in long-term interest rates in several foreign industrial countries during the intermeeting period. The futures path for WTI [West Texas intermediate] crude oil prices retraced somewhat in October. Accordingly, we have incorporated into this forecast global oil prices through 2007 that are about $2 per barrel lower than in the previous forecast. Nevertheless, the outlook for global crude oil prices remains elevated at about $60 per barrel for WTI and is more than $8 above the level six months ago. Clearly, factors related to crude oil supply have contributed at times to upward pressure on global crude oil prices. In addition to disruptions as a result of the hurricanes, there are market concerns about the change in leadership in Saudi Arabia, politics in Iran, Venezuela, and Russia, and reduced production as a result of violence in Iraq. However, the trend increase since 2003 in not only spot prices but also in far futures prices occurred despite expansion of global oil production, evidence that underlying global demand for crude oil is also importantly responsible for the price pressures. This persistent, strong, underlying demand for energy reflects fundamental robustness in global economic activity—perhaps more than has been generally recognized. As a consequence, we have observed during this year further moves up in energy prices and in prices for nonfuel primary commodities along with average real growth abroad that has remained moderately strong, although a bit below the rapid pace of 2004. As in September, we are calling for real GDP abroad on average to expand at about 3 percent in the current quarter, following growth at that pace in the third quarter, and to accelerate a bit in 2006 and 2007. This favorable picture incorporates a return to steady expansion in Japan and solid, albeit slightly moderating, growth in the emerging Asian region. In addition, real growth in Mexico should recover from a disappointing outcome during the first half of this year. November 1, 2005 18 of 114 mixed, but in Germany industrial orders have come in strong and the October Ifo measure of business climate jumped to a five-year peak. Among the emerging- market economies, Chinese industrial production accelerated through September, and retail sales growth remained above 12 percent. Korean real GDP growth rose to 7.5 percent in the third quarter, and Brazil continues to enjoy very strong export sales. The mix of sustained global growth and upward shifts in commodity prices, particularly crude oil prices, naturally heightens concerns about higher consumer price inflation. Headline inflation rates abroad have moved up significantly with the rise in crude oil prices. Our outlook, however, is for these prices to decelerate over the forecast period given our projection (and that of the futures markets) that crude oil prices will be about flat next year and edge down in 2007 and given that the effects of previous increases in crude prices on inflation will wane and then end. Such an outcome depends upon an absence of significant second-round effects of oil prices on domestic prices and wages abroad. To date, core inflation in the major foreign countries confirms this is the case. The combination of continued growth and contained inflation pressures sounds optimistic. Rest assured, we have found numerous risks about which to worry. The elevated energy prices could sap consumer demand more than we expect, undermining the pace of real growth. In the face of higher costs, business spending on new capital could falter, particularly in emerging Asia where few countries have petroleum production sectors. Wage demands could react to the increase in headline inflation and threaten to ignite a set of second- and third- round effects. We do not see evidence of these developments at this time, but it is too soon to conclude that the danger of such actions has passed. A second feature of the international forecast that merits a few minutes is the approximately neutral contribution of real net exports to U.S. real GDP growth in the third quarter, following a positive contribution in the second quarter. The third-quarter NIPA [national income and product accounts] data released last Friday imply a slightly smaller, less positive, contribution than we had incorporated in the Greenbook baseline forecast or in the September forecast. However, in the current quarter, compared with the September forecast, we are assuming a greater rebound in exports and have reduced our assessment of the extent to which the external sector will provide a drag on GDP growth. Accordingly, we expect that on a four-quarter change basis, the external sector will record a slightly positive contribution to U.S. real GDP growth for the year— the first annual positive contribution since 1995. However, we are not ready to declare that external adjustment has arrived, and we expect a return to a small drag on U.S. growth from the external sector in the current quarter and on balance over the forecast period. November 1, 2005 19 of 114 imports. But recently we have experienced weakness in other components of real imports. During this intermeeting period, imports again surprised us on the downside, with August data for nominal imports much weaker than expected. This negative surprise included both goods and services, and within goods, it was particularly the case for imports of consumer goods and industrial supplies. For the near-term forecast we have included some effects as a result of the hurricanes and the disruption to general trade they caused. As a result, there is some implicit payback in the forecast for real imports in the fourth quarter. Nevertheless, compared with the September Greenbook, we have lowered the growth of real imports in 2006 and 2007 in response to the somewhat softer outlook for U.S. activity and to a higher path for import prices. Growth of third-quarter real exports was also revised down, although not by enough to offset weaker imports. Hurricane effects also figure in our estimate for third-quarter exports. More significant has been the recent strike at Boeing. We judge that the strike had a more pronounced impact on September=s exports than we previously thought, leading us to weaken real exports for last quarter. But the rapid conclusion of that strike also led us to strengthen real exports for the current quarter. For 2006 and 2007, we expect export growth will average a bit above 5 percent per year, consistent with our outlook for steady real output growth abroad. In sum, actual trade data through August, our estimates of how the turbulent weather of recent months has affected exports and imports, and our projections of global primary commodity prices, particularly crude oil, combine to imply unusual quarter-to-quarter fluctuations in growth of real exports and real imports. Some of these developments have surprised us since the September Greenbook. Going forward, however, we expect that the transitory weather effects will fade by early 2006. We look for real exports and imports to expand at similar rates on balance in 2006 and 2007. With imports substantially greater than exports, this outcome implies a negative contribution from the external sector of about ⅓ percentage point each year. David and I will be happy to take your questions." FOMC20050920meeting--96 94,MS. PIANALTO.," Thank you, Mr. Chairman. The contours of the economic effects of Hurricane Katrina that are laid out in the Greenbook baseline look about right to me. But in the aftermath of the hurricane, and with the fragility in the energy markets, I found myself focusing September 20, 2005 71 of 117 business contacts, they appear to have more anxiety about future prospects than about the present circumstances. My business contacts who have retail stores, warehouses, and production facilities in the Gulf region all seem to have a good handle on the direct impacts of the storm, and for the most part they say that their losses are manageable. But they emphasize that the indirect effects of the storm, driven primarily by increases in costs of energy and building materials prices, will be difficult to discern for many months. Of particular concern to many of my directors is the reaction of consumers to the expense of filling their gas tanks and heating their homes during the winter. My directors report that they are already witnessing some retrenchment in consumer spending, and they don’t know how much of this is just a temporary reaction or how much of it is a preview of more adjustments to come. The preliminary release of the University of Michigan’s consumer sentiment survey illustrates this concern, and I think the Greenbook’s “sentiment slump” alternative scenario addresses the policy issues that such a development would entail. The latest spike in energy prices triggered by Katrina also has implications for the inflation outlook. On the positive side, most reports that I have been getting still have the flavor of businesses unable to pass on higher costs to their customers. Nevertheless, the headline and core inflation reports are likely to look scary for the next several months. Fortunately, as several of my contacts have explained, more than the usual number of price increases are taking the form of surcharges that are expected to be removed when energy and other raw materials prices recede. To the extent that this practice lies behind some of the near-term bad news that we are seeing on the inflation front, there is still reason to think that the Greenbook baseline projection September 20, 2005 72 of 117 scenario highlights a risk to the outlook that also troubles me a great deal. I’m very pleased that we’ve enjoyed the public’s confidence regarding our commitment to containing long-term inflation expectations for as long as we have during the successive energy price increases that we’ve been hit with, but I’m not anxious to test the limits of that confidence. Even if the odds of the sentiment slump and the deteriorating inflation expectations scenarios are similar, the policy implications are not. The Greenbook projects a GDP difference in those two scenarios that is very small, but the difference in the projected inflation outcomes is too sizable for me to ignore. Consequently, I think the more prudent course of action today is for us to continue to remove our policy accommodation. Thank you, Mr. Chairman." FOMC20071211meeting--40 38,MR. SHEETS.," Our reading of the recent data suggests that economic activity abroad decelerated toward the end of the third quarter and has remained on a decelerating path thereafter. In the euro area, the United Kingdom, and Canada, this softening of activity appears to reflect—at least in part—increasing drag from the ongoing financial turmoil. Notably, in the euro area, business and consumer confidence have weakened some in recent months, PMIs for both the services and manufacturing sectors have declined, and recent readings on retail sales and industrial production have softened. In the United Kingdom, indicators of sentiment and retail sales also have slipped of late, and a slowdown in the housing sector is now under way—with declines in net mortgage lending, mortgage approvals, and major indexes of house prices. In response, the Bank of England late last week cut its key policy rate 25 basis points, to 5½ percent. The Bank of Canada also lowered its policy rate a notch last week, citing concerns about financial market turmoil. In assessing the impact of the financial turbulence, we continue to see little evidence that the emerging-market economies are being significantly affected. Over the past month or so, debt spreads for many of these economies have risen, and their equity markets have given back some ground, but these moves are relatively mild when viewed from a longer-term perspective. All told, foreign growth is projected to step down from an average rate of nearly 4½ percent during the first three quarters of this year to below 3 percent in the current quarter and early next year. In addition to headwinds from the financial turmoil, this slowing reflects policy actions in some countries (particularly China) to rein in above-trend growth, as well as the softer pace of activity in the United States. Thereafter, we see foreign growth rising back to a rate of 3¼ percent. This outlook is weaker over the next few quarters than in our October projection, in line with the lower U.S. forecast. In addition, given the renewed market turbulence, we now see the drag from financial developments as likely to be larger and more protracted than we had previously assumed. We continue to believe that these effects will be felt mainly in the advanced economies, but an important downside risk to our forecast is the possibility that the emerging-market economies may be more affected than we now expect. On Friday, we received revised Japanese GDP data for the third quarter. The latest estimate cuts growth in the quarter to 1.5 percent at an annual rate, down 1 percentage point from the initial reading. Notably, this growth can be attributed entirely to net exports, as domestic demand contracted for the second consecutive quarter. Residential investment plunged in the third quarter, as new building regulations temporarily weighed on spending. Our forecast calls for domestic demand to bounce back quickly, but downside risks are increasingly evident; for example, the profitability of small and medium-sized companies has recently deteriorated, labor market conditions seem to be softening, and wages continue to contract. The spot price of West Texas intermediate approached $100 per barrel in late November, but mounting concerns about the near-term outlook for global activity have since pushed the price back below $90 per barrel. At that level, spot WTI is down a few dollars per barrel since the last FOMC meeting. Continued concerns about the longer-term supply-demand balance, however, have kept the far-futures price at its late-November level, near $87 per barrel—up about $7 since the last FOMC meeting. Nonfuel commodity prices fell sharply in the third quarter and have continued on a downward trajectory. The prices of copper and nickel have plunged, driven by concerns that rising inventories may signal a softening of global demand for these commodities. The price of zinc has fallen as well. Notably, however, the prices of food commodities, including wheat, corn, and soybeans, have continued to rise. This run-up in food prices, coupled with high oil prices, has stoked inflation in a number of countries. For example, in the euro area, twelve-month headline inflation has jumped from 1.7 percent in August to 3 percent in November, led by food and energy prices, thus prompting the ECB to leave policy on hold at its meeting last week. Going forward, this rise in inflation may continue to limit the ECB’s willingness to ease policy, as fallout from the financial turmoil weighs on activity. In the United Kingdom, however, a recent rebound in inflation to slightly above the Bank of England’s 2 percent target—driven in part by rising food prices—did not deter last week’s policy move. Indeed, in cutting rates, the BoE noted that “higher energy and food prices are expected to keep inflation above the target in the short term.” In China, food price inflation is running at more than 15 percent and has pushed overall inflation to 6.9 percent in November. The pace of inflation has elicited a range of policy responses from the authorities, including a move over the weekend to further increase reserve requirements. Our forecast sees global food and oil prices soon leveling off in line with quotes from futures markets, and this would contribute to a welcome moderation of inflationary pressures in a number of countries. Since the last FOMC meeting, the dollar has strengthened on balance, rising 1 percent on average against the major currencies and ½ percent in broad nominal terms. Notwithstanding this reprieve from dollar depreciation, we continue to see the current account deficit—which still exceeds 5 percent of GDP—as a key factor that is likely to weigh on the exchange rate going forward. Thus our forecast incorporates some modest further real depreciation of the dollar. Notably, this depreciation comes entirely against our emerging-market trading partners, and we have slightly raised our projections for the pace at which the renminbi and several other emerging Asian currencies appreciate against the dollar. I conclude with a few words about the U.S. external sector. We expect that export growth, following its red-hot 19 percent performance in the third quarter, will moderate to a still-strong pace of around 7 percent in the current quarter and through the next two years, as exports are supported by past declines in the dollar and still- solid foreign activity. Import growth in the current quarter will be sustained at its moderate third-quarter rate by a seasonal rebound in oil imports, but import growth is expected to fall off during the first half of next year, in line with the softer pace of U.S. activity. Thereafter, imports are projected to gradually accelerate, as growth in the United States firms. All told, we see net exports making positive arithmetic contributions to growth of 0.1 percentage point in the fourth quarter of this year, 0.5 percentage point in 2008, and a little over 0.1 percentage point in 2009. That concludes our prepared remarks, and we are happy to take questions." FOMC20080430meeting--192 190,MR. LACKER.," Thank you, Mr. Chairman. I find myself agreeing with my colleagues who have advocated alternative C. One way to think about our approach to the policy decision today is to look ahead and think about the probabilities associated with two bad outcomes. Will the economy go into a substantially deeper recession than we expect? Or coming out of this recession, will the trailing inflation rate be higher than it was when we went in? Although I hope neither of these occurs, my sense right now is that the chance of an increase in trend inflation is more likely than a much deeper recession, and I think we should alter our policy path accordingly. The incoming data since the beginning of the year have resulted in a more adverse outlook, and that change in the outlook is already, in my view, reflected in the current stance of policy. I noted yesterday that the real federal funds rate using the Greenbook's inflation forecast rather than four-quarter lagged core inflation is now between minus � and minus � percent. I think it makes sense to take advantage of information about foreseeable gaps between overall inflation and core, and the stance of policy strikes me as very stimulative, certainly plenty for the recession we now expect, when we look at back historical recessions. As I noted yesterday, at the retail level for firms and consumers, spreads aren't out of line with where they've been in past recessions. It is true that jumbo mortgage rates and some other rates have not come down as much as they've come down in past recessions, but I just remind people of the secular technology shift. There's a sort of level shift in intermediation technology that we're going through right now that really constitutes a change in the relative prices of different financial assets. Now, I can't think clearly about the stance of policy without talking first about the risk-free rate and then thinking about various spreads as really having to do with the relative prices of different financial claims. So in looking at and through retail rates, that's informative. But the riskfree rate is the risk-free rate, and an array of factors affects how those relative financial prices evolve. The securitization channel that seemed to work very well for a while is now exposed as more costly and less efficacious than once was thought. Some of these securitization vehicles didn't exist in past recessions or expansions, and only a couple of decades ago these spreads were as high as or higher than they are now. So I stick to thinking about the stance of monetary policy in terms of the real risk-free rate. I think our experience between the January and the March meetings with inflation expectations is pretty good evidence of their fragility in the current environment without our having articulated what our long-run objective is for inflation. I don't think that the level of inflation expectations is aligned with our objectives; I think it is too high relative to our objectives. Market participants see a good chance of our dropping the rate � point today and reversing field later in this year and raising rates again. I suspect they don't fully grasp how difficult it's going to be to reverse course while we negotiate the murky waters of the recovering economy later this year. Indeed, I think that the fiscal stimulus that we're going to get will make those waters even murkier. It will be even harder to divine the underlying, ex-fiscal-policy strength of the economy. So for these reasons, I believe that we should leave the fed funds rate alone today. The upward surprise at our last meeting did not appear to affect financial markets adversely. Coupled with that statement's emphasis on inflation risks, it did seem to have the beneficial effect of reversing the run-up in inflation expectations. I would expect that leaving the funds rate alone today would have a similar beneficial effect in stabilizing inflation expectations. So I favor alternative C, Mr. Chairman. " CHRG-109hhrg28024--220 Mr. Price," Thank you. There are some proposals that we ought to price index Social Security payments. Do you have any view as to that? " CHRG-110shrg50410--28 Secretary Paulson," Then I will just say the third thing, because you asked for all three, and I think this is important here, because we have all been working--and you, Senator, have been a champion in this area. We have been working to get reform with a world-class regulator. And I think that when that regulator is in place and that regulator is up and going, I think there will be a real opportunity to have the discussion for what is the right size, what are the risk characteristics, capital requirements, business activities. And so I think you are going to be able to address the longer term. and this also addresses the short term. Senator Shelby. Secretary, what is the trigger, at what point, in other words, would Treasury exercise this new authority? And what if, for example, the equity price falls below a dollar? We know the consequences of that, I think. Or if debt cannot be issued, or is it at the--is it too wide a spread over the Treasurys? In other words, a lot of these events--you just want to reserve that---- " CHRG-111shrg52966--21 Mr. Sirri," I think we all--I won't speak for others. I think we understood, and my impression was all of these regulators understood, that we were limited in part. We had dialog amongst ourselves. Staff on the ground talked to staff from other regulators. In addition, the firm--it is not like the firms drew up walls and said, we won't give you information on that bank, or we won't give you information on that thrift. They would provide such information. But in the sense of integrated enterprise risk management, I think it was not what it could be. Senator Reed. Senator Bunning, and take as much time as you want. Senator Bunning. Thank you, Mr. Chairman. Welcome back from your vacations that you have been on for the last 5 years, and I say that not kiddingly. I say that as meaningful as I can, because if we would have had good regulators, we wouldn't be in the crisis we are in right now. Ms. Williams, at the bottom of page 24, you said the Fed did not identify many of the issues that led to the failure of some large institutions. Can you tell us what some of these issues that they are, what they missed? Ms. Williams. Absolutely. I would direct your attention to a couple of pages later, on page 26. We note that the Fed began to issue risk committee reports, and in February of 2007 they issued perspectives on risk, and we list a number of issues that we pulled from that report. For example--the report stated that there were no substantial issues of supervisory concern for large financial institutions; that asset quality across the systemically important institutions remains strong; in spite of predictions of a market crash, the housing market correction has been relatively mild and while price appreciation and home sales have slowed, inventories remain high and most analysts expect the housing boom to bottom out in mid-2007. Overall, the impact on a national level will likely be moderate. However, in certain areas, housing prices have dropped significantly. They also noted that the volume of mortgages being held by institutions or warehouse pipelines had grown rapidly to support collateralized mortgage-backed securities and CDOs and noted that the surging investor demand for high-yield bonds and leveraged loans, largely through structured products such as CDOs, was providing a continuing strong liquidity that resulted in continued access to funding for lower-rated firms at relatively modest borrowing costs. So those are some of the---- Senator Bunning. Would you like to comment on counterparty exposures, particularly to hedge funds? Ms. Williams. This was another area that was identified. The regulators had focused on counterparty exposures, particularly to hedge funds. Senator Bunning. Mr. Cole, would you like to respond? " CHRG-111shrg54589--151 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM CHRISTOPHER WHALENQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. Yes. As I stated in my prepared remarks, where there is no underlying cash market that both parties to a derivatives transaction may observe, then the derivative has no true economic ``basis'' in the markets, and is entirely speculative. Where there is no cash market, there is, by definition, no price discovery. A derivative that is created without the benefit of an actively traded cash market is essentially a deception. In the case of credit default swaps and other ``derivatives'' where no actively traded cash market exists, the dealer pretends that a model can serve as a substitute for a true cash market basis. But such a pretense on the part of the dealer is patently unfair and, in my view, is really an act of securities fraud that should be prohibited as a matter of law and regulation.Q.1.b. If not, what specific, objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. See above. To the extent that the Congress is willing to continue to tolerate speculation in derivatives for which no cash market basis exists and are instead based upon models, then the dealers should be compelled to publish these models on a monthly basis for the entire market to see and assess. Requiring SEC registration might be another effective solution. Enhanced disclosure of models for OTC derivatives would likely lead to a multiplicity of new lawsuits by investors against the OTC derivatives dealers, thus the effect of compelling the disclosure of models used to price OTC derivatives would be to greatly lessen the complexity of these instruments. Think of this as a ``market based'' solution driven by the trial lawyers.Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative, and the model is effectively the basis, why should the models not be public?A.2. See response to 1b.Q.3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?A.3. Allowing speculators using OTC derivatives to effectively take positions against securities and companies in which they have no economic interest is a form of gaming that the Congress and Federal regulators should reject. The term ``hedge'' implies that the user has an economic position or exposure to a form of risk. The use of cash settlement OTC contracts by parties who have no interest in the underlying assets or company creates perverse incentives that essentially equate an owner of an asset with the speculator with no economic interest. The AIG episode illustrates an extreme example of this problem where AIG was actively using derivatives to engage in securities fraud, both for itself and others, and apparently with the full support and knowledge of the OTC dealers. Allowing speculators to use cash settlement OTC derivatives to game against real companies and real assets to which they have no connection creates systemic risk in our financial system and should be prohibited by law and regulation.Q.4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?A.4. No. Those critics who proclaim that regulation of OTC derivatives such as CDS will force the activity offshore are mistaken. Where will they take this vile business? London? No. The EU? No. China? No. Russia? No. Let the proponents of this market go where they will. The government of the U.S. should not allow itself to be held hostage by speculators. The fact is, the U.S. and EU are the only political jurisdictions in the world that are sufficiently confused as the true, speculative nature of CDS to allow their financial institutions to serve as a host for this reckless activity. Regulating the speculative activities of U.S. banks in the OTC derivatives markets and banning all OTC derivatives for which there is no actively traded bash basis market will effectively solve the problem of systemic risk.Q.5. In addition to the Administration's proposed changes to gain on sale accounting for derivatives, what other changes need to be made to accounting and tax rules to reflect the actual risks and benefits of derivatives?A.5. The key change that must be made is to distinguish between true derivatives, where there is an observable cash market basis, and pseudo derivatives based upon models such as CDS and collateralized debt obligations (CDOs) which have no observable basis and which have caused such horrible damage to the global financial system. Where there is no active market price for the underlying relationship upon which the derivative is ``derived,'' then the bank or other counterparty should be required to reserve 100 percent of the gross exposure of the position to cover the market, liquidity and counterparty risks created by these illiquid, difficult to value gaming instruments. Congress should explicitly forbid ``netting'' of OTC contracts such as CDS and any other derivative structure for which there is no cash basis market since there is no objective, independent way to value these instruments. How can any financial institution pretend to ``manage'' the risk of a CDS instrument or CDO when the only objective means of valuation is a private model maintained by a dealer?Q.6. Is there any reason standardized derivatives should not be traded on an exchange?A.6. No. All derivatives for which there is an active cash market basis may easily be traded on exchanges. Only those OTC derivatives for which there is no cash market and thus no price discovery will not be practical for exchange trading. The problem here is a basic one since the clearing members of an exchange are not likely to be willing to interpose their capital to jointly and severally guarantee a market based on a CDS model. Unless the clearing members and the customers of a partnership exchange possess the discipline of a cash market basis to support and validate valuations, then it is unlikely that an exchange-based approach will be practical.Q.7. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than renegotiate the debt?A.7. The simple answer is to require that CDS only be held by those with an economic interest in the debtor that is the underlying ``basis'' for the derivative. If, as under current law and regulation, you allow speculators with no economic interest in a debtor to employ CDS, then all weak banks and companies may be pushed into insolvency by parties whose sole interest is their failure. Allowing speculators to use CDS against debtors in which they have no economic interest essentially voids the traditional social purpose of the U.S. bankruptcy laws, namely a) to recover the maximum value for creditors of the bankruptcy estate in an equal and fair way and b) to provide a fresh start for the company, which has historically been seen as a benefit in social terms. The Congress needs to recall that the requirement imposed in the 18th century by our Nation's founders to establish Federal bankruptcy courts had both a practical and a social good component.Q.8. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?A.8. You cannot. CDS is essentially a low-cost substitute for performing actual credit research. As with credit ratings, investors use CDS to create or adjust exposures based upon market perception rather than a true analysis of the underlying value. And best of all, the spreads that are usually reflected in CDS pricing often are wrong and do not accurately reflect the true economic cost of default. Thus when speculators employ CDS to purchase protection against a default, the pricing is usually well-below the true economic value of the default. Or to put it another way, AIG was not nearly compensated for the risks that it took in the CDS markets--even though AIG was an insurer and arguably should have understood the difference between short-term ``price'' of an illiquid bond or loan vs. long-term ``value'' of a default event.Q.9. Do net sellers of credit protection carry that exposure on their balance sheet as an asset? If not, why shouldn't they?A.9. The treatment of CDS varies by country. All CDS positions, long or short, should be reflected as a contingent liability or asset, and carried on balance sheet in the appropriate way. The treatment used in the insurance industry for such obligations may be the best model for the Congress to consider as a point of departure for any legislation.Q.10. In her testimony Chairman Schapiro mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.10. Yes, it is another form of leverage and Chairman Schapiro addressed this issue directly. When a user of CDS creates the equivalent of a cash market position in a listed security, then that position should be reported to the SEC and disclosed to the marketplace. Allowing speculators to synthetically create the functional equivalent of a cash market position using CDS arguably is a violation of existing law and regulation. Why should an investor be required, for example, to disclose a conventional option to purchase listed shares but not the economic equivalent in CDS? This dichotomy only illustrates the true purpose of CDS, namely to evade established prudential norms and regulation.Q.11. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn't the economic benefit of that demand--higher value--flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?A.11. Agreed. One of the pernicious and truly hideous effects of OTC instruments such as CDS is that they equate true ``owners'' of assets with speculators who create ersatz positions in these assets via derivatives; that is, they ``rent'' the asset with no accountability to the owner. It could be argued that such activity amounts to an act of thievery and one that is encouraged by Federal bank regulators, particularly the academic economists who dominate the Fed's Board of Governors! Since the users of cash-settlement OTC contracts never have to deliver the underlying reference assets to the buyer, there is no economic connection between the real asset and the OTC derivative. Again, to repeat, this activity is best described as gaming, not risk management.Q.12. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn't that demand lead to a greater supply and thus more liquidity?A.12. Arguments that CDS are more liquid that the reference assets are disingenuous and stand the world on its head. As above, why allow a derivative at all when there is no cash reference market? Allowing speculators to create a short market in an illiquid corporate bond, for example, via single-name CDS does not improve price discovery in the underlying asset since there is no market in the first place. And since the ``players'' in this ersatz market are required to neither borrow nor deliver the underlying reference asset, the entire exercise is pointless in terms of price discovery. The only purpose is to allow the large dealer banks to extract supranormal returns and increase systemic risk. Again, it is just as easy to speculate on the outcome of a horse race as on the price of a CDS since there is no mechanistic connection between the wager and the actual reference ``asset'' or event.Q.13. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?A.13. No. See reply to Question 12.Q.14. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?A.14. A swap and futures/options are functionally equivalent. The OTC swaps for oil or interest rates can be and are actively traded against the corresponding exchange traded products because they share a common cash market basis. The advantage of OTC contracts is that they allow for customization regarding size and time periods for the counterparties. There is nothing inherently wrong with maintaining these two markets, exchange traded and OTC, side by side, so long as a cash market basis for both exists and is equally visible to the buyer and the seller. Only when the cash market basis is obscured or nonexistent does systemic risk increase because (a) the pricing is entirely speculative and thus subject to sudden changes in liquidity, and (b) cash settlement of OTC contracts such as CDS allows the risk inherent due to the lack of true price discovery to expand infinitely.Q.15. One of the arguments for keeping over-the-counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?A.15. The spreads on OTC contracts generally are wider than exchange traded instruments, a difference that illustrates the inefficiency of OTC markets vs. exchange traded markets. That said, the ability to specify size and duration of these instruments is valuable to end users and the Congress should allow the more sophisticated private participants in the markets to make that choice. For example, if a large energy company or airline wants to enter into a swap to hedge fuel sales or costs, respectively, in a way the exchange traded contracts will not, then the user of derivatives ought to have that choice to employ the OTC instruments. Again, OTC markets in and of themselves are not problematic and do not create systemic risk.Q.16. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.16. All open positions in OTC derivatives above a certain percentage of the outstanding contracts in any market should be (a) reported to the CFTC, and (b) publicly disclosed in aggregate form. Such disclosure would greatly enhance market efficiency, but it does not mitigate the concerns regarding CDS and other contracts for which there is no liquid, actively traded cash basis market. No amount of disclosure can address that basic flaw in the CDS and other markets which lack a cash basis.Q.17. What is insufficient about the clearinghouse proposed by the dealers and New York Fed?A.17. The proposed clearinghouse is entirely controlled by the dealer banks. As we wrote in The Institutional Risk Analyst in May of this year: In 2005, the New York Fed began to fear that the OTC derivatives market, at that time with a notional value of over $400 trillion dollars, was a sloppy mess--and it was. Encouraged by the Congress and regulators in Washington, the OTC market was a threat to the solvency of the entire global financial system--and supervisory personnel in the field and the Fed and other agencies had been raising the issue for years--all to no effect. This is part of the reason why we recommended to the Senate Banking Committee earlier this year that the Fed be completely relieved of responsibility for supervising banks and other financial institutions. Parties were not properly documenting trades and collateral practices were ad hoc, for example. To address these problems, the Fed of New York began working with 11 of the largest dealer firms, including Bear Stearns, Merrill Lynch, Lehman, C, JPM, Credit Suisse, and [Goldman Sachs]. Among the ``solutions'' arrived at by these talks was the creation of a clearinghouse to reduce counterparty credit risk and serve as the intermediary to every trade. The fact that such mechanism already existed in the regulated, public markets and exchanges did not prevent the Fed and OTC dealers from leading a multiyear effort to study the problem further--again, dragging their collective feet to maximize the earnings made from the existing OTC market before the inevitable regulatory clampdown. For example, in the futures markets, a buyer and seller agreeing to a transaction will submit it to a clearing member, which forwards it to the clearinghouse. As the sell-side counterparty to the buyer and the buy-side counterparty to the seller, the clearinghouse assumes the risk that a party to the transaction might fail to pay on its obligations. It can do this because it is fully regulated and by well capitalized. As the Chicago Mercantile Exchange is fond of saying, in 110 years no futures clearinghouse has ever defaulted. While the NY Fed believed that a central counterparty was necessary to reduce risks that a major OTC dealer firm might default, the banks firmly resisted the notion. After all, they make billions of dollars each year on the cash and securities which they required their hedge fund, pension fund and other swap counterparties to put up as collateral. Repledging or loaning these customer securities to other clients is very lucrative for the dealers and losing control over the clients collateral would dramatically impact large bank profits. A clearinghouse would eliminate the need for counterparties to post collateral and a lucrative source of revenue for the dealer firms. So they bought the Clearing Corporation, an inactive company that had been the clearinghouse for the Chicago Board of Trade. If they had to clear their trades, the dealer firms reasoned, at least they would find a way to profit by controlling the new clearing firm. Such is the logic of the GSE mindset. Meanwhile, other viable candidates for OTC derivatives clearing were eager to get into the business, such as the Chicago Mercantile Exchange and the New York Stock Exchange. Both had over 200 years experience in clearing trades and were well suited to serve as the impartial central counterparty to the banks and their customers. If the NYSE and CME were to trade derivatives, the big banks knew they would not be able to control their fees or capture the profits from clearing. Therefore, they sold The Clearing Corp. to the Intercontinental Exchange, or ICE, a recent start-up in the OTC derivatives business which had been funded with money originally provided by, you guessed it, the banks. In the deal with ICE, the banks receive half the profit of all trades cleared through the company. And the large OTC dealer banks made sure, through their connections with officials at the Fed and Treasury, that ICE was the winner chosen over the NYSE and CME offerings. That's right, we hear that Tim Geithner personally intervened to make sure that ICE won over the NYSE and CME clearing units. \1\--------------------------------------------------------------------------- \1\ See ``Kabuki on the Potomac: Reforming Credit Default Swaps and OTC Derivatives'', The Institutional Risk Analyst, May 18, 2009.Q.18. How do we prevent a clearinghouse or exchange from being ---------------------------------------------------------------------------too big to fail? And should they have access to Fed borrowing?A.18. Limit trading in OTC derivatives by (a) requiring sellers to deliver the basis of the derivative upon expiration of the contract and (b) ban those derivatives for which there is no actively traded cash basis market. If such reforms are enacted, there should be no need for the Fed to ever support a multilateral exchange or clearinghouse.Q.19. What price discovery information do credit default swaps provide, when the market is functioning properly, that cannot be found somewhere else?A.19. None. The argument that a derivative can aid in price discovery for an illiquid cash basis is circular and ridiculous. Trading in CDS is merely gaming between the parties vs. current market prices. As mentioned above, most single name CDS trade against the short-term yields/prices of the supposed basis, thus these contracts arguably do not provide any price discovery vs. the true cost of insuring against default. For example, the day before Lehman Brothers filed bankruptcy, the CDS was trading at roughly 700bp over the Treasury yield curve or roughly 7 percent per year (plus upfront fees totaling another couple of percentage points) to insure against default. Yet when Lehman filed for bankruptcy, the resulting default required the payment of 9,700bp to the buyers of protection or par less the 3 percent recovery rate determined by the ISDA auction process. Clearly, receiving 7 percent and having to pay 97 percent is not an indication of effective price discovery! The sad fact is that many (but by no means all) users of CDS employ these instruments to trade or hedge current market exposures, not to correctly price the cost of default insurance.Q.20. Selling credit default swaps is often said to be the same as being long in bonds. However, when buying bonds, you have to provide real capital up front and there is a limit to the lending. So it sounds like selling swaps may be a bet in the same direction as buying bonds, but is essentially a highly leveraged bet. Is that the case, and if so, should it be treated that way for accounting purposes?A.20. That is correct. In order to sell a bond short, the seller must be able to borrow the collateral and deliver same. In CDS, since there is no obligation to deliver the underlying basis for the contract, the leverage is far higher and, more important, there is no real connection between the price discovery in the cash market and the CDS. While services such as Bloomberg and others use cash market yields to estimate what they believe the valuation of CDS should be, there is no objective confirmation of this in the marketplace. The buyers of CDS protection should be required to deliver the underlying instrument in order to collect on the insurance. Indeed, this was the rule in the OTC market until the after the bankruptcy of Delphi Corporation. \2\ At a minimum, the Congress should compel ISDA to roll-back the template for CDS contracts to the pre-Delphi configuration and require that buyers of protection deliver the underlying basis.--------------------------------------------------------------------------- \2\ See Boberski, David, ``CDS Delivery Option: Better Pricing of Credit Default Swaps'', Bloomberg Books (2009), Pages 101-104.Q.21. Why should we have two regulators of derivatives, with two interpretations of the laws and regulations? Doesn't that ---------------------------------------------------------------------------just lead to regulation shopping and avoidance?A.21. Yes, in terms of efficiency, we should not have two regulators of derivatives, but the purpose of the involvement by the two agencies is not identical. When a derivative results in the creation of the economic equivalent of a listed security, then investors must be given notice via SEC disclosure. It should be possible for CFTC to exercise primary regulatory oversight of these markets while preserving the role of the SEC in enforcing the legal duty to disclose events that are material to investors in listed securities.Q.22. Why is synthetic exposure through derivatives a good idea? Isn't that just another form of leverage?A.22. Yes, it is another form of leverage against real assets. Like any form of leverage, it must be disclosed and subject to adequate prudential safeguards such as collateral and disclosure.Q.23. What is good about the Administration proposal?A.23. At least we are now talking about some of the important issues, but the Administration proposal essentially mirrors the position of the large banks and should not be taken as objective advice by the Congress.Q.24. Mr. Whalen, you suggest making all derivatives subject to the Commodity Exchange Act. The SEC says some derivatives should be treated like securities. Is that an acceptable option?A.24. See response to Question 21.Q.25. Is there anything else you would like to say for the record?A.25. To repeat my earlier testimony, the supranormal returns paid to the dealers in the CDS market is a tax. Like most State lotteries, the deliberate inefficiency of the CDS market is a dedicated subsidy meant to benefit one class of financial institutions, namely the large dealer banks, at the expense of other market participants. Every investor in the markets pay the CDS tax via wider spreads and the taxpayers in the industrial nations pay due to periodic losses to the system caused by the AIGs of the world. And for every large, overt failure like AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets. How does the continuance of this market serve the public interest? Additional Material Supplied for the Record" CHRG-111hhrg63105--76 Mr. Chilton," It is actually--we know that a lot of money went out. And it went--I mean, look, as the Chairman said, we are not price setters. We are supposed to be commodity blind, although I have a little bit of penchant for the ags, and price neutral. We are not price setters. And I also get concerned when oil is $150 but---- " CHRG-109hhrg31539--12 Mr. Bernanke," Yes, Mr. Chairman. First of all, you are absolutely correct that what matters to the average person is overall inflation, including energy prices and food prices, and we take that very seriously. Overall inflation is probably also what guides inflation expectations as people think about what inflation rate is likely to occur in the future, and that is another reason to be concerned about overall inflation. There are two reasons why we look at core inflation as well as overall inflation. The first has to do with forecasting. Historically oil prices, energy prices have been rather volatile, and if you look even today at the futures markets, the futures market predicts 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. " FOMC20060131meeting--97 95,MR. GUYNN.," Thank you, Mr. Chairman. I also have not had the occasion in the public farewell ceremonies to say thank you to you. So let me say what an honor it has been to serve under your leadership and to be associated with the great confidence and respect you’ve given people in what we do at the Fed. Thank you. Thank you very much. Given your request for brevity, let me confine my remarks to a few observations about our District that may have implications for the national outlook. Generally I would say that the anecdotal information and the available data suggest that economic growth in our southeast region continues at a very solid pace. At the past two meetings, I reported evidence of the slowing in the real estate markets, and those reports continue. It has become especially notable in a few selected markets, including several that have been hot for some time, like Florida. Banks are now clearly pulling back on their construction lending. We’re receiving increasing numbers of reports that planned projects have either been put on hold or are not going to come out of the ground. And we’re now beginning to see some signs of downward pressure on prices—in some cases in the high single digits, but in a few markets substantially higher than that. As an example, we heard one report that in the Panama City area of Florida, condos that had been going for $600 a square foot are now being priced at $450 a square foot. That’s a 25 percent correction. I think we have to view these corrections that are taking place as healthy. Worker shortages due to hurricane cleanup work in Louisiana and coastal Mississippi are also contributing to the slowdown in Florida. I would emphasize, again, that this evidence is not indicative of a broad trend throughout the District. Our general real estate situation still feels pretty solid. I’d also like to make a couple of comments on the situation of the hurricane areas, where, according to the staff , FEMA spending turned out to be less than expected in the fourth quarter. At the last meeting I noted it had become clear that the stimulus from the flow of government funds would be slower than expected. Work in both Mississippi and Louisiana is still mostly in the initial cleanup phase. Despite what we see in public statements, there is no substantial rebuilding under way yet, except for casino reconstruction in Mississippi. The grace period on mortgage payments has already or is about to run out, and this could bring additional hardship for the affected property owners, with obvious implications for lenders. Indeed, a handful of small community banks may actually be at risk. Considerable uncertainty exists concerning federal flood insurance policies going forward, and in certain areas no rebuilding can take place until flood maps are redrawn, building codes are reassessed, soil contamination is assessed, and permits are issued—all of which could take many, many months. Because so few people have been able to move back to their properties, even those homes that were only modestly damaged by the storm are now beginning to show signs of deterioration due to mold and a lack of maintenance and repairs. I think the take-away from this discussion is that the economic kick we’ve been expecting from hurricane rebuilding is probably going to be spread over 2006, 2007, and perhaps even a bit further. The damage to the energy sector in the Gulf now appears to have been worse than most had thought. Although national production of crude is reported back at about 92 percent of pre- hurricane levels and natural gas production is back to 95 percent of pre-hurricane levels, our sources tell us that 25 percent of the Gulf region capacity for crude and about 16 percent of the Gulf capacity for natural gas remain shut in. And that shortfall, in my view, remains significant. More than half the crude oil that is shut in is attributable to the production lost from Shell’s Mars platform, which isn’t expected to be operational until mid-2006. Our contacts are also now saying that natural gas production will probably not fully return to pre-hurricane levels because the production at several sites is already in decline—as much as 8 percent below the peak. Finally, as has been the case for some time, we’ve continued to receive information from our directors of pricing pressures, of plans to push through price increases, and of a greater willingness on the part of upstream purchasers to accept those increases. And I think we are likely seeing some of that in the latest inflation data. On the national front, very briefly, like everyone else, I was surprised and somewhat disappointed by the considerably weaker than expected initial report on fourth-quarter GDP, but like the Greenbook, I think I’m satisfied that we can explain most of the shortfall. I do not see it as an erosion of fundamentals, and in fact, I think we may well see some offsetting gains in the current quarter. I expect a return to solid growth in the current quarter. My own forecast for output, inflation, and unemployment for 2006 and 2007 remains positive. At the same time, there are some especially interesting unknowns and risks at the moment that we’ll have to watch being played out. As others have already suggested, energy remains a major wild card with the very delicate balance between worldwide supply and worldwide demand. With recovery of the energy industry in our Gulf Coast region not yet complete, with the fragile political situation in many oil-producing regions around the world, and with the ever-present risk of natural disaster and sabotage, it seems reasonable to expect continued elevated energy prices and substantial energy-price volatility. It’s not clear to me whether households and businesses have fully adjusted to these new realities. The residential real estate adjustment, which seems to be beginning to take place both in the level of activity and in prices, could have important implications, as Dave Stockton and others have already suggested. Whether consumers will be able and willing to continue to smooth their expenditures relative to current income seems to be substantially dependent upon home prices, mortgage interest rates, and the ability to tap home equity. And the potential inflation pressures we’ve highlighted for some while, and which still do not seem to have played out fully, should not be too easily and too quickly discounted. All things considered, I think we have to be reasonably comfortable with the outlook and the policy path we have been on, but I look forward to discussions of policy and the way we communicate what we see ahead. Thank you, Mr. Chairman." FOMC20050630meeting--336 334,MR. LEAHY., Is the question about the import prices or about going from import prices to the inflation measure? FOMC20070807meeting--116 114,MR. LACKER.," Thank you, Mr. Chairman. I think we have a couple of issues in front of us today. First, do we react to the recent inflation numbers? I have been pleased by the recent reports, as I said, coming in better than expected, but there seems to be a substantial chance that the improvement we have seen is temporary and that we will get some higher figures later this year. Moreover, inflation expectations remain above where I’d like them to be, so I don’t think we should relax our characterization of inflation in this statement. A second question we face is how to react to the recent turmoil in financial markets. I think we need to be careful to maintain our focus on the implications of market developments for the anticipated paths of inflation and real spending. At this point, I don’t see those implications being substantial enough to warrant a policy response on our part or a change in our sense of the likely near-term policy path, though obviously this assessment may change as events unfold. Absent evidence of such implications, our financial stability responsibilities can be met quite adequately through the automatic supply of reserves under the Desk’s operating procedures for targeting the overnight federal funds rate or through the supply of reserves to solvent institutions at the discount window. Unfortunately, the recent behavior of the fed funds futures market and recent financial press commentary suggest that some market participants, perhaps thinking back to 1987 or 1998, believe that financial market turbulence per se will induce us to respond with interest rate cuts. Even if we did cut rates to counter financial market volatility, financial market jitters might take some time to dissipate. We may be reluctant to undo such rate cuts in the meantime, and we would run the risk that policy then becomes too easy and we get behind the curve. My main concern is the risk that our communication today might mislead markets into thinking that we may cut rates in response to asset-price volatility per se, absent any expectation of sustained effects on the real economy or inflation. Accordingly, I believe the statement language should acknowledge the recent developments as in the second part of alternative B but not go any further. I’m concerned about paragraph 4 and adding the passage about downside risks to growth increasing. I’m concerned that it may go a bit too far in that direction. I think that the minutes should acknowledge the problems in subprime and private equity markets, and I also think the minutes should educate financial markets that the mitigation of volatility in asset prices is not an FOMC objective. Thank you." FOMC20071031meeting--45 43,MR. FISHER.," By that I mean, by the way, that the subprime market is a focus of angst, which it should be, but the ridiculous practice of the suspension of reason in valuing all asset classes, if not over, is in remission. We have a long way to go before full recovery and must acknowledge that shocks regarding access might occur. I am confident, as I have said in previous meetings, that—just to be polite—some cow patties might show up in the punchbowls of some portfolios, perhaps especially in Europe and Asia. But I would submit, Mr. Chairman, that we are on our way back to markets priced by reason rather than by fantasy. So, while we must remain ready to act as needed, I think it is appropriate to focus our discussion today and tomorrow foursquare on the economy, and I want to turn to that now. The wealth effect of the severe markdown in housing is as yet incalculable and worrisome. As the Greenbook states and my sounding with CEOs confirms, there are as yet no appreciable, let alone debilitating, signs of spillover into the rest of the economy. The economy has been weakened. You see it in the rails and trucking and retail. It has not shown signs of succumbing as much as one might have expected to the full-blown virus that is afflicting housing. As Dave mentioned, going back to July, banks in our District and everywhere else have reported tightening terms and standards on loans to businesses and households. The overall sentiment or mood of the country, as reported by the press and the surveys, is sour. Yet we haven’t seen sharp increases in initial claims, low PMI (purchasing managers index) readings, or sharply falling durable goods orders. Households are still reasonably optimistic about their job prospects. Consumer spending continues to grow, albeit at a slower pace. The CEO of Disney started his discussion with me this time by saying, “I hate to be the bearer of good news,” and went on to cite an internal survey they recently completed that shows that families plan to spend liberally on vacations, despite setbacks in presumed housing prices, as well as strong ad statistics for their broadcasting network. There remain widespread reports of labor shortages, not just in our District but also elsewhere. The bottom line, Mr. Chairman, is that, there is clearly a fat left tail on growth—the economy is growing slower. But the economy is growing at a positive pace. Some might say that it has slowed to a sustainable pace. In part, this is due to infrastructure investment, spending on nondefense capital goods that is better than expected, decent if not robust E&S demand, fiscal stimulus, and strong export performance that we talked about earlier, assisted by superior demand growth abroad, facilitated by a progressively weaker dollar. I note that we meet the day after the trade-weighted dollar celebrated a post–Bretton Woods low—not an easy thing for a strong dollar man to note. Certainly, there is a risk that downward economic momentum will emerge. I worry about the plight of the big, populous states like Florida and California under the crush of the housing implosion. I take note of the reports from UPS, the rails, and the truckers as to the deceleration in year-over-year trends in pre-holiday shipments. I realize that Wal-Mart same-store growth has slowed, that mall traffic is down, and so on. But not a single one of my thirty-five CEO interlocutors, except for the homebuilders, felt that the economy was at risk of falling off the table. Fluor and the other big builders—or logistics organizers, as I like to call them—report a booming domestic infrastructure business, especially in the petrochemical sector. The technology folks, as manifested by the earnings reports of Microsoft, Apple, and others, continue to find that demand is brisk. Cisco’s CEO confirms that business with all but the financial institutions “has begun to flow again” after being laid low by the uncertainty of August. The airlines report volume conditions as “less bad” than they were in the third quarter. UPS’s CFO, about to become CEO, who serves on President Lockhart’s board, is concerned, like the rails, about consumer holiday demand, and notes that trans-Pacific shipments into the United States have slowed. Yet when he digs deep into the data, he will tell you that the tech side looks good. So the net effect is that, while nowhere near robust, “domestically, conditions have not materially worsened.” Except for housing and Bill’s two law firms, we are not hearing of significant lagging of receivables or collectibles. Many of my interlocutors, however, worry about prices, as do our staff members in Dallas. We differ significantly, Mr. Chairman, from the central assumption of the Greenbook in our views on headline inflation looking forward. I noticed you cocking an eye in my direction, Brian, when you were talking about the outliers. The Greenbook has a 3 percent number for PCE inflation for this year, followed by a deceleration, to a pace of 1.8 percent in 2008 and 1.7 in 2009. We in Dallas are not as confident that we will continue to experience a disinflation of the momentum of the PCE. Partly this stems from concerns expressed anecdotally by big importers like Wal-Mart, who report stiffening Chinese prices, by the CEO of JCPenney, who is planning for cost increases of goods imported from China on the order of 3 to 4 percent next year, and by the users of pulp and recycled waste paper that are set to announce a 5 percent increase in essential paper products effective in February, having just announced a double-digit increase not too long ago. Our concern at the Dallas Fed stems from two more-pervasive sources than that anecdotal evidence I just cited, and those are food and energy, for which we anticipate a more pernicious pass-through effect from recent rapid price increases of underlying commodities. The concern we have for food is encapsulated in the eye-popping chart on page II-30 of Part 2 of the Greenbook. You have to have a hawk’s eye to see this chart from that end of the table, but it shows an incredible divergence between food prices and the core PCE. Now this pattern has a historical precedent. A spread of this magnitude between food prices and core indexes occurred on several occasions between 1951 and 1980. In 1973, the gap was 20 percent. In 1974, the gap was closed when the CPI rose up accordingly. But we have not seen a gap of this nature in over a quarter-century. Wholesale food prices are up 6.3 percent for the year to date. Through September, the CPI for food is up 5.7 percent. As mentioned by one of the previous interlocutors, milk and green grocery prices are rising at double-digit paces. This goes beyond ethanol, Mr. Chairman, as a driver of shifts in crop rotation and production. It is occurring against a ramping up of the caloric intake of a few billion new eaters in China, India, and elsewhere. This is hardly encouraging, and it injects a modicum of doubt in predicting a significant decline in PCE inflation. We spoke about energy price dynamics earlier. They further cloud the picture. If you talk to Exxon or Independence, they will tell you that there is no problem in finding oil, in refining it, or in delivering the final product. They will, however, note that there are two key impulses at work. First, there is no evident slowdown in demand growth according to them— that is, domestically—and the appetite in the BRICs (Brazil, Russia, India, and China) and in the developing countries was described as voracious. An enormous amount of infrastructure in chemical plant capacity is being constructed everywhere, from the Gulf Coast of the United States to the Middle East to China and Singapore, in order to be nearer to either feedstock or growing final demand. Any analysis of the income elasticity of demand for oil in low but rising income nations like China and India points to demand for oil that will grow even faster than their slightly slower but still rapidly growing income levels. Second, price pressures on crude at the margin are compounded by noncommercial activity, which we did not talk about earlier. Noncommercial contracts, the busywork of what are called “city refiners” in the industry—that is, the city of London and the financial exchanges—have of late been running at triple their traditional volume according to Exxon’s CEO, driving oil through $90. Thus far, gasoline and distillates, which is where the pass-through rubber hits the consumer price road, have been tame in response. Bill discussed the low crack spread, for example. Yet our models at the Dallas Fed for retail gasoline prices envision increases above $3 a gallon next year if crude stays above $85, which we consider a reasonable probability. Similarly, price pressures for distillates are increasingly probable. Finally, while currently high inventories continue, it is noteworthy that natural gas prices have reversed their summer slide downward to $5.50 per million Btu and are now quoted at $7 at the Henry Hub. All this gives me, Mr. Chairman, a sense of discomfort, like that expressed by President Hoenig and President Plosser, on the headline inflation front and is a reminder that the balance of risk is not necessarily skewed only toward slower growth. Thank you, Mr. Chairman." FOMC20051213meeting--97 95,CHAIRMAN GREENSPAN.," It’s interesting to listen to the discussion around this table today because the underlying facts are really somewhat different from what we had perceived at our last meeting. There is evidence that the economy is moving at a pace and in a direction that I don’t think we would have anticipated six weeks or two months ago, especially in the context of the hurricanes. The underlying real rate of growth is really powerful. We can see it in the United States but just as importantly, if not more so, we are beginning to see it abroad. Japan is finally getting its act together, as best I can judge. For a long period of time Japan had very poor financial results within its banking system; and while they had a nonperforming loan statistic, it certainly wasn’t anything like the type that we would calculate. Therefore it looked as though the economy was a fragile one, with a banking system that was largely reliant on real estate collateral whose prices continuously plummeted. Moreover, the state of financial intermediation in Japan was highly dubious because banking is the only vehicle they have for intermediation; there really isn’t an alternate means of moving savings into investment. However, the Japanese banking system has finally gotten to a point where it looks like a regular, old-fashioned banking system. Intermediation is now going on. A lot of the pieces are beginning to come together. And the reason December 13, 2005 66 of 100 even though it’s the second largest economy in the world. That’s because it just never moved. As a consequence, the Japanese economy wasn’t an important factor in the global outlook but it now seems to be moving in a favorable direction. And we’re even getting stirrings in Europe, where Germany, though still in very serious trouble, is clearly showing some signs of improvement. Obviously, their unit labor costs have stabilized, and the impact of their very serious structural problems seems not to be getting worse. When one looks around the world, most economies are improving. In the United States, some of the old-fashioned data, as I was mentioning to David yesterday, are showing some very strong signs. One example is that moribund industry which used to be the cutting edge fifty years ago, the steel industry. Durable goods, no matter how you cut it, are still largely made of steel, and those markets are quite strong. Scrap prices are up. U.S. Steel is booking its orders significantly far out into the future. There is buoyancy there and also in the nonferrous metals markets—markets we never used to worry about, but they still do matter. The reason it is tough to get similar information out of, say, the high-tech industries is that while they are growing very rapidly, the dispersion from one company to the other is dramatic. In other words, if you get an industry growth rate of 15 percent, say, you might find that one company grows 30 percent for two years and then its growth goes down to 2 percent and vice versa for some other firm. So, with the technology changing so rapidly, you can’t get the anecdotal readings from a lot of those companies the way you do on the old-fashioned industries where nothing changes all that much and you have a reasonably good base for making judgments. It’s hard to imagine an American economy that is as balanced as this one is. But most importantly, through all of this, we are literally seeing some resistance to the upside pressures on December 13, 2005 67 of 100 note. Every time pressures begin to move up the implicit rate on the 1-year maturity being issued nine years out, when the rate gets to somewhat over 5 percent it runs into resistance. What I think is happening relates to the discussion that I put on the table last meeting about the significant move of educated workforces into market economies from centrally planned economies—specifically the old Soviet Union, and now far more importantly China, and to a limited extent India, which still has characteristics of central planning as well. At the meeting six weeks ago, we had no data at all about the rate of change at which that transition is occurring but it’s clearly a level adjustment. And the rate at which it is happening is a determinant of changes in unit labor costs and, therefore, price changes or inflation. Some additional work has been done by Karen’s group, especially on China, in trying to get a judgment about the movement of workers from the centrally planned sector of the economy to the competitive free market sector. That work indicates in rough proxies—granted, these are extremely crude data—that the rate of change has been rising for a number of years and that there does not yet seem to be any evidence that it has peaked. Now, ordinarily that would not be a great insight because the data are so poor. But if you’re looking for explanations of why we’re running into upside resistance on prices—every time we get strong demand and increased short-term rates, long-term rates don’t want to move—this globalization of the workforce seems to be a factor. If you look at the charts on longer-term rates today, they go up, they run into trouble, they come down. There’s a ceiling out there apparently, which suggests that at least for the time being inflation expectations are clearly contained. But judging from the real-time price data, they’re also soft. And they are soft around the world, not just in the United States. We’re now getting price pressures in some places. In a couple of countries that are unbelievably expansionary and have December 13, 2005 68 of 100 issue before is that twenty years ago those rates would have been 20 percent. We’re not getting any of that. So this is not a U.S. issue. It has to be a global one. This suggests to me that we have a very unusual situation where conventional analysis tells us very concretely the following: We’re running out of spare capacity; things are tightening up; and wage rates are under pressure, though not so much in the skilled area in the United States as in the lesser skilled area where we’re beginning to see wage rates rise. Indeed, that is evident in the series we run using the wage and salary data in the NIPA [national income and product accounts] accounts—which of course are tied to virtually full coverage for the unemployment insurance system—and the employment and implicit hours data that come out of the establishment labor market survey. That survey reports data on average hourly earnings for production or non-supervisory workers. Using those data and the totals from the NIPAs, one can infer the average hourly wage for supervisory workers or skilled workers—that is, the 20 percent of the workforce not included in the average hourly earnings data. In the last several months, after having run well above 10 percent, the supervisory hourly wage rate has come down quite significantly, so that the ratio of wages for supervisory or skilled work to that for lesser skilled work is beginning to stabilize. And that suggests that we’re beginning to get a little more pressure on lesser skilled wages and somewhat less pressure on skilled wages. These data are very interesting in the sense that they’re based essentially on aggregated data, and they are something we never really looked at previously. But I think they tell us a great deal about what’s going on in the labor markets, and these data involve developments that we don’t ordinarily look at. This leads us to a very interesting question as to where policy should go from here. Let’s say we knew for certain that inflationary expectations were held down and that core inflation was December 13, 2005 69 of 100 we are constructing a situation in which interest rates are so low that we are encouraging, or indeed causing, underlying speculative activity that will create really serious imbalances in the overall system. So we’re dealing with a little more than the question of where inflation is going because, as I have mentioned previously, something that has become very evident in recent years is that overall asset prices worldwide, both equity and debt, are rising a good deal faster than product prices. And they are picking up because of—indeed, the rise in asset prices is being engendered by—the fact that interest rates are getting ever lower. Interest rates in emerging-market economies are as low as one can remember. And aside from the surprisingly high equity premium in the United States, we have very significant upward momentum in asset values. This is where the very important question of whether monetary policy should target asset prices comes in. The current situation is a very interesting case because I would say that we ought to be tightening at this particular point but not targeting the asset price increases. But it is clearly the potential for speculative activity—and its effect on asset prices—which is generating an assessment that we need to move, as far as evaluating the outlook for the overall economy. So where I come out on all of this is that unless we move a little to tighten up a bit further, I think we’re taking a risk of the system beginning to run faster than we would like. I conclude, as a consequence, that we need to move today. I think we have to indicate, as the statement for alternative B suggests, that we’ll move again in January. I would hope that after the statement comes out today the March futures for the federal funds rate do not come down. I would prefer that futures rates move up a bit, even if it’s our expectation—and it’s a plausible expectation—that the January increase will be the end of our tightening. I can conceive of that occurring, but I think we have more here to be December 13, 2005 70 of 100 getting product price inflation or not, and I think the odds are that we are not. But we are running into the question of whether we are opening up a very significant potential for a major increase in asset expansion. Remember that when we talk about liquidity, we’re talking about an increase in overall purchasing power; and common stocks as well as bonds are, in a sense, currency. And if prices of bonds and stocks go up, that will result in a very high degree of liquidity in the system, which may or may not hit on product prices. Frankly, I think it’s unlikely to do so. We have a global market and a global environment here, which I don’t think we yet fully understand. In fact, I know we don’t fully understand. Nevertheless, I think we need to tighten to be sure that we’re safe from these speculative incursions. I believe the risks of not doing so are far greater than tightening a little bit more than probably in retrospect we would have had to do. So I think we ought to move forward. My own personal view is that we should not drop the word “measured” from the statement because that would imply that we’re really beginning to see developments out there that are moving very rapidly, and I think it’s too soon to conclude that. My arguments, I think, are largely precautionary in the sense that there is something significant happening around the world that we cannot as yet fully explain, but it is one of the possible scenarios that has a high element of risk in it. And I think we have to address ourselves to that just from a risk management point of view. So I conclude that we ought to move the funds rate target up 25 basis points, which I think is the general consensus around here, and I believe the statement that we have in “B” fulfills our objectives with regard to communicating that. I would be cautious about indicating at any time that we are about to end the increases in the funds rate, even though we may well be doing that, because that will bring mortgage rates down through the usual effect on the 10-year note. I think whatever December 13, 2005 71 of 100 largely because mortgage rates have moved up and are beginning to have an impact. Remember, it’s not only the 30-year fixed rate but adjustable rates as well. And short-term rates have moved up quite significantly and are impacting the market. If we can contain the presumptive housing bubble, then we have a really remarkable run out there. But the real danger, in my judgment—where I think the risks lie—is in moving rates down too soon. When I say moving down, I mean that when we stop tightening, the long-term rates are going to come down. And in my view we have to be careful about how that happens and what the impact is on the economy. Indeed, our actions are going to have an impact on the world at large because they will affect what everybody does. When I sit in the G-7 meetings, it’s very evident that what the Federal Reserve does with respect to policy has a quite significant impact on the ECB and the Bank of England. The reason I know that is they tell me that. So, what we do is going to be quite important. So, my proposal is a 25 basis point increase in the funds rate target and the statement language of alternative B. Who would like to open up the discussion?" FOMC20060328meeting--72 70,MS. JOHNSON.," I’m not so sure exactly—we will give it thought. There’s a fair amount of literature developing about global capacity utilization. Is it defined? We don’t talk, for example, about capacity utilization in Oklahoma. We assume that if Oklahoma needs stuff from the rest of the United States, it just gets the stuff, and vice versa. Why is the global economy any different? Is the United States small enough relative to the whole world that it can just do that? That’s sort of the epitome of the small open economy model whereby it can buy anything it needs at the going world price and it can sell all it wants at the going world price. But if I take that model as my benchmark, it really does that all through prices. It says that the small open economy can buy imported products, resources, inputs, whatever, just by knowing the prices, and sells to an infinitely elastic demand curve for its output. So it is certainly true that we have paid attention to things like global commodity prices and global energy prices, as the activities elsewhere in the world have shifted global demand and have moved those prices. It is no end of frustrating to me that the futures markets always say that, however much those prices have gone up—or maybe even occasionally down—over the past so many weeks or months, they are going to flatten starting tomorrow. You just get very little dynamic out of those futures prices. No one is out there thinking about the global economy over the next three years, looking ahead at this, that, or the other thing. On the other hand, we’ve talked about not using those futures prices, and I don’t know whether on our own we have the capacity to do better than those prices. So I’m stuck. But I understand the point, and it is certainly the case that huge changes—supply shocks to the global economy—are in some sense part of what’s happening and that they ought to have some repercussions for us. Partly, I think, that’s a little bit of what’s going on in this notion of whether pass-through has declined over time. But we’ll give the subject some more thought, and we’ll see if we can come up with some other sorts of indications, such as bottlenecks, as when the shipping industry was having problems, whether it was just port congestion, huge prices on capacity, or something else. You could trace back bottlenecks, and you could think about the consequences of them for the U.S. forecast, say. But something that is more inclusive than particular bottlenecks for particular kinds of goods is a tougher question." FOMC20071031meeting--39 37,MR. PLOSSER.," Thank you, Mr. Chairman. There has been little change in the District economic conditions since our September meeting. Except for housing, activity is expanding at a modest pace, somewhat below trend. Our business contacts are cautious, generally expecting slow growth to continue over the next quarter, but they remain fairly optimistic for business conditions six to twelve months out. Payroll employment continues to expand at a slow pace in our three states, which partially reflects slow population growth, and so the unemployment rate remains slightly below that of the nation. Retail sales have generally held up, but there are divergent views among retailers regarding holiday sales. High-end stores expect a very strong finish to the year; lower-end merchants are more cautious. Housing construction and sales continue to decline, but the pace of that decline is in line with the expectations at our last meeting. The value of nonresidential building contracts has declined more sharply in our region than in the nation as a whole. Nevertheless, I would characterize nonresidential real estate markets as firm. That office vacancy rates are declining and commercial rents are rising suggests a positive outlook for commercial construction going forward. According to our business outlook survey, manufacturing activity in the District has been increasing at a modest pace for the past several months. The general index of economic activity moved down slightly, from 10.9 in September to 6.9. Shipments and new orders also weakened slightly. Staff analysis suggests that our manufacturing index, which precedes the release of national industrial production numbers, provides useful information in forecasting monthly manufacturing IP and total IP. That forecasting model is predicting a rise in both manufacturing IP and total IP in October. About two-thirds of the District manufacturers and service-sector firms we have polled said that recent changes in financial conditions have not prompted any change in their capital spending plans, and the other firms are about evenly split as expecting a slight decrease or a slight increase over the next six to twelve months compared with the past six to twelve months. However, in speaking with my business contacts, I do hear a sense of continuing caution among businesses in their capital spending plans. The manufacturers seem to be a bit stronger than the service firms, perhaps reflecting a more robust export market, which many of them are participating in. District bankers, in general, continue to express concern over housing and mortgage lending but see commercial and industrial lending as fairly stable and proceeding about as they had expected. There has been little change in the District’s inflation picture since our last meeting. Firms continue to report higher benefit costs, but other wage pressures have moderated. Our manufacturers reported having to pay higher prices for many inputs, particularly energy-related inputs and petroleum-based products as well as agricultural commodities. They have passed on many of those increases in terms of higher prices to their consumers. While retailers report only modest price increases for many products, food prices are generally higher. In summary, since our last meeting, there has been little change in the economic conditions in the District or in the outlook for the region. Overall, business activity in the region is advancing at a fairly modest pace, and most of our contacts expect that pace to continue for the next quarter or so. But in general, firms in the District remain optimistic about business six to twelve months from now. Turning to the nation, the economy appears less vulnerable to me than it did at the time of our last meeting. Financial markets have improved somewhat, as Bill Dudley was telling us. Conditions are not back to normal yet in all segments of the market, but the markets that are still under stress are the same ones that were under stress last month. Subprime and jumbo mortgages and asset-backed commercial paper are the ones that still are struggling. Price discovery still plagues many of these markets, and I suspect it will take some time before the markets can sort things out and trading returns to normal. That does not mean that the ultimate agreed-upon market prices for some of these assets will bear any resemblance to what they looked like before August. Indeed, they probably won’t, but that’s not necessarily a bad sign or a cause for concern; it may even be a healthy development. We haven’t seen disruption spread to other asset classes for the most part, and the level of stress in financial markets seems to have fallen even as volatility remains high. The spread of jumbo over conventional mortgage rates remains elevated, reflecting some concern, I think, about the risk that expensive homes may face greater price declines than other homes, but the premium is less than it was in September. Both investment-grade and non-investment-grade corporate bond issues have increased. Financial institutions have begun to write off some of their investments and take the losses. This has weighed heavily on equity markets, but I view the write-downs as a necessary part of the process toward stabilization in the markets. Earnings reports from nonfinancial firms have actually been pretty favorable. I’m not saying that we are out of the woods yet, but in my view the risks for a serious meltdown in financial markets have lessened somewhat since our last meeting. The news on general economic activity has improved somewhat since our last meeting as well. Indeed, some of the data have come in better than expected. Employment was revised up, and retail sales data suggest that consumer spending remains resilient, despite the downturn in housing. Like the Greenbook, my outlook for the economy has changed little since our last meeting, when we acted preemptively and lowered rates to “forestall some of the potential adverse effects of financial market disruptions and the expected intensification of the housing correction on the broader economy.” Housing investment and sales continue to decline but about as expected in our forecast. After all, the rapid reduction in subprime lending is exacerbating the decline in housing demand and thus home sales, contributing to the slower recovery of that sector. Other sectors of the economy have performed about as I expected, with little evidence as yet of any major spillovers from housing. Oil prices have moved higher than expected since our last meeting, as has been discussed, but it is unclear to me yet how permanent that increase will be or how much of a drag it might be on activity. The oil price rise is likely to show through to headline inflation in the coming months. Although core inflation measures have improved since the beginning of the year, the rise in energy prices has the potential to put upward pressure on core inflation. Thus, while inflation and inflationary expectations have been stable to date, I suspect that inflation risks are now more to the upside than they were in September. The forecast is an important context for our policy, in my view. We have stressed in the past year that we are data driven and respond to the evolution of our forecast. In general, like the Greenbook, as I said, my forecast of the economy going forward is little changed from my September view. I see that growth returns to trend, which I estimate to be about 2.7—a little higher than the Greenbook—late in 2008 as the housing correction runs its course and the financial market turbulence unwinds. Core PCE inflation remains slightly below 2 percent next year and moderates toward my goal of 1½ percent by 2010. I built in a 25 basis point easing sometime in early 2008 to bring the funds rate back down to a more neutral level, and in my baseline forecast I assume a constant funds rate thereafter. That forecast, however, is contingent on inflation and inflationary expectations remaining well behaved. Having said that, I repeat my caution that inflationary pressures are somewhat elevated at this point, and we run the risk that inflationary expectations may become unhinged if the markets suspect that we have lessened our commitment to keep inflation contained. Thus, I don’t rule out the possibility that we may have to reverse course and tighten policy sometime in 2008 or 2009 in order to achieve consistency between my target rate of inflation of 1½ and inflationary expectations. Thank you, Mr. Chairman." FOMC20050322meeting--134 132,MR. REINHART.,"2 Carol Low will be handing out copies of my presentation. As can be seen in the upper left panel of your first exhibit, the expected trajectory of Federal Reserve tightening now steps up considerably more steeply than was the case at the time of your February meeting. In part, this movement is an example of how words can matter: Chairman Greenspan’s testimony, along with other remarks by Federal Reserve officials, apparently led market participants to ratchet up their policy expectations and made them more suspicious of the current pricing of long- term assets. With this fresh look on asset returns, along with higher prices of oil and other commodities and a couple of faster readings on overall inflation, the 10-year nominal Treasury yield moved up to 4½ percent and now looks less like a conundrum than it did in mid-February. The information gleaned from options prices, plotted at the right, indicates that market participants think the funds rate will most likely be 3¼ percent going into your August meeting, but they see outcomes as decidedly skewed to the upside. The implied volatility of money market rates, plotted in the middle left panel, moved off its unusually low level of early February, suggesting a bit more uncertainty about your future actions. Some more detail about the actual day-to-day volatility of the staff’s measure of fed funds rate expectations might be helpful in thinking about your communications strategy. The blue bars in the middle right panel plot the average absolute daily March 22, 2005 72 of 116 change in the expected funds rate at horizons from three months to eighteen months ahead, observed from the fall of 1998 to the fall of 2003. The red bars do the same calculations for the past year and a half. The point I take away is that the relatively explicit nature of the Committee’s guidance about its policy outlook has anchored near-term market expectations but has had no material effect at horizons of one year or beyond. That is, the market still adjusts to news bearing on monetary policy but does so through changes in further-ahead expectations. How you feel about that observation will most likely color your views on how the Committee’s statement should evolve over coming meetings. For some of you, the reduced volatility of near-term expectations evidences an improved alignment of your own and market participants’ expectations that reduces the uncertainty confronting investors and allows them to better plan for the future. Others may hold the view that the elimination of near-term uncertainty has encouraged excessive risk-taking and leveraging—perhaps best embodied by the “carry trade” that so preoccupies the popular press—and may be seen as limiting the range of possibilities of your future action. As can be seen in the bottom panels, financial conditions showed mixed changes over the intermeeting period, as the ratcheting higher of corporate yields in line with those on Treasuries was accompanied by about unchanged equity values and modest depreciation of the foreign exchange value of the dollar. If you believe that these financial conditions are likely to be consistent with relatively favorable macroeconomic outcomes in coming quarters—perhaps (as in the top panel of exhibit 2) along the contours of the Greenbook forecast for resource slack and inflation—you would presumably want to deliver the policy path currently built into market expectations. What you’re expected to do is firm ¼ point today and signal that you believe you will continue marching the funds rate higher for some time thereafter, which is what we tried to convey with alternative B in the Bluebook. As can be seen in the middle panel, a nominal funds rate of 2¾ percent would fit within the range of recommendations for the second quarter from the policy rules that we routinely track. And the resultant real federal funds rate, the solid black line in the lower panel, would move closer to model-based estimates of its equilibrium value. March 22, 2005 73 of 116 Thus, issues for today’s meeting would seem to be what you anticipate doing at the next few meetings, and, working backwards, what that implies for the language of the Committee’s announcement today. Your answers to those questions, in turn, depend on how far you think the funds rate is from neutral. The top left panel of exhibit 3 provides a longer perspective on the path for the federal funds rate currently embodied in financial market prices. Judging from futures quotes, you’re expected ultimately to bring the funds rate to 4¼ percent. That is about the same answer we get from a multifactor model attempting to explain the term structure of Treasury yields, as plotted at the right. The solid line in the middle left panel plots the average response from the Blue Chip Survey, which asked economists where they expect the three-month Treasury bill rate to be six to ten years from now. Their answer—4½ percent—is only a bit higher than that inferred from financial prices. The survey also reports the averages of the 10 highest and the 10 lowest responses—plotted as the dashed lines—out of the 50 or so economist participants. The wide span covered by the survey responses underscores the range of views about the destination of your current tightening cycle. Those of you who identify relatively more with the respondents in the bottom quintile likely foresee pausing in the process of firming sometime soon. Working to reinforce that opinion would be the belief that recent higher inflation readings are largely transitory. In that regard, it is true that businesspeople have talked more of late about passing higher costs through to their customers and hinted about renewed “pricing power.” However, as shown in the middle right panel, fairly consistently over time (and for longer than the sample plotted here), the share of the small business respondents to the NFIB survey reporting plans to increase prices has moved closely with real oil prices. You might interpret that correlation as suggesting that anecdotes are heavily influenced by pressures posed by higher energy costs and may, as Governor Bernanke noted, be a feature of intermediate goods and services rather than an independent source of inflationary impetus. In that regard, you might take comfort from the fact that five-to-ten-year-ahead inflation compensation inferred from Treasury yields (and plotted as the red line in the lower left panel) is up only modestly and remains well off its 2004 peak. With longer-term inflation expectations well contained and resource slack apparently being worked down slowly, the Committee may see relatively little cost in continuing along a path of gradual removal of policy accommodation. That may incline you to choose the words of your statement so as, at the least, to keep market participants from marking up their expected path of tightening or, perhaps, even rotate that path down, which is what we tried to do with alternative A in the Bluebook. March 22, 2005 74 of 116 and forcefully, perhaps leading you to tighten 50 basis points today or to toughen the words of your statement so as to warn investors of such a possibility in May. (In that regard, such a decision might reflect a view of long-run outcomes for the short rate as being more likely than not at or above the Blue Chip average.) Even if you had a benign point forecast for inflation over the next two years, such as the Greenbook outlook for core PCE inflation shown as the solid line at the lower right, you might not view the outcomes on both sides of that central tendency with equanimity. And the width of the fan chart surrounding that forecast suggests that the odds of a different outcome are sizable. If inflation runs on the high side of the staff forecast, you may well have to pick up the pace of firming and work hard to contain inflation expectations, even as financial disruptions become more possible. In contrast, with the momentum of aggregate demand well entrenched, inflation falling short of what is currently expected could be dealt with more readily. At first market participants would unwind some of the anticipated restraint already embodied in financial prices, giving the Committee some time to calibrate its setting of policy through its communications. Some members may believe that projecting a more forceful sense of resolve now might lessen the risk of an adverse outcome by helping to keep inflation expectations firmly anchored. We tried to accomplish this with alternative C in the Bluebook, which introduced resource slack as a concern and asserts that inflation pressures have intensified. A common slur about economists is that they are drab and colorless. Not so. This Bluebook set new records for the varieties of hues used for fonts. The best example of this is repeated as your next exhibit, which was in a box in the policy alternatives section. Over upcoming meetings, the Committee likely faces five key issues concerning its statement language. First, as noted in the markup of the February FOMC statement, you will need to determine whether the characterization of the stance of policy—marked in red—should be modified in some way. Second, as noted in blue, the FOMC may need to revise its assessment of the pace of underlying productivity growth in light of the realized and anticipated slowing in actual productivity growth. Third, the assessment of inflation and inflation expectations— noted in green—may need to be revisited. Fourth, as marked in purple, the Committee may wish to remove the “measured pace” language at some time. This might be the case if the Committee judged that a pause in the process of removing policy accommodation might be called for or, alternatively, if it determined that economic circumstances could require a more rapid policy adjustment some time soon. However, eliminating the “measured pace” language without a replacement would leave the risk-assessment paragraph without a signal about the future direction of policy. That omission raises the fifth issue—noted in orange—regarding the balance of risks assessment. March 22, 2005 75 of 116 seemed important to highlight the Committee’s watchfulness about inflation developments. Hence, the rationale paragraph points out that inflation pressures have picked up, with this latest draft a bit tougher on that score than the earlier version. Second, it seemed important to remind people that keeping the risks balanced may take some effort. Hence, the assessment of risks is explicitly conditioned on an appropriate path for policy. The Committee has accompanied its six prior tightenings with an assessment of balanced risks, so observers must by now have inferred that it was based on an appropriate policy. However, I must admit that explicitly stating that conditionality will limit the usefulness of this form of the risk assessment in signaling the direction of future policy moves. But you may believe that the useful shelf life of this language has already passed. In the Bluebook, alternatives A and C offer an alternative formulation of the risk assessment that could work now or in the future. Both drop the “measured pace” language—in alternative A because it seems to rule out a pause any time soon and in alternative C so as to signal a faster pace of firming—and adopt a risk assessment based on an unchanged policy for the next few quarters. It may be premature to adopt such language now, but having a discussion about such a possibility might be the first step in the process." CHRG-109hhrg31539--229 Mr. Bernanke," Well, it is a global market, and there are many different sources. I expect that oil would be available but potentially at a very high price, and I would think the primary effects of that would be inflationary because of the impact on costs and impact on the consumer prices at the pump and so on. And also it would be a hit to growth if oil prices were to rise very, very significantly. " CHRG-109hhrg31539--222 Mr. Pearce," Thank you, Mr. Chairman. And thank you, Mr. Chairman. If we are talking about the price of gasoline and the price of crude oil being a component of that, isn't crude oil simply a function of supply and demand? If we increased the supply, then the price would fall? " CHRG-111shrg54589--143 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM PATRICIA WHITEQ.1.a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?A.1.a. Market participants use derivatives to manage and hedge a variety of risks. Some of these risks are associated with positions in actively traded cash instruments. For example, an insurance company that writes equity-linked annuities may use an equity derivative to hedge the risk of fluctuations in the referenced equity index. Some of these risks are associated with positions in relatively illiquid instruments. For example, a commercial bank may use a credit default swap to hedge against a concentrated exposure in its loan portfolio. Some of these risks may not be associated with any cash instrument. For example, some businesses use weather derivatives (futures contracts listed on the CME) to hedge their financial risk associated with fluctuations in the weather. All of these uses of derivatives seem appropriate, so it would not appear to be useful to limit the creation of derivatives based on the existence of an actively traded cash market.Q.1.b. If not, what specific, objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?A.1.b. The counterparties to a financial derivative contract must agree on the manner of calculating its value at expiration or at any intervals requiring periodic payments as part of the negotiations related to doing the trade. The agreed upon terms must be well-defined, and not subject to different interpretation by different parties. In some cases, a cash market price can be the basis for calculation of a contract's periodic contractual payments or final value. In other cases, such as the weather derivatives mentioned above, a calculation based on observable characteristics is utilized (e.g., temperature at a particular location at a particular time of day).Q.2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative, and the model is effectively the basis, why should the models not be public?A.2. For OTC derivatives that are standardized and widely held and traded, consensus generally exists regarding appropriate valuation models. Many of these can be found in an introductory finance textbook and often can be implemented with a personal computer. For customized OTC derivatives, valuation methods may be proprietary. For example, an oil company may enter into an OTC energy derivative whose value is based on expectations involving oil prices at particular locations, for particular types of oil products, at various points in the future. Not only can informed parties hold differing views regarding these future prices, but disclosure of the exact valuation formula could effectively reveal the oil company's future production plans and forecasts, which it may consider to be proprietary information. In addition to the valuation models, counterparties may also legitimately wish to keep private other contract provisions. Respecting a desire for confidentiality is consistent with the approach taken to most other bilateral contracts, which are not generally subject to public disclosure. Transparency needs of the public can be met more effectively in the ways described in the response to Question 4 below.Q.3. Should parties to derivative contracts be required to post cash collateral, or is other collateral acceptable? And is there any reason not to require segregation of customer collateral?A.3. Noncash collateral, appropriately haircut, can mitigate the counterparty credit risk associated with OTC derivative contracts. Noncash collateral has been used successfully by central counterparties (CCPs) for futures contracts for many years. The benefits from centralized clearing will be greatest if CCPs are structured so as to allow participation by end users within a framework that ensures protection of their positions and collateral. Segregation is an important and common tool for ensuring that customer positions and collateral can be transferred to a solvent clearing member in the event the customer's clearing firm defaults. The Board supports steps to ensure that segregation and other customer protection regimes have a sound legal basis so that the expected protection will be realized in the event an end-user's clearing firm defaults.Q.4. There seems to be agreement that all derivatives trades Deed to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?A.4. The Board supports requiring all OTC derivative trades to be reported either to a contract repository or to a central counterparty, which could provide the information to the relevant regulatory bodies. Both data on the flow of transactions and data on the stock of positions may be of interest to authorities. For example, prudential supervisors are interested in position information insofar as it affects the safety and soundness of the market participants whom they directly regulate. Agencies with an interest in financial stability have an interest in receiving position information that would enhance understanding of the network of exposures among major market participants. Central banks may benefit from information on the flow of transactions to the extent that transfers represented by OTC derivatives positions have effects on their respective currencies and payment systems. Finally, regulators with market integrity mandates are interested in both position and transaction information to aid their surveillance and enforcement activities. A subset of the information provided to regulatory authorities could be aggregated and reported to the public. Public reporting should support overall market transparency by providing investors, analysts, and the general public with a means for better understanding the OTC derivatives market. Until recently, there had been little or no such reporting for OTC derivatives, but progress has been made in the CDS market. The DTCC Trade Information Warehouse has published certain aggregate open interest information on its Web site, including breakdowns by category of counterparties, types of CDS products traded, and referenced underliers of CDS trades. This information is found on DTCC's Web site at: http://www.dtcc.com/products/derivserv/data_table_ i.php. Sensitive information such as the positions of individual market participants should not be publicly reported. Such disclosure would be undesirable as it would expose participants' trading or risk management strategies to competitors. Participants also may have fiduciary relationships or confidentiality agreements with clients that may be compromised by publishing identifiable positions. Finally, publishing such data may raise concerns about privacy laws in some jurisdictions.Q.5. Is there anything else you would like to say for the record?A.5. No. thank you. ------ FOMC20050202meeting--71 69,MR. GUYNN.," Thank you, Mr. Chairman. I also thank the staff for the helpful papers. My own views are closest to Cathy Minehan’s and Don Kohn’s. Like almost everyone who has spoken, I would remind all of us that we have been very successful in helping to achieve a long period of stable and low inflation. I think we have also achieved significant transparency in terms of our inflation preferences. I believe that each of us around this table has a general sense of what we think our target is. I believe that outsiders, including financial markets, get it as well. So, I don’t think there’s any great additional transparency to be achieved by announcing a specific numerical objective. I think there’s also considerable risk at this point in going down the path of choosing a more formal objective. We have a large group around this table, and I think it’s going to be very difficult—though perhaps not—and maybe even counterproductive to agree on a single price measure on a more formal basis and with a less flexible adjustment process. I think we could even February 1-2, 2005 42 of 177 time when we were so worried about deflation that we perhaps didn’t do as much as we could have in dissecting and decomposing some of the measures of inflation to see some of the things that were going on under the surface. If we focus on a single price measure, we may in fact miss that kind of opportunity to look at what really is going on. Although I agree with President Stern that having a specific objective would not tie our hands, literally, I think it would, in fact, cause us to give up at least some of the flexibility that we currently enjoy. And I see no reason to do that. There hasn’t been a lot of discussion of one of the items that Vincent mentioned in his paper, and that is the reaction of Congress to our attempts to set a price-related objective. I agree with others that we probably, in our way of government, have an obligation at least to consult with the Congress. I think there’s a clear risk that the Congress, with all good intentions, could want to substitute its judgment for ours regarding what would be an appropriate objective. And maybe, as Vincent’s paper suggests, Congress would even attempt to give us multiple objectives that could be internally inconsistent or, in fact, beyond the central bank’s ability to materially affect. I won’t repeat the arguments others have made about some of the new communications problems that we could create with a formal objective. I actually think what we need to do is to allow ourselves and others to celebrate an approach and operating process that has worked and worked very well in not only achieving low inflation but anchoring inflation expectations. I certainly agree with the suggestion in Vincent’s presentation that we should continue to work on other opportunities to explain our inflation preferences and intentions. But, to use the word that others use, I don’t think our current process is “broken.” I have much more confidence than some others that the people around this table and others who will follow us are not likely to break it. Mr. Chairman, I think we should stay where we are for the moment, although this issue certainly merits continued discussion. Thank you. February 1-2, 2005 43 of 177" FOMC20080625meeting--43 41,MR. SLIFMAN.," We expect foreclosures to rise--and to rise appreciably. One thing we have done in thinking about house prices is, in effect, to build in some extra house-price depreciation, above and beyond what our price�rent model would want to say, to reflect the kinds of factors that you are talking about--the foreclosures, what that means then for the vacancy rate, and what that does to house prices, particularly in certain parts of the country. I see President Yellen nodding her head because California, for sure, is one place where that could clearly be an important factor. " CHRG-111hhrg53021Oth--15 Mr. Bachus," Thank you, Mr. Chairman. As the Chairman and the Ranking Member of the Agricultural Committee have said, derivatives serve an important function in the market, they allow--they allow thousands of companies--I am going to start over. Thank you. Does that work? All right. As the three gentlemen before me said, derivatives serve an important function in the market. They allow companies to hedge against risk, to deploy capital more effectively, to lower their costs and to offer protection against fluctuating prices. Derivatives are about shifting risk, and my greatest concern is that we do not want a system, and I fear that the Administration is going down the path of shifting that risk, not to the investors or to the dealers, but ultimately to the taxpayers. The companies, the four companies that will deal in these derivatives--over-the-counter derivatives--the most will be four or five of the largest companies, financial companies in America. All of them will be deemed to be systemically significant. Part of the Administration's proposal is for when these companies get in trouble, and one reason they could get in trouble is trading in these over-the-counter derivatives, because they can protect against risk, they can lower costs. But as we saw with, I guess, Enron as a great example, they can take both dealers and investors down. And when that happens I would like some assurance that the taxpayers are not going to ultimately be the ones who assume that risk, that is not what we ought to be about. Now, leading up to last September, a lot of people made investments, they wrote over-the-counter derivatives, they made billions of dollars, profits on the way up, but when things turned down who was asked to come in and backstop them? Who was asked to take the risk, to suffer the loss? It was the taxpayer. Now I personally believe that we ought to allow corporations to continue to write customized derivatives and that yes, the government can look at them. But another thing that we ought to consider is whether the government is the best party to judge risk? And I say, no. I think the government has a very poor track record of regulators in identifying risk. Are we going to leave--when we start having standardized trading of over-the-counter derivatives, particularly the more complex ones and the regulators bless those trades, or say that they are safe, are we going to attract a whole new generation of investors who think that they are investing in a safe security or future. We found out with Fannie and Freddie that people began to think it was an implied government guarantee and they invested in those stocks. We need to totally avoid any implication that just because the government is going to regulate these markets they are going to insure these markets or backstop these markets. And I would like some assurance from the Secretary of the Treasury that however we ultimately decide the level of regulation--I look forward to the Memorandum of Understanding between the Fed, the CFTC and the SEC--that ultimately the taxpayers do not come in and take the burden, the risk, and the cost of over-the-counter derivatives gone bad. Thank you, Mr. Secretary. " CHRG-111hhrg53021--15 Mr. Bachus," Thank you, Mr. Chairman. As the Chairman and the Ranking Member of the Agricultural Committee have said, derivatives serve an important function in the market, they allow--they allow thousands of companies--I am going to start over. Thank you. Does that work? All right. As the three gentlemen before me said, derivatives serve an important function in the market. They allow companies to hedge against risk, to deploy capital more effectively, to lower their costs and to offer protection against fluctuating prices. Derivatives are about shifting risk, and my greatest concern is that we do not want a system, and I fear that the Administration is going down the path of shifting that risk, not to the investors or to the dealers, but ultimately to the taxpayers. The companies, the four companies that will deal in these derivatives--over-the-counter derivatives--the most will be four or five of the largest companies, financial companies in America. All of them will be deemed to be systemically significant. Part of the Administration's proposal is for when these companies get in trouble, and one reason they could get in trouble is trading in these over-the-counter derivatives, because they can protect against risk, they can lower costs. But as we saw with, I guess, Enron as a great example, they can take both dealers and investors down. And when that happens I would like some assurance that the taxpayers are not going to ultimately be the ones who assume that risk, that is not what we ought to be about. Now, leading up to last September, a lot of people made investments, they wrote over-the-counter derivatives, they made billions of dollars, profits on the way up, but when things turned down who was asked to come in and backstop them? Who was asked to take the risk, to suffer the loss? It was the taxpayer. Now I personally believe that we ought to allow corporations to continue to write customized derivatives and that yes, the government can look at them. But another thing that we ought to consider is whether the government is the best party to judge risk? And I say, no. I think the government has a very poor track record of regulators in identifying risk. Are we going to leave--when we start having standardized trading of over-the-counter derivatives, particularly the more complex ones and the regulators bless those trades, or say that they are safe, are we going to attract a whole new generation of investors who think that they are investing in a safe security or future. We found out with Fannie and Freddie that people began to think it was an implied government guarantee and they invested in those stocks. We need to totally avoid any implication that just because the government is going to regulate these markets they are going to insure these markets or backstop these markets. And I would like some assurance from the Secretary of the Treasury that however we ultimately decide the level of regulation--I look forward to the Memorandum of Understanding between the Fed, the CFTC and the SEC--that ultimately the taxpayers do not come in and take the burden, the risk, and the cost of over-the-counter derivatives gone bad. Thank you, Mr. Secretary. " FOMC20070131meeting--35 33,MR. DUDLEY.," I think that is definitely part of the story. Another part of the story is that in some countries, especially emerging market countries, the oil was heavily subsidized, and some of those subsidies are now coming off because continuing to subsidize as the oil price climbs entails a rather heavy budgetary burden. So you’re also seeing a sort of normalization of oil prices in a lot of places. Think about the oil that Russia used to sell to Eastern Europe or some of the surrounding countries at preferential prices. They are no longer getting those preferential prices, so there is a demand response. I think it is happening on both sides. There has been a demand response to higher oil prices, and there has been a supply response coming out of places like Africa." CHRG-109shrg21981--30 Chairman Greenspan," As usual, despite the fact that there is a DDS sign in front of the Committee, I, nonetheless, feel that it is a privilege to be here, as always, because I do find this an extraordinarily interesting discussion vehicle, and I trust that many of the issues will get clarified or, if not that, at least, the level of discussion will get heated sufficiently to engage us in considerable discussion, which I have a suspicion it may well. In the 7 months since I last testified before this Committee, the U.S. economic expansion has firmed, overall inflation has subsided, and core inflation has remained low. Over the first half of 2004, the available information increasingly suggested that the economic expansion was becoming less fragile and that the risk of undesirable decline in inflation had greatly diminished. Toward mid-year, the Federal Reserve came to the judgment that the extraordinary degree of policy accommodation that had been in place since the middle of 2003 was no longer warranted and, in the announcement released at the conclusion of our May meeting, signalled that a firming policy was likely. The Federal Open Market Committee began to raise the Federal funds rate at its June meeting, and the announcement following that meeting indicated the need for further, albeit gradual, withdrawal of monetary policy stimulus. Around the same time, incoming data suggested a lull in activity as the economy absorbed the impact of higher energy prices. Much as had been expected, this soft patch proved to be short-lived. Accordingly, the Federal Reserve has followed the June policy move with similar actions at each meeting since then, including our most recent meeting earlier this month. The cumulative removal of policy accommodation to date has significantly raised measures of the real Federal funds rate, but by most measures, it remains fairly low. The evidence broadly supports the view that economic fundamentals have steadied. Consumer spending has been well maintained over recent months and buoyed by continued growth in disposable personal income, gains in net worth, and the accommodative conditions in credit markets. Households have recorded a modest improvement in their financial position over this period, to the betterment of many indicators of credit quality. The sizable gains in consumer spending of recent years have been accompanied by a drop in the personal savings rate to an average of only 1 percent over 2004, a very low figure relative to the nearly 7-percent rate averaged over the previous 3 decades. Among the factors contributing to the strength of spending and the decline in saving have been the developments in housing markets and home finance that have spurred rising household wealth and allowed greater access to that wealth. The rapid rise in home prices over the past several years has provided households with considerable capital gains. Moreover, a significant increase in the rate of single-family home turnover has meant that many consumers have been able to realize gains from the sale of their homes. To be sure, such capital gains, largely realized through an increase in mortgage debt on the home, do not increase the pool of national savings available to finance new capital investment. But from the perspective of an individual household, cash realized from capital gains has the same spending power as cash from any other source. More broadly, rising home prices, along with higher equity prices, have outpaced the rise in household, largely mortgage, debt and have pushed up household net worth to about 5.5 times disposable income by the end of last year. Although the ratio of net worth to income is well below the peak attained in 1999, it remains above the long-term historical average. These gains in net worth help to explain why households, in the aggregate, do not appear uncomfortable with their financial position even though their reported personal savings rate is negligible. For their part, business executives apparently have become somewhat more optimistic in recent months. Capital spending and corporate borrowing have firmed noticeably, but some of the latter may have been directed to finance the recent backup in inventories. Mergers and acquisitions, though, have clearly perked up. Even in the current much-improved environment, however, some caution among business executives remains. Although capital investment has been advancing at a reasonably good pace, it has nonetheless lagged the exceptional rise in profits and internal cashflow. This is most unusual. It took a deep recession to produce the last such configuration in 1975. The lingering caution evident in capital spending decisions has also been manifested in less-aggressive hiring by businesses. In contrast to the typical pattern early in the previous business-cycle recoveries, firms have appeared reluctant to take on new workers and have remained focused on cost containment. As opposed to lingering hesitancy among business executives, participants in financial markets seem very confident about the future and, judging by the exceptionally low level of risk spreads and credit markets, quite willing to bear risk. This apparent disparity in sentiment between business people and market participants could reflect the heightened additional concerns of business executives about potential legal liabilities rather than a fundamentally different assessment of macroeconomic risks. Turning to the outlook for costs and prices, productivity developments will likely play a key role. The growth of output per hour slowed over the past half-year, giving a boost to unit labor costs after 2 years of declines. Going forward, the implications for inflation will be influenced by the extent and persistence of any slowdown in productivity. A lower rate of productivity growth in the context of relatively stable increases in average hourly compensation has led to slightly more rapid growth in unit labor costs. Whether inflation actually rises in the wake of slowing productivity growth, however, will depend on the rate of growth of labor compensation and the ability and willingness of firms to pass on higher costs to their customers. That, in turn, will depend on the degree of utilization of resources and how monetary policymakers respond. To date, with profit margins already high, competitive pressures have tended to limit the extent to which cost pressures have been reflected in higher prices. The inflation outlook will also be shaped by developments affecting the exchange rate of the dollar and oil prices. Although the dollar has been declining since early 2002, exporters to the United States apparently have held dollar prices relatively steady to preserve their market share, effectively choosing to absorb the decline in the dollar by accepting a reduction in their profit margins. However, the recent, somewhat quickened, pace of increase in U.S. import prices suggests that profit margins of exporters to the United States have contracted to the point where the foreign shippers may exhibit only limited tolerance for additional reductions in margins should the dollar decline further. The sharp rise in oil prices over the past year has no doubt boosted firms' costs and may have weighed on production, particularly, given the sizable permanent component of oil price increases suggested by distant-horizon oil futures contracts. However, the share of total business expenses attributable to energy costs has declined appreciably over the past 30 years, which has helped to buffer profits and the economy more generally from the adverse effect of high oil and natural gas prices. Still, although the aggregate effect may be modest, we must recognize that some sectors of the economy and regions of the country have been hit hard by the increase in energy costs, especially over the past year. Despite the combination of somewhat slower growth of productivity in recent quarters, higher energy prices, and a decline in the exchange rate for the dollar, core measures of consumer prices have registered only modest increases. The core PCE and CPI measures, for example, climbed about 1.25 to 2 percent, respectively, at an annual rate over the second half of last year. All told, the economy seems to have entered 2005, expanding at a reasonably good pace, with inflation and inflation expectations well-anchored. On the whole, financial markets appear to share this view. In particular, a broad array of financial indicators convey a pervasive sense of confidence among investors and associated greater willingness to bear risk than is yet evident among business managers. Over the past 2 decades, the industrial world has fended off two severe stock market corrections, a major financial crisis in developing nations, corporate scandals, and, of course, the tragedy of September 11, 2001. Yet overall economic activity experienced only modest difficulties. In the United States, only five quarters in the past 20 years exhibited declines in GDP, and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward. Yet history cautions that people experiencing long periods of relative stability are prone to excess. We must, thus, remain vigilant against complacency, especially since several important economic challenges confront policymakers in the years ahead. Prominent among these challenges in the United States is the pressing need to maintain the flexibility of our economic and financial system. This will be essential if we are to address our current account deficit without significant disruption. Besides market pressures, which appear poised to stabilize and over the longer-run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction. Central to that adjustment must be an increase in net national savings. This serves to underscore the imperative to restore fiscal discipline. Beyond the near-term, benefits promised to a burgeoning retirement-age population, under mandatory entitlement programs, most notably Social Security and Medicare, threaten to strain the resources of the working-age population in the years ahead. Real progress on these issues will unavoidably entail many difficult choices. But the demographics are inexorable, and call for action before the leading edge of baby boomer retirement becomes evident in 2008. This is especially the case because longer-term problems, if not addressed, could begin to affect longer-dated debt issues, the value of which is based partly on expectations of developments many years in the future. Another critical long-term economic challenge facing the United States is the need to ensure that our workforce is equipped with the requisite skills to compete effectively in an environment of rapid technological progress and global competition. Technological advances are continually altering the shape, nature, and complexity of our economic processes. But technology and, more recently, competition from abroad have grown to a point at which demand for the least-skilled workers in the United States and other developed countries is diminishing, placing downward pressure on their wages. These workers will need to acquire the skills required to compete effectively for the new jobs our economy will create. Although the long-run challenges confronting the U.S. economy are significant, I fully anticipate that they will ultimately be met and resolved. In recent decades, our Nation has demonstrated remarkable resilience and flexibility when tested by events, and we have every reason to be confident that it will weather future challenges as well. For our part, the Federal Reserve will pursue its statutory objectives of price stability and maximum sustainable employment, the latter of which we have learned can best be achieved in the long-run by maintaining price stability. This is the surest contribution the Federal Reserve can make in fostering the economic prosperity and well-being of our Nation and its people. Mr. Chairman, I request that my full statement be included for the record, and I look forward to your questions. " FOMC20060510meeting--231 229,MS. DANKER.," I will be reading the directive from page 29 of the Bluebook. “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with increasing the federal funds rate to an average of around 5 percent.” And the risk assessment from the press release that’s being handed around: “The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives.” Chairman Bernanke Yes Vice Chairman Geithner Yes Governor Bies Yes President Guynn Yes Governor Kohn Yes Governor Kroszner Yes President Lacker Yes Governor Olson Yes President Pianalto Yes Governor Warsh Yes President Yellen Yes" CHRG-110shrg50369--45 Mr. Bernanke," Well, Senator, you raise some important questions. First of all, we and our fellow regulators, both in the United States and around the world, are engaged, as you might imagine, in a very serious review of what has happened and what we can do better in the future. The Federal Reserve itself is looking at our own practices and staffing and all those issues. The President's Working Group is working on a set of recommendations looking broadly at the financial markets and the problems that arose. And all of those discussions and information will be feeding into an international analysis--the Financial Stability Forum, the Basel Committee, international groups of financial regulators, central banks, Finance Ministers, and so on--which will try to determine, what the problems were, where we can do better, and what we have learned from this episode. So we are certainly doing a lot of stock taking and trying to determine where there were problems. In terms of the banks it should be emphasized that we do work very closely with the other regulators--the OCC, the FDIC, and others, depending on the type of bank. Our focus, I think of necessity, is for the most part on things such as the overall structure of risk management, the practices and procedures that the banks follow. It is very difficult for us to second-guess the specific asset price or asset purchase decisions that they make. I think going forward we do need to look in a much tougher way at the risk management and risk measurement procedures that the banks have. But, again, it is very difficult for us to tell a bank that--when they make a certain investment that they think it is a good investment, and they have done all the due diligence--that it is a bad investment. That is not usually our role. Senator Reed. Let me follow up with two questions and ask for a brief response. First, when do you anticipate sharing with this Committee the results of this analysis you are doing of your regulatory position within the next several months in a detailed basis? " CHRG-109hhrg31539--216 Mr. Bernanke," I agree absolutely. We have seen about a tripling of energy prices over the last few years. That has raised gasoline prices, raised heating oil and other kinds of energy prices, and it has reduced our growth and been a burden on consumers and firms, and it has been inflationary for us so it has obviously been a problem for our economy. " FOMC20060629meeting--183 181,CHAIRMAN BERNANKE.," Well, let me thank you all very much for your extremely helpful and useful comments. I, too, think that we should raise 25 basis points at this meeting. I think it’s justified by the basic economic situation. The greater risk seems to be from inflation. I think also, following some things that President Lacker said, that a credibility–psychology issue is going on here. Late in April, perhaps because of my testimony, we had a small inflation scare. The TIPS spread widened. The commodity prices, metals prices, essentially went vertical for a while. The minutes, my remarks, the remarks of other Presidents and Governors succeeded in bringing those expectations down significantly, even though we had two upside surprises in the CPI during that period. So obviously some connection exists between our talk and market expectations. Having said that, I think we need to do what we say we’re going to do. Now, conditional on what we know today, I should also add that I think we’re getting very close to where we need to be. We don’t know for sure yet. Obviously we have to look for more information, but in our public utterances going forward we should be somewhat more balanced about the risks and also somewhat more uncertain about where we’re going in the future. The risk- management calculations associated with this move are quite difficult. President Poole has mentioned the risk that if inflation expectations get embedded at a higher level, it would be much more expensive to reduce them later than it is to nip them in the bud, so to speak, at this point. That risk argues for moving earlier rather than waiting to see what happens. That being said, I recognize that there are also some downside risks, some potential nonlinearities in housing markets and financial markets. So where I come out is that I think we should move but try to keep our options open and to move slowly if we do move further. With respect to the statement, I’m the first to agree it’s not a work of art. We have a very difficult balancing act here. First, we have achieved some credibility gains in the past few weeks. We’d like to hold onto those or at least as much of them as possible. However, we want to keep our options open for August, and we don’t want to generate in the market a fear that we are completely focused on inflation with no regard for output, the other part of our mandate. It’s a delicate balancing act to show that we are aware of the inflation situation but that we are not single-mindedly focused on the inflation situation. The statement is designed to show that we are cognizant of the inflation risk. We take note of the elevated readings. We mention that inflation risks remain. We also note, however, that output is moderating and give some reasons for that, and we say in section 4 that the moderation in output will reduce some of the pressure. Obviously there’s disagreement about how flat the Phillips curve is, but all else being equal, that will be a factor. Responding to Governor Bies’ suggestion, I think putting that first sentence of section 4 into the rationale in section 3 is more logical, but the way section 3 is structured, first it says, “Here are the things that are slowing inflation,” and then it says, “But here’s what we’re worried about.” So if we put it there, it will downgrade it somehow; if we put it in section 4, it will say that we are aware of the output risk. There’s also perhaps a subtlety in section 4 that the firming will depend on the evolution of the outlook for both inflation and economic growth. That’s actually an adaptation of a suggestion that President Minehan made, and what it does, I hope, is indicate that we’re looking at both variables as we make our decision. So I’m hopeful that this statement will strike the balance between conveying our vigilance, conveying our concern, maintaining our credibility gains, and removing the notions from the market that we are certain we will move in August or that we will pursue inflation single-mindedly at a rapid rate and independent of whatever happens on the real side of the economy. Again, with respect to some of the suggestions that were made, I think they’re all very interesting. President Poole made a very interesting case. I don’t think there’s a consensus for going to the restrictive language right now. However reasonable it may be in principle to use the first sentence in alternative C, section 4, or to say that readings are unwelcome, I fear it will tip the balance toward a higher probability in August; perhaps this nuance is too fine, but I am concerned about the effect on the markets of perceiving the Fed as too aggressive. There is a new Chairman. They don’t know me. As far as they know, I am an inflation nutter, and I want to make sure that they understand that output is one of our concerns. Those were the main points I wanted to make. Governor Bies suggested striking the last phrase in alternative B, section 4. I don’t feel strongly about that. Does anyone have a view on that? Vice Chairman Geithner." FOMC20080430meeting--180 178,MR. KOHN.," Thank you, Mr. Chairman. I think I can be brief by just associating myself with the comments of President Stern. This is a difficult decision. You could make a case for either of these. But on balance, I think we should be lowering interest rates 25 basis points, as under alternative B. As President Stern said, I don't think just subtracting past inflation from the nominal federal funds rate is a good metric for where the stance of policy is today. It would be if financial conditions were consistent with historical relationships, but they're not. We have very tight credit conditions in many sectors of the market, and a zero or negative federal funds rate means a very different thing today than it did even in the early 1990s, Gary, because then you had the banking system broken but the securities markets working. Now you have the banking system broken and the securities markets not working very well. So I think we have stronger--I guess Greenspan called them ""50 mile an hour""--headwinds. I would say they are 60 or 70 today, at least for now. We expect the headwinds to abate; and as they abate, policy will look a lot more accommodative. But I don't think we really have insurance right now against the contingency that the headwinds don't abate very quickly or even get worse, or against the contingency that the staff is right and we are entering a recessionary period in which consumption and investment fall short of what the fundamentals would suggest. I think that 25 basis points probably won't buy us much, if any, insurance, but it will get policy calibrated a little better to the situation that we are facing today. I expect a small decrease in the funds rate to be consistent with further increases in the unemployment rate--and everybody does, I think, judging from the central tendencies of the forecast--which will put downward pressure and help to contain inflation. I agree that there is an upside risk from continued increases in commodity prices that feed through, as President Plosser noted, into core inflation. I think that this is a very different situation from the 1970s. I looked this morning at the Economic Report of the President, at those tables in the back. The stage for the 1970s was set in the 1960s. Core inflation rose from 1� percent in the mid-1960s to 6� percent in 1969. That's a situation, obviously, in which inflation expectations can become unanchored, and then these relative price shocks feed through much more into inflation expectations. Looking in the Greenbook, Part 2, page II-32, every measure of core inflation for 2007 was lower than the measure of core inflation for 2006, and half of them--these are Q4-to-Q4 measures of core inflation--are lower than for 2005. So we are not in a situation of a gradual upcreep in core inflation, which I think was what set the stage for the 1970s. I don't expect a small decrease in interest rates to result in higher inflation through this dollar�commodity price�inflation expectations channel either. The decrease in interest rates is already in the markets. If anything, a statement like alternative B might firm rates a bit; and taking out ""downside risks"" and ""act in a timely manner"" reinforces the notion that the Federal Reserve is not poised to ease any more. I wouldn't expect interest rates to go down; therefore, I wouldn't expect the dollar to go down, and I wouldn't expect commodity prices to go up from this. I think the markets reacted very well over the intermeeting period to incoming data. They saw the tail risk decrease. They raised interest rates. The dollar firmed. They put a U shape in our interest rate path. It seems to me that path is very close to what many of us said we expected and thought was appropriate, give or take � point, for the federal funds rate over the coming couple of years. I don't see any reason to act in a way that changes those expectations; I think the market expectations are fine. I wouldn't lower interest rates � point just to confirm market expectations. I think it is the right thing to do, and I don't see any reason to lean against it to change expectations. I think that expectations are lined up pretty well with our objectives. Thank you, Mr. Chairman. " FOMC20050202meeting--129 127,MR. MOSKOW.," Actually, Illinois is leading the Big Ten in basketball. [Laughter] They are undefeated so far. On the price front, there’s more talk that higher costs for plastics and other energy-related inputs are working their way downstream, but we’re certainly not hearing widespread reports of major price increases. With regard to labor markets, the two large temporary staffing firms that we speak with regularly continue to report roughly 10 percent overall growth relative to a year ago, with demand for skilled workers rising fastest. Like us, they have been expecting a period of more robust employment growth. But the further we get from the recession, the more they are becoming resigned to the idea that the growth rates we’ve seen over the last year may be as high as we’ll get in this cycle. The president of one of the temp firms made an interesting observation about the February 1-2, 2005 85 of 177 reasons are industry-specific.” This is an improvement from a year or so ago when many firms reported being worried about the strength of the overall economy. His observations pretty much match my impressions. Things aren’t exactly roaring, but few businesses regard the expansion as fragile. Turning to the national outlook, once again the data we’ve received since the last meeting have not materially changed our outlook for 2005. We continue to expect that output will expand at a rate somewhat above potential and that there will be little change in core inflation. I think the alternative simulations in the Greenbook did a good job of laying out a number of the risks to the forecast. Overall, I think these risks are balanced. The “higher long-term interest rates” simulation did give me some pause, especially because of the talk that foreign investors may be revising their thinking about U.S. securities. But I remain concerned about another risk that we talked about last time, namely, that, instead of some appreciable slack remaining in the economy, we may already be essentially at potential or approaching potential. This view was raised by some of the participants, albeit a minority, in the meeting we had last week of our academic advisors and Chicago-area business economists. When asked about the course of policy going forward, there was a roughly even split between those who thought that the path implicit in futures markets was about right and those who thought we should be raising rates at a faster pace. My own view is that we will probably have to raise rates this year to levels that are higher than those expected by futures markets. As we all know, we will face communication challenges as the year proceeds. It’s probably not critical today, but it will become more so as we move through the year." FOMC20050920meeting--72 70,MR. SANTOMERO.," David, I want to talk a little bit about how the Board’s modeling incorporates higher oil prices on output produced elsewhere and imported into the United States. Is it just through import prices alone? The reason I ask is that we’ve spent a lot of time talking about the fact that higher energy costs haven’t really impacted us as much as other countries. We’ve given two reasons for it. One is that we’re more energy-efficient. The second is that the output we produce is less energy- intensive. Presumably, our actual consumption hasn’t shifted as much as our production, which means that more of the energy-intensive output is being produced externally and shipped into the United States. Now, that would presumably mean that energy-intensive goods would have higher prices because of the global price of oil, and import prices would go up to a greater extent than before because of the shift in mix. Yet the forecast has import prices falling. How does that all work its way through? What’s that dynamic?" FOMC20080805meeting--173 171,MR. FISHER.," Well, Mr. Chairman, I'm already out of the closet in terms of my economic proclivities. I realize it's awkward for some folks, but I haven't heard enough today that would change my view that we are running an over-accommodative monetary policy. I agree with your point very much that the rates and the terms being faced by those who drive the economy count. As to Governor Kohn's point that some of these key rates have not come down, I think that has more to do with risk premiums, and I hate to see it migrate toward inflation premiums, which I believe is a significant risk. I'm obviously driven by what I hear from my contacts, although I respect the analytics you mentioned, Governor Mishkin. My long-run thinking is as conditioned by globalization as it is by domestic policy, and I just still have a great concern about the wage�price spiral that's taking place in some of our manufacturing centers in the developing countries. I think it would be wise, just to shift my analogy here and think in canine terms, to take a newspaper across the snout and call for a 25 basis point increase. We're always talking about tightening at some point. I think it just becomes increasingly difficult to take that first step. I grant you that the economy is weak. The financial situation is brittle. That hasn't changed in my view, but the inflationary behavioral patterns that I'm beginning to hear about reinforce my concern about an updrift in the core and the headline data. So I apologize, it perhaps is being a little too strong to say that we've become unmoored or that maybe we are no longer anchored. I think that is nonetheless a real perception. I'm going to vote against alternative B and for alternative C. I may be a minority of one, but perhaps I'll be a sea anchor, if you understand the sailing analogy here, and assist the process of our commitment to be focused on inflation as a risk just as we focused on downside risk to growth. Thank you, Mr. Chairman. " CHRG-110hhrg44901--51 Mr. Bernanke," Congresswoman, as I indicated in my testimony, we at this point are balancing various risks to the economy. And as we go forward, my colleagues and I are going to have to, you know, see how the data come in and how the outlook is changing and try to find the policy that best balances those risks and best achieves our mandate of sustainable growth and price stability. So I don't know how to answer beyond that, other than to say that we are going to be responsive to conditions as they evolve. I noted today the importance of not letting inflation from commodities enter into a broader and more persistent and more pernicious inflation. That is certainly an important priority. But in general, we are going to have to just keep evaluating the new information and see how it affects the outlook. Monetary policy works with a lag. We can't look out the window and do something that will affect the economy today. So the best we can do is try to make forecasts and try to adjust our policy in a way that brings the forecast towards the desired outcome. Ms. Velazquez. Well, Mr. Chairman, I understand all the steps and actions taken by the Fed. But it seems to me that the lending tools are proving to be ineffective at this point. Doesn't this prove that the current economic conditions have moved beyond a liquidity crisis that can be mitigated through Federal lending and is now proven to be a capital crunch? " CHRG-110shrg50369--104 Chairman Dodd," Fine. Senator Tester. Thank you, Senator Schumer, and thank you, Mr. Chairman, and thank you, Chairman Bernanke. I appreciate your forthrightness today and always. I want to talk about commodities for a little bit. I am a farmer. I am happy when commodities go up. But as was earlier pointed out today, oftentimes this can end up potentially like it was in the 1970s when we saw a big commodity raise; we saw the inputs that went into agriculture go through the roof; we saw food prices on the shelf go up because commodity prices were higher; and then commodity prices fell back. Those inputs that went into production agriculture stayed up, and the food on the shelf stayed up, too, because they said there was not enough wheat in a loaf of bread to make a difference after they raised the prices because commodities went up. My question to you is: Do you see that playing out the same way? I mean, we are going to see food prices go up probably, it would be my guess. We already have. And we have already seen inputs go up on the farm for production agriculture. I anticipate this commodity price will not stay where it is at forever. They usually do adjust, and they usually adjust down. And food prices will stay up, inputs will stay up. Do you see that same thing happening again? And is there anything we can do if it is that way? " fcic_final_report_full--195 In the September , , memo that would recommend that Fannie be placed into conservatorship, OFHEO would expressly cite this practice as unsafe and un- sound: “During  and , modeled loan fees were higher than actual fees charged, due to an emphasis on growing market share and competing with Wall Street and the other GSE.”  : “Moving deeper into the credit pool” By the time housing prices had peaked in the second quarter of , delinquencies had started to rise. During the board meeting held in April , Lund said that dis- location in the housing market was an opportunity for Fannie to reclaim market share. At the same time, Fannie would support the housing market by increasing liq- uidity.  At the next month’s meeting, Lund reported that Fannie’s market share could increase to  from about  in .  Indeed, in  Fannie Mae forged ahead, purchasing more high-risk loans.  Fannie also purchased  billion of sub- prime non-GSE securities, and  billion of Alt-A.  In June, Fannie prepared its  five-year strategic plan, titled “Deepen Seg- ments—Develop Breadth.” The plan, which mentioned Fannie’s “tough new chal- lenges—a weakening housing market” and “slower-growing mortgage debt market”—included taking and managing “more mortgage credit risk, moving deeper into the credit pool to serve a large and growing part of the mortgage market.” Over- all, revenues and earnings were projected to increase in each of the following five years.  Management told the board that Fannie’s risk management function had all the necessary means and budget to act on the plan. Chief Risk Officer Dallavecchia did not agree, especially in light of a planned  cut in his budget. In a July , , email to CEO Mudd, Dallavecchia wrote that he was very upset that he had to hear at the board meeting that Fannie had the “will and the money to change our culture and support taking more credit risk,” given the proposed budget cut for his department in  after a  reduction in headcount in .  In an earlier email, Dallavecchia had written to Chief Operating Officer Michael Williams that Fannie had “one of the weakest control processes” that he “ever witnessed in [his] career, . . . was not even close to having proper control processes for credit, market and operational risk,” and was “already back to the old days of scraping on controls . . . to reduce expenses.” These deficiencies indicated that “people don’t care about the [risk] function or they don’t get it.”  FOMC20070807meeting--108 106,MR. MADIGAN.,"3 Thanks, Mr. Chairman. I’ll be referring to the package labeled “Material for FOMC Briefing on Monetary Policy Alternatives.” Financial markets have experienced exceptional strains over the intermeeting period. The Bluebook provided a thorough review of these developments through Thursday, and I had intended to provide only a brief summary of and update on those developments, as in exhibit 1, and some thoughts on their implications for monetary policy. But given the extensive discussions of this topic so far this morning, those points seem all to have been made, and I will turn directly to a discussion of policy alternatives. As noted at the top of exhibit 2, the risk of weakness in aggregate demand stemming from tighter credit conditions and disruptions in credit flows formed part of the rationale for the 25 basis point easing of alternative A that was presented in the Bluebook. Even if your views about the modal outlook are similar to the Greenbook baseline forecast, you may be concerned that the deterioration in credit conditions, the significant increase in market volatility, and potential declines in confidence have tilted the risks to growth distinctly to the downside. You may also see the recent spate of soft spending indicators as having raised the likelihood of sluggish growth in aggregate demand. The considerable gap between the Greenbook-consistent real federal funds rate, the dashed green line in the panel to the right, and the range of model-based estimates of the equilibrium real federal funds rate, shown in red, may add to questions about the possibility of weaker growth than in the staff forecast and reinforce your belief that some easing of policy is appropriate. Moreover, you may be more optimistic than the staff about either productivity growth or the NAIRU or both. Indeed, as I mentioned earlier, several of you noted just such optimism in the narratives accompanying your trial-run projections. The financial stimulus from a policy easing, of course, would help support growth directly. A policy action might be highly potent in current circumstances, possibly helping to buoy consumer and business confidence in a period when sentiment may well be deteriorating. You may 3 Materials used by Mr. Madigan are appended to this transcript (appendix 3). also believe that the inflation outlook would support a near-term policy easing. Core inflation readings have been relatively subdued in recent months, wage growth seems to have remained moderate, and labor market pressures may be starting to ease, although the evidence on that score is so far quite limited. In the staff forecast, core inflation converges toward 2 percent, an outcome that, judging by your projections, some of you would find acceptable—and your forecasts suggest that you think the odds favor a prompter and slightly steeper decline in inflation. In contrast, as noted in the bottom left-hand panel, you may concur with the Greenbook forecast for spending and prices, given its policy assumptions, but judge that the forecasted trajectory for inflation is too slow and leaves inflation at a level that is too high to foster optimal economic performance. If so, you may be inclined to firm policy ¼ percentage point, as in alternative C. The decline in core inflation in the Greenbook is slight and slow. As shown in the bottom right panel, the optimal control simulation in the Bluebook based on a 1½ percent target for core PCE inflation suggests an increase in the federal funds rate of about ¾ percentage point over the next year. Credibility or learning effects that might flow from a policy firming, as in the simulation, could limit the output and employment sacrifice necessary to foster a lower path for inflation. Moreover, you may agree with the staff’s baseline assumption that the effects of current market strains will prove temporary, that markets will soon resume clearing, albeit at higher and perhaps more- rational and more-sustainable spreads, and that the restraint on aggregate demand will be modest. Finally, you might see the risks to the inflation outlook as tilted to the upside, given high levels of resource utilization and increased energy prices. Alternative B, discussed in exhibit 3, may be seen as an appropriate balancing of the considerations motivating alternative A, on the one hand, and alternative C, on the other. Under this alternative, the Committee would leave the stance of policy unchanged today. The statement would acknowledge the recent volatility of financial markets and tighter credit conditions but would also convey an expectation that moderate growth will likely continue. Core inflation would be characterized as subdued in recent months but subject to upside risk. The Committee would expressly refer to increased downside risk to growth but indicate that its predominant policy concern remains the risk that inflation will fail to moderate as expected. A rationale for alternative B is laid out in the upper left-hand panel. In the baseline Greenbook forecast, the economy expands at a moderate pace, resource pressures ease slightly, and core inflation ebbs to 2 percent with the federal funds rate held at its current level through next year. That forecast may be close to your own view about the modal result, and you may see it as an acceptable outcome. As shown to the right, optimal control simulations based on the Greenbook baseline and an assumed core inflation objective of 2 percent would suggest leaving the federal funds rate unchanged for the rest of the year before easing slightly. Returning to the left- hand panel, holding steady at this meeting would also be consistent with the Committee’s past behavior as captured by the estimated outcome-based and forecast- based policy rules presented in the Bluebook. You may also believe that alternative B represents a suitable weighting of the risks. For example, even if you are a bit more optimistic about potential growth and the NAIRU than the staff, you may nonetheless see maintaining the federal funds rate at its current level as an appropriate risk-management approach, given the upside risks to inflation and the higher costs should they be realized. Careful consideration of the most recent developments also may incline you toward alternative B. In particular, even if the incoming data and increased financial market strains of recent weeks incline you to believe that the downside risks to growth have increased, you may be quite unsure about the extent of those risks and not wish to exaggerate them. As suggested by yesterday’s developments, it is not inconceivable that markets will soon begin to right themselves and that the Greenbook baseline assumption of only modest financial restraint will prove correct. In these circumstances, watchful waiting may be the best approach in order to allow more information to accumulate that will enable you to better assess the likely eventual adjustments of market prices and flows and the appropriate policy response. Indeed, you may be especially concerned about the risk of overreacting (or being perceived as overreacting) to temporary market developments—particularly if you see a significant probability that markets could misinterpret changes in the stance of policy, or in your words, as an indication that you place a higher priority on financial market stability or economic growth than on price stability. Moreover, your inflation concerns may not have diminished much, if at all, over the intermeeting period. While the most recent core inflation readings have been relatively low, you may concur with the staff that some of that good performance will likely prove transitory. Also, overall inflation has remained high, and with resource utilization elevated, you may be worried that high rates of overall inflation could allow inflation expectations to move higher. The statement associated with the revised version of alternative B is provided in the bottom panel. Given the volatile market conditions of late, getting a reliable read on market participants’ expectations at this point is difficult, but an announcement roughly along these lines seems to be anticipated by most market participants. Notably, the statement explicitly mentions downside risks to growth. That mention may be seen as opening the door a crack to future easing or at least giving the Committee greater scope to move in that direction. Although only a minority of market participants apparently expect the Committee to point explicitly to downside risks to growth, a sizable market reaction to the inclusion of such a reference in paragraph 4 seems unlikely, as the Committee still would state that inflation risks are its predominant concern. The final exhibit is an updated version of table 1 for your reference. Changes" FinancialCrisisReport--70 Mr. Vanasek agreed: “I could not agree more. All the classic signs are there and the likely outcome is probably not great. We would all like to think the air can come out of the balloon slowly but history would not lean you in that direction. Over the next month or so I am going to work hard on what I hope can be a lasting mechanism (legacy) for determining how much risk we can afford to take ….” Despite Mr. Killinger’s awareness that housing prices were unsustainable, could drop suddenly, and could make it difficult for borrowers to refinance or sell their homes, Mr. Killinger continued to push forward with WaMu’s High Risk Lending Strategy. (6) Execution of the High Risk Lending Strategy WaMu formally adopted the High Risk Lending Strategy in January 2005. 179 Over the following two years, management significantly shifted the bank’s loan originations towards riskier loans as called for in the plan, but had to slow down the pace of implementation in the face of worsening market conditions. In retrospect, WaMu executives tried to portray their inability to fully execute the plan as a strategic choice rather than the result of a failed strategy. For example, Mr. Killinger testified at the Subcommittee hearing that the bank’s High Risk Lending Strategy was only contemplated, but not really executed: “First, we had an adjustment in our strategy that started in about 2004 to gradually increase the amount of home equity, subprime, commercial real estate, and multi-family loans that we could hold on the balance sheet. We had that long-term strategy, but … we quickly determined that the housing market was increasing in its risk, and we put most of those strategies for expansion on hold.” 180 Mr. Killinger’s claim that the High Risk Lending Strategy was put “on hold” is contradicted, however, by WaMu’s SEC filings, its internal documents, and the testimony of other WaMu executives. Washington Mutual’s SEC filings contain loan origination and acquisition data showing that the bank did implement its High Risk Lending Strategy. Although rising defaults and the 2007 collapse of the subprime secondary market prevented WaMu from fully executing its plans, WaMu dramatically shifted the composition of the loans it originated and purchased, nearly 179 See 3/13/2006 OTS Report of Examination, at OTSWMS06-008 0001677, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 180 April 13, 2010 Subcommittee Hearing at 88. doubling the percentage of higher risk home loans from 36% to 67%. The following chart, prepared by the Subcommittee using data from WaMu’s SEC filings, demonstrates the shift. 181 FOMC20050630meeting--40 38,MR. GALLIN.," Loosely speaking, what we’re trying to do is to get a sense of changes in the price of a typical home—what has been happening to that price over time—adjusting for quality. I guess I’ll start with my concerns about the constant-quality figure, and then I’ll address Dick’s concerns about the transactions price index that I used. One reason I worry about the constant-quality number, and Dick alluded to it, is that it’s a constant-quality price index for new homes, and new homes typically are not built where existing homes are already situated. You can see that when you drive out of any city, basically. The big developments are on the outskirts of the cities, and those outskirts are moving further out. I recognize that cities can be multi-centered and so forth, but new homes—while not always built on the cheapest available land—typically are built on the cheapest available land. And the constant- quality price index for new homes has only crude controls for location. So I don’t think that index is able to fully handle that issue. That’s why I like the repeat-transactions price index. As Dick mentioned, it basically matches up addresses over time and looks at the price changes." CHRG-110shrg50369--26 Mr. Bernanke," Well, Senator, to answer that question, the PPI, the Producer Price Index, that you referred to mostly reflects the effects of large increases in prices of energy and other commodities. We live in a world where energy and metals and other commodities are globally traded, food as well, and demand of emerging market economies and a growing global economy has put pressure on the available supplies of those resources and has driven up those prices. And as I mentioned, the price of oil has quintupled or more. Senator Shelby. Do you see that abating? " FOMC20070807meeting--59 57,MR. FISHER.," Mr. Chairman, at the past few meetings I have spoken about my District as having strong growth. I have asked questions about the strength of the growth in the national economy, and I have described the global economy from the standpoint of the way the staff here writes about it and the way we do our own work as “hotter than a $2 pistol.” Nothing has really changed since my last intervention. I would note that, unlike President Moskow’s District, our District is unusual on the other side: We are not experiencing the kind of decline in home prices that is being experienced elsewhere. We’re suffering from widespread labor shortages, for both unskilled and skilled labor. We believe that we are seeing significant labor hoarding in our District. Unemployment is strikingly and historically low in the two major cities of Dallas and Houston at 4.1 percent, in Austin at 3.5 percent, and along the border areas unprecedentedly in the low single digits. Salaries for accountants in our District are up 5 to 8 percent. Law firms—I note that there are 1.2 million lawyers in America and 1.1 million people who work in the auto industry from parts to final assembly, which is a statement on our society—[laughter] are raising first- and second-year annual compensation by double digits for their new lawyers. So there is still price inflation in the service sector. We perceive, through our discussions with CEOs around the country, that while there has been a net downward movement in the more-robust measurements of price inflation—the trimmed mean—there still are some threats on the inflation front. For example, the CEO of Wal-Mart USA told me yesterday that, internally, when they evaluate their comparable store measurements, the comps are being driven by inflation, not by volume. As for the demand for ships—if you read the Wall Street Journal yesterday or from the interviews I have had with large shippers, the bulk carriers are trading at record highs. The Baltic index is at a record high, driven by exports of iron ore, pulp, and other products to voracious Chinese demand and by the return of exports from China to a voracious European demand. Container shipments are up 20 percent year over year in terms of European imports. The price pressures being exerted there seem to be invading other areas. One of the more interesting observations was what has happened recently in terms of the pricing of paper products being led by SCA, which is a European corporation. Kimberly-Clark and the others have fallen in line. They are asking for double-digit increases. So although we are seeing some mitigation of price pressures, I am nonetheless concerned that, given the international dynamics, we still have the potential for price increases and a bit of resistance to what I would like to see. In terms of economic growth nationally, I just want to comment on some things that the staff presented. I thought the Greenbook was excellent. I did speak to two of the five largest publicly held builders. They report that all-in, with incentives, their prices have been marked down an average of 25 to 35 percent from a year ago. Those are significant numbers. For example, in the Imperial Valley of California, homes selling for $550,000 to $600,000 have been now marked down to $400,000 to $450,000. The builder with the most experience—forty years of experience—who has lived through all kinds of cycles is of the strong belief that we are in the second year of a five-year correction. Like the point that you made, President Yellen, this is of great concern. So net from the Dallas Fed standpoint, we have lowered our expectation for second-half growth to 2 percent. We are still concerned, despite the encouragement of marginal movement, on the inflation front. I’d like to leave the discussion of the economy there and just turn to the previous discussion we had and the references made by President Moskow and President Yellen. This may be a bit harsh, but if you look at the front page of the Wall Street Journal from this morning, I see what I call the “Churchillian maxim” at play, which is, “I shall fare well in history because I shall rewrite that history.” Whether you use Greg Ip to rewrite the history or you rewrite it yourself, no amount of rewriting of history will exonerate us if we are not prepared for the more-dire scenarios that were presented by the staff. I would ask that we do some scenario preparation in terms of, should we encounter increased financial market turbulence, what actions we might take to deal with it. For example, it is not clear to me that a widespread opening of the discount window solves the problem given the structure of what I call “ersatz credit” that is then spread throughout the system. It’s not clear to me that even dealing, for purposes of the present meeting, with the fed funds rate is the issue because it is not an issue of just pricing in the marketplace. It’s a structure issue, and it’s a covenant issue. It’s an availability issue. I started my career, Mr. Chairman, with Herstatt. [Laughter] That was not an auspicious beginning. I lived through the corrections of the S&L market, portfolio insurance, the crashes of ’87, ’97, and so on. When you sort through them, all of them have a common basis, and that is a search for greater yields or greater return, leverage in order to achieve that return, and some assumption of risk mitigation leading to what I call “rational complacency.” I believe that’s at play presently. I agree fully with President Yellen that it presents a significant risk. However, I want to exercise great caution in interpreting these signals. I think we have to be extremely careful about what we do and what we say. Just to show my hand, I would not be in favor of cutting the federal funds rate at this juncture. I think we have to analyze the language carefully. But my request is that, in addition to our exercise on communication, we take a serious look at the various scenarios that might obtain, so that no one could ever accuse us of being unprepared in case the worst obtains. Thank you, Mr. Chairman." FOMC20060510meeting--110 108,MR. HOENIG.," Thank you, Mr. Chairman. Let me start with our District. Evidence from the District continues to show strong growth. While consumer spending has shown some modest slowing, retailers remain very optimistic in our surveys about future sales, and this despite some of the recent increases in energy prices. Manufacturing activity continues to grow solidly, and energy activity remains, of course, very strong in our area, with continued reports of shortages of both labor and equipment. Housing markets in the District are cooling, as you’ve heard described elsewhere, and illustrate I think a potential downside risk overall. Though it’s still high by historical standards, residential construction continues to edge downward. Home sales were still growing modestly in most areas but not fast enough to absorb the supply of homes being brought on the market. As a result, first-quarter inventories in the largest District markets have grown markedly relative to a year ago. In addition, foreclosures also point to some weakening in the housing market. I guess the most notable is a 31 percent increase in March over the previous month that pushed Colorado to the highest foreclosure rate in the nation—as reported anyway. One factor behind the increase is the unusually widespread use of interest-only mortgages in that state. However, nonresidential construction in Colorado and elsewhere in the District appears to be taking up some of the slack from the housing side. Let me turn to the nation and try to be brief. The contours of the outlook that we have are similar to what I reported at our last meeting and not unlike that from the Greenbook. Several factors suggest that the economy will slow over the forecast period. First, as I’ve suggested before, the removal of policy accommodation continues to have its effect. Second, long-term interest rates have, as others reported, risen noticeably. Third, energy prices continue to increase, reducing consumer purchasing power. Finally, we’ve been forecasting a slowdown in housing, but there is a risk that the slowdown could be actually larger than expected. Of course, there are counterbalancing factors that would show continued growth. Those have been outlined by others, but certainly the past stimulus in the amount of liquidity in the market has its effects. In addition, we are seeing improvements in employment and in income, which should help keep the economy moving forward. On the inflation outlook, as others have noted, the recent increase in inflation is a concern to me, but it is not a surprise. We have been expecting last year’s increase in energy prices to feed into a temporary rise in core inflation. We’ve seen that. More recent increases in energy are going to complicate that situation. So in the end, as we prepare for the next portion of this discussion this morning, I would agree with all my colleagues on one thing—monetary policy is going to be much more difficult in the next few months. [Laughter]" CHRG-111hhrg56847--26 Mr. Bernanke," The signal that gold is sending is in some ways very different from what other asset prices are sending. For example, the spread between nominal and inflation index bonds, the breakeven remains quite low, suggests that markets expect about 2 percent inflation over the next 10 years. Other commodity prices have fallen quite severely, including oil prices and food prices. So gold is out there doing something different from the rest of the commodity group. I don't fully understand the movements in the gold price, but I do think that there is a great deal of uncertainty and anxiety in financial markets right now and some people believe that holding gold will be a hedge against the fact that they view many other investments as being risky and hard to predict at this point. " CHRG-111hhrg74855--25 CONGRESS FROM THE STATE OF CALIFORNIA Ms. Matsui. Thank you, Mr. Chairman. Thank you for calling today's hearing. I would like to thank today's panelists for joining us today to discuss legislation that would affect FERC's jurisdictional markets and the transactions and products created for use in these regulated markets. I look forward to hearing all of your expert opinions. The expertise you share here will be useful throughout the committee process as we continue to discuss these matters. I think all of us here would agree that the recent financial crisis revealed serious weaknesses in the U.S. financials regulation. While it is critical that we respond to the risky trading strategies that nearly brought the American economy to the brink of collapse, it is equally crucial that we acknowledge the potential effects that legislative efforts to improve transparency and stability in over-the-counter derivatives markets may have on our energy markets, particularly electricity and natural gas. Toward this end, I believe that it is important to note that electric utilities and other stakeholders have expressed serious concerns about providing the CFTC the authority already possessed by FERC to regulate regional electric markets. In my district, the Sacramento Municipal Utility District, SMUD, enters into natural gas supply contracts and OTC derivative agreements to reduce Sacramento's exposure to price volatility. Unfortunately, most Californians vividly recall at the beginning of this decade the rationing of electricity which led to an artificial scarcity that created opportunities for market manipulation by energy speculators. We cannot allow our best intentions to examine regulatory authorities to impair the ability of utilities to employ tools to manage price risk and help keep rates affordable for consumers, and we need to continually examine systemic risk and the implications of applying certain means of transparency to the derivatives markets. I look forward to hearing from the panelists on the bill before us today, and working with the committee and stakeholders on these important matters. Once again, I thank you, Mr. Chairman, for highlighting this important topic and I yield back the balance of my time. " FOMC20061212meeting--44 42,MR. PLOSSER.," Thank you, Mr. Chairman. I have two questions that are sort of related. The first question has to do with the acceleration in core PCE prices that we saw earlier this year and were all obviously very concerned about. One rationale we’ve offered in trying to understand that acceleration was the pass-through effects from the previous year’s rise in energy prices from about $50 a barrel to something like $75 a barrel. Given that energy prices have now fallen and it looks as though they’re stabilizing around $60 a barrel at least for now, how do you measure the effect on the pass-through into core PCE prices from that roughly 20 percent drop in oil prices? I can see the measurement going on in the headline; but as I look at your forecasts of core, they haven’t responded to that same effect. Is there much pass-through in the model to core PCE prices from energy prices, or is there not? I’m trying to understand how you guys think about that. The second question is related to inflation as well. In trying to understand this automobile thing—which I clearly do not entirely understand at this point—I saw your suggestion that an apparently anomalous large drop occurred in the PPI for trucks or something like that. Was that real or accurate? Are there any ramifications from that anomalous drop in the PPI? Does that measurement problem carry over to other price indexes—for example, the CPI? If it does carry over, does that mean that our estimates of the CPI are perhaps understated in the near term because of the same measurement problem? I don’t know whether or not there’s any relation between those two. Those are my two questions." FOMC20050202meeting--168 166,MR. REINHART.,"5 Thank you, Mr. Chairman. At least from the perspective of most investors, your policy decision today seems foreordained. The universal belief in the market holds that the Committee will raise its target for the federal funds rate ¼ point, to 2½ percent and issue virtually the same announcement as was released after its December 14 meeting. Presumably, this settled opinion results from market participants’ reading of your recent statements—including the minutes from the December meeting, which I can assure you did not escape the world’s attention—as well as incoming economic data that seemed to present no obstacles to deflect the Committee from its path of continuing to remove policy accommodation. In other words, the case for a ¼ point tightening at this meeting, which is laid out in your first exhibit, is expected by people outside this room to be compelling to you. In particular, the Committee may be inclined toward such action—what we dubbed alternative B in the Bluebook—if it believes that market participants have pegged the desired pace of tightening just about right. As can be seen in the upper left panel, the path of money market futures rates can be read as indicating the expectation of a succession of ¼ point moves until the summer, followed by a slower pace of firming that puts the funds rate at around 3¾ percent by the end of 2006, a little above the staff assumption in the Greenbook. The staff views such a trajectory for policy as likely to be consistent with working down resource slack, which is shown in terms of the unemployment rate at the upper right, and with about steady inflation, as measured by the core PCE inflation rate shown just below. You might find some appeal in those outcomes and seek a decision that preserves the path of expectations thought consistent with them. In that case, you should probably direct Michelle Smith to take the statement from your last meeting and substitute February 2 for December 14, ½ for ¼, and be done for the day. You might, however, harbor some concerns that those favorable macro- economic outcomes are predicated upon liquidity conditions, including low long- term interest rates, that could be encouraging excessive risk-taking in a wide range of asset markets. Indicia of a relaxed attitude toward and lessened perception of risk on the part of investors may include the narrow spreads in the markets for corporate and sovereign debt (as shown in the middle left panel), as well as low levels of implied volatilities of financial prices, and high and rising home values (not shown). But perceived excesses in financial markets have not triggered action by this Committee in the past. In that regard, policymakers have tended to follow the logic outlined in the middle right panel. To be sure, some asset prices importantly influence economic behavior. However, because the determinants of asset prices are difficult to know February 1-2, 2005 123 of 177 with precision, it is neither obvious that asset price bubbles can be identified in real time nor clear what policymakers should do if they were confident that some prices were misaligned. Moreover, there may be other instruments of policy better suited to dealing with such problems, including supervisory restraint. As a result, you might conclude that asset prices should influence monetary policy decisions only to the extent that they have a material effect on the outlook for the things you care about— output and inflation. Any sentiment to shade toward a firmer policy than in alternative B because of concerns about potential asset market imbalances might well be tempered by the range of policy prescriptions based solely on these macroeconomic objectives shown in the bottom panel. You already have moved the policy rate toward the high end of the range of standard recommendations—the green shaded area—and are anticipated in futures markets to move even higher relative to that range in the quarters to come. I earlier described prevailing market expectations as consistent with a string of ¼ point moves followed by a more gradual pace of tightening. With the aid of exhibit 2, I’d like you to consider an alternative characterization that also fits the data and that may be more appropriate if market participants have taken the word “measured” to mean regular and methodical, like a metronome. The key identifying assumption is listed in the upper left panel. In particular, suppose market participants expect you to firm ¼ point at every meeting until you stop this tightening cycle for good. The unknown in markets, then, is when you will end the current firming cycle. We can use futures quotes—which represent the market’s average of the possibilities of continuing to tighten and of stopping—to back out the probabilities attached to action at each upcoming meeting being your last. This interpretation of the path for the expected federal funds rate is given at the right. Current futures rates are consistent with a median probability that you will have halted policy firming by the September meeting. Such an eventuality would deliver the path for the nominal funds rate given at the middle left: Along that path, five more hikes (including one at this meeting) will cumulate to put the federal funds rate at 3½ percent by August. Assuming that inflation holds around its recent pace and that short-run measures of the equilibrium real rate don’t move, that nominal rate would accord with a real federal funds rate that is about one-half of the way up the red river of estimates of its equilibrium in the familiar Bluebook chart plotted in the bottom panel. February 1-2, 2005 124 of 177 say, in the higher blue region—you might not stop firming until the winter or spring of 2006. According to the frequency distribution, it seems that investors put the probability at about two-in-three that you would be done before that. There are three reasons why I have walked you through this alternative explanation of futures rates. First, it underscores that our understanding of financial prices is sufficiently imprecise that there can be several plausible interpretations that are observationally equivalent. Second, if you would prefer that market participants not anticipate an unbroken string of policy moves, you could reiterate that “measured” means tightening that is carefully calibrated, not actions that are routinized and mechanical, and is consistent with a pause if that proves necessary. Mention of that sentiment in the minutes of this meeting may prove helpful in aligning market expectations with your own—as it seemed to be the case when similar notions were published previously. Third, the current structure of futures rates is consistent with a noticeable probability mass placed on the bet that this firming cycle will soon come to a close, with the median guess being that you will be done after the August meeting. If that market expectation does not seem unreasonable, then you are going to have to come to grips relatively soon with various aspects of your statement, including the characterization of the degree of policy accommodation and the risk assessment—the communication challenges diplomatically referred to by President Moskow. The next exhibit focuses on the risk assessment, with the top panel repeating the last paragraph of the statement released after your December meeting. Historically, this paragraph and its predecessors have been designed to provide some guidance about the future direction of interest rates. The statement has evolved to a point such that either of two parts of this paragraph could convey such a message. It can be done obliquely by describing the risks to your macroeconomic objectives (as in the sentence typed in green that is the successor to the balance-of-risks language) or it can be done more directly by stating the direction of rates and the pace with which you anticipate acting (the sentences in blue type that are the successors to the “considerable period” language of 2003). In both places, there is the opportunity to convey that these judgments are conditional in nature. February 1-2, 2005 125 of 177 thought you were behind the curve and expected to stay that way or thought that the possible outcomes had a decided skew. Thus, this formulation will generally not be informative about the direction of rates. As the time approaches when you are no longer confident there is any more policy accommodation left to remove, you will face the three choices listed in the bottom panel. First, the Committee could get out of the business of hinting—either obliquely or directly—about its future actions. While this has been advocated previously by some on the Committee, you would be giving up an opportunity to help to keep market interest rate expectations aligned with your own—opportunities you took over the past 1½ years and which apparently paid off. Even if you are not sure where rates are headed, there may be some merit in revealing your tentative assessment so as to make it less likely that investors come to a different and inappropriate conclusion. Second, the Committee could try to revive the risk assessment. One way, as I suggested back in August, would be to base it on the explicit assumption of an unchanged stance of policy for the next few quarters and couch it in terms of probabilities rather than risks. You might find it appealing to introduce such language when potential outcomes really seem even-sided at the prevailing federal funds rate—a possibility not necessarily that distant in time. Such language need not be formulaic, as history suggests that agreeing on a formula is neither a happy experience nor one that results in a durable solution. Third, you could feel that the balance-of-risks assessment in the first part of the paragraph is no longer necessary and instead rely on the gradual evolution of the latter part to convey your sense of the future path of interest rates. As a governance issue, though, it will be harder to be inclusive in drafting when there is less of a structural foundation agreed upon in advance. These may be worries for the future which you do not feel as palpably as does your Secretary, but time is passing by. Your final exhibit repeats Table 1 from the Bluebook without change. I draw your attention to alternative B, which basically repeats the statement that you issued in December." FOMC20081007confcall--40 38,MS. YELLEN.," Thank you, Mr. Chairman. I strongly support your proposal to cut the federal funds rate by 50 basis points today and the wording of the statement. I'm pleased that the FOMC will take this step as part of a coordinated program with other central banks. In my opinion, a larger action could easily be justified and is ultimately likely to prove necessary. We're witnessing a complete breakdown in the functioning of credit markets, and it is affecting every class of borrowers. The financial developments are dangerous and are having a pronounced impact on the economic outlook. The outlook has deteriorated very sharply, and even so, I still see the risks to the downside. Moreover, recent data on consumer and capital spending and on housing confirm that a sharp contraction in domestic demand is under way. As far as I'm concerned, for the reasons you gave, inflation risks have diminished markedly. Indeed, in a contraction as severe as that which is now on the horizon, I anticipate that inflation will decline noticeably below my own estimate of price stability. I think the Board has taken a wide array of creative and massive actions to provide liquidity to the credit markets. I think these are very appropriate and necessary. I hope we will do more, but they are not completely a substitute for cutting the federal funds rate. I think that's an important complement to the liquidity actions. " CHRG-110hhrg44903--164 Mr. Lynch," I am talking something much more basic. I am just talking about price, putting the right price on this product, how do you do that? " FOMC20050503meeting--150 148,MS. YELLEN.," Thank you, Mr. Chairman. I support, of course, your proposal to raise the federal funds rate 25 basis points, and I think the strategy that you suggest with respect to the May 3, 2005 94 of 116 minimal changes in the statement, as alternative B does. I think market expectations are essentially entirely sensible, and it does not make sense today to do a great deal to perturb those expectations. I think the policy path we’re on, as Don put it, likely has a positive slope. I’m comfortable with the term “measured pace” because I think it continues to indicate that whether we call policy accommodative or somewhat accommodative, the likely direction of the federal funds rate is up, and I think we ought to be communicating that. I believe that we retain considerable flexibility to pause or to be more aggressive. We see that, as you pointed out, Mr. Chairman, in the futures path as the market responds to the news. So, I think we do have flexibility. But I agree with Governor Ferguson that we need an exit strategy from this exit strategy, and my proposal is to get rid of the balance-of-risk statement. Maybe today is not the right day to do it, but as part of our ultimate exit strategy, which we may well need at the next meeting, I would love to see that go. I feel that we do need to communicate something about the future, but in my view crafting a simple English sentence or two to describe the consensus on the Committee is the way to do it. To me the balance-of-risk statement was an attempt to give hints about the future path of policy without saying anything about the funds rate directly but instead about the determinants of policy. And I just don’t think that’s possible. I read President Poole’s memo and I understand the desirability of having standard language, but we have a Committee that hasn’t obtained a consensus on the determinants of policy. We don’t have a common definition of maximum employment or price stability. We don’t have a common view on the importance of forecasts or an agreement on relative values of gaps versus growth rates in making those forecasts. Without that kind of consensus, we just can’t come up with a formulaic assessment about the balance of risks. It might work for a couple of meetings, but then we’re going May 3, 2005 95 of 116 So, going forward, it may be that the time to change this language is when we do pause and no longer feel certain what the direction of policy is. Maybe at that time a simple statement that says something like this will be the sensible way to go: “Under current conditions, policy seems well positioned to achieve our dual goals and we will respond, as needed, to fulfill our obligations to foster price stability and sustainable economic growth.”" CHRG-111shrg57923--39 Mr. Mendelowitz," Yes, Senator. This discussion about the housing bubble, I think, gives us an insight into what the need for the NIF is. While Steve said back in 2007 he saw it, those of you--but basically 5 years ago, I started predicting a major credit event in the housing sector that was going to push the economy into the worst recession since the Second World War, and it was really just based upon looking at relatively small data sets that went to what was happening to housing prices, what was happening to household income, and what was happening on the delinquency and default rate on mortgages, all of which was readily available data. So it was easy to predict a major credit event in housing and it was easy to predict, because of the widespread nature of home ownership, that this was going to lead to a recession that was going to be driven by falling consumption. That was the easy piece of it. Now we are saying the fact the Fed didn't see it, because they were using the standard monetarist model, and if you can't see something with the monetarist model, you don't see it. But what I didn't see and couldn't see and couldn't understand was how what was happening in the housing sector was going to lead to the collapse in the financial sector. And it is the kind of data that we are talking about the NIF collecting that would provide that insight, and there is no substitute for that. There is no alternative. There is no shortcut. Because at the end of the day, you have to know where the concentrations of risks are and you have to know what the nature of the intertwined network of financial firms and their obligations are, because it is the combination of concentrations of risk and the exposure of the network that can produce a domino effect of multiple failures that creates a systemic risk. And so it is one thing to see a macroeconomic crisis tied to something like housing. It is something entirely different--the data needs are entirely different when it comes to understanding the systemic risk that flows from those concentrations of risk. Senator Reed. I want to thank you all for excellent testimony, thought provoking, and also for your advancing this issue. I think we leave here with, one, we need better data. We need better analysis. And if we don't achieve it in the next several months, the bubbles that might be out there percolating, if that is the right term, will once again catch us by surprise and we shouldn't let that happen. But thank you all very, very much. Thank you. " FOMC20060920meeting--9 7,MR. KOS.,"1 Thank you, Mr. Chairman. Among market participants, September has a reputation for being difficult on portfolios, for sudden bursts of volatility that lead to risk aversion and wider spreads, and for sometimes spectacular blowups in the speculative community. The ERM crisis in 1992, Long-Term Capital Management in 1998, and the aftermath of the terrorist attacks in 2001 are three of the more notable examples. Until Monday, this year looked different. Spreads were and they continue to be narrow. Volatility has generally been low, with the notable exception of energy. Yields are benign, and equity prices, if anything, have been rising in recent weeks. 1 The materials used by Mr. Kos are appended to this transcript (appendix 1). The massive loss disclosed on Monday by a large hedge fund has had remarkably, almost suspiciously, little spillover effects thus far. But with political crises suddenly popping up in Hungary and Thailand, it may suggest that risks in some of these smaller, less-liquid market sectors such as emerging markets and commodities have risen. Overnight the Thai baht was slightly weaker, Thai banks and markets were closed, and currencies and equity markets of neighboring countries were, on balance, only marginally weaker. Meanwhile in the G3, markets have generally been calm, though recent moves suggest a more sober outlook for growth than had been priced in earlier this summer. On page 1 of your handout, the top panel graphs the three-month Eurodollar deposit rate in black and the same rate three, six, and nine months forward in red since the beginning of the year. In recent weeks, forward rates traded through the cash rate as assorted reports—especially housing and inflation data—convinced market participants that (1) the Committee would continue to hold the target funds rate steady for sometime longer and (2) the probability of an ease early next year was far more likely than a resumption of the tightening cycle. That view was seemingly shared by investors in the Treasury market. As shown in the middle panel, two-year and ten-year yields have been gently declining since the June meeting. The ten-year yield currently trades about 50 basis points below the target funds rate—the widest negative spread since March 2001. Meanwhile, various measures of the yield curve have now been mildly inverted for several weeks—perhaps also reflecting the market’s view that a slowdown is in the offing. The bottom panel graphs the straight ten-year breakeven rate and the five-year rate five years forward. Both declined modestly since the last meeting, helped by inflation readings that did not repeat this spring’s elevated numbers and also by the moderation of commodity prices in general and energy prices in particular. The view that growth may be less robust was reflected in overseas markets as well. On page 2, the top panel graphs the calendar spread for interest rate futures between the December 2007 and the December 2006 contracts for the G5 economies since January 1. In recent weeks that spread has, on balance, been declining slightly as markets have taken out tightenings that had been priced in for coming quarters. Even in Europe, where the ECB has been talking tough, market participants are reassessing what effect a U.S. slowdown would have on the ECB’s trajectory. The middle panel graphs ten-year sovereign yields for the United States, Canada, the United Kingdom, and, as a proxy for the euro area, France. Those yields rose during the first six months of the year and have retreated more recently. While there is a story for each economy, the most recent sets of data have been slightly less favorable, and forecasts for the next few quarters have been trimmed back. Meanwhile, as shown by the middle right panel, U.S. and Canadian breakevens have declined slightly. In contrast, breakeven rates in the United Kingdom and France have risen somewhat. Indeed, the ECB has repeatedly voiced concerns about rising headline inflation and the persistence of that trend. Japan is a somewhat special case. Through midyear, forecasts for Japanese growth had been rising. Deflation was ebbing, loan growth was rising, and the BoJ opportunistically exited its quantitative easing policy in March and then exited the zero interest rate policy in mid-July. However, as shown in the bottom left panel, yields could not get past 2 percent and then began to decline as data such as machinery orders disappointed investors and led them to question how fast the BoJ would raise interest rates. Then on August 24, Japan released revisions to the CPI, which showed that inflation had been lower than previously reported. Markets quickly pushed back the timing of future call rate increases despite the BoJ’s assertions that the revisions did not change its basic outlook. Japan does have a nascent inflation-linked Japanese government bond market. The bottom right panel graphs the breakeven, which has fallen from about 1 percent to about 60 basis points. As shown in the top panel of page 3, the entire JGB curve has shifted down since the last FOMC meeting. One factor that has continued to work in favor of Japan’s export sector has been the exchange rate. The yen’s nominal value has been falling against most currencies in recent weeks and hit its lowest level against the euro since the single currency’s launch. The middle panel takes a much longer perspective on the yen; it graphs the real effective exchange rate since the beginning of the floating rate era. The real effective rate has been falling steadily since 2000 and is at its lowest level in more than 20 years despite the chronic trade and current account surpluses that Japan has generated in the interim. The bottom two panels on page 3 reflect the recent volatility in commodity prices, with metal prices on the bottom left and energy prices on the bottom right. Metal prices continue to fluctuate but show some signs of having topped out for the time being. Energy prices, however, have made a round trip from where they were at the beginning of the year. The retracing of prices has fed discussions about whether the so-called speculative premium in energy prices has now been taken out. Certainly there are signs that speculators have been exiting some of these positions. Those signs are most visible for natural gas, which is something of an outlier in the bottom right. Last week’s sharp decline in prices may have been related to the liquidation of positions by the large hedge fund that was closing out positions. If the speculative money is being chased out, for natural gas but also for other products, then perhaps energy prices now better reflect underlying fundamentals. Finally, I want to come back briefly to a topic I mentioned at the last meeting related to the nascent development of an early-return fed funds market. As background, fed funds contracts do not generally dictate the timing of the return leg. So, not surprisingly, most fed funds are returned to the lender late in the day. The GSEs have been interested in developing an early-return facility to meet the principal and interest payment timetable given the new PSR (payment system risk) rules. The data are sparse, and our conclusions are tentative, but I wanted to give you a brief update. On page 4, the blue bar in the top panel graphs daily volumes of regular overnight fed funds contracts. The smaller green bar represents overnight early- return volumes. The black line shows the percentage of overall volumes represented by early returns. The time series starts on August 8, which is when data first became available to us. This series does not include term trades with early-return provisions. In general, early returns make up about 10 percent of overall volumes. The middle panel graphs the effective rate for those trades with early-return provisions in red. The blue line is the 9:00 a.m. rate. Early-return trades are transacted in midmorning and thus show a strong correlation with the 9:00 a.m. rate, generally trading about 2 basis points below regular funds. Finally, as shown in the bottom panel, early-return trades have far less volatility. The reason for the lower volatility is primarily that these trades are executed in midmorning rather than during the late afternoon rush, when the funds rate often can move with large swings. Getting back to the GSEs, they in fact have not been active users of overnight early-return fed funds. They have, however, used term fed funds of up to a month maturity with early-return provisions timed to mature on the date of their large P&I dates. For term rates, unlike for overnight trades, there is no rate concession. Mr. Chairman, there were no foreign exchange operations for the period. I will need a vote to approve domestic operations." FOMC20051101meeting--138 136,VICE CHAIRMAN GEITHNER.," We view the balance of developments since the last meeting as strengthening the case for further firming of monetary policy. The underlying pace of demand growth seems reasonably strong—a bit stronger than we thought at our last meeting. The inflation outlook to us looks largely the same as it did in September, with the expected path of core inflation higher than we would like and some risk of further acceleration. On the assumption that we increase the fed funds rate on the higher trajectory now priced into November 1, 2005 62 of 114 potential in ’06—somewhere between 3 and 3.5 percent—and for the rate of increase in the core PCE to stay in the vicinity of 2 percent. Of course, this has to be considered an implausibly benign view of the world [laughter] and the expansion still faces a familiar array of risks. But we don’t see evidence yet of a substantial slowdown in demand nor of a troubling acceleration in underlying inflation. The balance of risks in this forecast has changed a bit. I’m a little less concerned that the cumulative rise in energy prices will itself bring about a more substantial and extended slowdown in growth, although that obviously has to remain a concern and possibly the principal risk to the growth outlook. We believe that the modest expected tightening of financial conditions will have less of a dampening effect on demand growth than the Greenbook assumes. We don’t see strong evidence yet of a significant deceleration in housing price appreciation or expectations of that outcome in household spending behavior, although both would be desirable. The evidence of strong stability in the growth of household consumption is, in a sense, borrowing against a future cushion, and that perhaps raises the probability of a more adverse path to future consumption. But it’s not here yet. As in September, the relative probabilities of alternative inflation outcomes still seem slightly skewed to the upside, thus probably justifying more cumulative firming in monetary conditions. Core PCE has remained moderate, compensation growth modest, productivity growth strong, and long-term inflation expectations reassuringly low. But the size of the rise in headline inflation and the deterioration in near-term expectations creates the possibility of some further drift up in underlying inflation if, as we expect, the labor market firms further and unit labor costs eventually start to rise more rapidly. We’re seeing some drift upward in core inflation outside of the United November 1, 2005 63 of 114 On balance, to us this suggests we need to make sure that the market remains confident we’ll do enough to bring inflation and inflation expectations down over the next two years. To put it differently, we should make sure that we take out enough insurance to avoid a more adverse inflation outcome, and in this sense we should be pleased that the market has raised its estimate of the terminal fed funds rate to around 4½ percent. Our statement today, I believe, should be designed to be neutral to those expectations, rather than to raise or lower the expected path. I do think it would be helpful if the minutes reflected some discussion today about the approaching need—the approaching need, not the need today—for some changes in the structure of the statement. We’ve been very fortunate to date in how well we have managed this transition in monetary policy, with the market expecting a sustained period of tightening but its expectation of the terminal fed funds rate varying with changes in the outlook. Our decision to put a soft, qualified, conditional ceiling on the fed funds rate path at 25 basis points a meeting has not cost us to date any erosion in long-term credibility, though it probably has encouraged the market’s investors to take more duration risk. The remarkable stability in quarterly GDP growth and in core inflation we’ve seen has tended to reinforce expectations about the outlook for monetary policy, adding an unusual degree of certainty about the likely path of the fed funds rate. This has to change. As we become less certain about the path ahead, that increase in uncertainty needs to get built into market expectations. The question is when and how we alter our statement to reflect this. So far, the dominant strategy before us has been to keep moving 25 basis points, to signal that we will continue to do so, and to defer any major changes to the structure of the statement until we are confident we have made our last move. Now, this may turn out to be the optimal choice, but the language feels increasingly stale. And it may be better, in fact, to change the November 1, 2005 64 of 114 might make the transition ahead more gentle. It would give us more than one shot at recalibrating the signal, and it might help bring the market’s uncertainty about what’s ahead more in line with our own. There are two areas where changes in the statement seem indicated. The first is in how we characterize the rationale for our action. There we have some room to become more explicit about our view of the outlook relative to our objectives without going all the way to a fully articulated, quantitative forecast. The second, of course, is in the end of the statement. If the world in December looks about how it looks now, with a high probability of one or more moves still ahead of us, we could, for example, replace the last three sentences of the statement with two which state our views more simply. They would state first that the outlook for growth and inflation suggests that further monetary policy firming is likely to be necessary, and, second, that the Committee will respond to changes in economic prospects as needed to maintain price stability so as to achieve sustainable growth. This would get us out of some of the risks of repeating “measured” going forward. It would help address some of the problems in using the word “accommodation” to signal tightening. And it would eliminate the awkwardness in the superfluous balance of risk sentence we now have. This would allow an easy evolution to a more neutral signal when that becomes appropriate—with a simple statement that policy is now roughly appropriate but that we will act as necessary to achieve our objectives going forward. Of course, the world may look different in December, and we have to assess then what makes the most sense. I don’t know that we can say with confidence today that evolution in December is ideal or necessary, but I think we need to prepare ourselves and the markets for some evolution. November 1, 2005 65 of 114" CHRG-111hhrg52397--34 Mr. Fewer," Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, my name is Donald Fewer. I would like to thank the subcommittee for the opportunity to share my views on the regulation of the over-the-counter derivatives market and address the areas of interest outlined by the subcommittee. I have also submitted a larger statement for the record. Analysis of the credit crisis points to the need for enhanced regulation of the OTC market. Results from such analysis point to multiple, and sometimes conflicting, causes of the crisis and the role played by the OTC derivatives market. We suggest creating a cohesive regulatory regime with a systemic risk regulator that has the authority and accountability to regulate financial institutions that are determined to be systemically important. Regulation need not reshape the market or alter its underlying functionality. The U.S. share of global financial markets is rapidly falling and oversight consolidation should not create a regulatory environment that prohibits capital market formation, increases transaction costs, and pushes market innovation and development to foreign markets. The use of CCPs by all market participants, including end users, should be encouraged by providing open and fair access to key infrastructure components, including central clearing facilities, private broker trading venues, and derivative contract repositories. Central clearing will reduce systemic risk by providing multilateral netting and actively managing daily collateral requirements. Mandated clearing of the most standardized and liquid product segments is congruent with efficient global trade flow. Given the size, history and global scope of the OTC derivatives market, migration toward exchange execution has been, and will be, minimal apart from mandatory legislative action. OTC derivative markets will use well-recognized protocols of size, price, payment and maturity dates. Because of these internationally-recognized protocols, OTC dealers globally are able to efficiently customize and best execute at least cost trillions of dollars of customer orders within generally acceptable terms to the market. There is a class of OTC product that is extremely conducive to exchange execution and can warrant exchange listing. The over-the-counter market has a well-established system of price discovery and pre-trade market transparency that includes markets such as U.S. Treasuries, U.S. repo, and EM sovereign debt. OTC markets have been enhanced by higher utilization of electronic platform execution. The unique nature of the OTC markets' price discovery process is essential to the development of orderly trade flow and liquidity, particularly in fixed income credit markets. We are in a period of abundance of mispriced securities where professional market information and execution is required. OTC derivatives and underlying cash markets use an exhaustive price discovery service that can only be realized in the OTC market via execution platforms that integrate cash and derivative markets. Post-trade transparency for all OTC derivative transactions can be properly serviced by CCPs and central trade repositories that aggregate trading volumes and positions, as well as specific counterparty information. These institutions can be structured to maintain books and records and provide access to regulatory authorities on trade-specific data. I would not endorse OTC trade reporting to the level that is currently disclosed by trace. There is ample evidence in the secondary OTC corporate bond market that the trace system has caused dealers to be less inclined to hold inventory and to make capital to support secondary markets. Successful utilization of electronic trade execution platforms is evident in markets such as U.S. Government bonds and U.S. Government repo. I would caution against the mandated electronic execution of OTC cash-in derivative products by regulatory action. Effective implementation of such platforms should be the result of a clear demand made by market makers and a willingness by dealers to provide liquidity electronically. Our experience in North America is that the dealer community has refrained from electronic execution due to the risk of being held to prices during volatile market conditions. I would strongly endorse the hybrid use of electronic platforms where market participants utilize the services of voice brokers in conjunction with screen trading technology. Mr. Chairman, Mr. Ranking Member, and members of the subcommittee, I appreciate the opportunity to provide this testimony. I am available to answer any questions you may have. [The prepared statement of Mr. Fewer can be found on page 156 of the appendix.] " FOMC20071031meeting--173 171,MS. YELLEN.," Thank you, Mr. Chairman. I found the choice between alternatives A and B to be a tough call. I’ve struggled with this over the past week, and in the end I find the arguments for alternative A for a 25 basis point rate cut more persuasive. I have several reasons for this judgment. First, as I argued yesterday, further action to my mind is appropriate, even leaving aside the recent financial shock. With output near potential and inflation near my objective, the stance of policy should be close to neutral, and while we can debate exactly what the equilibrium real interest rate is—that’s an important discussion to me—it appears that, even after our action in September, policy is somewhat restrictive. I agree with President Plosser’s view that we need to maintain some consistency in our thinking over time, and I would say that I expressed this identical view at our last meeting and said at that time that I did envision a 75 basis point cut during 2007. So my views haven’t changed, and the data that we have seen in the intermeeting period haven’t suddenly pushed me in the direction of this move—instead, if anything, slightly away from it, but I regard those data as largely uninformative. So my views really haven’t changed about this, but it seems to me that the argument that we should be moving toward neutral does allow for quite a bit of flexibility in the timing of an additional rate cut. It doesn’t have to be something that we do in October. We could do it in December, or it could wait until January. So that argument in and of itself doesn’t completely persuade me that we have to do it today. But I do think it would be prudent to act today for a couple of reasons. The first has to do with the effects of the financial shock of the summer. When we came into the meeting last month, we faced credit conditions that were quite restrictive, and our goal was to offset that shock to avoid a significant economic slowdown. I think the favorable inflation results over the previous six months did give us the flexibility to take strong action, which we did. My judgment is that we have had some success so far. Financial conditions appear to be easier than they were in September, and arguably, as I said yesterday, I think we may have roughly neutralized the shock. But an important element in our success has been the decline in Treasury rates along with the further decline we’ve seen in the dollar and the increase in equity prices since we last met. Those changes are supported by the market’s expectations that we will ease further at this meeting and beyond. In other words, if we don’t ease today as the market expects, then rates may move up, and that raises concern to my mind about whether we will have accomplished the goal of offsetting the restrictive effects of the recent financial shock. A second reason for easing today is the asymmetric nature of the risks we face in achieving our goals. I do see some upside risk to inflation although I have not read the recent increase in five-to-ten-year inflation compensation as really reflecting a market perception of a deterioration in long-term inflation expectations. In my view, the more serious risk is the one that our Chairman discussed yesterday of unleashing negative nonlinear dynamics in the real and financial economy that could be difficult to reverse. Conditions in housing markets and their possible implications for housing prices and, in turn, consumption are at the center of these concerns. In addition, although liquidity in financial markets has improved, I think the markets are still rather fragile and subject to further sudden disruptions. I’m comfortable with the wording in alternative A, including the balance of risk assessment. Through the fed funds rate being 25 basis points lower, I do see the upside risk to inflation as being roughly balanced with the downside risk to growth. I think the statement does give us sufficient flexibility to respond in whatever way we need to, and that includes the possibility of taking back some of this easing should there be upside surprises. I do think that it’s important to signal to markets that this is not yet another step in a planned series of continuing rate cuts." FinancialServicesCommittee--43 Ms. S CHAPIRO . I would say that while we did have tremendous volatility in October of 1987, we had many more market partici- pants who don’t have the same sort of affirmative obligations to the marketplace that we had at that time with specialists, with mar- ket-makers on the NASDAQ stock market. So speed, volume, veloc- ity of trading, volatility, and lesser obligations to the market as a whole. Mr. C AMPBELL . My time has expired. Thank you. Chairman K ANJORSKI . Thank you very much. Now, we will hear from the gentleman from Illinois, Mr. Foster. Mr. F OSTER . Thank you, Mr. Chairman. Does anyone yet understand the origin of the tremendously high share prices that were bid, at least reported, $100,000 for Sotheby’s and so on? Were these algorithmic bids, or what was the nature of them and what was the nature of the firms that made them? Ms. S CHAPIRO . I believe we are still looking at that, and I will ask Robert to jump in here. Interestingly, there were 20 stocks that traded at 90 percent above their 2 p.m. price during that period when there were 250 or more stocks that traded at 90 percent below their 2 p.m. price. But I don’t know if we know yet the rea- son. Mr. C OOK . No, we don’t. There are many more that traded below their 2 p.m. price than above, but we don’t yet know the nature of the orders that came in that fed into those prices above. Mr. F OSTER . So you don’t even know who made them? Mr. C OOK . Not at this time. That is part of the information we are gathering together, because we are pulling together the infor- mation as to where the orders originated, at which trading venue, and then we will go back further and find out who put them in through the brokers. Mr. F OSTER . So this many days later, you don’t know who it was that made these funny-sounding bids. Chairman Gensler, would that be the case with you? Mr. G ENSLER . No. In the futures market, we didn’t have either, because there are so many curbs and limits in this risk manage- ment. One of the things that high-frequency or algorithmic traders do is called ‘‘sniping,’’ if I may use the term, in which the com- puters actually put in a bid, one contract or one security at a time, and try to pull out the liquidity and find it. If there was a resting order, a resting bid at a penny or a resting bid at $100,000, the computers can strip through and maybe find it. That may be a pos- sible thing to look at it—it may have been what happened. Mr. F OSTER . Are there mandates that automated trading firms appropriately version and archive their algorithmic code and their databases so they can reproduce their trading decisions after the fact in the course of these investigations? Mr. G ENSLER . We have actually asked for some of these largest traders to actually sit down and see their code. Our folks in our Division of Market Surveillance are sitting down this week with a number of the largest ones and are actually looking at their codes. Mr. F OSTER . Right. But it is a possible response that they say, ‘‘We just don’t know. We had some version, but then we overrode it.’’ FOMC20050322meeting--142 140,CHAIRMAN GREENSPAN.," If you actually trace through the cost structure, energy prices can impact on core prices in only two ways—in unit labor costs or in petrochemical feedstock prices spreading out through various constituent elements in the production processes it affects. The latter is actually a very small part of GDP." CHRG-111shrg54589--130 PREPARED STATEMENT OF KENNETH C. GRIFFIN Founder, President, and Chief Executive Officer, Citadel Investment Group, L.L.C. June 22, 2009 Chairman Reed, Senator Bunning, Members of the Committee, I am Kenneth Griffin, President and CEO of Citadel Investment Group. I appreciate the opportunity to testify and share our views regarding effective oversight of the over-the-counter derivatives market. Citadel's nearly two decades of experience in the OTC marketplace, as well as its role as a leading liquidity provider in the equity markets and the options market in the United States, give us insights into the benefits of appropriate market structure. Sadly, it now also gives us insights into the wreckage that can be wrought by opaque and unregulated markets. As one of the largest alternative asset managers, Citadel has a vested interest in the safety and soundness of our financial markets and in fostering fair, orderly and transparent markets. As an American taxpayer, I have a vested interest in ensuring that the financial crisis that we have experienced never happens again. To be clear, Citadel also has an economic interest in the outcome of this issue as a partner with CME Group in the development of a neutral, open access, central counterparty clearing solution for credit default swaps. CME is also supported by other institutional investors and alternative asset managers in this initiative. For many years, Citadel has advocated for central counterparty clearing. I am confident that if OTC derivatives were cleared through a properly structured and transparent central counterparty, the impact of AIG and Lehman Brothers would have been much different. Without a central counterparty clearing framework in place, their failures have contributed to the loss of hundreds of thousands of jobs and the use of hundreds of billions of dollars of taxpayer money. Citadel is committed to maintaining the benefits of credit default swaps products while reducing the systemic risk they present to the market, to the economy as a whole and to American taxpayers. We wholeheartedly support a comprehensive framework for over-the-counter derivatives and the realignment of capital incentives as an immediate, tangible undertaking to realize these goals. We stand ready to help this Committee meet these goals.Derivatives and Their Benefits Credit default swaps and other derivatives play a crucial role in helping American businesses prudently manage their balance sheets as well as their interest rate and credit exposure. When used and overseen properly, credit default swaps and other derivatives play a vital role in helping our economy function smoothly and grow. Examples of the benefits of derivatives abound. Institutional investors, such as pension funds, 401k managers, foundations and endowments make frequent use of derivatives to achieve their portfolio objectives and to manage risk. A regional bank may use credit default swaps to buy credit protection on its loan portfolio. By transferring credit risk, the bank can free up capital and make more loans at a time of contracting credit availability. Manufacturers use these instruments to hedge the risk that their key suppliers might go bankrupt and not fulfill outstanding obligations. Suppliers may protect against the risk that their customers might fail to pay. The imprudent use of these instruments, however, when coupled with (1) an antiquated and opaque market structure, (2) the lack of comprehensive margin and capital requirements, and (3) the absence of a central counterparty clearing framework can have devastating consequences. This is an issue of profound importance to our capital markets and the American people.Reform Measures Essential to the Market The derivatives market has grown because of its utility. Between 2003 and 2008, it is estimated the market for credit default swaps grew from $3.8 trillion to nearly $40 trillion, and has become highly liquid and standardized. At the end of 2008, it was estimated there were approximately $325 trillion in gross notional value of interest rate swaps outstanding. Yet the derivatives market today largely functions as it did three decades ago. The current market structure is characterized by the notable absence of certain structural safeguards that are the hallmark of mature and efficient markets: a central counterparty, segregation of margin deposits and positions, price transparency, and appropriate capital requirements for all market participants, including dealers and highly rated counterparties. In the current market structure: Dealers are generally not obligated to post margin to initiate a trade. Customers are often required to post initial margin to their dealer counterparties to initiate a trade. These funds are held by the dealers in accounts that are commingled with the dealers' own funds. Because customer margin is not segregated, customer funds could be lost in a dealer default. In times of stress, customers will rush to close out positions to recover their margin. This can intensify a liquidity crisis, and may precipitate bankruptcy, as we saw with Lehman Brothers. Market data, such as transaction prices, is closely held and not published. As a result, many market participants cannot accurately value their portfolios nor prudently manage their investments. Had there been objective and real time price transparency and a uniform margin methodology available last fall, the AIG fiasco may never have happened.The Right Incentives Today, the vast majority of credit default and interest rate swap contracts have standard terms similar to equity options, and trade in large daily volumes. The same parties that trade credit default and interest rate swap contracts participate in other markets that benefit from central clearing, transparent and consistent margins, and account segregation. In the absence of one or more central clearinghouses available to all market participants, a tremendous amount of risk is concentrated with a handful of financial institutions. These financial institutions earn extraordinary profits from the lack of transparency in the marketplace and from the privileged role they play as credit intermediaries in almost all transactions. Unfortunately, we have seen the cost borne by our broader economy when one of these highly interconnected institutions fails. Capital requirements on the trading of over-the-counter derivatives should reflect the significant systemic risk they create. We should also consider the imposition of a requirement for financial institutions to use clearinghouses for the most commonly traded over-the-counter derivatives. This problem has an international dimension. We must work to coordinate our actions with foreign regulators. Otherwise, we face the risk of cross-border capital and regulatory arbitrage. We are hopeful that once appropriate capital requirements are established, trading of over-the-counter derivatives will naturally flow to regulated clearinghouses with mutualized risk and natural netting capabilities. And with it, price transparency, reduction of systemic risk, and continued evolution of the core market will follow. The status quo cannot be allowed to continue. We must work together to drive market structure reform that fosters orderly and transparent markets, facilitates the growth and strength of the American economy and protects taxpayers from losses such as those we have witnessed in the last year. Thank you for the opportunity to testify today. I would be happy to answer your questions. ______ FOMC20060808meeting--94 92,MS. MINEHAN.," Thank you very much. In my memory, this is about the toughest decision I’ve ever been a part of at this table. Over the past twelve, thirteen, or so years that I’ve been here, we haven’t faced the combination of potential for slower growth and rising inflation that is certainly not optimal for a central bank, and I really do find this choice to be very difficult along the lines that Don mentioned earlier. Not only do we have to figure out what to do, we have to figure out what to say about it, and that’s another complicating factor that has just grown over the years. We began raising interest rates more than two years and 425 basis points ago, but at some point we have to stop or at least pause. What makes this particularly difficult is that price growth is on an uptick and moderation occurs only in projections and not yet in the data. I think you, Ben, anticipated in one of your earlier testimonies—perhaps in the first one you gave—that we might have to pause in the midst of adverse incoming price data. The thought wasn’t well received at the time, as I recall; and now that we’re faced with that decision, I find myself uncomfortable. The logic is clear. Inflation data are backward looking, and if we continue to increase rates until incoming information suggests that moderation has occurred, we will undoubtedly overdo the tightening process. But knowing that doesn’t make choosing when to stop or even to pause easier when you see, as I do, many risks that both growth and inflation pressures may well be stronger than we now forecast. In that regard, I think Don and I are probably just micromeasurements away from each other, but I’m sort of on the other side of the line. At the margin I favor increasing the federal funds rate 25 basis points. I believe inflation risks are on the upside and that we’re at risk that the current higher rates of inflation will become embedded in business practices and, therefore, get reflected in the market expectations and the expectations that we measure. I don’t think we’re way behind the curve, but I do think we need to ensure that policy stays less rather than more accommodative. As I noted earlier, if one looks at real interest rates, among other things, financial conditions are more rather than less accommodative than earlier in the summer, and I personally don’t think that’s consistent with the inflation risks that we face. Now, Don pointed out that the market is not anticipating this. For some reason or another, the market saw the minutes of our last meeting as very soft. I didn’t read them that way. As I recall our discussion at the last meeting, we wanted to give ourselves some flexibility. We would be happy if the market saw a 50-50 chance. Probably reflecting on growth in Q2 that was slower than they expected and on some of the employment data, they’ve obviously tilted it the other way. I recognize that surprising the market with an increase would be a surprise, [laughter] but I’m not at all sure that’s a bad thing, particularly if we are as concerned about inflation around the table as I have heard many of us say. I recognize that I may be in the minority here. So I would strongly advocate that, if we do talk about pausing, we not suggest to the markets that we think the risks in the economy are balanced. We have to signal clearly that our concerns are on the upside with regard to inflation. If I were a voting member, I’d vote to raise the fed funds rate 25 basis points and to use some form of alternative C, possibly by adjusting the last line to indicate an ongoing concern about inflation but probably not going all the way in the direction of alternative D. I recognize that’s not likely to be the consensus here. So then I would strongly favor alternative B in terms of language, with the change that Don just mentioned—taking section 3 and moving it into alternative B—to perhaps give a stronger cast to the overall assessment." CHRG-111shrg57319--205 Mr. Cathcart," Well, I would say there was a lot of focus and concern on disclosure issues. In other words, ensuring that when the product was sold, that the customer understood the product, and a great deal of focus between the regulators and the bank took place on that front. As far as the structure of the product itself is concerned, the criteria associated with origination were supposed to be sufficiently strong, meaning the borrowers were supposed to be sufficiently strong that the negative amortization was not considered to be a key issue. Of course, I had concerns about it, because negative amortization is intuitively counter to what standard risk appetite would suggest, but I would say the portfolio had performed very well, and in retrospect, was overly dependent on the continued appreciation in house prices. Senator Levin. And when WaMu qualified a borrower for an Option ARM loan, did the bank use the payment that the borrower would have to make at a recast or did they use a lower payment? " FinancialCrisisInquiry--327 BORN: Thank you. I’m going to address first issues regarding the enormous and unregulated over-the- counter derivatives market. Your institutions are four of the largest OTC derivatives dealers in the world. The Office of the Comptroller of the Currency has reported that, in September 2009, you collectively held over-the-counter derivatives positions of more January 13, 2010 than $230 trillion in notional amount. Your positions consist of more than a third of the world market in over-the-counter derivatives. Mr. Blankfein, in your written testimony, you’ve stated that standardized derivatives should be exchanged, traded, and cleared through a central clearinghouse. And you further state, quote, “This will do more to enhance price discovery and reduce systemic risk than, perhaps, any specific rule or regulation.” I would like to ask your opinion of the role that over-the- counter derivatives played in causing or contributing to the financial crisis. FOMC20061212meeting--41 39,MR. STOCKTON.," To answer the latter question: If we really threw away the information in the nonfarm business compensation that is taken from the national income accounts and focused solely on the ECI, we’d have a lower inflation forecast. In our overall price inflation projection, we use a variety of models. I talked about this a little earlier in the year when we got that big upward surprise. We have some models that just say, “Don’t pay any attention to the labor market data: They’re all so bad and they have so little predictive content for prices that you’re better off just circumventing them altogether.” Now, we have never felt comfortable that the right thing to do was to give zero weight to the labor market side of things; so in the projection we have looked at some of the models that incorporate those effects and used the ECI in some models and compensation per hour in others. Again, if you went totally with the nonfarm business compensation per hour in those models, you’d probably be at or maybe slightly above our current forecast. So I think there’s a lot of uncertainty here. One of the things that we wanted to signal was that there are huge amounts of uncertainty about what the NAIRU and potential output are. We show a simulation with a lower NAIRU. In constructing our forecast, we have to take a stand because we have to show you a forecast that is moving an economy back toward equilibrium. Sitting in your chair, however, you would obviously want to view this from a risk-management perspective and understand that our ability to be very precise there is quite weak. The recent compensation data put back on the table the possibility that we’re getting a signal from the labor market that not as much pressure is coming from the labor cost side as we had earlier thought." FOMC20060328meeting--247 245,MS. YELLEN.," Thank you, Mr. Chairman. I think overall we are in a good position at this point with the economy essentially at full employment and growth homing in on potential, which will, I hope, hold unemployment roughly steady. Core inflation is pretty steady although, at least by several measures and particularly the core PCE, it is in the top half of the range that I would like to see. But I agree with Governor Kohn that this is a matter that we should consider. What index, and where it is relative to what we would like, bears further thinking about. If you take inflation to be in the top half of a comfort range as opposed to the middle, an optimal policy setting would place the funds rate toward the upper end of a neutral range or would be minimally restrictive. I say “minimally” because we are at most a little above the middle of the so-called comfort range and also because the various rules presented in chart 7 of the Bluebook suggest that the appropriate response of policy to a deviation of inflation from the middle of the range is actually quite small. If inflation were to decline, say, 50 basis points, from 2 percent to 1½ percent, the response, according to most of the rules in the table, of the fed funds rate to that deviation is on the order of 25 or 30 basis points. So it is sort of a one-policy-move difference. At this point, it seems to me, policy is pretty close to appropriately positioned. In terms of risk assessments, I share Governor Kohn’s concern about the possibility that growth won’t actually slow to a sustainable pace and so the economy may overheat. But I am also concerned about overshooting, in part because the delayed effect of our policy actions may show up especially in the housing sector with greater force than we expect and we are a little uncertain— David mentioned this yesterday—about just what the spillovers might be to consumer spending via balance sheet effects or wealth effects. I think we do need to be sensitive to the possibility of overshooting, and here I would endorse President Hoenig’s comments on that. So I can certainly support a 25 basis point tightening today coupled with some slight policy inclination for further firming. But I would not like to do anything to boost the market’s perceptions of the likely ending point of the cycle. I’m not sure what the best way is to accomplish that. I had first found myself having some preference for using the alternative language suggested for B that would say that some modest additional policy firming may be needed. But I am not sure that is the right way to go. As I look forward, I share the concern that a number of you have expressed—that as we get to the May meeting we are going to find not only that markets expect us to go another 25 but also that an additional 25 will be priced into the market. And it seems to me that the construction of our statement raises the likelihood that markets are going to continue to build in expectations for moves beyond 5 percent. Let me explain in part what I’m worried about. I am worried about the way in which line 3 of alternative B characterizes our concerns about energy and commodity prices. As I looked at the new Bluebook handout that Vince just gave us, I liked the change that has been made in line 2 where it says that the economic growth has rebounded but in effect then adds, “But look, in our Committee forecast, we wanted to let you know we’re expecting really strong numbers for Q1, but we think it is then going to moderate to a more-sustainable pace.” Now, we might have tried to do the same thing in line 3, but unfortunately we didn’t. We don’t state what our forecast is to give markets a reasonable way to judge incoming data. Let me get a bit more specific about what I mean. Consider the Greenbook forecast for core PCE inflation for the remainder of this year. I’m more optimistic than the Greenbook is, but the Greenbook forecast is that, for the remainder of this year, core PCE inflation is going to come in at 2.2 percent, which is certainly above the top end of the comfort range that I or anyone else who has opined on this has suggested. So what will the market response be if the Greenbook forecast actually materializes? It seems to me that the Greenbook projects that the uptick would be temporary, so we needn’t respond. But the statement in B essentially says, “Look. The run-up in energy prices has had only a modest effect on core inflation.” In effect, it says we continue to think that that will be the way the world transpires, and in the end I think it says that we regard it as an upside risk to our forecast that elevated prices of energy and other commodities have the potential to add to inflation pressure. So if, in point of fact, the Greenbook is right and we start seeing 2.2 for core PCE, what will markets conclude? “Yes, this is what they’re worried about. They’re really worried that an upside risk to their inflation forecast is that inflation is going to come in this high. What are we to conclude other than that this is a negative surprise to the Committee, and therefore they are going to go above 5 percent?” So we have told market participants in line 2, “Don’t be surprised if you see a very strong growth number in Q1. We think that’s temporary. It’s going to abate.” What we haven’t told markets is the comparable thing, namely, that we may well see a boost in core PCE inflation for the next couple of quarters, but we think it is temporary. One thing that we could do would be to change the phrasing and say in line 3 that the elevated prices of energy and other commodities may boost core inflation modestly for a time. That would distinguish this from the case of rising inflation due to resource utilization, which we do see as an upside risk to our forecast. But generally whether or not we make this change, I am concerned that we are going to see more increases priced into fed funds futures, and I would cheerfully endorse the kind of move that has been made in this draft of alternative B, in which the Committee’s forecast for growth has been clearly enunciated. And moving in that direction for our baseline forecast for inflation would be a useful way to go as well. If I could just spend one more second, I would like to propose a bit more wordsmithing in alternative B. A principle, or a practice, that I learned at the Council of Economic Advisers that I think would be a good one for us is that you never make a statement that purports to be a statement of fact unless it can be fact-checked. [Laughter] This process is rigorous there. I would say the first statement in line 3—“as yet the run-up in the prices of energy and other commodities has had only a modest effect on core inflation”—is not fact-checkable. I believe that’s the case. I think most of you believe that’s the case. I wouldn’t want to have to fact-check it. I don’t know how you would do it. I would add something like “has apparently had only a modest effect on core inflation.” The point about the fact that productivity gains have held the growth of unit labor costs in check, I don’t personally mind that at all. I agree with that. I simply think that it is not the only thing—arithmetically modest compensation gains have done the same thing. So I do not mind listing it, but I would say “have helped.”" FOMC20050322meeting--3 1,MR. KOS.,"1 Thank you, Mr. Chairman. At the Committee’s last meeting I characterized markets in the preceding weeks as “more of the same,” inasmuch as trends, such as the gradual rise of short-term interest rates, a flattening yield curve, narrowing credit spreads, and low volatilities, were continuing their well-established patterns. In the past six weeks, some of those trends ceased, though it is too soon to declare that they have gone into reverse. Questions about the pace of tightening and prospects for inflation in the medium term became a more prominent source of concern among investors. The top panel on page 1 of your handout graphs eurodollar deposit contracts maturing in June 2005, December 2005, and June 2006. What had been a steady rise in futures rates accelerated after the Chairman’s semiannual monetary policy testimony, especially for contracts beyond the front month. The spreads between the June ’06 and June ’05 contracts widened to reflect this more aggressive expected path of tightening. And while some traders ran to their dictionaries to look up the meaning of “conundrum,” perhaps the more important event with regard to the testimony was the expectation among many market participants that the Chairman would use the occasion to signal a pause in tightening or to elucidate the factors that could lead to a pause. Receiving no clarification on either point, the market pushed out the length of the tightening cycle and, at times, even the pace—with both anecdotal comments and some fed funds futures reflecting a stronger sense that the Committee might at some point ratchet up the pace of tightening to 50 basis points. Yields moved higher at both the short and long ends of the curve. As shown in the middle left panel, the two-year Treasury yield, which had been treading water earlier in the tightening cycle, increased about 40 basis points—thus widening the spread to the target funds rate. As shown in the middle right panel, 10-year yields rose from roughly 4.10 percent at the time of the February meeting to more than 4½ percent today. Besides revised expectations of policy and increased worries about inflation, there were also periodic bouts of anxiety about foreign central bank actions to diversify away from dollars and/or Treasury securities. The 10-year yield is now back to roughly the level it was last summer when the tightening cycle began. March 22, 2005 4 of 116 Until the last few weeks, the combination of a gentle rise in short-term rates and an immovable 10-year yield had substantially flattened the yield curve. The recent price moves did not reverse that trend but did, as shown in the bottom panel, stabilize the shape of the curve, which stopped flattening at about 80 basis points. The last few weeks also featured an increased preoccupation among traders and investors with the prospects for inflation. Several inflation reports were higher than expected, and commodity prices continued to rise. For example, the top panel of page 2 shows the CRB [Commodity Research Bureau] index since January 2004. Unlike other popular commodity indexes, the CRB does not have a large energy component and was more contained during 2004. The recent breakout had contributions from nearly every segment of the index. Focusing on energy, the middle panel depicts the oil futures curve out to two years for West Texas intermediate [WTI] as of two dates. The green line shows the curve as of October 26, 2004, the day oil prices hit their highs last fall and when the front-month contract topped $55 per barrel. The curve sloped downward by more than $10, and, for contracts at the end of that two-year horizon, oil was trading below $45. The blue line graphs the WTI curve as of this past Friday. The front-month contract was trading at about $57, but the curve has only a small downward slope; and the contract 24 months out is trading near $53, suggesting that market participants do not expect much softening in oil prices. The bottom panel graphs in blue the five-year TIPS [Treasury inflation-protected securities] breakeven inflation rate, which has been rising the past few weeks and is up substantially from a year ago. This rise in the breakeven rate has been contemporaneous with the most recent increase in oil prices. During last fall’s oil price rise, the breakeven was falling. Higher oil prices were seen more as a restraint on activity than as a catalyst for inflation. The situation has now reversed, though there are lots of caveats one needs to consider when interpreting breakeven rates. Other market-based measures of inflationary expectations are tame. For example, the five-year breakeven five years ahead has remained in a narrow range, as shown by the red line, and, in fact, is very little changed from a year ago. One question that has occupied market participants is whether risk is being mispriced. The narrowing of spreads over the past two years and the fall of volatility suggest that investors have been in risk-seeking mode. In the intermeeting period, that trend did not reverse, though it did moderate somewhat. March 22, 2005 5 of 116 specific corporate events. Though sudden, the recent widening was modest compared to other widening episodes during the last two years and relative to the previous narrowing episodes. Of course, the widening did not affect all issuers equally. The bottom left panel graphs the spreads of investment-grade issuers by credit rating. The AA, A, and BBB sectors are all narrower than they were a year ago, but in the past few weeks the BBB sector underperformed, as investors got nervous about the auto sector in general and General Motors in particular after that company reported disappointing earnings. The bottom right panel graphs the auto sector in green and representative 10-year GM and GMAC bond spreads. GM credit default swaps widened as well. The pessimist will take this price action as suggesting that risks are mispriced and that market participants have not been adequately anticipating deteriorating outlooks. The optimist will conclude from the GM news that markets are discriminating among issuers as new information becomes available and are repricing accordingly. Turning to page 4, the top panel depicts the EMBI+ [Emerging Markets Bond Index Plus] spread, which also widened in recent weeks but only to levels observed in January. The conclusion of the Argentine debt package, with its large haircuts, did not appear to have a contagion effect on the spreads of other large issuers. Parts of the outer rim of the risk spectrum did feel a chill, as shown in the middle and bottom panels. The middle panel graphs movements of a select group of emerging-market currencies against the dollar in the period between October and March 7. Several of these currencies had rallied by more than 10 percent. The green bars show the depreciations of the past two weeks. The bottom panel shows the same set of relationships for the broad equity market indexes of the same group of countries. Yes, there has been some unwinding of these positions in both currencies and equities. But, to date, the retracing has been mild and represents only a fraction of the appreciation observed in previous months. In short, if this is the beginning of a more general unwinding, there is far more to go. I should also note that the dollar has been firmer against the euro and other major currencies the past few days, which may suggest a bit of risk aversion, as the possibility of a more aggressive tightening cycle is causing a reassessment among the large contingent of dollar shorts. Mr. Chairman, there were no foreign operations in the intermeeting period. I will need a vote to approve domestic operations. Bob and I will be happy to take any questions about markets or about the memo I circulated last week regarding some changes we are planning to make to the yen reserves portfolio." FinancialCrisisReport--433 The failure of the Bear Stearns hedge funds triggered another decline in the value of subprime mortgage related assets. The ABX Index, which was already falling, began a steep, sharp decline. The collapse had further negative effects when the hedge funds’ massive subprime holdings were suddenly dumped on the market for sale, further depressing prices of subprime RMBS and CDO assets. The creditors of the Bear Stearns hedge funds met with Bear Stearns management in an attempt to organize a “workout” solution to stabilize the funds. 1776 While those efforts were underway, Goldman and Bear Stearns agreed to an unwind in which Goldman bought back $300 million of two AAA CDO tranches of Goldman’s Timberwolf CDO, which the hedge funds had purchased two months earlier in April 2007. Goldman paid Bear Stearns 96 and 90 cents on the dollar, respectively, for the two Timberwolf tranches. 1777 Goldman also bought a few other RMBS and CDO assets, which it immediately sold. 1778 The attempt to organize a workout solution for the funds was ultimately unsuccessful. Large blocks of subprime assets from the Bear Stearns hedge funds’ inventory began flooding the market, further depressing subprime asset values. 1779 Goldman’s Structured Product Group (SPG) took the collapse of the Bear Stearns hedge funds as the signal to begin rebuilding its net short position. As Joshua Birnbaum, the head ABX trader on the SPG Desk, later wrote: “[T]he Bear Stearns Asset Management (BSAM) situation changed everything. I felt that this mark-to-market event for CDO risk would begin a further unraveling in mortgage 1776 1777 6/12/2007 email to Craig Broderick, “BSAM Bullet Points,” GS MBS-E-009967117. See 6/22/2007 emails from David Lehman, “BSAM Repo Summary, ” GS MBS-E-001916435. See also 6/18/2007 email from David Lehman, “Today’s Bear Stearns Prices,” GS MBS-E-001919600; 6/27/2007 email from Daniel Sparks to David Viniar, “CDO^2s, ” GS MBS-E-009747489. The prices Goldman paid to Bear Stearns on the A1B and A1C tranches of Timberwolf were approximately one cent (or 100 basis points) above its own internal marks on the Timberwolf tranches in the week of June 18, which were then at 95 and 89 points, respectively. Id. In May 2007, Goldman had completed a re-evaluation of its CDO assets, which suggested on a preliminary basis that the AAA Timberwolf securities should be marked down dramatically in value. Accordingly, Goldman may have been generous toward Bear Stearns in buying back the Timberwolf positions at 96 and 90. On the other hand, repurchasing the Timberwolf securities near its own low internal marks might have reduced the price Goldman could obtain in reselling the tranches, which it identified in a June 22 sales directive to its sales force and recommended selling at 98.5 and 95, respectively. When asked about the buyback of the Timberwolf tranches, Mr. Viniar told the Subcommittee that Goldman had financed the purchase of both tranches and may have been legally entitled to seize them, but there are circumstances in which Goldman voluntarily settles a dispute on agreed terms, rather than going through the legal process entailed in seizing and selling collateral. Subcommittee interview of David Viniar. (4/13/2010). 1778 6/22/2007 email from Tom Montag to Daniel Sparks, “Few Trade Posts,” GS M BS-E-010849103 (Mr. Montag: “Can I get a complete rundown on everything we bought from BSAM and what ’s left? ” Mr. Sparks: “Yes – main thing left is 300mm timberwolfs Other large positions were tmts - gone, octan - gone, abacus - we will collapse against short There were some small rmbs positions.”). 1779 At the time, a trader from another bank stated in a market update: “[T]he BSAM [Bear Stearns Asset Managment] story will dictate the tone in the market in the short term, as a continued liquidation of their holdings will put further downward price pressure on ... ABX trading.” 6/18/2007 email to Edwin Chin, “ABX Open,” GS MBS-E-021890868. credit. Again, when the prevailing opinion in the department was to remain close to home, I pushed everyone on the [SPG] desk to sell risk aggressively and quickly. We sold billions of index and single name risk.” 1780 fcic_final_report_full--32 Maker told the board that she feared an “enormous economic impact” could re- sult from a confluence of financial events: flat or declining incomes, a housing bub- ble, and fraudulent loans with overstated values.  In an interview with the FCIC, Maker said that Fed officials seemed impervious to what the consumer advocates were saying. The Fed governors politely listened and said little, she recalled. “They had their economic models, and their economic mod- els did not see this coming,” she said. “We kept getting back, ‘This is all anecdotal.’”  Soon nontraditional mortgages were crowding other kinds of products out of the market in many parts of the country. More mortgage borrowers nationwide took out interest-only loans, and the trend was far more pronounced on the West and East Coasts.  Because of their easy credit terms, nontraditional loans enabled borrowers to buy more expensive homes and ratchet up the prices in bidding wars. The loans were also riskier, however, and a pattern of higher foreclosure rates frequently ap- peared soon after. As home prices shot up in much of the country, many observers began to wonder if the country was witnessing a housing bubble. On June , , the Economist magazine’s cover story posited that the day of reckoning was at hand, with the head- line “House Prices: After the Fall.” The illustration depicted a brick plummeting out of the sky. “It is not going to be pretty,” the article declared. “How the current housing boom ends could decide the course of the entire world economy over the next few years.”  That same month, Fed Chairman Greenspan acknowledged the issue, telling the Joint Economic Committee of the U.S. Congress that “the apparent froth in housing markets may have spilled over into the mortgage markets.”  For years, he had warned that Fannie Mae and Freddie Mac, bolstered by investors’ belief that these in- stitutions had the backing of the U.S. government, were growing so large, with so lit- tle oversight, that they were creating systemic risks for the financial system. Still, he reassured legislators that the U.S. economy was on a “reasonably firm footing” and that the financial system would be resilient if the housing market turned sour. “The dramatic increase in the prevalence of interest-only loans, as well as the in- troduction of other relatively exotic forms of adjustable rate mortgages, are develop- ments of particular concern,” he testified in June. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is be- ginning to add to the pressures in the marketplace. . . . Although we certainly cannot rule out home price declines, espe- cially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications. Nationwide banking and widespread securitization of mortgages makes it less likely that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections.  FOMC20051101meeting--86 84,MR. STOCKTON.," A couple of tenths. One of the reasons for raising this issue is that it remains a matter of considerable uncertainty on our part. And I think a good case could be made that we haven’t really seen much sign yet of any underlying inflation being built into the labor cost side especially. That’s still just a part of our forecast. The pickup we’re projecting in compensation costs is, in part, a feed-through of higher headline inflation. It’s also, in part, a feed-through of better productivity finding its way eventually into real wages. But we haven’t really seen it yet. So I think a case could be made that even the small amount that we have built in could be overdoing it. And that’s one of the reasons we wanted an alternative simulation in the Greenbook in which we showed you what would happen if we’re wrong about that. Obviously, on the other side, it’s hard to know whether or not your actions and your statements perhaps have been the key factors keeping overall inflation expectations relatively well contained. Your actions and communications about policy intentions may have, in essence, conditioned both the wage- and price-setting environment in which workers and firms currently find November 1, 2005 22 of 114 On the other side of our forecast, if you were to stop tightening soon and communicate that basically the inflation situation wasn’t a problem, there is some risk that observers would interpret that to mean you would be more likely to acquiesce to higher inflation going forward. And that could feed through to expectations. So we also showed a simulation in which things deteriorate more noticeably on our funds rate assumption than we built into the baseline. As I said, I feel that we’ve balanced the risks. As I looked ahead and asked myself if no change in inflation expectations going forward would be a balanced forecast—meaning, “is it just as likely that they’ll be going down as going up over the next year?”—I didn’t think that scenario, in fact, had balanced risks. So we felt comfortable building in a little more upside on the thought that that would probably better balance the risks given the inflation pressures that are currently confronting firms and workers." FOMC20050202meeting--22 20,MR. WILCOX.,"1 Thank you, Mr. Chairman. We’ll be referring to the package of material entitled “Considerations Pertaining to the Establishment of a Specific, Numerical, Price-Related Objective for Monetary Policy.” As a prelude to your discussion this afternoon, Doug Elmendorf and I will briefly summarize some of the main points made in the R&S [Research and Statistics] staff paper that was distributed to the Committee. Then Vincent will address the issues related to communications and governance that would arise were you to define a numerical objective. As can be seen in the top panel of your first exhibit, inflation as measured by any of the major indexes has been both low and stable by historical standards for the last several years. With the economy now operating in the neighborhood of price stability, some analysts have pressed for more clarity and precision about your ultimate objectives with respect to the price-related piece of your dual mandate. Others, however, have expressed serious reservations about moving away from what they perceive to be a successful status quo. The background paper discusses the major issues the Committee would need to consider in determining whether to adopt a specific, numerical, price-related objective. We view the key characteristics of such an objective, listed in the middle panel, as the following: First, it would be numerical rather than qualitative. Second, February 1-2, 2005 7 of 177 it would be stated in terms of a particular published index. And third, it would involve a commitment to either inflation control or price-level control. To give meaning to such an objective, the Committee would presumably aim to achieve it on average over some extended period of time. As noted in the lower panel, a premise of the paper is that a price objective should be chosen to minimize the costs of deviations from price stability. If you share that premise, then you might conclude, as we did, that the objective should be defined with respect to the price index most closely related to such costs. Such an index need not be the best short-run indicator of underlying price trends. For example, an overall price index might be a better gauge of the costs incurred as a result of deviations from price stability—and therefore a better point of reference for a medium-term price objective—even though a core index might be a better real- time indicator of underlying inflation. One counterargument to this view is that a smoother measure of inflation would breach a band of any given width less frequently and so would present the Committee with fewer communications challenges. This is true enough; we would simply note that the width of any band would be a choice available to the Committee. In the paper, we underscored that we see the question of whether the Committee should adopt a specific, numerical, price-related objective as distinct from the question of whether it should adopt an inflation targeting regime. However, even the more limited step of establishing an explicit price objective presumably would involve important changes in the Federal Reserve’s relationships with the public and the Congress—issues that will be addressed by Vincent in his remarks. Your second exhibit summarizes some of the potential benefits and costs of adopting a specific, numerical price objective. On the benefits side, advocates believe that publicly announcing such an explicit price goal could help preserve the present commitment to price stability by raising an impediment to backsliding on the part of some future FOMC. Second, announcing an explicit price objective could better anchor long-run inflation expectations. In turn, better-anchored expectations about future inflation might reduce the volatility of current inflation through its effect on price-setting and might reduce the volatility of real activity by giving the Federal Reserve greater scope to offset shocks. February 1-2, 2005 8 of 177 All that said, skeptics of a specific, numerical price objective argue that the burden of proof should be on those who would disturb the status quo, and they see several sources of potential harm. For one thing, if the Committee meant to preserve the current balance of emphasis between price stabilization and activity stabilization, then adopting an explicit objective for prices—but not for unemployment or output—might mislead the public into believing that your emphasis had shifted toward the price objective. Second, pursuing such a course could, in fact, cause the Committee inadvertently to place more emphasis on the price objective. A third potential cost could arise if your credibility were seen to be diminished when inflation differed from the stated objective. Finally, a commitment to an explicit price objective could constrain future actions of the FOMC in an unhelpful manner. For example, the Committee might feel inhibited in responding as aggressively as it would like to a financial crisis if inflation were already to the high side of the Committee's objective. Unfortunately, empirical evidence on these potential costs and benefits is quite limited, as summarized in the bottom panel. Little to no evidence exists regarding the likely influence of a specific price objective on FOMC decisionmaking or the quality of communications with the public. Evidence is also limited on whether an explicit price objective would improve macroeconomic performance. As documented in the background paper from the Division of International Finance and noted in the second bullet, there are some hints from the foreign experience that specific price objectives have helped anchor long-term inflation expectations. However, survey-based expectations measures have been quite stable in the United States of late, so expectational gains from adopting a specific price objective are not guaranteed and probably would be modest if they did occur. Moreover, the foreign experience does not speak clearly as to whether better-anchored expectations have yielded better macroeconomic performance. A key question on the empirical front is whether an explicit price objective would change the way that private agents form their expectations. Insight into this question might be gained by investigating whether the profound change in the conduct of monetary policy over time in the United States has induced changes in the formation of inflation expectations. Unfortunately, the evidence on this point is disputed, as noted in the third bullet: Some analysts attribute the reduced volatility of inflation and real output in recent decades to the changes in monetary policy, but other analysts point to different factors. February 1-2, 2005 9 of 177 real output. However, this result is admittedly sensitive to the assumptions underlying the specification of these models. In summary, then, we concur with our colleagues in the International Finance Division in reading the evidence as suggesting that adoption of a numerical price objective probably would not yield either large benefits or large costs, relative to the conduct of monetary policy in recent years. Unfortunately, we also see that evidence as incapable of resolving the question of whether such a step would generate net benefits or costs on a more modest scale. That leaves us believing that the most relevant and important issues for the Committee to discuss may be ones that only you can adequately assess: On the plus side, the extent to which an explicit objective may aid your internal dynamics by ensuring that everyone is pulling toward a common objective and may facilitate your communication with financial markets, and, on the minus side, the extent to which such an objective may skew the priorities you assign to the two legs of your mandate." CHRG-111hhrg52397--181 Mr. Johnson," No, no, they are quite different from each other. I think one thing the market has done though is that the pricing of them is very easy to do in terms of everyone is able to price them and come up based on how LIBOR moves and come up with them. " FOMC20080430meeting--11 9,MR. DUDLEY.," Yes. They are priced every day; and if they are downgraded, there will be an automatic substitution. So you are protected both on price and on the ability to substitute. " FOMC20050630meeting--60 58,MR. GRAMLICH.," So if we see house prices going up, we’re in effect cutting the funds rate while the house prices are going up?" FOMC20080430meeting--93 91,MR. FISHER.," Mr. Chairman, I want to focus my comments today on what I have heard from my CEO contacts. With regard to my District, it continues to do well relative to the rest of the country, but it is not immune to the pathology that is afflicting the overall economy. Although still positive, economic growth and employment creation are slowing, and our manufacturers in the survey we just took are experiencing substantial price pressures. Seventy-one percent of our manufacturers in the survey report higher prices, and 65 percent are expecting input prices to be even higher six months from now. Setting aside the 11th District, I spoke in depth to 31 CEOs nationwide. You have that list, Mr. Chairman, and I would like to speak to what I deduced from triangulating those conversations with what I read in the Bluebook and the Greenbook. Let me note that the focus of my conversations with these CEOs and CFOs was not what they have seen or what they are seeing now but how their behavior is likely to be affected going forward and how they are budgeting going forward. Distilling the inputs to their essence, it's clear that activity is likely to weaken further. Those 21 miles of 89-foot flat cars that haul lumber, Mr. Chairman, are now up to 22.6 miles. Inventories of unsold homes are clearly building, and that is important against the background that March is almost always a good month in the housing or home sales business. The CEO of Centex reports that this is the first down March he has seen, and he has been in the business since 1974. It came down hard--20 percent. Consumer confidence is weak. Job insecurity is spreading. Companies are tightening their head counts. Banks are tightening credit standards, as we have discussed. According to the CEO of MasterCard, year-over-year retail sales to date in April--that is, ex-autos and ex-gas--were 2.2 percent, the lowest he has ever seen. Citibank, Chase, Bank of America, and the other credit card purveyors are experiencing high delinquency rates and a significant slowdown in their revenues from credit cards, and Wal-Mart reports the ""cascading"" use of credit as a form of payment, as their CEO for U.S. operations put it. In short, the consumer-driven corrective credit cycle is prolonging the economic slowdown and vice versa. Consistent with this sustained headwind, we have revised downward the Dallas forecast and continued for longer our projection of economic ""anemia"" (we are not among the four that included the word ""recession"") not only for '08 but also for '09, and we have revised upward, to the upper end, our sense of projected unemployment. Thus, from what I am hearing, from what I am reading, and from what we are getting from our analysis, I acknowledge the thesis of the presence of a negative feedback loop among GDP growth, employment growth, and credit market conditions. I find more worrisome the reports I am receiving on expected price developments and behavior, and I see a feedback loop of another kind at work. Page 30 of the Bluebook notes, as I think President Plosser pointed out and President Evans referred to, that core PCE inflation has averaged more than 2 percent in every year since 2004 and is forecasted, as per David's earlier comments, as doing so again in 2008. What concerns me more is the left-hand panel in chart 1 on page 4 of the Bluebook that indicates that the staff's index of inflation expectations and uncertainty is now at the top of its range over the last decade. This is confirmed by my corporate contacts. Something persistent and pernicious, Mr. Chairman, has been occurring on the inflation front and calling into question the credibility of our continued reliance on core measures. Here is what I am hearing from my corporate contacts. I'm going to just mention a few because it is fairly consistent across the board. From the CEO of the largest retailer in the country, not to be named but located in Arkansas, [laughter] I reported last time that they are budgeting price increases on 10,000 items of a little over 5 percent in 2008. Yet his comment to me was, ""Inflation is our number 1 concern, and it's escalating significantly."" He added, ""All the information we have points to an intermediate- and longer-term supply�demand problem, especially for food and any energy-dependent articles."" By the way, that was verified by the CEO of Frito-Lay, who tells me that they are offsetting their input price escalation of 11 percent in 2008 by raising prices 9 percent effective last Sunday. He added that--and this is interesting in terms of the mindset--""We have to--otherwise we'll disappoint the Street, and in these markets no one can afford at this fragile time to do so."" The price pressures are less for clothing and nonfood items, but they are still there. I would like to use the example of JCPenney. JCPenney sells clothing to one-half of all the families in America, and 60 percent of their sales are apparel. The average price point for an apparel sale at that retailer is $15. The leading source of apparel is China. According to Penney's CEO, increases in China's labor costs, changes in their labor rules, and the cost of fuel and of cotton fibers have led to significantly escalating price pressures. He says that they can eat some of those costs and drive them down through other offsets and tighter controls, but they are planning a 4 percent increase in apparel costs in 2009. Here is his punch line, and it is not funny--this is a first-rate CEO, one of the best in the country: ""We think the customer can take a little more price. After all, what's 40 to 60 cents on $15? It won't even be noticed."" This is the essence of the accommodation of inflationary expectations, and you are beginning to see this mentality set in in several industries. For example, the airlines. We talked about the increase in the price of crude. If you take what is called the crack spread and figure out what has happened in terms of jet fuel, year over year through mid-April jet fuel was up 70 percent. That's an industry average, mitigated somewhat by the hedging of Southwest Airlines, which has been successful. According to the CEO of American Airlines, ""This oil is a tsunami. We will have to get some pricing power, or we'll be left with only one airline, Southwest."" Kimberly-Clark, a paper producer, notices that the weaker dollar and oil are driving realized costs increasingly up from, in their case, $250 million in '07 to an estimated $600 million in '08. They have raised prices, as I have previously mentioned, but the CEO feels that--and this is a winner--""We are having to learn how to run a business in an inflationary environment. We got used to productivity as the driver, but we can't drive productivity any harder than we can. We will need more pricing."" It even affects semiconductor producers. Texas Instruments reports that the weakness of the dollar and the prices of energy, gold, and copper offset by their hedges added 2� percent nonannualized to their costs in the first quarter. Asked what he envisions going forward, the CFO said, ""Well, that just means we can't spend it elsewhere. We have to take it out of our employees' backs or out of cap-ex."" One CEO of a company that is expecting soon to lay off between 12,000 and 15,000 people and is, therefore, carefully surveying the attitudes of their employees because they have a morale problem, is finding out that employees are tapping into their 401(k) plans or not funding them. In their surveys they find the leading complaint is that ""the price of gasoline and food is eating into my living standards. I can't afford them."" Last but not least, just to bring this home, the Eagle Scout who mows my lawn in Dallas sent me a very nice, beautiful letter. It is clear that he and his mother had prepared it on a printer and put a fancy title on it, but the rest of the letter was, ""Dear Mr. Fisher, I have to levy a 7 percent fuel surcharge."" [Laughter] We gave into it--he is a nice boy. In summary, Mr. Chairman, while there are many who have voiced concern with the adverse feedback loop that runs from the economy to tighter credit conditions and back to the economy, I am very troubled by a different adverse feedback loop--namely, the inflation dynamic whereby reductions in fed funds rates lead to a weaker dollar and upward pressures on global commodity prices, which feed through to higher U.S. inflation. That higher U.S. inflation not only has a price impact but also leads to cutbacks by consumers and by employers so as to offset the effects of inflation. I am worried that, if we do not respond to higher inflation, the whole cycle will intensify. When economic growth and activity return to normal, inflation is likely to have notched up considerably, according to our sense. I know my respected colleagues say that we are willing to be equally aggressive in raising rates once the outlook for real activity improves, but the practicability of that notion I find in talking to my interlocutors is met with some skepticism and doubt. With that, Mr. Chairman, I see a tail risk on the downside of growth. I acknowledge the argument of President Yellen and others. I think I'm sympathetic, but I see a fatter tail, perhaps an otter's tail, on inflation. I am hearing this loud and clear from my corporate contacts. I believe that the risk posed by inflation is more significant than the extension of further anemia in the economy, especially now that we have put in place innovative liquidity bridging mechanisms, which we are amplifying upon today. Mr. Chairman, the other day Governor Kohn reminded me that reasonable people can disagree, and he quipped that he hoped that we could agree on the following--that we are at least reasonable people. [Laughter] I'm doing my very best, I hope, to provide reasonable alternative perspectives, and I hope you will judge me on that basis. Thank you, Mr. Chairman. " fcic_final_report_full--228 With over  metro areas representing nearly one-half of the na- tion’s housing stock experiencing or about to experience price declines, national house prices are also set to decline. Indeed, odds are high that national house prices will decline in .  For , the National Association of Realtors announced that the number of sales of existing homes had experienced the sharpest fall in  years. That year, home prices declined . In , they would drop a stunning . Overall, by the end of , prices would drop  from their peak in .  Some cities saw a particularly large drop: in Las Vegas, as of August , home prices were down  from their peak. And areas that never saw huge price gains have experienced losses as well: home prices in Denver have fallen  since their peak. In some areas, home prices started to fall as early as late . For example, in Ocean City, New Jersey, where many properties are vacation homes, home prices had risen  since ; they topped out in December  and fell  in the first half of . By mid-, they would be  below their peak. Prices topped out in Sacramento in October  and are today down nearly . In most places, prices rose for a bit longer. For instance, in Tucson, Arizona, prices kept increasing for much of , climbing  from  to their high point in August , and then fell only  by the end of the year.  One of the first signs of the housing crash was an upswing in early payment de- faults—usually defined as borrowers’ being  or more days delinquent within the first year. Figures provided to the FCIC show that by the summer of , . of loans less than a year old were in default. The figure would peak in late  at ., well above the . peak in the  recession. Even more stunning, first payment de- faults—that is, mortgages taken out by borrowers who never made a single payment— went above . of loans in early .  Responding to questions about that data, CoreLogic Chief Economist Mark Fleming told the FCIC that the early payment de- fault rate “certainly correlates with the increase in the Alt-A and subprime shares and the turn of the housing market and the sensitivity of those loan products.”  Mortgages in serious delinquency, defined as those  or more days past due or in foreclosure, had hovered around  during the early part of the decade, jumped in , and kept climbing. By the end of , . of mortgage loans were seriously delinquent. By comparison, serious delinquencies peaked at . in  following the previous recession.  Serious delinquency was highest in areas of the country that had experienced the biggest housing booms. In the “sand states”—California, Arizona, Nevada, and Florida—serious delinquency rose to  in mid- and  by late , double the rate in other areas of the country (see figure .).  CHRG-110shrg38109--34 Chairman Bernanke," Thank you. Chairman Dodd, Senator Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. Real activity in the United States expanded at a solid pace in 2006, although the pattern of growth was uneven. After a first-quarter rebound from weakness associated with the effects of the hurricanes that ravaged the Gulf Coast the previous summer, output growth moderated somewhat on average over the remainder of 2006. Real gross domestic product is currently estimated to have increased at an annual rate of about 2.75 percent in the second half of the year. As we anticipated in our July report, the U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable average pace of growth. The principal source of the ongoing moderation has been a substantial cooling of the housing market, which has led to a marked slowdown in the pace of residential construction. However, the weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy. Consumer spending has continued to expand at a solid rate, and the demand for labor has remained strong. On average, about 165,000 jobs per month have been added to nonfarm payrolls over the past 6 months, and the unemployment rate, at 4.6 percent in January, remains low. Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen in large part as a result of declines in the price of crude oil. Readings on core inflation--that is, inflation excluding the prices of food and energy--have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated. In the five policy meetings since the July report, the Federal Open Market Committee, or FOMC, has maintained the Federal funds rate at 5.25 percent. So far the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and the gradual ebbing of core inflation. However, in the statement accompanying last month's policy decision, the FOMC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected and that it is prepared to take action to address inflation risks if developments warrant. Let me now discuss the economic outlook in a little more detail, beginning with developments in the real economy and then turning to inflation. I will conclude with some brief comments on monetary policy. Consumer spending continues to be the mainstay of the current economic expansion. Personal consumption expenditures, which account of more than two-thirds of aggregate demand, increased at an annual rate of about 3.5 percent in real terms during the second half of last year, broadly matching the brisk pace of the previous 3 years. Consumer outlays were supported by strong gains in personal income, reflecting both the ongoing increases in payrolled employment and a pick-up in the growth of real wages. Real hourly compensation, as measured by compensation per hour in the nonfarm business sector deflated by the personal consumption expenditures price index, rose at an annual rate of around 3 percent in the latter half of 2006. The resilience of consumer spending is all the more striking given the backdrop of the substantial correction in the housing market that became increasingly evident during the spring and summer of last year. By the middle of 2006, monthly sales of new and existing homes were about 15 percent lower than a year earlier, and the previously rapid rate of house price appreciation had slowed markedly. The fall in housing demand in turn prompted a sharp slowing in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about 4\1/2\ months' supply in 2005 to nearly 7 months' supply by the third quarter of last year. Single-family housing starts have dropped more than 30 percent since the beginning of last year, and employment growth in the construction sector has slowed substantially. Some tentative signs of stabilization have recently appeared in the housing market. New and existing home sales have flattened out in recent months. Mortgage applications have picked up, and some surveys find that homebuyers' sentiment has improved. However, even if housing demand falls no further, weakness in residential investment is likely to continue to weigh on economic growth over the next few quarters as homebuilders seek to reduce their inventories of unsold homes to more comfortable levels. Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid, and delinquency rates on most types of consumer loans and residential mortgages remain low. The exception is subprime mortgages with variable interest rates, for which delinquency rates have increased appreciably. The labor market is expected to stay healthy, and real incomes should continue to rise, although the pace of employment gains may be slower than that to which we have become accustomed in recent years. In part, slower average job growth may simply reflect the moderation of economic activity. Also, the impending retirement of the leading edge of the baby-boom generation and an apparent leveling out from women's participation in the workforce, which had risen for several decades, will likely restrain the growth of the labor force in coming years. With fewer job seekers entering the labor force, the rate of job creation associated with the maintenance of stable conditions in the labor market will decline. All told, consumer expenditures appear likely to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal incomes, if, as we expect, households respond to the slow pace of home equity appreciation by saving more out of current income. The business sector remains in excellent financial condition with strong growth and profits, liquid balance sheets, and corporate leverage near historical lows. Last year, those factors helped to support continued advances in business capital expenditures. Notably, investment in high-tech equipment rose 9 percent in 2006, and spending on nonresidential structures, such as office buildings, factories, and retail space, increased rapidly through much of the year, after several years of weakness. Growth in business spending slowed toward the end of last year, reflecting mainly a deceleration of spending on business structures, a drop in outlays in the transportation sector where spending is notably volatile, and some weakness in purchases of equipment related to construction and motor vehicle manufacturing. Over the coming year, capital spending is poised to expand at a moderate pace, supported by steady gains in business output and favorable financial conditions. Inventory levels in some sectors, most notably at motor vehicle dealers and in some construction-related manufacturing industries, rose over the course of last year, leaving some firms to cut production to better align inventories with sales. Remaining imbalances may continue to impose modest restraint on industrial production during the early part of this year. Outside the United States, economic activity in our major trading partners has continued to grow briskly. The strength of demand abroad helped stir a robust expansion in U.S. real exports, which grew about 9 percent last year. The pattern of real U.S. imports was somewhat uneven, partly because of fluctuations in oil imports over the course of the year. On balance, import growth slowed in 2006 to 3 percent. Economic growth abroad should further support steady growth in U.S. exports this year. Despite the improvements in trade performance, the U.S. current account deficit remains large, averaging about 6.5 percent of nominal GDP during the first three quarters of 2006. Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the members of the Board of Governors and presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts, which are based on the information available at that time and on the assumption of appropriate monetary policy, is for real GDP to increase about 2.5 to 3 percent in 2007 and about 2.75 to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. The difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4.5 to 4.75 percent. The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006. I turn now to the inflation situation. As I noted earlier, there are some indications that inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated. Recent declines in overall inflation have primarily reflected lower prices for crude oil, which have fed through to the prices of gasoline, heating oil, and other energy products used by consumers. After moving higher in the first half of 2006, core consumer price inflation has also edged lower recently, reflecting a relatively broad-based deceleration in the prices of core goods. That deceleration is probably also due to some extent to lower energy prices, which have reduced costs of production and thereby lessened one source of pressure on the prices of final goods and services. The ebbing of core inflation has likely been promoted as well by the stability of inflation expectations. A waning of the temporary factors that boosted inflation in recent years will probably help to foster a continued edging down of core inflation. In particular, futures quotes imply that oil prices are expected to remain well below last year's peak. If actual prices follow the path currently indicated by futures prices, inflation pressures would be reduced further as the benefits of the decline in oil prices from last year's high levels are passed through to a broader range of core goods and services. Non-fuel import prices may also put less pressure on core inflation, particularly if price increases for some other commodities, such as metals, slow from last year's rapid rates. But as we have been reminded only too well in recent years, the prices of oil and other commodities are notoriously difficult to predict, and they remain a key source of uncertainty to the inflation outlook. The contribution from rents and shelter costs should also fall back following a step-up last year. The faster pace of rent increases last year may have been attributable in part to reduced affordability of owner-occupied housing, which led to a greater demand for rental housing. Rents should rise somewhat less quickly this year and next, reflecting recovering demand for owner-occupied housing as well as increases in the supply of rental units, but the extent and pace of that adjustment are not yet clear. Upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period. The rate of resource utilization is high, as can be seen in rates of capacity utilization above their long-term average, and most evidently in the tightness of the labor market. Indeed, anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in certain occupations. Measures of labor compensation, though still growing at a moderate pace, have shown some signs of acceleration over the past year, likely in part the result of tight labor market conditions. The implications for inflation of faster growth in nominal labor compensation depend on several factors. Increases in compensation might be offset by higher labor productivity or absorbed by a narrowing of firms' profit margins rather than passed on to consumers in the form of higher prices. In these circumstances, gains in nominal compensation would translate into gains in real compensation as well. Underlying productivity trends appear favorable, and the mark-up of prices over unit labor cost is high by historical standards, so such an outcome is certainly possible. Moreover, as activity expands over the next year or so at the moderate pace anticipated by the FOMC, pressures in both labor and product markets should ease modestly. That said, the possibility remains that tightness in product markets could allow firms to pass higher labor costs through their prices, adding to inflation and effectively nullifying the purchasing power of at least some portion of the increase in labor compensation. Thus, the high level of resource utilization remains an important upside risk to continued progress on inflation. Another significant factor influencing medium-term trends in inflation is the public's expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as those created by changes in energy costs, become embedded in wage and price decisions and so leave a lasting imprint on the rate of inflation. It is encouraging that inflation expectations appear to have remain contained. The projections of the members of the Board of Governors and the presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next. In particular, the central tendency of those forecasts is for core inflation, as measured by the price index for personal consumption expenditures, excluding food and energy, to be 2 to 2.25 percent this year and to edge lower to 1.75 to 2 percent next year. But as I noted earlier, the FOMC has continued to view the risk that inflation will not moderate as expected as the predominant policy concern. Monetary policy affects spending and inflation with long and variable lags. Consequently, policy decisions must be based on an assessment of medium-term economic prospects. At the same time, because economic forecasting is an uncertain enterprise, policymakers must be prepared to respond flexibly to developments in the economy when those developments lead to a reassessment of the outlook. The dependence of monetary policy actions on a broad range of incoming information complicates the public's attempts to understand and anticipate policy decisions. Clear communication by the central bank about the economic outlook, the risks to that outlook, and its monetary policy strategy can help the public to understand the rationale that is behind policy decisions and to anticipate better the central bank's reaction to new information. This understanding should in turn enhance the effectiveness of policy and lead to improved economic outcomes. By reducing uncertainty, central bank transparency may also help anchor the public's longer-term expectations of inflation. Much experience has shown that while anchored inflation expectations tend to help stabilize inflation and promote maximum sustainable economic growth, good communication by the central bank is also vital for ensuring appropriate accountability for its policy actions, the full effects of which can be observed only after a lengthy period. A transparent policy process improves accountability by clarifying how a central bank expects to attain its policy objectives and by ensuring that policy is conducted in a manner that can be seen to be consistent with achieving those objectives. Over the past decade or so, the Federal Reserve has significantly improved its methods of communication, but further progress is possible. As you know, the FOMC last year, established a subcommittee to help the full committee evaluate the next steps in this continuing process. Our discussions are directed at examining all aspects of our communications and have been deliberate and thorough. These discussions are continuing, and no decisions have been reached. My colleagues and I remain firmly committed to an open and transparent monetary policy process that enhances our ability to achieve our dual objectives of stable prices and maximum sustainable employment. I will keep Committee Members apprised of the developments as our deliberations move forward. I look forward to continuing to work closely with the Members of the Committee and your colleagues in the Senate and the House on the important issues pertaining to monetary policy and the other responsibilities with which the Congress has charged the Federal Reserve. Thank you. I would be happy to take questions. " CHRG-111hhrg56776--59 Mr. Bernanke," It is a difficult--central banking is an art and we need to balance our dual mandate. Our dual mandate is to maximize employment and price stability. We need to try to find an appropriate policy that gets us as close as we can to both sides of that mandate. Dr. Paul. The free market people say the dependency on regulation is just imaginary because the fault is all these mistakes being made because they have false information. Price fixing, nobody is advocating wage and price controls because of all the false information. You cannot run the economy with price fixing. That is why socialism fails. If you fix the price with interest rates, it is one-half of the economy because you are messing around with the monetary system, and then all of a sudden instead of dealing with that, we say we just need more and smarter regulations and we are going to solve all these problems. That does not concern you at all? " FOMC20080121confcall--53 51,MS. DANKER.," I will read the directive and then the statement and call the roll. ""The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee, in the immediate future, seeks conditions in reserve markets consistent with reducing the federal funds rate to an average of around 3� percent."" The statement goes, ""The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3� percent. The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets. The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully. Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks."" Chairman Bernanke Vice Chairman Geithner President Evans President Hoenig Governor Kohn Governor Kroszner President Poole Yes Yes Yes Yes Yes Yes No " FOMC20080130meeting--338 336,MR. GIBSON.," As noted in the top left panel of exhibit 5, we would like to stress two key points on the rating agency and investor issues. First, credit rating agencies are one of the weak links that helped a relatively small shock in the subprime mortgage market spread so widely, though certainly not the only one. This is not just our staff working group's view--most market participants have also expressed the opinion that rating agencies deserve some of the blame. Second, the way that some investors use ratings for their own risk management has not kept up with financial innovations, such as the growth of structured finance. These financial innovations have made a credit rating less reliable as a sufficient statistic for risk. The top right panel provides a roadmap to our presentation. To start, I'll expand on some of the points that Pat made on the role of rating agencies in the financial crisis. My aim is to show why credit rating agencies were a weak link, which will lead naturally to our recommendations on rating agency practices. As we go, I'll point out several places where the rating agency issues link up with the investor practices issues that you'll hear about next from Bev. We feel strongly that the ratings and investor issues are really just two angles on the same underlying issue. The crisis began in the subprime market, the subject of the next panel. The subprime mess happened--and keeps getting worse--in part because of the issues associated with rating agencies (though as I said earlier, there is plenty of blame to go around). Our staff working group was asked whether the rating agencies got it wrong when they rated subprime RMBS. The answer is ""yes""--they got it wrong. Rating agencies badly underestimated the risk of subprime RMBS. Last year, Moody's downgraded 35 percent of the first-lien subprime RMBS issued in 2006. The average size of these subprime RMBS downgrades was two broad rating categories--for example, a downgrade from A to BB--compared with the historical average downgrade of 1 broad rating categories. As indicated in the exhibit, the rating methodologies for subprime were flawed because the rating agencies relied too much on historical data at several points in their analysis. First, the rating agencies underestimated how severe a housing downturn could become. Second, rating agencies underestimated how poorly subprime loans would perform when house prices fell because they relied on historical data that did not contain any periods of falling house prices. Third, the subprime market had changed over time, making the originator matter more for the performance of subprime loans, but rating agencies did not factor the identity of the originator into their ratings. Fourth, the rating agencies did not consider the risk that refinancing opportunities would probably dry up in whatever stress event seriously threatened the subprime market. Of course, the rating agencies were not alone in this. Many others misjudged these risks as well. Some have suggested that conflicts of interest were a factor in the poor performance of rating agencies. While conflicts of interest at rating agencies certainly do exist, because the rating is paid for by the issuer, we didn't see evidence that conflicts affected ratings. That said, we also cannot say that conflicts were not a factor. The SEC currently has examinations under way at the rating agencies to gather the detailed information that is needed to check whether conflicts had a significant effect. In the next panel, I turn to the ABS CDOs that had invested heavily in subprime. Rating agencies got it wrong for ABS CDOs. The downgrade rate of ABS CDOs in 2007 was worse than the previous historical worst case, just as it was for subprime. AAA tranches of ABS CDOs turned out to be remarkably vulnerable: Last year, twenty-seven AAA tranches were downgraded all the way from AAA to below investment grade. As indicated in the exhibit, the main reason that rating agencies got it wrong for ABS CDOs was that their rating models were very crude. Rating agencies used corporate CDO models to rate ABS CDOs. They had no data to estimate the correlation of defaults across asset-backed securities. Despite the many flaws of credit ratings as a sufficient statistic for credit risk, the rating agencies used ratings as the main measure of the quality of the subprime RMBS that the ABS CDOs invested in. And the rating agencies did only limited, ad hoc analysis of how the timing of cash flows affects the risk of ABS CDO tranches. As a result, the ratings of ABS CDOs should have been viewed as highly uncertain. As one risk manager put it, ABS CDOs were ""model risk squared."" A final point on ABS CDOs is that the market's reaction to the poor performance of ABS CDOs makes it clear that some investors did not understand the differences between corporate and structured-finance ratings. Because structured-finance securities are built on diversified portfolios, they have more systematic risk and less idiosyncratic risk than corporate securities. They will naturally be more sensitive to macroeconomic risk factors like house prices, and by design, downgrades of structured-finance securities will be more correlated and larger than downgrades of corporate bonds. Turning to the bottom panel, as Pat noted, in August of last year the subprime shock hit the ABCP markets, especially markets for ABCP issued by SIVs. Rating agencies also got it wrong for the SIVs. More than two-thirds of the SIVs' commercial paper has been downgraded or has defaulted. The problem with the ratings was that the rating agencies' models for SIVs relied on a rapid liquidation of the SIVs' assets to shield the SIVs' senior debt from losses. While this might have worked if a single SIV got into trouble, the market would not have been able to absorb a rapid liquidation by all SIVs at the same time. Once investors began to understand the rating model for SIVs, even SIVs with no subprime exposure could not roll over their commercial paper. Investors who thought they were taking on credit risk became uncomfortable with the market risk and liquidity risk that are inherent in a SIV's business model. The next exhibit presents the staff subgroup's recommendations for addressing the weaknesses in credit ratings for structured-credit products. A common theme of our recommendations is drawing sharper distinctions between corporate ratings and structured-finance ratings. First, we recommend that rating agencies should differentiate structured-finance ratings from corporate ratings by providing additional measures of the risk or leverage of structured-finance securities to the market along with the rating. We don't make a specific recommendation on exactly what measures of risk or leverage because we believe rating agencies and investors should work out the details together (on this and the recommendations to follow). Second, rating agencies should convey a rating's uncertainty in an understandable way. The ratings of ABS CDOs were highly uncertain because the models were so crude. This is what I call the Barry Bonds solution--put an asterisk on the rating if you have doubts about the quality. [Laughter] Third, we recommend more transparency from rating agencies for structured-finance ratings. What we need is not just a tweak to the existing transparency, but a whole new paradigm that actually helps investors get the information they want and need. For example, why can't the rating agency pass on to investors, along with its rating, all the information it got from the issuer that it used to assign the rating? Fourth, we recommend that rating agencies be conservative when they rate new or evolving asset classes. Fifth, the rating agencies should enhance their rating frameworks for structured products. For example, when they rate RMBS, they should consider the originator as well as the servicer as an important risk factor. Our last recommendation is addressed to regulators, including the Federal Reserve. When we reference a rating, we should differentiate better between corporate and structured-finance ratings. Sometimes we do that already, but we could provide some leadership to the market by doing more. Now Bev will discuss the work on investor practices. " FOMC20050630meeting--29 27,CHAIRMAN GREENSPAN.," So you actually have data on each individual farm. You have a database from which one could actually construct the price changes over time to at least learn what is happening as the urban fringe moves out. So you have at least one dimension, which is this issue that you raise with respect to new homes and existing homes. Has anybody tried to look at that? I ask because they are the only data that I’m aware of which actually show a level of land prices over a significant period of time. And no one uses them on the grounds that agricultural land prices have nothing to do with residential land prices. But that can’t be true." FOMC20060510meeting--89 87,MR. LACKER.," Yes, we do on the manufacturing side: We have prices paid and prices received. In the service sector, we don’t distinguish; we just ask. And we have separate retail and nonretail service sectors. On the manufacturing side, they are always pessimistic, so prices received never seem as though they’re going up as fast as prices paid, especially in the last couple of years. But over time, if you look at their movements from month to month, you can get a distinct sense. They really moved up markedly in the fall, tapered off a little and softened in the winter, and now have moved up markedly again and are at or above where they were before." FOMC20050630meeting--153 151,MR. STOCKTON.," Let me make one other point on the reasons why there may have been an increase in the equilibrium price-rent ratio, because I certainly agree with you and President Yellen that there are some good reasons. Those reasons could well include financial innovation, changes in capital gains taxation, and supply constraints. However, lots of asset price misalignments start out with situations where there are good reasons why those prices are rising rapidly. Productivity innovation and changes in business models, and so forth, were I think probably valid explanations for the increase in stock market prices, but that doesn’t mean—" CHRG-110hhrg41184--43 Mr. Bernanke," Well, the oil prices rose in 2007 by almost two-thirds. It was an enormous increase and put a lot of pressure, obviously, directly on energy products and is also feeding through into air fares and other energy intensive goods and services. Oil prices are very volatile. They've moved around a lot in the last month or so, but the end-of-year futures markets have oil prices about $95. Oil prices don't have to come down to reduce inflation pressure; they just have to flatten out. Mr. Miller of California. But if they don't flatten out? " CHRG-111shrg54589--126 PREPARED STATEMENT OF PATRICIA WHITE Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System June 22, 2009 Chairman Reed, Ranking Member Bunning, and other Members of the Subcommittee, I appreciate this opportunity to provide the Federal Reserve Board's views on the development of a new regulatory structure for the over-the-counter (OTC) derivatives market. The Board brings to this policy debate both its interest in ensuring financial stability and its role as a supervisor of banking institutions. Today, I will describe the broad objectives that the Board believes should guide policy makers as they devise the new structure and identify key elements that will support those objectives. Supervision of derivative dealers is a fundamental element of the oversight of OTC derivative markets, and I also will discuss the steps necessary to ensure these firms employ adequate risk management.Policy ObjectivesMitigation of Systemic Risk The events of the last 2 years have demonstrated the potential for difficulties in one part of the financial system to create problems in other sectors and in the macroeconomy more broadly. OTC derivatives appear to have amplified or transmitted shocks. An important objective of regulatory initiatives related to OTC derivatives is to ensure that improvements to the infrastructure supporting these products reduce the likelihood of such transmissions and make the financial system as a whole more resilient to future shocks. Centralized clearing of standardized OTC products is a key component of efforts to mitigate such systemic risk. One method of achieving centralized clearing is to establish central counterparties, or CCPs, for OTC products. Market participants have already established several CCPs to provide clearing services for some OTC interest rate, energy, and credit derivative contracts. Regulators both in the United States and abroad are seeking to speed the development of new CCPs and to broaden the product line of existing CCPs. The Board believes that moving toward centralized clearing for most or all standardized OTC products would have significant benefits. If properly designed, managed, and overseen, CCPs offer an important tool for managing counterparty credit risk, and thus they can reduce risk to market participants and to the financial system. The benefits from centralized clearing will be greatest if CCPs are structured so as to allow participation by end users within a framework that ensures protection of their positions and collateral. Infrastructure changes in OTC markets will be required to move most standardized OTC contracts into centralized clearing systems in a way that ensures the risk-reducing benefits of clearing are realized. Such changes include agreement on the key terms that constitute ``standardization'' and the development of electronic systems for feeding trade data to CCPs--in other words, building better pipes to the CCPs. For their part, CCPs must have in place systems to manage the risk from this new business. Of particular importance are procedures to handle defaults in OTC products that are cleared, because these products are likely to be less liquid than the exchange-traded products that CCPs most commonly handle. Although implementation challenges no doubt lie ahead, the Board will work to ensure that these challenges are addressed quickly and constructively. Major dealers have committed to making improvements in back-office processes such as increased electronic processing of trades and speedier confirmation of trades for equity, interest rate, commodity, foreign exchange, and credit products. These back-office improvements are important prerequisites for centralized clearing, and efforts by supervisors to require dealers to improve these practices have helped lay the groundwork for developing clearing more quickly. Dealers also have committed to clearing standardized OTC products, and they will be expected to demonstrate progress on this commitment even as the broader regulatory reform debate evolves. Clearly there is much to be done, and we are committed to ensuring that the industry moves promptly. An important role of policy makers may be establishing priorities so that efforts are directed first at the areas that offer the greatest risk-reduction potential. Some market observers feel strongly that all OTC derivative contracts--not just the standardized contracts--should be cleared. Requiring CCPs to clear nonstandard instruments that pose valuation and risk-management challenges may not reduce risk for the system as a whole. If, for example, the CCPs have difficulty designing margin and default procedures for such products, they will not be able to effectively manage their own counterparty credit risk to clearing members. In addition, there are legitimate economic reasons why standardized contracts may not meet the risk-management needs of some users of these instruments. A flexible approach that addresses systemic risk with respect to standardized and nonstandardized OTC derivatives, albeit in different ways, is most likely to preserve the benefits of these products for businesses and investors. That said, however, it is particularly important that the counterparties to nonstandardized contracts have robust risk-management procedures for this activity. Nonstandard products pose significant risk-management challenges because they can be complex, opaque, illiquid, and difficult to value. Supervisors must ensure that their own policies with respect to risk management and capital for firms active in nonstandardized products fully reflect the risks such products create. If supervisors are not comfortable with their ability to set and enforce appropriate standards, then the activity should be discouraged. I will return to a broader discussion of supervision and risk management later.Improving the Transparency and Preventing the Manipulation of Markets Throughout the debates about reform of the OTC derivatives market, a persistent theme has been concern that the market is opaque. Discussions of market transparency generally recognize the multiple audiences that seek information about a market--market participants, the public, and authorities--and the multiple dimensions of transparency itself--prices, volumes, and positions. Participants, the public, and authorities seek different information for different purposes. Transparency is a tool for addressing their needs and, in the process, fostering multiple policy objectives. Transparency to market participants supports investor protection as well as the exercise of market discipline, which has sometimes clearly been lacking. Transparency to the public helps to demystify these markets and to build support for sound public policies. Transparency to authorities supports efforts to pursue market manipulation, to address systemic risk through ongoing monitoring, and, when necessary, to manage crises. Substantial progress in improving the transparency of volumes and positions in the credit default swap (CDS) market occurred with the creation of the Depository Trust Clearing Corporation's Trade Information Warehouse, a contract repository that contains an electronic record of a large and growing share of CDS trades. Participation in that repository is voluntary, however, and its present coverage is limited to credit products. Nevertheless, major dealers, who are counterparties to the vast majority of CDS trades, have recently committed to supervisors that they will record all their CDS trades in the warehouse by mid-July. The Board supports creating contract repositories for all asset classes and requiring a record of all OTC derivative contracts that are not centrally cleared to be stored in these repositories. The Trade Information Warehouse currently makes aggregate data on CDS contracts public. Aggregate data on volumes and open interest should be made public by other repositories that are created, and more detailed data should be made available to authorities to support policy objectives related to the prevention of manipulation and systemic risk. Enhancing price transparency to the broader public through post-trade reporting of transaction details is also an important goal. Even where contracts are not traded on exchanges or on regulated electronic trading systems, the prompt dissemination of information can provide significant benefits to market participants on a range of valuation and risk-management issues. The Board believes that policy makers should pursue the goal of prompt dissemination of prices and other trade information for standardized contracts, regardless of the trading venue.Supervision and Risk Management Although the creation of CCPs will provide an important new tool for managing counterparty credit risk, enhancements to the risk-management policies and procedures for individual market participants will continue to be a high priority for supervisors. If the reforms outlined here are implemented, the firms currently most active in bilateral OTC markets will become the firms most active as clearing members of CCPs. As such, the quality of their internal risk management is important to the CCP because sound risk management by all clearing members is critical if centralized clearing is to deliver risk-reducing benefits. Supervisors have recognized that financial institutions must make changes in their risk-management practices for OTC derivatives by improving internal processes and controls and by ensuring that traditional credit risk-management disciplines are in place for complex products, regardless of the form they take. Efforts already under way include improving collateralization practices to limit counterparty credit risk exposures and examining whether the current capital regime can be improved to increase incentives for sound risk management. An important parallel process involves ensuring that firms that are large and complex enough to pose risks to the broader system are subject to appropriate oversight and resolution authority, even if they operate outside the traditional regulated banking system. The Board believes that all systemically critical firms should have a consolidated supervisor, as well as be subject to the oversight of any systemic regulator that might be created. The scope of a firm's activities in the OTC derivatives market will likely be an important factor in making that assessment.Conclusion Policy issues associated with OTC derivatives are not limited to the United States. The markets are global. Past work to strengthen OTC derivatives markets has often involved a large measure of international coordination, and the current policy issues are unlikely to be fully and effectively addressed without broad-based input. Despite the problems that have been associated with OTC derivatives during the financial crisis, these instruments remain integral to the smooth functioning of today's financial markets. Much work must be done to strengthen the market further. But with effective oversight by supervisors, prudent risk management by end users and dealers, and appropriate changes in the regulatory structure, the systemic risks stemming from OTC derivatives can be reduced, and derivatives can continue to provide significant benefits to the businesses and investors who use them to manage financial market risks. ______ FOMC20051101meeting--135 133,MR. POOLE.," Another example that I thought was quite interesting was that UPS is actually shifting its over-the-road shipments away from the piggyback rail system to long-distance trucks in order to gain shorter transit time. My contact said that the railroads are simply unwilling to put the investment into their track and equipment and operating systems to match the delivery times. Obviously, it’s much less fuel-efficient to ship by truck, but the pressure on delivery times was leading UPS to switch its operations in that direction. On the price front, my Wal-Mart contact said that general merchandise prices are still falling a little bit. Food prices have been up about 1½ percent over the last year. However, Wal-Mart noted that its suppliers—I think this would be primarily domestic suppliers—have indicated that they expect to take some price increases after January 1, although not enough to completely cover their cost increases. Wal-Mart is not seeing price increases on goods that are sourced abroad, particularly from China of course. Wal-Mart has continued to absorb increases in transportation costs and utility costs. That’s the story for retailers generally. It’s obvious that they’re not going to absorb those costs forever, but they have been doing so temporarily. My Wal-Mart contact also noted that their construction costs for new stores and other facilities are rising in a range of 10 to 15 percent. And in a recent luncheon in St. Louis with local real estate people, house builders, and others in the business, many said that they also see substantial upward pressure on construction costs. It’s not just the cost of land—or ground, as the homebuilders put it—but materials and labor costs are under substantial upward pressure. One other thing that I thought was interesting came from my contact at UPS, where they’ve just completed—I think the negotiations are completed—negotiations with their pilots. Apparently November 1, 2005 61 of 114 lump sum. And I suspect that these lump sum payments will escape inclusion in the ECI measurement, given the way the ECI is put together. I see Dave Stockton shaking his head. The other thing that was really quite surprising is that they are paying signing bonuses for new airplane captains of $45,000 to $60,000. You would think, with all the pilots being released from the passenger airlines, that they wouldn’t have any trouble hiring pilots. But apparently the strength of the union is such that it has been able to work that deal as part of the settlement. UPS is anticipating that their pilots, now making $190 per hour, will be up to $223 per hour in 2006. They will be the highest paid pilots in the industry. The one other thing I would say is that I share the Greenbook forecast, but I do believe that the inflation risks are asymmetric. It’s much easier for me to imagine a ½ point forecast error with inflation coming in on the high side, rather than the low side, of the point forecast. I think that’s where I’ll stop now. Thank you." FOMC20080130meeting--404 402,MR. GREENLEE.," Thank you. To support the Financial Stability Forum's Working Group on Market and Institutional Resilience, as noted in the top panel of exhibit 8, supervisors from France, Germany, Switzerland, the United Kingdom, and the United States formed the ""senior supervisors group"" in late October. Participating U.S. supervisors included the OCC and SEC as well as the Federal Reserve. The group's goal was to develop a common understanding, through a series of interviews with selected firms, of how the risk-management systems of core financial institutions performed during the financial market turbulence. The top right panel of exhibit 8 shows the 11 banking firms that supervisors interviewed. This effort was not a complete review of all firms and events. For example, we did not meet with Bear Stearns or Morgan Stanley as part of this effort. Rather, it was designed to inform supervisory authorities about the general effectiveness of risk management at global financial institutions. The supervisors have prepared a paper detailing their findings, which will be conveyed to the FSF and released publicly. The bottom panel lists some observations about the firms' overall performance. Most large financial services firms, while affected by market developments, generally avoided significant losses. Although most firms' risk-management processes worked as intended, there were some definite outliers. Some firms recognized the emerging additional risks and took deliberate actions to limit or mitigate them. Others recognized the additional risks but accepted them. Still other firms did not fully recognize the risks in time to mitigate them adequately. Moreover, the risk-management practices varied by firm and by strategy, as did the range of outcomes to date. I should note that the primary risk-management weaknesses observed here are not new. They have been observed in past episodes and are thoroughly discussed in existing risk-management literature and supervisory guidance. As noted in the top panel of exhibit 9, the senior supervisors group identified four primary factors that differentiated the organizations that suffered larger losses from those that did not: (1) the effectiveness of senior management oversight of balance sheet, liquidity, and capital positions; (2) the effectiveness of communications among senior management, business lines, and risk-management functions; (3) the sophistication, diversity, and adaptability of risk measures utilized; and (4) the attention devoted to valuation issues. With respect to senior management oversight, as indicated in the bottom panel of exhibit 9, the more effective firms were more disciplined in measuring and limiting these risks in advance of the crisis and proved to be more agile in reducing exposures or hedging when the crisis occurred. These firms focused on maintaining a strong balance sheet with strong capital and liquidity positions throughout the entire organization. Senior management of these organizations had established adequate capital and liquidity buffers that could sustain the firm through a period without access to the market for funding. They have created and effectively enforced internal pricing mechanisms, capital allocation methodologies, and limits that provided effective incentives for individual business line managers to control activities that might otherwise lead to significant balance sheet growth or contingent liquidity demands. Conversely, the less effective firms were not as focused on the overall strength of their balance sheet across all legal entities and thus operated with more limited liquidity and capital buffers. These organizations had weaker controls over their balance sheets and were more focused on earnings growth or defense of a market leadership position. These firms did not have limit structures that were consistently or effectively enforced, which allowed business lines to grow balance sheet exposures rapidly and increase contingent liquidity exposures. They did not properly aggregate or monitor off-balance-sheet exposures across the organization, including the exposure to contingency back-up lines of credit to ABCP programs and generally did not have in place effective financial controls, including capital allocation processes, commensurate with the business strategy. The top panel of exhibit 10 provides additional detail on the importance of effective communications among senior management, business lines, and riskmanagement functions. The more effective firms emphasized a comprehensive, firmwide, consolidated assessment of risk. Senior managers of these organizations were actively engaged and had in place a disciplined culture and well-established processes for routine discussion of current and emerging risks across the business lines, risk management, and the corporate treasury function. Senior managers at these organizations collectively made decisions about the firm's overall risk appetite, exposures, and risk mitigation strategies rather than relying solely on the judgment of business lines. They were able to effectively leverage the assessment of risks from one business line to consider how subprime exposures, for example, might affect other businesses. As a result, the more effective firms had a more timely and wellinformed perspective on how market developments could unfold. In some cases, senior management had almost a year to evaluate the magnitude of the emerging risks from subprime mortgages on its various business lines. This, in turn, enabled them to implement plans for reducing their exposures while it was still practical and more cost effective to do so. Conversely, less effective firms were siloed, did not effectively share information across business lines on emerging risks, and were comparatively slower in taking actions to mitigate exposures as each business line had to assess and consider emerging risks on their own without the benefit of views or actions taken by other business line managers. With regard to the risk measures utilized, as shown in the bottom panel, the more effective firms used a wide range of risk measures and analytical tools to discuss and challenge views on credit and market risk broadly across different business lines within the firm in a disciplined fashion. These firms have thought more thoroughly about the interplay of their risk measures than the other firms and used a combination of different risk measures and scenario analysis to understand risk exposures. It also appears that the more effective firms had committed more resources to riskmanagement and management information systems. As a result, they had more timely and scalable management information systems and in large part did not have to create new management reports to understand risks and exposures. Conversely, the less effective firms were too dependent on a single quantitative risk measure, and they did not utilize scenario analysis in their decisionmaking and tended to apply a ""mechanical"" risk-management approach. Management information systems also were not as scalable, and there was a need to develop a number of ad hoc reports to help senior management understand the risks and exposures of the company. The top panel of exhibit 11 elaborates on the fourth factor that proved critical, which is the attention devoted to valuation issues. The more effective organizations were more disciplined in how they valued the holdings of complex or potentially illiquid securities. They employed more-sophisticated valuation practices and had invested in the development of pricing models and staff with specialized expertise. These organizations were skeptical of and less reliant on external ratings and emphasized mark-to-market discipline in their businesses in ways that others did not. Less effective organizations in some cases did not have key valuation models in place prior to the market disruption, relied heavily on third-party views of risk, and tended to have a narrower view of the risks associated with their CDO business as mainly being credit risk and did not actively seek market valuation information. The bottom panel explains how supervisors are planning to address the specific deficiencies. As I mentioned earlier in my presentation, the risk-management deficiencies identified during this exercise are not new, and existing supervisory guidance addresses these issues. Therefore, supervisory efforts will include addressing risk-management deficiencies at each company through the supervisory process and re-emphasizing the importance of strong, independent risk management through a series of speeches, industry outreach, and possible re-issuance of existing guidance. In addition, supervisors plan to complete the work already under way within the Basel Committee on Bank Supervision to update liquidity risk management guidance to strengthen industry practices. A review of existing Federal Reserve guidance on market and liquidity risk management is under way to ensure that it effectively outlines the need for banks to use a number of tools to include multiple ways of viewing quantitative and qualitative risk analysis, including VAR, stress tests, and scenario analysis. Finally, supervisors plan to develop, on an interagency basis, guidance related to the management of the originate-to-distribute model to ensure that banking organizations effectively manage the credit, market, and operational risks of this activity. I will now turn it over to Art Angulo to discuss related regulatory policies. " fcic_final_report_full--265 Even high-quality assets that had nothing to do with the mortgage market were declining in value. One SIV marked down a CDO to seven cents on the dollar while it was still rated triple-A.  To raise cash, managers sold assets. But selling high-qual- ity assets into a declining market depressed the prices of these unimpaired securities and pushed down the market values of other SIV portfolios. By the end of November, SIVs still in operation had liquidated  of their portfo- lios, on average.  Sponsors rescued some SIVs. Other SIVs restructured or liquidated; some investors had to wait a year or more to receive payments and, even then, re- couped only some of their money. In the case of Rhinebridge, investors lost  and only gradually received their payments over the next year.  Investors in one SIV, Sigma, lost more than .  As of fall , not a single SIV remained in its original form. The subprime crisis had brought to its knees a historically resilient market in which losses due to subprime mortgage defaults had been, if anything, modest and localized. MONEY FUNDS AND OTHER INVESTORS: “DRINK ING  FROM A FIRE HOSE ” The next dominoes were the money market funds and other funds. Most were spon- sored by investment banks, bank holding companies, or “mutual fund complexes” such as Fidelity, Vanguard, and Federated. Under SEC regulations, money market funds that serve retail investors must keep two sets of accounting books, one reflect- ing the price they paid for securities and the other the fund’s mark-to-market value (the “shadow price,” in market parlance). However, funds do not have to disclose the shadow price unless the fund’s net asset value (NAV) has fallen by . below  (to .) per share. Such a decline in market value is known as “breaking the buck” and generally leads to a fund’s collapse. It can happen, for example, if just  of a fund’s portfolio is in an investment that loses just  of its value. So a fund manager cannot afford big risks. But SIVs were considered very safe investments—they always had been—and were widely held by money market funds. In fall , dozens of money market funds faced losses on SIVs and other asset-backed commercial paper. To prevent their funds from breaking the buck, at least  sponsors, including large banks such as Bank of America, US Bancorp, and SunTrust, purchased SIV assets from their money market funds.  FOMC20060808meeting--14 12,MS. JOHNSON.," If I could just comment on the worldwide aspect of your point, I’d say that the one piece that’s missing is that globally we have not seen this inflation pressure translate into an acceleration in wages and labor compensation—not so much here in the United States and not in rest of the world. Even in places where central banks are tightening monetary policy in recognition of the inflation that they are experiencing in their consumer prices, one is not hearing stories about an acceleration of wages. So there’s truth in everything you’ve said, and I wouldn’t disagree that it’s worrisome, but we’ve seen huge changes in the structure of global economic activity. Those changes may have effected significant changes in relative prices, particularly of energy on the one hand and of other kinds of primary commodities on the other. We keep saying that those price changes are going to end, right? Every FOMC I come here, and I tell you that those prices are flattening out starting this morning. [Laughter] Then I come back six weeks later, and I say it again—and that’s not lost on me. However, there is a question in my mind as to trend versus relative price effects here, and I think there are surely some of both types of effects. It may be wrong to attribute the pressure entirely to a relative price shock that’s going to go away immediately, but it’s certainly also wrong to call it all inflation trend with no relative price component." FOMC20060629meeting--98 96,MS. MINEHAN.," New England’s economy remains in relatively good shape, though not particularly vibrant or reflective of great strength going forward. Employment growth has been positive but slow in comparison to the nation. New England usually has a lower unemployment rate than the nation does, but for the first time in a decade or so the region’s unemployment rate has converged, mostly because the national rate dropped, but the region has flattened out over the past several months. Local measures of year-over-year inflation are about on track with the nation as well, though growth of local fuel and utility costs is considerably higher. Many business people talk about their efforts to limit their energy costs by upgrading capital equipment and facilities to be more energy efficient and by looking into alternative sources of energy. They also report mild success in passing along increased costs to consumers. Perhaps reflecting this, the rising price of gasoline, or even the consistently rainy weather over the past couple of months, consumer confidence has sagged a good deal. But not all the news is gloomy. Business sentiment, as suggested by surveys and our meetings with our Small Business Advisory Group, remains positive overall as businesses report solid growth and positive hiring plans. Many continue to note how hard it is to find the skilled labor they need. Class A office vacancies have declined in both downtown and suburban markets, and rents are rising a bit. State tax collections, in particular sales and personal income taxes, are exceeding budgets in every state except Rhode Island, which appears to be experiencing an extended, though as yet unexplained, soft spot. In general, I sense a good deal of optimism among my business contacts about their own firms but uncertainty as well when they look at the evolution of both the regional and the national economies. Indeed, both the coincident regional index done by the Philadelphia Fed and the leading index for Massachusetts that’s done by the University of Massachusetts indicate that the regional economy is likely to grow only at a modest pace over the next year or so, buoyed by a resurgence in worldwide demand for high-tech and biotech products but weighed down by subdued consumer spending in the midst of high energy costs and declines in local housing markets. I just want to reflect a bit on regional residential real estate markets. Here various data sources—and there are lots of them—suggest that regional markets have slowed, with sales falling in April and to a lesser degree in May, and unsold inventories continuing to rise, with the number of months’ supply growing from about 8.7 in May of last year to more than 11 in May of this year. However, prices, depending on whether you look at median sales or repeat sales, either have fallen only slightly or have risen at about half the pace they had been rising. Most analysts see this as a soft landing or a period of stabilization after several years of strong price appreciation. Thus, while the local media and many pundits, national as well as local, wring their hands over the potential for major real estate problems, at least up to now the market correction in New England appears to be proceeding in a fairly benign way. Turning to the national scene, incoming data have served to reinforce a sense of risk on both sides of the Greenbook forecast. As I noted earlier, that forecast is not markedly different from our own, so when I talk about risk it will be the risk to our own forecast as well. To some degree, both slower growth and higher inflation were expected in the forecasts that we’ve made over the past six months or so, but recent data may be exceeding those expectations. On the growth side, residential construction has slowed a bit more rapidly than we thought. Consumer confidence has fallen off. Weaker equity markets, higher gas prices, and somewhat lower housing prices have likely affected consumer spending, and recent data on job growth have been slower. But there continue to be a good number of supports to growth. Household wealth remains high. Growth abroad remains solid. Financial conditions outside equity markets are accommodative. Businesses remain highly profitable and cash rich as reflected in the mini-boom in investment in nonresidential structures, and productivity growth remains strong. Indeed, if one averages Q1 and Q2 expected growth, it’s a bit above our earlier forecast, though clearly one needs to be mindful of the fact that the first half started with a bang and its recent momentum has been considerably cooler. Does this recent cooling portend a faster and steeper slowdown for the rest of ’06 than reflected in the current Greenbook forecast or our own? Or could there be enough underlying strength to take us back to the growth scenario of our earlier projections? In particular, I wonder a bit about the slow rate of job growth that is embedded in the Greenbook forecast for 2007. I don’t know what the possibility is of some surprise on the upside to the Greenbook’s current ’06 and, particularly, ’07 projections, but I think there may well be some. The incoming data have been more disquieting on the price front. I’m not a person who believes that a given level of inflation is bad in and of itself, within reason of course. I think it’s important to assess the level of inflation against everything else going on in the economy. So at times a level of 2 percent and change might be fine; at other times it might bear watching. And as far as I know, it’s been hard to prove that specific low levels of inflation—let’s say, below 3 percent—are bad in and of themselves. But I do believe that a rapid increase or decrease in the rate of inflation growth can portend debilitating change in the economy. Such increases or decreases need to be monitored carefully and figure importantly in the policy discussion. Thus, I have viewed the six- and three-month changes in core CPI and PCE with some alarm as the rate of change has been faster than I am comfortable with and certainly faster than our forecast expected. Looking at the first half of this year, and using the Greenbook forecast for Q2, we see that core inflation is nearly 50 basis points higher than what we, in Boston at least, had expected. Our analysis suggests that most of the reason for this surge in inflation over the past couple of years has been higher energy costs. Barring untoward geopolitical events, that should mean that inflation growth will moderate. But given the small to nonexistent output gap we see currently reflected in the low unemployment rate, there is more than a minor risk that resource pressures could begin to play a role in inflationary growth. The Greenbook forecast suggests that slower growth will provide a moderating influence on inflation. That’s our best bet as well, but prudent risk management might suggest some hedging of that bet. Thank you." FinancialCrisisReport--354 Although the Gemstone 7 offering circular did not describe Deutsche Bank’s role in the asset selection process, the private engagement agreement between HBK and Deutsche Bank did. 1374 According to the terms of the engagement agreement, Deutsche Bank agreed to provide, among other items, the following service: “advising the Issuer [Gemstone 7] and the Company [HBK] on the selection and acquisition of the Underlying Assets” and “the scope of due diligence for the Underlying Assets.” 1375 Under both the engagement agreement and a separate risk sharing agreement, Deutsche Bank also had the right to reject assets selected by HBK for the Gemstone warehouse account. 1376 When asked about Deutsche Bank’s obligations under these agreements, Mr. Lippmann told the Subcommittee that he viewed Deutsche Bank as having an obligation to the entity, Gemstone 7, to price the assets accurately as they were purchased, which included comparing the price of each security or CDS contract on the date it went into the warehouse account to its market price and ensuring that the CDO did not overpay for the assets it purchased. 1377 Mr. Lippmann’s trader, Mr. Milman, and Mr. Kamat, of Mr. Lamont’s CDO Group, agreed with that assessment. 1378 All three also stated that the engagement agreement did not require Deutsche Bank to analyze the quality of the assets being purchased or how those assets were expected to perform. On the other hand, documents reviewed by the Subcommittee indicate, in at least a few instances, that Deutsche Bank personnel voiced concerns about an RMBS security being placed in the deal due to performance concerns in addition to price. For example, Mr. Kamat, who also assisted Mr. Lippmann’s trading desks, wrote to Mr. Jenks about the quality of an asset being 1373 See, e.g., 1/9/2007 email from Jason Lowry to Greg Lippmann, GEM7-00002154; and 12/11/2006 email from Greg Lippmann to Kevin Jenks, GEM7-00002805. The term “heat” refers to an RMBS security issued by Home Equity Asset Trust. 1374 The Gemstone 7 offering circular states that with regard to the purchase of underlying assets: “The Issuer [Gemstone 7] will acquire Underlying Assets from a warehouse facility (the ‘Warehouse Facility’) provided by an affiliate of DBSI [Deutsche Bank Securities, Inc.], which provides for the purchase of Asset-Backed Securities at the direction of the Collateral Manager [HBK] on behalf of the Issuer prior to the Closing Date.” Gemstone 7 Offering Circular, GEM7-00000427-816 at 494. 1375 10/25/2006 signed letter agreement between HBK and Deutsche Bank, GEM7-00000071-89 at 72. 1376 Id.; 10/24/2006 Risk Sharing Agreement, GEM7-00000090-99 at 91. 1377 Subcommittee interview of Greg Lippmann (10/18/2010). 1378 Subcommittee interview of Jordan Milman (10/22/2010) and Abhayad Kamat (10/8/2010). considered for Gemstone 7. Mr. Kamat wrote: “MLMI 2005-HE1 B3 [is] on credit watch – do you want to move this out of the portfolio – investors might question/resist[.]” Mr. Jenks responded: “[N]o let’s leave it in[.]” 1379 CHRG-110shrg50420--286 Mr. Nardelli," I think the pricing of the credit is really driven by the markets today, just like our pricing is driven--we can set a price. The consumer dictates the price. And the same is true in the credit market, sir. When you go back to the industry, when it was 17-plus million, you quickly see where the credit was and the ability to make credit accessible to a much lower FICO score that allow consumers to really step into these vehicles along with the lease program. Twenty percent of our volume I think across the board was lease programs. Senator Reed. Thank you. " CHRG-110shrg50369--57 Chairman Dodd," Well, that is a good question and one we ought to--if you have the ability to give us some information on that, I would be very interested in that as well, Mr. Chairman. Let me turn to Senator Menendez. Senator Menendez. Thank you. Thank you, Mr. Chairman, for your testimony and your service. It seems to me--and I am sure all of us--that the central bank is faced increasingly with the contradictory pressures of the slowing economy and rising consumer prices--gas prices, food prices, energy prices as a whole, to name a few. Isn't revving up a slow economy far easier than slowing inflation once it has become entrenched? " CHRG-110hhrg46591--152 Mr. Stiglitz," Dangerous--what I want to say is you have to ask about not only the recent experience, but knowing the fact that house prices can go up, but they can also go down. And you have to ask not only what has happened in the last 5 years, or even 10 years, but what would happen if the prices returned to--or say the price-income ratio returned to a more normal level-- " FOMC20080625meeting--41 39,MR. SHEETS.," Yes. The spike that we have seen is driven particularly by commodity prices. The depreciation of the dollar has played a secondary role, so the decline in core import price inflation to below 2 percent next year is conditioned crucially on commodity prices flattening out and the dollar not depreciating as rapidly as it has over the past few years. " CHRG-110hhrg41184--119 The Chairman," Thank you. The gentleman from Texas, a ranking member of the subcommittee. Dr. Paul. Thank you, Mr. Chairman. Chairman Bernanke, earlier you were asked a question about the value of the dollar, and you sort of deferred and said, ``You know that is the Treasury's responsibility.'' I always find this so fascinating, because it has been going on for years. Your predecessor would always use that as an excuse not to talk about the value of the dollar. But here I find the Chairman of the Federal Reserve, who is in charge of the dollar, in charge of the money, in charge of what the money supply is going to be, but we don't deal with the value of the dollar. You do admit you have a responsibility for prices, but how can you separate the two? Prices are a mere reflection of the value of the dollar. If you want to control prices, then you have to know the value of the dollar. But if you are going to avoid talking about the dollar, then all you can do then is deal with central economic planning. You know, if we stimulate the economy, maybe there will be production and prices will go down, and if prices are going up too fast you have to bring on a recession. You have to try to balance these things, which I think is a totally impossible task and really doesn't make any sense, because in a free market if you had good economic growth you never want to turn it off, because good economic growth brings prices down just like we see the prices of computers and cell phones, those prices come down where there is less government interference. But you know the hard money economists who have been around for awhile, they have always argued that this would be the case. Those who want to continue to inflate will never talk about the money, because it isn't the money supply that is the problem, it is always the prices. And that is why the conventional wisdom is, everybody refers to inflation as rising prices, instead of saying inflation comes from the unwise increase and supply of money and credit. When you look at it, and I mentioned in my opening statement that M3, now measured by private sources, is growing by leaps and bounds. In the last 2 years, it increased by 42 percent. Currently, it is rising at a rate of 16 percent. That is inflation. That will lead to higher prices. So to argue that we can continue to do this, continue to debase the currency, which is really the policy that we are following, is purposely debasing, devaluing a currency, which to me seems so destructive. It destroys the incentives to save. It destroys--and if you don't save, you don't have capital. Then it just puts more pressure on the Federal Reserve to create capital out of thin air in order to stimulate the economy, and usually that just goes in to mal-investment, misdirected investment into the housing bubbles, and the NASDAQ bubble. And then the effort is once the market demands the correction, what tool do you have left? Let's keep pumping--pump, pump, pump. And it just is an endless task, and history is against you. I mean, history is on the side of hard money. If you look at stable prices, you have to look to the only historic, sound money that has lasted more than a few years, fiat money always ends. Gold is the only thing where you can get stable prices. For instance, in the last 3 to 4 years, the price of oil has tripled, a barrel of oil went from $20 to $30 up to $100 a barrel. And yet, if you look at the price of oil in terms of gold it is absolutely flat, it is absolutely stable. So if we want stable prices, we have to have stable money. But I cannot see how we can continue to accept the policy of deliberately destroying the value of money as an economic value. It destroys, it is so immoral in the sense that what about somebody who saved for their retirement and they have CDs. And we are inflating the money at a 10 percent rate, their standard of living is going down and that is what is happening today. The middle class is being wiped out and nobody is understanding that it has to do with the value of money, prices are going up. So how are you able to defend this policy of deliberate depreciation of our money? " CHRG-111shrg62643--172 Mr. Bernanke," Again, forecasts are very uncertain, but I do not view deflation as a near-term risk for the United States. If you look at inflation expectations as measured by Government bond markets or by surveys, there has not really been much decline in expected inflation, and that stability of inflation expectations is one important factor that will keep inflation from falling very much. So, again, the forecasts of the FOMC are for a gradual increase of inflation toward a more normal, say 2-percent level, and there is not at this point, a very high probability that deflation will become a concern. I think there are very important differences between the U.S. and Japan. Some of them are structural. The Japanese economy has been relatively low productivity in recent years. It has got a declining labor force, and so its potential growth rate is lower than the U.S., and it has been a less vibrant economy in that respect. Also in Japan are much longer-lived problems with their banking system, which were not addressed for some years. For better or worse, we were very aggressive in addressing our banking system issues, and I think, as I mentioned to a couple of folks our system is strengthening and looks to be doing much better. So I do not think that will be a source of long-term drag either. And, finally, I would comment that I think the Federal reserve does have the capacity, the tools, should deflation occur--which I do not believe is very likely--to reverse it, and we would be assiduous in doing that. So I do not consider this to be a very high risk at this point, but, of course, we will continue to monitor the economy and the price level. " FinancialCrisisInquiry--175 CHAIRMAN ANGELIDES: Yes. SOLOMON: So the real problem we have is it’s like that movie Hedgehog... CHAIRMAN ANGELIDES: Groundhog. SOLOMON: Groundhog. We wake up every day and it’s the same thing. And the reason I point it out in my testimony, folks have mentioned too is how many crisis we’ve had. This is like recurring non-recurring losses. CHAIRMAN ANGELIDES: Right. By the way, I saw my wife laughing. It’s my favorite movie because if you’ve ever been a candidate it is your life. Mr. Bass? BASS: One thing we talk about around our office is the brevity of financial memory. I think it’s only about five years when you look back through the financial marketplace. So, but to answer your first question with regard to where we are today as what is still a systemic problem, it’s what Mrs. Born is focused on up there and OTC derivatives. We have to nail those down. We have—absolutely need to get not only a clearing house, but a data repository put together so that the appropriate regulator, whoever we deem to be that appropriate regulator can see everything. Right now no one knows anything. You have to go in institution-by-institution, fund-by- fund. And these are just contracts between a buyer and a seller. There needs to be a clearinghouse, a repository and price transparency because I think that will eliminate an enormous amount of systemic risk. And when you require collateral to be posted to enter transactions it will self police the size of that marketplace. So that’s what I think is the biggest risk. FOMC20070131meeting--136 134,MR. FISHER.," Yes. But here are some data to put this statement in perspective. The contact from the largest company reports that cancellation rates, which were running at 50 percent in their most stressed markets, particularly in California and Florida, have come back to 20 to 25 percent—relatively good news. One aspect worth noting is that they are getting relief from their subcontractors—they estimate, on average across the industry, about 10 percent cost relief. Another predictable behavior pattern becoming manifest is that the large contractors with very strong balance sheets are looking to buy the distressed smaller contractors. David, I agree with you that we haven’t seen all the downturn in housing yet in terms of its effect on the economy, but we may well come out of it with an even more tightly consolidated industry. The bottom line on growth from the Eleventh District perspective is a Wagnerian summation—that is, the economy’s growth dynamic is not as bad as we thought it was sounding when we last read the score. I would summarize it by saying that the tail in terms of the risk of recession has become much slimmer. However, my conclusion is the opposite with regard to inflation—that is, on reflection and working with our staff and listening to CEOs, I think the tail in terms of risk of higher inflation has fattened, and this is reflected in several reports. Just very quickly—because of my Australian DNA—Anheuser-Busch decided to raise beer prices 2 to 3 percent at year-end. That doesn’t bother me. What bothers me is the price of skilled workers who drink that good beer in terms of what’s happening for wages and total compensation of skilled and unskilled labor. You know that I have talked about the massive projects that Texas Utility plans for coal to gas conversion and whether they get the so-called Dirty Dozen that they’re planning or just a handful. I did go over with the CEO the studies that McKinsey, BCG, and Bechtel have provided for them, and some interesting data points came out that I want to summarize. In the summer of ’05, they estimated that all-in labor costs for these plants, which they estimated per plant, would take 4.6 million worker hours at $36.25 an hour. Today they don’t believe they can get the job done for less than $44 an hour; and because of worker quality issues, they now believe it will take 5.2 million worker hours for each plant. So if you have a 21 percent per hour increase and a 13 percent increase in hours, one wonders about the ability to see a short-term reduction in skilled and unskilled labor costs. These numbers, by the way, take into account the recent slippage in oil rig activity, which is down for the fifth straight week, and also the slowdown in housing and some initial slowdown in commercial construction. It dovetails with reports like that of BP’s to us that they decided to pay all their salaried operators, to whom only two years ago they were offering incentive packages to leave, $25,000 bonuses per year for the next two years to stay. Fluor’s CEO reports that they are having the largest year in their history of hiring college graduates, and the 900 mechanics who work for a large truck dealer with which I regularly talk are now fetching $35 an hour. Another piece of data comes from a study by McKinsey and BCG, and I want to talk about it very briefly in terms of the intermodal transportation system of our country. The shippers tell me that port congestion is very high. The fleet utilization rate is running at about 95 percent. You know that I like to talk about Panamax ship rates because of their size and liquidity. Prices have not eased since we last met, and the interesting factoid is that the ten-year-old fleet is available for purchase at the same price as the fleet expected to be delivered two and a half years from now. These ships run $39 million apiece before their add-ons, which tells you that there’s a short-term tightness. If you talk to the rails and the effective two operators—there’s really a duopoly in this country between Burlington Northern and Union Pacific—their pricing is based on opportunity costs because they do not foresee the ability to expand their networks. This may well facilitate an upward price spiral as all the infrastructure projects currently on the drawing boards begin, whether TXU’s or some other liquefied natural gas companies’ projects that we have heard about. A couple of other points with regard to inflation that I think bear watching: These inputs are anecdotal, but I think we have a pretty good survey in terms of the oil and gas operators. Most of the major oil and gas operators would not be surprised to see $40 oil and to see a range between $40 and $60 oil—that fits with the Brown-Yücel model that we developed in Dallas—and for natural gas prices to ease to a level of about $5 in the spring. That’s the good news. I want to mention two other negative news items. One was referred to earlier, and that regards corn prices. The price for corn was $2.30 a bushel last year, if you looked on the graph that Bill, I think, presented earlier. Corn is now running $4.00 a bushel, and the food production companies we talked to project the price to be $5.00 by the end of the year. Now, this is good for farmers. It’s good for John Deere. It’s not good if you raise a chicken, a cow, or a pig, and it’s certainly not good if you’re a human who eats at Whataburger, one of my other new contacts. I won’t use the language that the CEO used, but he reports that his margins are coming under pressure. The second development may be a bit more disturbing; it concerns the cost of imported goods from China into Wal-Mart’s network. According to Wal-Mart’s CEO for international operations and their vice chairman, Chinese import prices into Wal-Mart’s network were depreciating at an annual rate of between 2 and 5 percent. Recently, however, the rise in China’s labor costs for their suppliers net of the increase in productivity is leading to import price costs that are increasing at a rate of approximately 1 percent. To me this development raises an issue that I think President Moskow touched on regarding our views on inflation and perhaps rates going forward, which we’ll talk about tomorrow. At home, we’re seeing unacceptably high and sustained wage developments for certain critical components of labor, which I mentioned earlier. Abroad from Germany to China, we’re seeing economic growth rates that are well above sustainable trends, which is why I asked the question about your gap analysis earlier. My own staff calculates that, if you do a gap analysis—that is, if you compare current growth to what they estimate trend growth to be—there is no significant inflationary pressure. However, if you analyze capacity utilization rates in the G7 countries and in the BRICs, we are getting closer, given the economic growth that has been experienced, to more heavily used capacity and to igniting inflationary pressures. The bottom line for inflation from our perspective is that what was once a tailwind generated by globalization may be closer to becoming a headwind than our models indicate and our limited understanding of the effect of globalization otherwise leads us to understand. Thank you, Mr. Chairman." CHRG-110hhrg34673--10 Mr. Bernanke," Chairman Frank, Representative Bachus, and other members of the committee, I am pleased to present the Federal Reserve Monetary Policy Report to the Congress. Real activity in the United States expanded at a solid pace in 2006, although the pattern of growth was uneven. After a first quarter rebound from weakness associated with the effects of the hurricanes that ravaged the Gulf Coast in the previous summer, output growth moderated somewhat on average over the remainder of 2006. Real Gross Domestic Product is currently estimated to have increased at an annual rate of about 2\3/4\ percent in the second half of the year. As we anticipated in our July report, the U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable average pace of growth. The principal source of the ongoing moderation has been a substantial cooling in the housing market which has led to a marked slowdown in the pace of residential construction. However, the weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy. Consumer spending has continued to expand at a solid rate, and the demand for labor remains strong. On average, about 165,000 jobs per month have been added to nonfarm payrolls over the past 6 months. And the unemployment rate, at 4.6 percent in January, remains low. Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall, inflation has fallen in large part as a result of declines in the price of crude oil. Readings on core inflation--that is inflation excluding the prices of food and energy--have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated. In the five policy meetings since the July report, the Federal open market committee, or FOMC, has maintained the Federal funds rate at 5\1/4\ percent. So far, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing of core inflation. However, in the statement accompanying last month's policy decision, the FMOC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected, and that it is prepared to take action to address inflation risks, if developments warrant. Let me now discuss the economic outlook in a little more detail beginning with developments in the real economy and then turning to inflation. I will conclude with some brief comments on monetary policy. Consumer spending continues to be the mainstay of the current economic expansion. Personal consumption expenditures, which account for more than two-thirds of aggregate demand, increased at an annual rate of around 3\1/2\ percent in real terms during the second half of last year, broadly matching the brisk pace of the previous 3 years. Consumer outlays were supported by strong gains in personal income reflecting both the ongoing increases in payroll employment and a pickup in the growth of real wages. Real hourly compensation, as measured by compensation per hour in the nonfarm business sector deflated by the personal consumption expenditures price index, rose at an annual rate of about 3 percent in the latter half of 2006. The resilience of consumer spending is all the more striking, given the backdrop of the substantial correction in the housing market that became increasingly evident during the spring and summer of last year. By the middle of 2006, monthly sales of new and existing homes were about 15 percent lower than a year earlier, when the previously rapid rate of house price appreciation had slowed markedly. The fall in housing demand in turn prompted a sharp slowing in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about 4\1/2\ months' supply in 2005 to nearly 7 months' supply by the third quarter of last year. Single family housing starts have dropped more than 30 percent since the beginning of last year. And employment growth in the construction sector has slowed substantially. Some tentative signs of stabilization have recently appeared in the housing market. New and existing home sales have flattened out in recent months. Mortgage applications have picked up. And some surveys find that homebuyers' sentiment has improved. However even if housing demand falls no further, weakness in residential investment is likely to continue to weigh on economic growth over the next few quarters as homebuilders seek to reduce their inventory of unsold homes to more comfortable levels. Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid. And delinquency rates on most types of consumer loans and residential mortgages remain low. The exception is subprime mortgages with variable interest rates for which delinquency rates have increased appreciably. The labor market is expected to stay healthy. And real incomes should continue to rise, although the pace of employment gains may be slower than those to which we have become accustomed in recent years. In part, slower average job growth may simply reflect a moderation in economic activity. Also, the impending retirement of the leading edge of the baby boom generation, and an apparent leveling out of women's participation in the workforce, which had risen for several decades, will likely restrain the growth of the labor force in coming years. With fewer job seekers entering the labor force, the rate of job creation associated with the maintenance of stable conditions in the labor market will decline. All told, consumer expenditures appear likely to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal incomes if, as we expect, households respond to the slow pace of home equity appreciation by saving more out of current income. The business sector remains in excellent financial condition with strong growth in profits, liquid balance sheets, and corporate leverage near historical lows. Last year, those factors helped support continued advances in business capital expenditures. Notably, investment in high tech equipment rose 9 percent in 2006. And spending on nonresidential structures such as office buildings, factories, and retail space increased rapidly through much of the year after several years of weakness. Growth in business spending slowed toward the end of last year, reflecting mainly a deceleration of spending on business structures, a drop in outlays in the transportation sector where spending is notably volatile, and some weakness in purchases of equipment related to construction and motor vehicle manufacturing. Over the coming year, capital spending is poised to expand at a moderate pace, supported by steady gains in business output and favorable financial conditions. Inventory levels in some sectors, most notably in motor vehicle dealers and in some construction-related manufacturing industries, rose over the course of last year leading some firms to cut production to better align inventories with sales. Remaining imbalances may continue to impose modest restraints on industrial production during the early part of this year. Outside the United States, economic activity in our major trading partners has continued to grow briskly. The strength of demand abroad helped spur a robust expansion in U.S. real exports, which grew about 9 percent last year. The pattern of real U.S. imports was somewhat uneven partly because of fluctuations in oil imports over the course of the year. On balance, import growth slowed in 2006 to 3 percent. Economic growth abroad should further support steady growth in U.S. exports this year. Despite the improvements in trade performance, the U.S. current account deficit remains large, averaging about 6\1/2\ percent of nominal GDP during the first three quarters of 2006. Overall, the U.S. economy seems likely to expand at a moderate pace this year and next with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the members of the Board of Governors and presidents of the Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts--which are based on information available at that time and on the assumption of appropriate monetary policy--is for real GDP to increase about 2\1/2\ to 3 percent in 2007, and about two- or three-quarters to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. This difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4\1/2\ to 4\3/4\ percent. The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from the developments in the housing market onto consumer spending and employment and housing related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006. I turn now to the inflation situation. As I noted earlier, there are some indications that inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated. Recent declines in overall inflation have primarily reflected lower prices for crude oil, which have fed through to the prices of gasoline, heating oil and other energy products used by consumers. After moving higher in the first half of 2006, core consumer price inflation has also edged lower recently reflecting a relatively broad-based deceleration in the prices of core goods. That deceleration is probably also due, to some extent, to lower energy prices, which have reduced costs of production, and thereby lessened one source of pressure on the prices of final goods and services. The ebbing of core inflation has likely been promoted as well by the stability of inflation expectations. A waning of the temporary factors that boosted inflation in recent years will probably help foster a continued edging down of core inflation. In particular, futures quotes imply that oil prices are expected to remain well below last year's peak. If actual prices follow the path currently indicated by futures prices, inflation pressures would be reduced further as the benefits of the decline in oil prices from last year's high levels are passed through to a broader range of core goods and services. Nonfuel import prices may also put less pressure on core inflation particularly if price increases for some other commodities, such as metals, slow from last year's rapid rates. But as we have been reminded only too well in recent years, the prices of oil and other commodities are notoriously difficult to predict. And they remain a key source of uncertainty in the inflation outlook. The contribution from rents and shelter costs should also fall back following a step up last year. The faster pace of rent increases last year may have been attributable in part to the reduced affordability of owner-occupied housing which led to a greater demand for rental housing. Rents should rise somewhat less quickly this year and next reflecting recovering demand for owner-occupied housing as well as increases in the supply rental units. But the extent and pace that of that adjustment is not yet clear. Upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period. The rate of resource utilization is high, as can be seen in rates of capacity utilization above their long term average, and most evidently, in the tightness of the labor market. Indeed anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in certain occupations. Measures of labor compensation--though still growing at a moderate pace--have shown some signs of acceleration over the last year, likely, in part, as the result of tight labor market conditions. The implications for inflation of faster growth in nominal labor compensation depend on several factors. Increases in compensation might be offset by higher labor productivity or absorbed by a narrowing of firm's profit margins rather than passed on to consumers in the form of higher prices. In these circumstances, gains in nominal compensation would translate into gains in real compensation as well. Underlying productivity trends appear favorable. And the markup of prices over unit labor costs is high by historical standards, so such an outcome is certainly possible. Moreover, if activity expands over the next year or so at the moderate pace anticipated by the FOMC, pressures in both labor and product markets should ease modestly. That said, the possibility remains that tightness in product markets could allow firms to pass higher labor costs through to prices, adding to inflation and effectively nullifying the purchasing power of at least some portion of the increase in labor compensation. Thus, the high level of resource utilization remains an important upside risk to continued progress on inflation. Another significant factor influencing medium term trends in inflation is the public's expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as those created by changes in energy costs, become embedded in wage and price decisions, and so leave a lasting imprint on the rate of inflation. It is encouraging that inflation expectations appear to have remained contained. The projections of the members of the Board of Governors and the presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next. In particular, the central tendency of those forecasts is for core inflation--as measured by the price index for personal consumption expenditures excluding food and energy--to be 2 to 2\1/4\ percent this year and to edge lower to 1\3/4\ to 2 percent next year. But as I noted earlier, the FMOC has continued to view the risk that inflation will not moderate as expected as the predominant policy concern. Monetary policy affects spending and inflation with long and variable lags. Consequently, policy decisions must be based on an assessment of medium term economic prospects. At the same time, because economic forecasting is an uncertain enterprise, policy makers must be prepared to respond flexibly to developments in the economy when those developments lead to a reassessment of the outlook. The dependence of monetary policy actions on a broad range of incoming information complicates the public's attempts to understand and anticipate policy decisions. Clear communication by the central bank about the economic outlook, the risk to that outlook, and its monetary policy strategy, can help the public to understand the rationale behind policy decisions and to anticipate better the central bank's reaction to new information. This understanding should, in turn, enhance the effectiveness of policy and lead to improved economic outcomes. By reducing uncertainty, central bank transparency may also help anchor the public's longer term expectations of inflation. Much experience has shown that well-anchored inflation expectations help to stabilize inflation and promote maximum sustainable economic growth. Good communication by the central bank is also vital for ensuring appropriate accountability for its policy actions, the full effects of which can be observed only after a lengthy period. A transparent policy process improves accountability by clarifying how a central bank expects to attain its policy objectives and by ensuring that policies are conducted in a manner that can seen to be consistent with achieving those objectives. Over the past decade or so, the Federal Reserve has significantly improved its methods of communication, but further progress is possible. As you know, the FOMC last year established a subcommittee to help the full committee evaluate the next steps in this continuing process. Our discussions are directed at examining all aspects of our communications and have been deliberate and thorough. These discussions are continuing and no decisions have been reached. My colleagues and I remain firmly committed to an open and transparent monetary policy process that enhances our ability to achieve our dual objectives of stable prices and maximum sustainable employment. I will keep members of this committee apprised of developments as our deliberations move forward. I look forward to continuing to work closely with the members of this committee and your colleagues in the Senate and the House on the important issues pertaining to monetary policy and the other responsibilities with which the Congress has charged the Federal Reserve. Thank you. I would be happy to take questions. [The prepared statement of Chairman Bernanke can be found on page 71 of the appendix.] " CHRG-110shrg50414--87 Mr. Bernanke," Well, we know more or less what the fire-sale prices are. Those are the marks that a lot of companies have. You know, there are a lot of different ways--auctions, auctions combined with expert evaluations and so on--to try to determine the hold-to-maturity price. So, for example, if the Government tries to acquire a substantial portion of a security, the marginal seller would be somebody who has a hold-to-maturity interest in it, for example. So I think there are methods to determine that hold-to-maturity price. Senator Bennett. OK. Well, the best place to determine a price, obviously, is willing buyer and willing seller. But this is not going to be your ordinary auction because the Treasury is going to be there with a $700 billion checkbook. And the question that arises in my mind is: Who is going to bid against the Treasury? Against whom is the Treasury bidding? And what effect will that have on the price? " CHRG-111hhrg51698--23 Mr. Duffy," Thank you; and let me echo my fellow panelists and thank you, Chairman Peterson and Ranking Member Lucas, for the opportunity to present our views. The CME Group Exchanges are neutral marketplaces. Our Congressionally mandated role is to operate markets that foster price discovery and hedging in a transparent, efficient, self-regulated environment overseen by the CFTC. We provide producers and processors with necessary information to make important economic decisions and serve their global risk management needs. We offer a comprehensive selection of benchmark products in all major asset classes. We are also joining market users to operate a green exchange. This exchange will provide trading and clearing services to serve cap and trade programs respecting emissions and allowances. Additionally, we are joint venturers with Citadel to provide trading and clearing platforms for credit default swaps. Our risk analytics and financial safeguards have been thoroughly examined by the CFTC, the Federal Reserve, and the SEC. So we appreciate the proposed clarification that will enhance our ability to provide clearing services for credit default swap contracts. We also appreciate that it will not infringe on the SEC's regulatory responsibilities and will permit competition in this very important market. The draft bill is offered as an amendment to the Commodity Exchange Act to bring greater transparency and accountability to commodity markets. We support the bill's purpose to enhance the enforcement capabilities and structure of the CFTC, but it is essential that care be taken to avoid constraints on U.S. markets that would further weaken the already fragile U.S. economy, damage the competitiveness of U.S. markets, hurt U.S. consumers, produce less transparency, and deprive the Commission of vital information. We understand that there may be some markets in which excessive speculation, as defined in the Commodity Exchange Act, may cause price distortion. All agricultural and natural resource futures and options contracts are subject to either Commission or exchange spot month speculative position limits. The CFTC and the exchanges enforce those limits. We do not agree that hard position limits play a constructive role, either with commodities that are not physically delivered or with commodities whose trading does not affect any physically delivered market. We do not agree that the CFTC should be the front-line regulator setting hard limits. We also disagree with the creation of advisory committees for setting hard limits in agriculture and energy products. The proposed committees are dominated by long and short hedgers who are not constrained by any standards, and who do not operate subject to a defined process. We are concerned that these committees may excessively influence the setting of limits. Also, they may adversely affect the ability of our markets to efficiently perform their price discovery function. In addition, we believe the bill's direction to the Commission is overly restrictive in defining a direct hedging transaction; and it is restrictive with respect to dealers, funds, and others who have assumed risks in the over-the-counter market which are consistent with their legitimate businesses. We are strong proponents of the benefits of central counterparty clearing. It is an effective means to collect and provide timely information to regulators. It also greatly reduces systemic risk imposed on financial systems by unregulated bilateral OTC transactions. We would benefit from section 13 of the draft bill, but we are not confident that it is workable. If the OTC dealers do not embrace clearing, they can easily transact in another jurisdiction. In that way, they could avoid the obligations imposed by the draft bill. This could cause significant damage to a valuable domestic industry. We urge the Committee to shape its bill in recognition of the reality of markets that operate in a global economy. Trading systems are electronic, banking is international, and every important trader has easy access to markets that are not regulated by the CFTC and not constrained by this bill. We are concerned with prohibitions or costly impediments to legitimate business activities in the United States. We believe they will divert business to jurisdictions that adopt other regulatory measures to protect against future meltdowns. We are eager to work with the Committee and the industry to help shape incentives that will encourage clearing and other provisions that support the goal of this bill. My written testimony highlights several technical issues in the draft. More importantly, it offers our pledge to work with the Committee and help assure that U.S. futures markets remain positive contributors to our economy. Thank you, sir. [The prepared statement of Mr. Duffy follows:] Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman, CME Group Inc., Chicago, IL I am Terrence Duffy, Executive Chairman of Chicago Mercantile Exchange Group Inc. (``CME Group'' or ``CME''). Thank you Chairman Peterson and Ranking Member Lucas for this opportunity to present our views.CME Group Exchanges CME Group was formed by the 2007 merger of Chicago Mercantile Exchange Holdings Inc. and CBOT Holdings Inc. CME Group is now the parent of CME Inc., The Board of Trade of the City of Chicago Inc., NYMEX and COMEX (the ``CME Group Exchanges''). The CME Group Exchanges are neutral market places. They serve the global risk management needs of our customers and producers and processors who rely on price discovery provided by our competitive markets to make important economic decisions. We do not profit from higher or lower commodity prices. Our Congressionally mandated role is to operate fair markets that foster price discovery and the hedging of economic risks in a transparent, efficient, self-regulated environment, overseen by the CFTC. The CME Group Exchanges offer a comprehensive selection of benchmark products in all major asset classes, including futures and options based on interest rates, equity indexes, foreign exchange, agricultural commodities, energy, and alternative investment products such as weather and real estate. We are in the process of joining with market users to operate a green exchange to provide trading and clearing services that will serve cap and trade programs respecting emissions and allowances. We are joint venturers with Citadel to provide trading and clearing platforms for credit default swaps. Our risk analytics and financial safeguards have been thoroughly vetted by the CFTC, the Federal Reserve and the SEC. Our efforts to open our doors have been complicated by jurisdictional issues, but we are very close to a launch of the service. We also offer order routing, execution and clearing services to other exchanges as well as clearing services for certain contracts traded off-exchange. CME Group is traded on NASDAQ under the symbol ``CME.''Executive Summary The draft bill that was recently circulated is purposed as an amendment ``to the Commodity Exchange Act to bring greater transparency and accountability to commodity markets.'' We support that statement of the bill's purpose. We unequivocally support enhancing the enforcement capabilities and machinery of the CFTC, but it is essential that care be taken to avoid constraints on U.S. markets that will further weaken the already fragile U.S. economy; damage the competitiveness of U.S. markets; hurt U.S. consumers and produce less transparency and deprive the Commission of vital information. We understand that there may be some markets in which ``excessive speculation,'' as defined in the CEA, may cause price distortion; we set hard limits in those markets or enforce CFTC limits. We do not agree that hard position limits play a constructive role with respect to commodities that are not physically delivered and commodities whose trading does not affect any physical delivery market. We do not agree that the CFTC should be the front-line regulator setting hard limits. We disagree with the creation of ``advisory'' committees for setting hard limits in agriculture and energy products. The proposed committees are dominated by long and short hedgers, who are not constrained by any standards and who do not operate subject to a defined process. We are concerned that these committees will inordinately influence the setting of limits and will adversely affect the ability of our markets to efficiently perform their price discovery function. We believe that the bill's direction to the Commission to define a bona fide hedging transaction is overly restrictive both with respect to direct hedgers and its constraints on the ability of dealers, funds and others who have assumed risks in the over the counter market, which are consistent with their legitimate businesses. We are strong proponents of the benefits of central counterparty clearing as an effective means to collect and provide timely information to prudential and supervisory regulators and to greatly reduce systemic risk imposed on the financial system by unregulated bilateral OTC transactions. We would be a major beneficiary of section 13 of the draft bill, but we are not confident that it is practicable. If the OTC dealers do not embrace clearing, they can easily transact in another jurisdiction, avoid the obligations imposed by the draft bill and cause significant damage to a valuable domestic industry. We urge the Committee to shape its bill in recognition of the reality of markets that operate in a global economy. Trading systems are electronic, banking is international, and every important trader has easy access to markets that are not regulated by the CFTC and not constrained by this bill. Prohibitions or costly impediments to legitimate business activities in the U.S. will simply divert business to jurisdictions that adopt rational measures to deal with the causes and protection against future financial meltdowns. We are eager to work with the Committee and the industry to shape incentives that will encourage clearing in appropriate cases and bring us quickly to the end position envisioned by the bill. Finally, we appreciate the proposed clarification that will enhance our ability to provide clearing services for credit default swap contracts in a manner that does not infringe on the SEC's regulatory responsibilities and that will permit competition in this important market across regulatory regimes. We are concerned, however, that the bill will foreclose trading of CDSs in the U.S.Drafting and Technical Issues We welcome a dialogue with the Committee's staff to resolve our technical and philosophical concerns with the draft. For convenience, we describe our most serious concerns below.Sec. 3. Speculative Limits and Transparency of Offshore Trading. Subpart (a) directs the Commission to preclude direct access from the U.S.: ``to the electronic trading and order matching system of the foreign board of trade with respect to an agreement, contract, or transaction that settles against any price (including the daily or final settlement price) of one or more contracts listed for trading on a registered entity,'' unless the foreign board of trade satisfies a broad set of conditions respecting position limits, information sharing, and the definition of bona fide hedging. The draft bill is calibrated appropriately to focus only on a narrow range of contracts that might be traded on a foreign board of trade, although we wonder why it is restricted to financially settled contracts and does not include substantially identical physically settled contracts. We are, nonetheless, concerned that this effort may provoke retaliatory behavior from foreign governments or regulatory agencies that could severely impair our business.Sec. 4. Detailed Reporting and Disaggregation of Market Data. Section 4 amends the CEA to require that the Commission issue a ``rule defining and classifying index traders and swap dealers (as those terms are defined by the Commission) for purposes of data reporting requirements and setting routine detailed reporting requirements for any positions of such entities . . . .'' The draft requires the Commission to impose ``routine detailed reporting requirements'' on such traders. It is unclear that a higher level of routine reporting for such traders is necessary or appropriate; the Commission is empowered to issue special calls for information without demonstrating any cause. Section 4 also requires swap dealers and index traders to report all positions on foreign boards of trade, without regard to whether those positions implicate any U.S. regulatory interests. It is not clear that this was intended; it is not necessary and imposes an unnecessary burden on the CFTC. Section 4 also includes a reporting provision that we do not understand. The Commission is required to publish: ``data on speculative positions relative to bona fide physical hedgers in those markets to the extent such information is available.'' The Commission does not have information on hedgers who do not exceed speculative limits: in consequence this number is likely to be highly misleading.Sec. 5. Transparency and Recordkeeping Authorities. Subpart (a) extends the reporting requirements for CFTC registrants beyond trading on any board of trade in the United States or elsewhere to include OTC ``trading of transactions and positions traded pursuant to subsection (d), (g), (h)(1), or (h)(3) of section 2, or any exemption issued by the Commission by rule, regulation or order.'' We agree that these transactions should not escape CFTC scrutiny but question whether subsection (a) is necessary in light of the special call provisions in subpart (b).Sec. 6. Trading Limits To Prevent Excessive Speculation. Section 6 requires the Commission to: ``establish limits on the amount of positions, as appropriate, other than bona fide hedge positions, that may be held by any person . . .'' The mandatory limits apply to all commodities traded on regulated markets, without regard to whether excess speculation has ever been an issue in the commodity or whether it is a foreseeable danger. The standard that the Commission must apply is: ``(B) to the maximum extent practicable, in its discretion-- (i) to diminish, eliminate, or prevent excessive speculation as described under this section; (ii) to deter and prevent market manipulation, squeezes, and corners; (iii) to ensure sufficient market liquidity for bona fide hedgers; and (iv) to ensure that the price discovery function of the underlying market is not disrupted; and (C) to the maximum extent practicable, in its discretion, take into account the total number of positions in fungible agreements, contracts, or transactions that a person can hold in other markets.'' We are concerned that the bill imposes conflicting standards and offers no guidance to the Commission on how those conflicts are to be resolved other than that each is to be fulfilled to the maximum extent practicable. Position limits are a device to promote liquidation and orderly delivery in physical contracts. If position limits are not being used for those purposes they artificially impose restrictions on access to markets and are more likely to prevent prices from reaching a true equilibrium than to serve a positive purpose. Moreover, position limits are not appropriate for all commodity contracts. Where the final price of the futures contract is determined by reference to an externally calculated index that is not impacted by the futures market, for example rainfall during a fixed period, position limits cannot be justified. Most financial futures traded on CME Group are not settled by delivery of an underlying commodity and therefore are not readily susceptible to market manipulation. In such a case, accountability levels are more appropriate than position limits. Mandating position limits in non-spot month physical delivery contracts is unnecessary because those contracts do not have a close, direct impact on the price discovery function for the cash market of the underlying commodity. Accountability levels are sufficient to deter and prevent market manipulation in non-spot months. CME Group has numerous surveillance tools, which are used routinely to ensure fair and orderly trading on our markets. Monitoring the positions of large traders in our market is a critical component of our market surveillance program. Large trader data is reviewed daily to monitor reportable positions in the market. On a daily basis, we collect the identities of all participants who maintain open positions that exceed set reporting levels as of the close of business the prior day. Generally, we identify in excess of 85% of all open positions through this process. This data, among other things, are used to identify position concentrations requiring further review and focus by Exchange staff. Any questionable market activity results in an inquiry or formal investigation. Section 6 also requires that the Commission establish advisory committees with respect to agriculture based futures and energy based futures to advise the Commission on speculative position limits. These advisory committees are, by law, dominated by enterprises that have a direct interest in the markets on which they are advising. In addition to this inherent conflict, the bill offers no standard to direct the deliberations of these advisory committees. Instead, it puts 19 or 20 people, with diverging financial interests, in a room and tells them to make a decision. We strongly oppose this process, which empowers market participants whose objectives differ materially from the CEA's purpose in establishing position limits. Regulated futures markets and the CFTC have the means and the will to limit speculation that might distort prices or distort the movement of commodities in interstate commerce. Former CFTC Acting Chairman Lukken's testimony before the Subcommittee on Oversight and Investigations of the Committee on Energy and Commerce United States House of Representatives (December 12, 2007) offers a clear description of these powers and how they are used: All agricultural and natural resource futures and options contracts are subject to either Commission or exchange spot month speculative position limits--and many financial futures and options are as well. With respect to such exchange spot month speculative position limits, the Commission's guidance specifies that DCMs should adopt a spot month limit of no more than \1/4\ of the estimated spot month deliverable supply, calculated separately for each contract month. For cash settled contracts, the spot month limit should be no greater than necessary to minimize the potential for manipulation or distortion of the contract's or underlying commodity's price. For the primary agricultural contracts (corn, wheat, oats, soybeans, soybean meal, and soybean oil), speculative limits are established in the Commodity Exchange Act and changes must be approved via a petition and public rulemaking process. http://www.cftc.gov/stellent/groups/public/@newsroom/documents/ speechandtestimony/opalukken-32.pdf. Subsection (2) directs the Commission to define a bona fide hedge, which permits traders to exceed the hard speculative limits. Proposed subpart (A) pertains to hedgers acting for their own accounts. Subpart (B) governs swap dealers and others who are hedging risks assumed in the OTC market. We believe that subpart (A) has unintended and highly detrimental consequences respecting the ability of regulated futures exchanges to provide hedging opportunities for important business enterprises. The bill provides that a futures position does not qualify as a bona fide hedge unless it: ``(A)(i) represents a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel . . . .'' This interpretation is compelled by the linking of clauses (i), (ii) and (iii) by the conjunctive ``and,'' which requires that all three conditions be satisfied.\1\ As a result, the provisions in (ii) and (iii), which currently operate as independent grounds for a hedge exemption, are nullified. This works perfectly for a grain elevator or farmer who shorts his inventory or expected crop. Futures markets, however, are also used for more sophisticated hedging.--------------------------------------------------------------------------- \1\ ``(2) For the purposes of contracts of sale for future delivery and options on such contracts or commodities, the Commission shall define what constitutes a bona fide hedging transaction or position as a transaction or position that-- ``(A)(i) represents a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel; ``(ii) is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise; and ``(iii) arises from the potential change in the value of-- ``(I) assets that a person owns, produces, manufactures, processes, or merchandises or ant- icipates owning, producing, manufacturing, processing, or merchandising; ``(II) liabilities that a person owns or anticipates incurring; or ``(III) services that a person provides, purchases, or anticipates providing or purchasing;''--------------------------------------------------------------------------- Obviously, this limitation precludes electric utilities from hedging capacity risks associated with weather events by use of degree day unit futures contracts. That hedge involves no substitute for a transaction in a physical marketing channel. Insurance companies may not hedge hurricane or other weather risks. Enterprises that consume a commodity that is not used in a ``physical marketing channel'' such as airlines that use fuel, generating facilities that use gas and produce electricity, freight companies whose loads depend on geographic pricing differentials and hundreds of other important examples that readily present themselves, will not be entitled to a hedge exemption from mandatory speculative limits. Even if ``or'' were substituted, a significant number of clearly legitimate hedging transactions are precluded. Subpart (B) offers swap dealers a very narrow window within which to qualify for a hedge exemption. The position being hedged must reduce: ``risks attendant to a position resulting from a transaction that--. . . was executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction . . . .'' On a practical basis, swap dealers use the futures market to reduce their overall risk; we do not believe that particular futures positions can be linked to identified OTC transactions. Thus, the utility of futures markets as a risk transfer venue will be seriously impaired. We are happy to work with the staff to devise language that will eliminate the use of OTC intermediaries as a mask for trading that would otherwise violate position limits. We believe that the bill's direction to the Commission to define a bona fide hedging transaction set out in section 6(2) is overly restrictive with respect to its constraints on the ability of dealers, funds and others who have assumed risks in the over-the-counter market, which are consistent with their legitimate businesses, to transfer the net risk of their OTC positions to the futures markets. CME Group is concerned that this limitation on hedge exemptions for swap dealers will limit the ability of commercial enterprises to execute strategies in the OTC market to meet their hedging needs. For example, commercial participants often need customized OTC deals that can reflect their basis risk for particular shipments or deliveries. In addition, not all commercial participants have the skill set necessary to participate directly in active futures markets trading. Swap dealers assume that risk and lay it off in the futures market. This restriction contravenes the otherwise clear intent of the draft bill to limit systemic risk by driving OTC generated risk into a central counterparty clearing context. The consequences of this constraint are magnified by the simultaneous imposition of hard position limits on financial futures that are settled by reference to prices that are not susceptible to manipulation, such as Eurodollars or currencies.Sec. 8. Review of Prior Actions. Section 8 of the proposed bill imposes a burden on the Commission that is not justified and that will divert it from the important responsibilities assigned to it in section 7. It requires the Commission to: ``review, as appropriate, all regulations, rules, exemptions, exclusions, guidance, no action letters, orders, other actions taken by or on behalf of the Commission, and any action taken pursuant to the Commodity Exchange Act by an exchange, self- regulatory organization, or any other registered entity, that are currently in effect, to ensure that such prior actions are in compliance with the provisions of this Act.'' No guidance is offered as to what is appropriate, and we are unaware of any action that the Commission has taken, including those with which we have disagreed, that could be found to be ``not in compliance with the `provisions of this Act.' '' The review of the rules of the rules of registered entities and the NFA will be a massive undertaking, given the size and complexity of the rule books, interpretations and notices that govern the business of the registered entities and the NFA and the lack of direction. We are not aware of any significant dissatisfaction with the Commission's actions or the actions of the registered entities and the SRO's that would compel so wide-reaching a review.Sec. 11. Over-The-Counter Authority. Section 11 authorizes the Commission to impose position limits on transactions exempted or excluded from the CEA by ``subsections (d), (g), (h)(1), and (h)(3) of section 2,'' if it first finds that such contracts are: ``fungible (as defined by the Commission) with agreements, contracts, or transactions traded on or subject to the rules of any board of trade or electronic trading facility with respect to a significant price discovery contract . . . .'' We are surprised by the use of the term ``fungible,'' which is generally limited to contracts that may be offset. We assume that this power should apply when the contracts are close economic substitutes. Second, the reference to the defined term ``board of trade'' rather than the phrase ``designated contract markets and derivatives transaction execution facilities'' or ``registered entity'' (as is ordinarily used in the bill) is bound to be afforded some significance, which escapes us. While we are generally in agreement with the purposes of this section, we expect that representative of the participants in the OTC market are best positioned to discuss the impact of this provision and any other technical drafting issues.Sec. 12. Expedited Process. Section 12 grants the Commission authority to act in an expedited manner ``to carry out this Act if, in its discretion, it deems it necessary to do so.'' The Commission currently has comprehensive authority to respond to an emergency. This provision eliminates the salutary requirement that there be an emergency before the Commission is empowered to act precipitously and we do not agree that it is either necessary or appropriate to grant such powers.Sec. 13. Certain Exclusions and Exemptions Available Only for Certain Transactions Settled and Cleared Through Registered Derivatives Clearing Organizations. Section 13 is intended to force certain transactions that were exempted from the exchange trading requirement and most other Commission regulations by 2(d)(1)(C), 2(d)(2)(D), 2(g)(4), 2(h)(1)(C), or 2(h)(3)(C) of the Act either onto a regulated trading platform or to be cleared by a CFTC Designated Clearing Organization or a comparable clearing house. While this section appears to favor our organization and advances our goals, we are concerned that it will fail to produce the desired result and negatively impact the U.S. derivatives industry. We discussed this point in the introductory portion of this testimony.Sec. 14. Treatment of Emission Allowances and Offset Credits. Section 14 authorizes the trading of: ``any allowance authorized under law to emit a greenhouse gas, and any credit authorized under law toward the reduction in greenhouse gas emissions or an increase in carbon sequestration.'' The CEA was already sufficiently broadly worded to permit such contracts to be traded on futures exchanges subject to the Commission's exclusive jurisdiction. We are concerned that the specific description may, in the future, be read as a limitation on the authority to create futures contracts relating to the greening of America and we believe that the Committee needs to generalize the language to avoid that implication.Sec. 16. Limitation on Eligibility To Purchase A Credit Default Swap. Section 16, which makes it: ``unlawful for any person to enter into a credit default swap unless the person would experience financial loss if an event that is the subject of the credit default swap occurs'' is worded in a manner that prohibits the use of credit default swaps for any purpose. The language requires both the buyer and seller of credit protection to suffer a loss if the event were to occur and there was no credit default swap in place. Obviously, only the buyer of credit protection qualifies. However, even if the language were corrected, we are opposed to this provision as an unwarranted restriction on functioning of free markets. This provision punishes the instrument and legitimate users of the instrument for the excesses of the management of AIG. The instrument was innocent as were the vast bulk of the users of the instrument and the markets in which the instruments were transacted. We do not purport to be the appropriate spokesperson for the industry, but we can assure you that all of our plans to clear CDSs will come to naught if this provision is adopted. Credit default contracts serve an important economic purpose in an unfortunately imperfect manner. At the ideal level, credit default contracts permit investors to hedge specific risk that a particular enterprise will fail or that the rate of failure of a defined group of firms will exceed expectations. However, because credit default contracts are not insurance, investors who are not subject to any specific risk can assume default risk to enhance yield or buy protection against a default to speculate on the fate of a company or the economy generally. Credit default contracts are also an excellent device to short corporate bonds, which otherwise could not be shorted. If such contracts are executed in a transparent environment, if the regulators responsible for controlling systemic risk can easily keep track of the obligations of the banks, brokers and other participants in the market and if a well regulated clearing house acts as the central counterparty for such contracts, we believe that they can serve an important role in our economy without imposing undue systemic risks.Conclusion: Futures markets perform two essential functions--they create a venue for price discovery and they permit low cost hedging of risk. Futures markets depend on short and long term speculators to make markets and provide liquidity for hedgers. Futures markets could not operate effectively without speculators and speculators will not use futures markets if artificial barriers or tolls impede their access. CFTC-regulated futures markets have demonstrated their importance to the economy, the nation's competitive strength and America's international financial leadership. We have the means and the power to protect our markets against speculative excesses and are committed to doing so. " FinancialCrisisInquiry--16 The past two years have been unlike anything I’ve seen in my 40 years in financial service. Unprecedented illiquidity and turmoil on Wall Street saw the fall of two leading franchises and the consolidation of others. We saw credit markets seize, the competitive landscape remade, and vast governmental intervention in the financial sector. And the consequences have obviously spread far beyond Wall Street. Millions in America today are struggling to find work. They’ve lost homes. They watched their retirements evaporate their savings. I believe the financial crisis exposed fundamental flaws in our financial system. There is no doubt that we as an industry made mistakes. In retrospect it’s clear that many firms were too highly leveraged. They took on too much risk, and they didn’t have sufficient resources to manage those risks effectively in a rapidly changing environment. The financial crisis also made clear that regulators simply didn’t have the visibility, tools or authority to protect the stability of the financial system as a whole. Let me briefly walk you through what happened from Morgan Stanley’s viewpoint and our response to the crisis. As the commission knows, the entire financial service history was hit by a series of macro shocks that began with the steep decline in U.S. real estate prices in 2007. Morgan Stanley, like many of its peers, experienced significant losses related to the decline in the value of securities and collateralized debt obligations backed by residential mortgage loans. This was a powerful wake-up call for this firm, and we moved quickly and aggressively to adapt our business to the rapidly changing environment. We cut leverage. We strengthened risk management. We raised private capital and dramatically reduced our balance sheet. We increased total average liquidity by 46 percent, and we entered the fall of ‘08 with $170 billion in cash on our balance sheet. Thanks to these prudent steps, we were in a better position than some of our peers to weather the worst financial storm, but we did not do everything right. When Lehman Brothers collapsed in early September of ‘08, it sparked a severe crisis of confidence across global financial markets. Like many of our peers, we experienced a classic run on the bank as the entire investment banking business model came under siege. Morgan Stanley and other financial institutions experienced huge swings and spreads on the credit-default swaps tied to our debt and sharp drops in our share price. This led clearing banks to request that firms post additional collateral causing further depletion of cash resources. FOMC20050503meeting--95 93,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. We think the fundamentals underpinning a forecast of a reasonably strong expansion with moderate inflation seem reasonably persuasive. However, we are less confident than we were at the last meeting. On the assumption that we continue to move the fed funds rate higher on a path close to that now in the market, we expect the economy to grow at a 3½ percent rate during the balance of this year and in 2006. And we still expect core PCE inflation to come in below 2 percent, although just below, over the balance of the forecast period, but we think it will follow a somewhat higher path. As this implies, we’re very close to the Greenbook projection on the overall contour of the forecast, and we’re close on the components as well. We see greater uncertainty in the forecast, with some downside risk to growth and some upside risk to inflation. We think the probability of inflation coming in higher is greater than the probability that growth will be lower. And, of course, that judgment about the change in relative May 3, 2005 56 of 116 On the growth front, the anecdotal reports we’re exposed to are weaker than they have been. They’re weaker than the national numbers and may imply some further deceleration ahead. We don’t have much basis for confidence that these numbers tell us much about the future, but the sentiment does seem a bit more fragile. The fact that confidence seems to have eroded so quickly in the face of a relatively limited period of weaker numbers might itself suggest greater vulnerability to the forecast. Despite all of this, though, we think the near-term fundamentals of the economy look fairly good. The resilience of the recent past seems likely to be durable. We think the labor market still looks to be on a path of gradual improvement. Investment growth still seems likely to be pretty healthy, with profit margins high, balance sheets strong, and credit conditions favorable. We think the factors supporting solid investment growth remain compelling. And we still are inclined to believe that structural productivity growth is likely to remain strong, which should provide both continued impetus to investment and continued confidence about future income growth. It’s hard to find other constraints out there that could limit the expansion. Of course, we still face some risk of an abrupt change in household saving behavior, and the effects of that could be significant. On the inflation front, we’ve been surprised by the extent of the acceleration in core prices and we are a bit concerned about the higher expectations reflected in some surveys. The economy is growing at a rate that seems likely to be sufficient to continue to absorb remaining slack, unit labor costs have moved up, and we hear continued reports of increased pricing power. And some measures of expectations at the intermediate horizon—the horizon over which we expect monetary policy can affect inflation—are above the desirable level of inflation. Accordingly, we see greater risk that inflation will follow a higher path than we are comfortable with. This seems a prudent view May 3, 2005 57 of 116 has been modest to date—profit margins remain very high, of course—and despite expectations of fairly good future structural productivity growth. The modest widening in credit spreads and the volatility in equity prices we’ve seen recently have been absorbed reasonably well. I’d be inclined to view this modest repricing of risk and uncertainty as welcome and healthy rather than as foreshadowing a deeper, more protracted deceleration. On balance, we believe that monetary policy should continue to be directed at moving the real fed funds rate higher. At our last meeting we introduced a bit more uncertainty into the monetary policy signal by putting in more qualifications about the likely path of monetary policy going forward and about the cumulative amount of tightening. The overall effect of these changes to our statement was to continue to signal that we think the slope of the funds rate path remains positive, implying, of course, that monetary policy is still too accommodative. But we also indicated, through these changes to this statement, that we have less certainty about the slope and shape of that path. Long-term measures of inflation expectations moderated immediately following the meeting, and some measures of uncertainty about future rates went up. And since then, market participants have demonstrated a very significant degree of sensitivity to incoming data—at least in terms of the fed funds path priced into the markets To me this suggests that we got the balance about right last time. We bought ourselves the desirable increase in flexibility to respond to a somewhat more uncertain set of conditions going forward, and I think we should try to preserve that balance in our signal today. We need to acknowledge, of course, the moderation in the rate of growth in output and demand we’ve seen and the higher inflation numbers, but I don’t see a good reason to try to alter May 3, 2005 58 of 116 The increased uncertainty in the market about the forecast reflects some greater dispersion in the likely path of the fed funds rate, and I think it suggests little gap between the market’s view and our own view of policy uncertainty going forward. So I don’t see a case for altering the statement significantly today in a way that would introduce a greater degree of uncertainty about monetary policy than is already reflected in the markets at this point. Thank you." FOMC20051213meeting--75 73,MR. LACKER.," Thank you, Mr. Chairman. On balance, economic activity is growing at a solid pace in the Fifth District, though auto sales are faltering and housing markets are cooling. On the upside, employment conditions have been strengthening, with signs that the job numbers are increasing even at District factories. Outside of autos and big-ticket items though, retail sales strengthened substantially this month. Retailers indicate that holiday sales are solid, and they’ve become more optimistic about prospects for the first half of ’06. Auto sales are weak, though, and December 13, 2005 41 of 100 revenues and employment growing over the last two months. Home sales remain at high levels but we are receiving widespread reports that activity is decelerating, particularly in northern Virginia where markets have been quite robust in recent years. A number of independent reports describe “a return to normalcy” in residential real estate markets, with houses actually being on the market and not getting multiple bids on the first day. Manufacturing continues to hold its own. Although shipments and new orders were softer in early December, the hiring index was up for our District, and firms have become notably more optimistic about their early ’06 prospects. District price pressures seem to have eased somewhat in December. Although retail prices were reported to have advanced at the same strong pace as in November, outside the retail sector services’ prices have decelerated from October to December. Manufacturing price gains peaked in November in our series, and our preliminary numbers show that both prices paid and prices received slowed sharply this month. Turning to the national economy, we’ve received a string of favorable data since our October meeting, suggesting both that the economy had considerable momentum prior to this fall’s storms and that the effects of the storms on economic activity outside the affected region and the energy sector have not been as large as feared. I’m particularly encouraged by the continued strength in business investment spending in the present quarter, as evidenced by capital goods orders and the ISM numbers. I’m also encouraged by anecdotal reports of a cooling in District and national housing markets. These reports are consistent with a continuing handoff from residential to business investment. That said, I’m tempted to paraphrase Solow, though, and say that the slowdown in housing appears to be visible everywhere but in the housing activity data. [Laughter] Consumer spending has held up quite well. My sense is that the most important source of this December 13, 2005 42 of 100 reason, given the Greenbook forecast for income growth in the near term, I would not expect a flattening of housing prices to seriously dampen consumer spending. Rather, I expect, consistent with the Greenbook, consumer spending growth to come in on the strong side going forward, with the saving rate rising only slowly. The inflation picture has also improved notably since our last meeting, in my mind. The October core PCE number was heartening, and inflation expectations have been well behaved. Both survey measures and TIPS compensation spreads have come down off the post-Katrina highs they reached earlier this fall. While the inflation picture is somewhat better, it does leave some room for concern, in my view. This Greenbook forecasts a 2.2 percent core inflation rate for the first half of ’06, less than the last Greenbook, but it still makes me somewhat uncomfortable. With oil prices appearing to have found a stable range in the neighborhood of $60 a barrel and with natural gas prices remaining high and volatile, I think it will be several months before the risk of pass-through can be completely put to bed. As for the econometric evidence about pass-through, I’d note that expectations regarding our policy response represent a latent variable that of necessity is omitted in most econometric exercises. I take less comfort from the econometric evidence than you do, President Yellen. Our preemption may be required for the pattern you found in the ’90s to actually continue to be confirmed in the data. In the meantime, I think we need to ensure that the public understands our resolve with regard to inflation. And the real funds rate in the neighborhood of 2 percent is very likely too low for an economy that’s in a sustained expansion with relatively full resource utilization. So I think it’s appropriate to follow through today with a 25 basis point increase in the funds rate. December 13, 2005 43 of 100" CHRG-111hhrg52397--128 Mr. Price," You do not? " CHRG-110hhrg46591--160 Mr. Price," And-- " CHRG-109hhrg28024--216 Mr. Price," Indeed. " CHRG-111hhrg48674--230 Mr. Price," Is that where we are? " CHRG-111shrg50815--27 Mr. Ausubel," Good morning, Chairman Dodd, Ranking Member Shelby, and members of the Committee, and thank you for inviting me here. My name is Lawrence Ausubel. I am a professor of economics at the University of Maryland and the author of perhaps the most cited article on credit cards in the scholarly literature. Penalty interest rates or risk-based pricing, this is the question of the day. Consumer advocates assert that when the typical issuer raises the credit card interest rate by 12 to 15 percent following a late payment, this is penalty pricing intended to take revenues from their most vulnerable customers. However, industry representatives respond that consumers who miss payments are the most likely to eventually default and all they are doing is requiring the riskiest consumers to shoulder their true cost. My testimony will seek to address which characterization is more accurate. The consumer view would justify legislation, such as the Dodd bill, while the industry view would suggest that such rules are misplaced. Unfortunately, the data necessary to answer this question are typically confidential and out of reach. However, in 2008, Morrison and Foerster issued a data study on behalf of lenders which tracks various delinquency events such as going 16 to 30 days past due or going three or more days past due on two separate occasions, and it reports the percentage of consumers who ultimately default. Using their reported numbers, one can perform simple back-of-the-envelope calculations that answer the question of the day. The data enable me to reach the conclusion that the increases in interest rates bear no reasonable relation to default risk, i.e., these are penalty interest rates that demand regulation. Here is a simple calculation. Accounts that were 16 to 30 days past due in May 2006 experienced higher defaults than accounts that were current. Twenty-point-seven percent of these balances went into default, as defined by the study, over the following 22 months as compared to 9.3 percent for accounts that were current. Converting these percentages into annual rates of net credit losses gives an increased economic loss per year of 4.5 percent. However, the standard repricing in the marketplace is a 12 percent to 15 percent increase. Let me repeat that. Economic loss of 4.5 percent versus standard repricing of 12 to 15 percent. This is three times greater. By any standard, this is penalty pricing, not risk-based pricing. Moreover, this calculation is overly generous to the industry in several respects. For example, the data study omits late fees, typically $39, which are imposed above and beyond the interest rate increases. Further, to be more than fair, I selected 16 to 30 days late as my selection criterion. Using a trigger of just two to 5 days late, as some banks do, one can get the economic loss down below 2.5 percent per year. And again, the standard increase is 12 to 15 percent. At the end of the day, the economic conclusion is inescapable that these are penalties based not on cost, but on demand factors, and observe that the demand of consumers facing penalty rates is rather inelastic. They are often borrowed up, distressed, and have diminished alternative borrowing opportunities. I should also emphasize that a retroactive penalty rate increase for distressed consumers is precisely the opposite policy prescription that we apply in other areas of lending. For example, there is a growing consensus today that in the mortgage area, loan modification, i.e., reductions as opposed to penalties, are needed. To summarize, economic analysis of recent data supports stricter regulation of the credit card industry, particularly with respect to penalty interest rates imposed on existing balances. The Fed has taken some action in this area, but regrettably, the regulations are weak and the effective date is not until July 1, 2010. The current economic crisis makes it all the more urgent that Congress adopt the Dodd bill sooner. So to close, Chairman Dodd, I support the bill you introduced yesterday. " CHRG-110shrg38109--170 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System February 14, 2007 Chairman Dodd, Senator Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. Real activity in the United States expanded at a solid pace in 2006, although the pattern of growth was uneven. After a first-quarter rebound from weakness associated with the effects of the hurricanes that ravaged the Gulf Coast the previous summer, output growth moderated somewhat on average over the remainder of 2006. Real gross domestic product (GDP) is currently estimated to have increased at an annual rate of about 2\3/4\ percent in the second half of the year. As we anticipated in our July report, the U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable average pace of growth. The principal source of the ongoing moderation has been a substantial cooling in the housing market, which has led to a marked slowdown in the pace of residential construction. However, the weakness in housing market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy. Consumer spending has continued to expand at a solid rate, and the demand for labor has remained strong. On average, about 165,000 jobs per month have been added to nonfarm payrolls over the past 6 months, and the unemployment rate, at 4.6 percent in January, remains low. Inflation pressures appear to have abated somewhat following a run-up during the first half of 2006. Overall inflation has fallen, in large part as a result of declines in the price of crude oil. Readings on core inflation--that is, inflation excluding the prices of food and energy--have improved modestly in recent months. Nevertheless, the core inflation rate remains somewhat elevated. In the five policy meetings since the July report, the Federal Open Market Committee (FOMC) has maintained the Federal funds rate at 5\1/4\ percent. So far, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing of core inflation. However, in the statement accompanying last month's policy decision, the FOMC again indicated that its predominant policy concern is the risk that inflation will fail to ease as expected and that it is prepared to take action to address inflation risks if developments warrant. Let me now discuss the economic outlook in a little more detail, beginning with developments in the real economy and then turning to inflation. I will conclude with some brief comments on monetary policy. Consumer spending continues to be the mainstay of the current economic expansion. Personal consumption expenditures, which account for more than two-thirds of aggregate demand, increased at an annual rate of around 3\1/2\ percent in real terms during the second half of last year, broadly matching the brisk pace of the previous 3 years. Consumer outlays were supported by strong gains in personal income, reflecting both the ongoing increases in payroll employment and a pickup in the growth of real wages. Real hourly compensation--as measured by compensation per hour in the nonfarm business sector deflated by the personal consumption expenditures price index--rose at an annual rate of around 3 percent in the latter half of 2006. The resilience of consumer spending is all the more striking given the backdrop of the substantial correction in the housing market that became increasingly evident during the spring and summer of last year. By the middle of 2006, monthly sales of new and existing homes were about 15 percent lower than a year earlier, and the previously rapid rate of house-price appreciation had slowed markedly. The fall in housing demand in turn prompted a sharp slowing in the pace of construction of new homes. Even so, the backlog of unsold homes rose from about 4\1/2\ months' supply in 2005 to nearly 7 months' supply by the third quarter of last year. Single-family housing starts have dropped more than 30 percent since the beginning of last year, and employment growth in the construction sector has slowed substantially. Some tentative signs of stabilization have recently appeared in the housing market: New and existing home sales have flattened out in recent months, mortgage applications have picked up, and some surveys find that homebuyers' sentiment has improved. However, even if housing demand falls no further, weakness in residential investment is likely to continue to weigh on economic growth over the next few quarters as homebuilders seek to reduce their inventories of unsold homes to morecomfortable levels. Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid, and delinquency rates on most types of consumer loans and residential mortgages remain low. The exception is subprime mortgages with variable interest rates, for which delinquency rates have increased appreciably. The labor market is expected to stay healthy, and real incomes should continue to rise, although the pace of employment gains may be slower than that to which we have become accustomed in recent years. In part, slower average job growth may simply reflect the moderation of economic activity. Also, the impending retirement of the leading edge of the baby-boom generation, and an apparent leveling out of women's participation rate in the workforce, which had risen for several decades, will likely restrain the growth of the labor force in coming years. With fewer jobseekers entering the labor force, the rate of job creation associated with the maintenance of stable conditions in the labor market will decline. All told, consumer expenditures appear likely to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal incomes if, as we expect, households respond to the slow pace of home-equity appreciation by saving more out of current income. The business sector remains in excellent financial condition, with strong growth in profits, liquid balance sheets, and corporate leverage near historical lows. Last year, those factors helped to support continued advances in business capital expenditures. Notably, investment in high-tech equipment rose 9 percent in 2006, and spending on nonresidential structures (such as office buildings, factories, and retail space) increased rapidly through much of the year after several years of weakness. Growth in business spending slowed toward the end of last year, reflecting mainly a deceleration of spending on business structures; a drop in outlays in the transportation sector, where spending is notably volatile; and some weakness in purchases of equipment related to construction and motor vehicle manufacturing. Over the coming year, capital spending is poised to expand at a moderate pace, supported by steady gains in business output and favorable financial conditions. Inventory levels in some sectors--most notably at motor vehicle dealers and in some construction-related manufacturing industries--rose over the course of last year, leading some firms to cut production to better align inventories with sales. Remaining imbalances may continue to impose modest restraint on industrial production during the early part of this year. Outside the United States, economic activity in our major trading partners has continued to grow briskly. The strength of demand abroad helped spur a robust expansion in U.S. real exports, which grew about 9 percent last year. The pattern of real U.S imports was somewhat uneven, partly because of fluctuations in oil imports over the course of the year. On balance, import growth slowed in 2006, to 3 percent. Economic growth abroad should support further steady growth in U.S. exports this year. Despite the improvements in trade performance, the U.S. current account deficit remains large, averaging about 6\1/2\ percent of nominal GDP during the first three quarters of 2006 (the latest available data). Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the Members of the Board of Governors and Presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts--which are based on the information available at that time and on the assumption of appropriate monetary policy--is for real GDP to increase about 2\1/2\ to 3 percent in 2007 and about 2\3/4\ to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. This difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4\1/2\ to 4\3/4\ percent. The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006. I turn now to the inflation situation. As I noted earlier, there are some indications that inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated. Recent declines in overall inflation have primarily reflected lower prices for crude oil, which have fed through to the prices of gasoline, heating oil, and other energy products used by consumers. After moving higher in the first half of 2006, core consumer price inflation has also edged lower recently, reflecting a relatively broad-based deceleration in the prices of core goods. That deceleration is probably also due to some extent to lower energy prices, which have reduced costs of production and thereby lessened one source of pressure on the prices of final goods and services. The ebbing of core inflation has likely been promoted as well by the stability of inflation expectations. A waning of the temporary factors that boosted inflation in recent years will probably help foster a continued edging down of core inflation. In particular, futures quotes imply that oil prices are expected to remain well below last year's peak. If actual prices follow the path currently indicated by futures prices, inflation pressures would be reduced further as the benefits of the decline in oil prices from last year's high levels are passed through to a broader range of core goods and services. Nonfuel import prices may also put less pressure on core inflation, particularly if price increases for some other commodities, such as metals, slow from last year's rapid rates. But as we have been reminded only too well in recent years, the prices of oil and other commodities are notoriously difficult to predict, and they remain a key source of uncertainty to the inflation outlook. The contribution from rents and shelter costs should also fall back, following a step-up last year. The faster pace of rent increases last year may have been attributable in part to the reduced affordability of owner-occupied housing, which led to a greater demand for rental housing. Rents should rise somewhat less quickly this year and next, reflecting recovering demand for owner-occupied housing as well as increases in the supply of rental units, but the extent and pace of that adjustment is not yet clear. Upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period. The rate of resource utilization is high, as can be seen in rates of capacity utilization above their long-term average and, most evidently, in the tightness of the labor market. Indeed, anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in certain occupations. Measures of labor compensation, though still growing at a moderate pace, have shown some signs of acceleration over the past year, likely in part the result of tight labor market conditions. The implications for inflation of faster growth in nominal labor compensation depend on several factors. Increases in compensation might be offset by higher labor productivity or absorbed by a narrowing of firms' profit margins rather than passed on to consumers in the form of higher prices; in these circumstances, gains in nominal compensation would translate into gains in real compensation as well. Underlying productivity trends appear favorable, and the markup of prices over unit labor costs is high by historical standards, so such an outcome is certainly possible. Moreover, if activity expands over the next year or so at the moderate pace anticipated by the FOMC, pressures in both labor and product markets should ease modestly. That said, the possibility remains that tightness in product markets could allow firms to pass higher labor costs through to prices, adding to inflation and effectively nullifying the purchasing power of at least some portion of the increase in labor compensation. Thus, the high level of resource utilization remains an important upside risk to continued progress on inflation. Another significant factor influencing medium-term trends in inflation is the public's expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as those created by changes in energy costs, become embedded in wage and price decisions and so leave a lasting imprint on the rate of inflation. It is encouraging that inflation expectations appear to have remained contained. The projections of the Members of the Board of Governors and the Presidents of the Federal Reserve Banks are for inflation to continue to ebb over this year and next. In particular, the central tendency of those forecasts is for core inflation--as measured by the price index for personal consumption expenditures excluding food and energy--to be 2 to 2\1/4\ percent this year and to edge lower, to 1\3/4\ to 2 percent, next year. But as I noted earlier, the FOMC has continued to view the risk that inflation will not moderate as expected as the predominant policy concern. Monetary policy affects spending and inflation with long and variable lags. Consequently, policy decisions must be based on an assessment of medium-term economic prospects. At the same time, because economic forecasting is an uncertain enterprise, policymakers must be prepared to respond flexibly to developments in the economy when those developments lead to a reassessment of the outlook. The dependence of monetary policy actions on a broad range of incoming information complicates the public's attempts to understand and anticipate policy decisions. Clear communication by the central bank about the economic outlook, the risks to that outlook, and its monetary policy strategy can help the public to understand the rationale behind policy decisions and to anticipate better the central bank's reaction to new information. This understanding should, in turn, enhance the effectiveness of policy and lead to improved economic outcomes. By reducing uncertainty, central bank transparency may also help anchor the public's longer-term expectations of inflation. Much experience has shown that well-anchored inflation expectations tend to help stabilize inflation and promote maximum sustainable economic growth. Good communication by the central bank is also vital for ensuring appropriate accountability for its policy actions, the full effects of which can be observed only after a lengthy period. A transparent policy process improves accountability by clarifying how a central bank expects to attain its policy objectives and by ensuring that policy is conducted in a manner that can be seen to be consistent with achieving those objectives. Over the past decade or so, the Federal Reserve has significantly improved its methods of communication, but further progress is possible. As you know, the FOMC last year established a subcommittee to help the full Committee evaluate the next steps in this continuing process. Our discussions are directed at examining all aspects of our communications and have been deliberate and thorough. These discussions are continuing, and no decisions have been reached. My colleagues and I remain firmly committed to an open and transparent monetary policy process that enhances our ability to achieve our dual objectives of stable prices and maximum sustainable employment. I will keep Members of this Committee apprised of developments as our deliberations move forward. I look forward to continuing to work closely with the Members of this Committee and your colleagues in the Senate and House on the important issues pertaining to monetary policy and the other responsibilities with which the Congress has charged the Federal Reserve. Thank you. I would be happy to take questions. FOMC20050630meeting--338 336,MR. LEAHY.," Well, our forecast, obviously, is for import prices to decelerate. That’s based on forecasts that the dollar will flatten out, roughly, or decline only moderately going forward, and that commodity prices will also be relatively flat. So, to the extent you put a lot of confidence into those forecasts, I think you could transfer that to our outlook for import prices. That’s how we do the forecasts." FOMC20060920meeting--157 155,MR. REINHART.,"3 Thank you, Mr. Chairman and some participants. [Laughter] Over the intermeeting period, tumbling oil prices, better-behaved inflation, and the minutes of the August meeting, which conveyed a more widespread disinclination to tighten than investors suspected, pulled nominal interest rates lower. As can be seen by the solid line in the upper left panel of your first exhibit, the rate on three-month Eurodollar futures expiring this December declined a touch, on net, and is now consistent with the federal funds rate remaining at 5¼ percent for the remainder of the year. Investors seem to expect policy easing thereafter, in that the contract expiring one year later has a rate about ½ percentage point lower. This can be seen most clearly by the black line in the upper right panel, which shows that the path expected for the federal funds rate over the next two years has a decidedly negative slope. As indicated by the shift from the black dotted to the black solid line in the lower left panel, this revision to policy expectations was associated with a roughly parallel step downward in the term structure of nominal Treasury yields over the intermeeting period. The yield curve for indexed securities moved up closer to its nominal counterpart—the shift from the dotted to the solid red line—implying that the difference, inflation compensation, declined. These relative movements can be made more precise by putting them in terms of changes in implied forward rates, as at the right. Nominal forward rates (the top panel) declined in a relatively uniform fashion, from 8 to 15 basis points. The rotation up in the real yield curve, however, was associated with sizable increases in short-term real forward rates and declines at longer horizons. The arithmetic difference between the two is plotted in the bottom right panel: Inflation compensation fell noticeably at short horizons, but the decline tapered off as the maturity lengthened. 3 Materials used by Mr. Reinhart are appended to this transcript (appendix 3). One way to tie these disparate movements into a neat package is to argue that the substantial decline in oil prices in recent weeks represents a disinflationary impetus that is anticipated to be only partly offset by you. That is, nominal rates will move lower but by less than the drop in inflation so as to keep real interest rates higher for a time. In this story, the decline in oil prices represents an opportunity to disinflate—an opportunity that investors expect you to take by being slow to lower nominal interest rates. The same story, however, can take on a darker hue if it is argued that the fall in the prices of oil and other commodities evidenced a slowing in global activity brought on at least in part by your previous 17 policy firmings—that is, this opportunity for disinflation could be one of your own making. Either explanation—one of omission or one of commission—produces a moderation in spending and a drift down in inflation that would seem to be consistent with holding the funds rate at 5¼ percent for now, a possibility examined in more detail in exhibit 2. At its August meeting, the Committee assessed the risks to be such that it could hold policy unchanged given its expectation that growth would moderate and inflation decline. The information received since then would seem to strengthen that determination. As shown in the top left panel, inflation compensation measured in the Treasury market is about unchanged at the longer horizon (the red line) and distinctly lower in the near term (the black line). How much of this decline represents a drop in inflation expectations as opposed to a decline in inflation risk premiums is hard to say, but the evidence at the right may be suggestive. Merrill Lynch conducts a monthly survey of global fund managers about their views of macroeconomic risks and portfolio inclinations. More than 200 of them typically reply, and last month an increased share of them were of the view that inflation would be lower, rather than higher, than in recent months. This view seems to be underpinned by the expectation that economic growth will moderate so that resource slack will open up, perhaps as in the staff forecast in the middle left panel. Indeed, when asked about global economic growth, the fund managers surveyed by Merrill Lynch mostly expected it to slow, as at the middle right, with more of them of that view than earlier in the year. As can be seen directly below, the slowing is not anticipated by investors to be so precipitous as to tip the world economy into recession. More than 90 percent of the managers view such an outcome as unlikely. Thus, they wouldn’t seem to be putting much weight on the flatness of the yield curve, plotted at the bottom left, as a leading indication of recession—nor would you if you’re inclined to keep policy on hold. In that regard, as the chart makes clear, the yield curve has had some predictive power for recession over the past forty years. For instance, the inversion of the term structure in 2000 was sending a signal that, in retrospect, might have warranted a response. This indicator may seem less compelling now for two reasons. First, a flattening yield curve has sent false signals as well over the years, including of recessions that didn’t occur in the mid-1990s. Second, much of the downward tilting of the term structure seems due to a decline in term premiums, which might be a sign of reduced uncertainty rather than a sign of increased economic vulnerabilities. Indeed, some Committee members may be far from seeing the economy as vulnerable—perhaps to the point of inclining them toward firming policy 25 basis points, as in exhibit 3. In particular, financial market participants do not seem to have heard the message of the August statement that the risks were tilted toward higher policy rates. Rather, as shown in the top left panel by the spread of the December 2007 Eurodollar futures contract below the December 2006 one, about 50 basis points of easing is expected next year. This expectation of ease may be contributing to low credit spreads (the top center panel) and the recent rise in equity prices (the top right panel). This financial impetus might be seen as a reason that spending will not moderate sufficiently to make a noticeable dent in inflation. Even if those expectations are wrung out of financial market prices over time—as in the staff forecast—the resulting path of inflation may not be acceptable to the Committee. As shown in the middle panel, core PCE inflation is projected by the staff to remain above 2 percent through the end of 2008, which would mark the fifth consecutive year of such an outcome. The survey expectations of CPI inflation— plotted at the bottom left—similarly remain well above 2 percent. While survey responses came down over the intermeeting period, you might discern a slight uptrend in the past few years that could be taken as an erosion of the public’s confidence. In such a circumstance, members may believe that more-acceptable progress toward price stability will likely involve a firmer stance of policy, a judgment that would be strengthened if you thought the spike in the growth of compensation per hour plotted at the right was not as likely to roll back as the staff projects. The Bluebook lived up to its title, “Monetary Policy Alternatives,” by offering the five different options given in exhibit 4—three formal ones and two variants (which are shaded) that were discussed in the text. If your intent is to solidify current market expectations of easing, switching to balanced risks, as in A, probably has some appeal. The words of alternative B were designed to leave market rates about unchanged, whereas B+ emphasizes that tightening is more likely than easing. It doesn’t really say anything new, but we thought the force of repetition might get the attention of market participants. The alternative labeled C- couples tightening with a removal of the rate bias, signaling that the Committee may be done, whereas C imposes considerable additional restraint by retaining an assessment of upside risks even after firming. Your last exhibit repeats table 1 from the Bluebook with a minor change noted in red in the second row." FOMC20051101meeting--100 98,MR. STOCKTON.," On the house price front, obviously, there aren’t market signals. But we’ve confronted the very same problem of trying to forecast an asset price that we don’t have enormous confidence in. So the approach that we have taken is that we presented a few models at the special briefing last July—some models that rely more on the momentum in underlying house prices and other models that take seriously some sort of error correction to a rent-price ratio to bring that ratio back into equilibrium. And our forecast is a mix of those various approaches. I guess I’d plead guilty in the sense that our house price forecast, along with our rent forecast, does imply by the end of the projection horizon a little of what we view as the current over- valuation diminishing. But mostly that forecast is fairly neutral in that our assessment of over- valuation pretty much involves prices holding at that higher level going forward. It gets a little worse in the near term and then gets a little better a bit further out. But it is an element of the forecast that obviously is important and about which there is considerable uncertainty. November 1, 2005 26 of 114" CHRG-111shrg57319--5 MUTUAL BANK " Mr. Vanasek," OK. Mr. Chairman, Senator Coburn, and distinguished Members of the Committee, thank you for the opportunity to discuss the mortgage and financial crisis from the perspective of a Chief Credit Officer in the sixth-largest bank in this country.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Vanasek appears in the Appendix on page 134.--------------------------------------------------------------------------- I was the Chief Credit Officer and later the Chief Risk Officer of Washington Mutual during the period of September 1999 to December 2005, when I retired. Prior to serving in this capacity, I had worked for several large banking companies in senior credit-oriented roles, including PNC, First Interstate Bank, Norwest/Wells Fargo. Altogether, I have 38 years of experience in credit-oriented positions and have been fortunate enough to have well-established histories and constructive relationships with all of the major banking regulators. The failure of Washington Mutual occurred in September 2008, nearly 3 years after my retirement, so much of what I will tell you today is historical information about the company's strengths and weaknesses during the years of my direct involvement. Washington Mutual was a reflection of the mortgage industry characterized by very fast growth, rapidly expanding product lines, and deteriorating credit underwriting. This was a hyper-competitive environment in which mistakes were made by loan originators, lending institutions, regulatory agencies, rating agencies, investment banks that packaged and sold mortgage-backed securities, and the institutions that purchased these excessively complex instruments. It was both the result of individual failures and systemic failures fueled by self interest, failure to adhere to lending policies, very low interest rates, untested product innovations, weak regulatory oversight, astonishing rating agency lapses, weak oversight by boards of directors, a cavalier environment on Wall Street, and very poorly structured incentive compensation systems that paid for growth rather than quality. One must also seriously question the wisdom of the elimination of Glass-Steagall and its impact on the securitization market. Washington Mutual was a company that had grown with exceptional speed due to acquisitions primarily in California during the industry crisis of the early 1990s. By 2000, it was a company in search of identity. At one point, the CEO wanted the company to expand the commercial lending area in an effort to earn a higher price earnings ratio on the stock, only to abandon the strategy 3 years later. The focus then shifted to rapidly expanding the branch network by opening as many as 250 locations within 12 months in cities where the company had no previous retail banking experience. Ultimately, this proved to be an unsuccessful strategy due in part to the effort to grow too quickly. The focus then shifted away from the diversification to becoming the so-called low-cost producer in the mortgage industry. This effort was likewise unsuccessful, in large measure due to an expensive undertaking to write a completely new mortgage loan origination and accounting software system that ultimately failed and had to be written off. By mid-2005, the focus had shifted again to becoming more of a higher-risk subprime lender at exactly the wrong time in the housing market cycle. This effort was characterized by statements advocating that the company become either via acquisition or internal growth a dominant subprime lender. In addition to subprime, the company was a large lender of adjustable-rate mortgages, having had 20 years' experience with the product. As in the case of subprime, the product had only been available to a narrow segment of customers. Adjustable-rate mortgages were sold to an ever-wider group of borrowers. Product features were also expanded. Historically, plain vanilla mortgage lending had been a relatively safe business. During the period 1999 to 2003, Washington Mutual mortgage losses were substantially less than one-tenth of one percent, far less than losses of commercial banks. But rapidly increasing housing prices masked the risks of a changing product mix and deteriorating underwriting, in part because borrowers who found themselves in trouble could almost always sell their homes for more than the mortgage amount, at least until 2006 or 2007. There is no one factor that contributed to the debacle. Each change in product features and underwriting was incremental and defended as necessary to meet competition. But these changes were taking place within the context of a rapidly increasing housing price environment and were, therefore, untested in a less favorable economic climate. It was the layering of risk brought about by these incremental changes that so altered the underlying credit quality of mortgage lending which became painfully evident once housing prices peaked and began to decline. Some may characterize the events that took place as a ``perfect storm,'' but I would describe it as an inevitable consequence of consistently adding risk to the portfolio in a period of inflated housing price appreciation. The appetite of Wall Street and investors worldwide created huge demand for high-yielding subprime mortgages that resulted in a major expansion of what was historically a relatively small segment of the business led by Household Finance. The Community Reinvestment Act also contributed by demanding loans--that banks make loans to low-income families, further expanding subprime lending. One obvious question is whether or not these risks were apparent to anyone in the industry or among the various regulatory or rating agencies. There is ample evidence in the record to substantiate the fact that it was clear that the high-risk profile of the entire industry, to include Washington Mutual, was recognized by some but ignored by many. Suffice it to say, meeting growth objectives to satisfy the quarterly expectations of Wall Street and investors led to mistakes in judgment by the banks and the mortgage lending company executives. A more difficult question is why boards of directors, regulatory agencies, and rating agencies were seemingly complacent. Another question may be my personal role and whether I made significant effort to alter the course of lending at Washington Mutual. In many ways and on many occasions, I attempted to limit what was happening. Just a few examples may suffice. I stood in front of thousands of senior Washington Mutual managers and executives in an annual management retreat in 2004 and countered the senior executive ahead of me on the program who was rallying the troops with the company's advertising line, ``The power of yes.'' The implication of that statement was that Washington Mutual would find some way to make a loan. The tag line symbolized the management attitude about mortgage lending more clearly than anything I can tell you. Because I believed this sent the wrong message to the loan originators, I felt compelled to counter the prior speaker by saying to the thousands present that the power of yes absolutely needed to be balanced by the wisdom of no. This was highly unusual for a member of the management team to do, especially in such a forum. In fact, it was so far out of the norm for meetings of this type that many considered my statement exceedingly risky from a career perspective. I made repeated efforts to cap the percentage of high-risk and subprime loans in the portfolio. Similarly, I put a moratorium on non-owner-occupied loans when the percentage of these assets grew excessively due to speculation in the housing market. I attempted to limit the number of stated income loans, loans made without verification of income. But without solid executive management support, it was questionable how effective any of these efforts proved to be. There have been questions about policy and adherence to policy. This was a continual problem at Washington Mutual, where line managers, particularly in the mortgage area, not only authorized but encouraged policy exceptions. There had likewise been issues regarding fraud. Because of the compensation systems rewarding volume versus quality and the independent structure of the originators, I am confident at times borrowers were coached to fill out applications with overstated incomes or net worth to meet the minimum underwriting requirements. Catching this kind of fraud was difficult at best and required the support of line management. Not surprisingly, loan originators constantly threatened to quit and to go to Countrywide or elsewhere if the loan applications were not approved. As the market deteriorated, in 2004, I went to the Chairman and CEO with a proposal and a very strong personal appeal to publish a full-page ad in the Wall Street Journal disavowing many of the then-current industry underwriting practices, such as 100 percent loan-to-value subprime loans, and thereby adopt what I termed responsible lending practices. I acknowledged that in so doing the company would give up a degree of market share and lose some of the originators to the competition, but I believed that Washington Mutual needed to take an industry-leading position against deteriorating underwriting standards and products that were not in the best interests of the industry, the bank, or the consumers. There was, unfortunately, never any further discussion or response to the recommendation. Another way I attempted to counteract the increasing risk was to increase the allowance for loan and lease loss to cover the potential losses. Regrettably, there has been a longstanding unresolved conflict between the SEC and the accounting industry on one side and the banks and the bank regulators regarding reserving methodology. The SEC and accounting profession believed that more transparency in bank earnings is essential to investors and that the way to achieve transparency is to keep reserves at levels reflecting only very recent loss experience. But banking is a cyclical business, which the banks and the bank regulators recognize. It is their belief and certainly my personal belief that building reserves in good times and using those reserves in bad times is the entire purpose of the loan loss reserves. What is more, the investors, the FDIC, and the industry are far better protected reserves that are intended to be sufficient to sustain the institution through the cycle rather than draining reserves at the point where losses are at their lowest point. At one point, I was forced by external auditors to reduce the loan loss reserve of $1.8 billion by $500 million or risk losing our audit certification. As the credit cycle unfolded, those reserves were sorely needed by the institution. In my opinion, the Basel Accord on bank capital requirements repeats the same mistake of using short-term history rather than through-the-cycle information to establish required capital levels, and as such has been a complete and utter failure. The conventional wisdom repeated endlessly in the mortgage industry and at Washington Mutual was that while there had been regional recessions and price declines, there had never been a true national housing price decline. I believe that is debatable. But it was widely believed, and partially on this premise, the industry and Washington Mutual marched forward with more and more subprime high loan-to-value and option payment products, each one adding incrementally to the risk profile. Thank you for your time and attention. I will be happy to address your questions. Senator Levin. Thanks, Mr. Vanasek. Mr. Cathcart. TESTIMONY OF RONALD J. CATHCART,\1\ FORMER CHIEF ENTERPRISE RISK OFFICER (2006-2008), WASHINGTON MUTUAL BANK " FOMC20050503meeting--88 86,MR. HOENIG.," Mr. Chairman, I’ll start off by repeating the obvious: There have been a couple of surprises since our last FOMC meeting. The economy has lost momentum after the end of May 3, 2005 47 of 116 the first quarter has led me to join others in marking down my forecast for growth this year to about 3½ percent. I expect growth in the second half of this year to be about 3¾ percent and then slow perhaps back to 3½ percent next year. With trend growth of about 3¼ percent, the output gap and labor market slack should continue to diminish, as we’ve said before. I would agree with those who attribute much of the slowdown to the persistence of higher energy prices. This is especially the case for consumer spending and confidence, as we see it. Higher energy costs have also reduced growth in other countries, and I think that probably has contributed to some of the worsening in our trade balance. Obviously, we need a little more time and information to determine whether the recent economic performance reflects temporary factors or is likely to be more permanent. If it is temporary, then, as energy prices level off or perhaps decline somewhat, I would expect the fundamental forces of growth to take over—those being monetary policy that, in my opinion, remains accommodative and financial conditions that are, perhaps, highly accommodative. I’ll digress here by giving you just one anecdote. I talked recently to an executive of one of our major banks that lends across the nation in some of the hot markets. He described a condominium deal, a fairly large one, where the construction cost was about $100 million. The developers had $3 million of equity in the project. Those who lent $97 million lent those funds on a pro forma sale price that finished out at $140 million. So there is a lot of speculation, I think, in these markets. And that is something that we have to take into account. But I also see that the labor and capital markets that we talk about here are strengthening. So overall I think the evidence is that the economy will improve. And I would say, from a regional perspective, that the Tenth District mostly provides support for an improving outlook, though I May 3, 2005 48 of 116 including travel and tourism, rose solidly in March and early April, and most retailers said sales were up substantially from a year ago. In addition, housing activity turned up, following a pause in late 2004 and early 2005 in our region. Housing starts and permits rose solidly in March, and home sales were strong in most of our District’s cities. Still, preliminary data from our manufacturing survey suggest some evidence of a slowdown. In fact, in April the production and shipments indexes both fell. More worrisome, though, was the large decline in the six-month-ahead production, shipments, and new orders indexes. This bears watching, since it may suggest a more permanent slowdown than we currently expect. In addition, a number of contacts expressed concerns to us about higher energy prices. For example, in our April manufacturing survey, some firms said that they were delaying shipments in order to assure full truckloads and thus save on fuel costs. A few firms also said that they expect to cut back on production due to high energy costs. In addition, some retailers were worried that higher gasoline prices would eventually take a toll on their sales. Of course, for our region, higher energy prices are positive for some of our District’s states, particularly Oklahoma and Wyoming, where we see nearly boom conditions. Turning to the inflation outlook, I do expect to see further increases in core inflation, with core PCE inflation averaging almost 2 percent in 2005 and core CPI inflation averaging 2½ percent, similar to the Greenbook forecast. However, unlike the Greenbook, I expect core inflation to remain elevated in 2006 rather than to fall back. I take note of the fact that energy price increases may be a rock in the pond, but I think the substantially accommodative monetary policy we have had is more like a boulder. And it is carrying itself forward, which is what we need to be aware of and alert to. We continue to see increases in core inflation. Whether measured in 3-, 6-, or 12-month May 3, 2005 49 of 116 inflation is now higher than at any time since the second half of 2001. In my opinion it is above comfortable levels. Measured from six months ago, core CPI inflation is about 2½ percent and core PCE inflation is above 2 percent. Clearly, some of the increase represents temporary factors—such as the energy prices we keep talking about and the prices of some commodities—and may be reversed. However, I would take note that the pass-through of energy prices to core inflation is difficult to predict, as we talked about earlier, and may be greater than some suggest. I also believe that there is more to the inflation story than energy prices. Even if we exclude the two largest quarterly rates, core CPI inflation over the last four quarters was 2 percent, which is significantly higher than core inflation over the previous four quarters. I believe some of the increase is the result of our continued accommodative policy. We’ve seen inflation rise over the last year in the presence of sizable slack and a rising funds rate. I’m concerned that, with less slack in the economy, we will continue to see higher inflation going forward. In addition, maintaining an accommodative monetary policy poses an upside risk to inflation, with the federal funds rate currently below many estimates of the lower bound of the neutral rate. If we are slow in removing this accommodation, I would be concerned that the increase in core inflation also might be passed through to higher expected inflation. We’re also seeing some evidence of pricing power in the Tenth District, as manufacturers continue to raise their output prices to cover what they’ve referred to as rising costs of energy and other inputs. In addition, the share of our Beige Book retail contacts who reported to us that they were raising prices this time was the highest in the last five years. These are my concerns. The one other thing I would mention relates to our statement. I would agree with those who would like to abbreviate our statement today. Since people are, in fact, May 3, 2005 50 of 116" CHRG-111shrg50815--31 Chairman Dodd," Thank you very much, and I appreciate your comments, and all of you here this morning for your counsel on this issue, which is, again, a complex one and one that deserves our attention. I want to also make two points. One is credit cards are a tremendously valuable and worthwhile tool for consumers. I think it is very important. This is not a Committee, or at least an individual here that is hostile to the notion of credit cards at all. Quite the contrary. Second, I respect immensely that Ben Bernanke and the Federal Reserve moved on the issue of regulation, and while there are gaps and problems I have with what they have done, he is the first Chairman of the Fed that has actually moved in this area, despite the issue having been raised for a long time, and I certainly want to reflect my appreciation for the steps they have taken. I am disappointed that you have got to wait until July of 2010 for them to become effective, but nonetheless I want the record to reflect it. I was very impressed, Mr. Levitin, with this study and I highly recommend to my colleagues. It is lengthy in some ways. It is a number of pages long, some 20 pages long, this analysis of the credit card industry and how it works. But one thing that struck me at the outset of the report is something I think we kind of blow through, and that is the credit instruments that we use as Americans are tremendously valuable--the home mortgage, the car loan, the student loan. And the point that you make, or that this report makes is, of course, the pricing points, and I think it is a very worthwhile point to make. In almost every one of these other transactions, pricing points are rather clear. They are one or two or three, maybe four, but you have a pretty clear idea. You know with almost certainty what your mortgage is going to be, what your car payments are going to be, what your other payments are regardless if you take credit. When you get into this area, it is exactly the opposite, and I was stunned at the pricing points and why, in terms of taking on this responsibility, knowing what your responsibilities are going to be, you are faced with the following, just on pricing points, an astounding array of points--annual fees, merchant fees, teaser interest rates, base interest rates, balance transfer interest rates, cash advance interest rates, overdraft interest rates, default interest rates, late fees, over-limit fees, balance transfer fees, cash advance fees, international transaction fees, telephone payment fees. These are all the pricing points in credit card negotiations. To expect a consumer to appreciate and absorb that many pricing points when you are trying to determine whether or not taking on that financial responsibility--now, again, we are not going to eliminate all of these, but the idea that a consumer is able to juggle and understand that many different pricing points when you are making a determination as to whether or not you ought to engage in a service or a product purchase. I was stunned, as well, on the issues of bankruptcy and the like in terms of driving these costs up and the complexity of dealing with it. Again, I draw my colleagues' attention to this report. I think it is extremely useful. It gets into the issue of the risk-based pricing issue, as well, that Dr. Ausubel referenced, but I think it is an important point, as well. It is an industry that started out making its money on interest rates, and that was where the money was made. It has transferred itself from interest rates to fees, and that is the $12 billion increase in fees that have occurred that have added so much cost and confusion. Mr. Clayton, thank you for being here. One of the issues that is obviously of concern to many of us is the universal default. I think most people understand it, but the idea that if you are current on your credit card responsibilities, but if you are late on an electrical bill or a phone bill or the like, that we have seen examples where the issuers will then raise fees or rates as a result of your late payments on unrelated responsibilities, financial responsibilities. Now, it is true that, in a sense, the new rule to some degree eliminates the universal default. But under the rule, as well, and having conversations with the Fed about this, issuers can still look to off-comp behavior to increase interest rates. And so while it talks about banning it on one hand, it still tolerates the issue of actually accounting for off-balance behavior to increase rates that consumers pay. I would still call that universal default. If, in fact, the issuer can raise rates by considering these late payments in unrelated matters to the credit card, then it still seems to me that universal default exists. How do you respond to that? " FOMC20050630meeting--197 195,CHAIRMAN GREENSPAN.," May I raise a question, which puzzles me, on chart 13? That has the new home price index and the OFHEO index. I don’t think there’s a big problem understanding the prices of new homes ex land. Since homes are largely customized, one would expect that, as indeed the data show, the growth in productivity—and presumably in unit labor costs in residential construction—is less than the average. That would lead you to conclude that at constant margins the average real price of homes is going up. And the number is, as I recall, somewhere between 0.5 and 0.8 or 0.9, or something like that. Now, after a house is constructed and priced, the price from there forward either is flat or goes down—I don’t think anybody presumes it goes up. This gets to the issue of whether the modernization or the depreciation overwhelms. You have a system in which you have initial prices of new homes, and let’s assume there’s a decay rate. So, as the homes age, if the decay rates are all constant, clearly any measure of constant- June 29-30, 2005 69 of 234 that prices of existing homes on average are rising faster—generally going almost all the way back—than those of new homes. That could imply that there is a change in mix. In other words, if there’s a decay rate, then the presumption is that the average age of existing homes that are being sold is moving down. But none of the credible hypotheses—because that can’t go on very long— explains this difference. We know that the constant-quality new home price is a hedonic, reasonably well-constructed series. How do we reconcile these data? What’s happening?" CHRG-111hhrg51698--289 The Chairman," All right. I thank the panel. I thank the Committee Members. The Committee stands adjourned subject to the call of the chair. [Whereupon, at 4:10 p.m., the Committee was adjourned.] [Material submitted for inclusion in the record follows:] Submitted Statement by American Public Gas Association Chairman Peterson, Ranking Member Lucas and Members of the Committee, the American Public Gas Association (APGA) appreciates this opportunity to submit testimony to you today. We also commend the Committee for calling this hearing on the important subject of derivative trading. APGA would also like to commend Chairman Peterson and the House Agriculture Committee for its ongoing focus on market transparency and oversight. APGA is the national association for publicly-owned natural gas distribution systems. There are approximately 1,000 public gas systems in 36 states and over 700 of these systems are APGA members. Publicly-owned gas systems are not-for-profit, retail distribution entities owned by, and accountable to, the citizens they serve. They include municipal gas distribution systems, public utility districts, county districts, and other public agencies that have natural gas distribution facilities. APGA's number one priority is the safe and reliable delivery of affordable natural gas. To bring natural gas prices back to a long-term affordable level, we ultimately need to increase the supply of natural gas. However, equally critical is to restore public confidence in the pricing of natural gas. This requires a level of transparency in natural gas markets which assures consumers that market prices are a result of fundamental supply and demand forces and not the result of manipulation, excessive speculation or other abusive market conduct. We, along with other consumer groups, have watched with alarm over the last several years certain pricing anomalies in the markets for natural gas. More recently, we have noted much greater volatility in the price of energy and other physical commodities. APGA has strongly supported an increase in the level of transparency with respect to trading activity in these markets from that which currently exists. We believe that additional steps are needed in order to restore our current lack of confidence in the natural gas marketplace and to provide sufficient transparency to enable the CFTC, and market users, to form a reasoned response to the critically important questions that have been raised before this Committee during the course of these hearings. APGA believes that the increased regulatory, reporting and self-regulatory provisions relating to the unregulated energy trading platforms contained in legislation that reauthorizes the Commodity Futures Trading Commission (``CFTC'') is a critically important first step in addressing our concerns. Those provisions are contained in Title XIII of the farm bill which has become law. We commend this Committee for its work on this important legislation. The market transparency language that was included in the farm bill will help shed light on whether market prices in significant price discovery energy contracts are responding to legitimate forces of supply and demand or to other, non-bona fide market forces. However, APGA believes that more can, and should, be done to further increase transparency of trading in the energy markets. Many of these steps would likely also be useful in better understanding the current pricing trends in the markets for other physical commodities as well. Although the additional authorities which have been provided to the CFTC under Title XIII of the 2008 Farm Bill will provide the CFTC with significant additional tools to respond to the issues raised by this hearing (at least with respect to the energy markets), we nevertheless believe that it may be necessary for Congress to provide the CFTC with additional statutory authorities. We are doubtful that the initial steps taken by the reauthorization legislation are, or will be, sufficient to fully respond to the concerns that we have raised regarding the need for increased transparency. In this regard, we believe that additional transparency measures with respect to transactions in the Over-the-Counter markets are needed to enable CFTC to assemble a more complete picture of a trader's position and thereby understand a large trader's potential impact on the market. We further believe, that in light of the critical importance of this issue to consumers, that this Committee should maintain active and vigilant oversight of the CFTC's market surveillance and enforcement efforts, that Congress should be prepared to take additional legislative action to further improve transparency with respect to trading in energy contracts and, should the case be made, to make additional amendments to the Commodity Exchange Act, 7 U.S.C. 1 et seq. (``Act''), that allows for reasonable speculative position limits in order to ensure the integrity of the energy markets.Speculators' Effect on the Natural Gas Market As hedgers that use both the regulated futures markets and the OTC energy markets, we value the role of speculators in the markets. We also value the different needs served by the regulated futures markets and the more tailored OTC markets. As hedgers, we depend upon liquid and deep markets in which to lay off our risk. Speculators are the grease that provides liquidity and depth to the markets. However, speculative trading strategies may not always have a benign effect on the markets. For example, the 2006 blow-up of Amaranth Advisors LLC and the impact it had upon prices exemplifies the impact that speculative trading interests can have on natural gas supply contracts for local distribution companies (``LDCs''). Amaranth Advisors LLC was a hedge fund based in Greenwich, Connecticut, with over $9.2 billion under management. Although Amaranth classified itself as a diversified multi-strategy fund, the majority of its market exposure and risk was held by a single Amaranth trader in the OTC derivatives market for natural gas. Amaranth reportedly accumulated excessively large long positions and complex spread strategies far into the future. Amaranth's speculative trading wagered that the relative relationship in the price of natural gas between summer and winter months would change as a result of shortages which might develop in the future and a limited amount of storage capacity. Because natural gas cannot be readily transported about the globe to offset local shortages, the way for example oil can be, the market for natural gas is particularly susceptible to localized supply and demand imbalances. Amaranth's strategy was reportedly based upon a presumption that hurricanes during the summer of 2006 would make natural gas more expensive in 2007, similar to the impact that Hurricanes Katrina and Rita had had on prices the previous year. As reported in the press, Amaranth held open positions to buy or sell tens of billions of dollars of natural gas. As the hurricane season proceeded with very little activity, the price of natural gas declined, and Amaranth lost approximately $6 billion, most of it during a single week in September 2006. The unwinding of these excessively large positions and that of another previously failed $430 million hedge fund--MotherRock--further contributed to the extreme volatility in the price of natural gas. The Report by the Senate Permanent Subcommittee on Investigations affirmed that ``Amaranth's massive trading distorted natural gas prices and increased price volatility.'' \1\--------------------------------------------------------------------------- \1\ See ``Excessive Speculation in the Natural Gas Market,'' Report of the U.S. Senate Permanent Subcommittee on Investigations (June 25, 2007) (``PSI Report'') at p. 119.--------------------------------------------------------------------------- Many natural gas distributors locked-in prices prior to the period Amaranth collapsed at prices that were elevated due to the accumulation of Amaranth's positions. They did so because of their hedging procedures which require that they hedge part of their winter natural gas in the spring and summer. Accordingly, even though natural gas prices were high at that time, it would have been irresponsible (and contrary to their hedging policies) to not hedge a portion of their winter gas in the hope that prices would eventually drop. Thus, the elevated prices which were a result of the excess speculation in the market by Amaranth and others had a significant impact on the price these APGA members, and ultimately their customers, paid for natural gas. The lack of transparency with respect to this trading activity, much of which took place in the OTC markets, and the extreme price swings surrounding the collapse of Amaranth have caused bona fide hedgers to become reluctant to participate in the markets for fear of locking-in prices that may be artificial. Recently, additional concerns have been raised with respect to the size of positions related to, and the role of, passively managed long-only index funds. In this instance, the concern is not whether the positions are being taken in order to intentionally drive the price higher, but rather whether the unintended effect of the cumulative size of these positions has been to push market prices higher than the fundamental supply and demand situation would justify. The additional concern has been raised that recent increased amounts of speculative investment in the futures markets generally have resulted in excessively large speculative positions being taken that due merely to their size, and not based on any intent of the traders, are putting upward pressure on prices. The argument made is that these additional inflows of speculative capital are creating greater demand then the market can absorb, thereby increasing buy-side pressure which results in advancing prices. Some have responded to these concerns by reasoning that new futures contracts are capable of being created without the limitation of having to have the commodity physically available for delivery. This explains why, although the open-interest of futures markets can exceed the size of the deliverable supply of the physical commodity underlying the contract, the price of the contract could nevertheless reflect the forces of supply and demand. As we noted above, as hedgers we rely on speculative traders to provide liquidity and depth to the markets. Thus, we do not wish to see steps taken that would discourage speculators from participating in these markets using bona fide trading strategies. But more importantly, APGA's members rely upon the prices generated by the futures to accurately reflect the true value of natural gas. Accordingly, APGA would support additional regulatory controls, such as stronger speculative position limits, if a reasoned judgment can be made based on currently available, or additional forthcoming market data and facts, that such controls are necessary to address the unintended consequences arising from certain speculative trading strategies or to reign in excessively large speculative positions. To the extent that speculative investment may be increasing the price of natural gas or causing pricing aberrations, we strongly encourage Congress to take quick action to expand market transparency in order to be able to responsibly address this issue and protect consumers from additional cost burdens. Consumers should not be forced to pay a ``speculative premium.''The Markets in Natural Gas Contracts The market for natural gas financial contracts is composed of a number of segments. Contracts for the future delivery of natural gas are traded on NYMEX, a designated contract market regulated by the CFTC. Contracts for natural gas are also traded in the OTC markets. OTC contracts may be traded on multi-lateral electronic trading facilities which are exempt from regulation as exchanges, such as the IntercontinentalExchange (``ICE''). ICE also operates an electronic trading platform for trading non-cleared (bilateral) OTC contracts. They may also be traded in direct, bilateral transactions between counterparties, through voice brokers or on electronic platforms. OTC contracts may be settled financially or through physical delivery. Financially-settled OTC contracts often are settled based upon NYMEX settlement prices and physically delivered OTC contracts may draw upon the same deliverable supplies as NYMEX contracts, thus linking the various financial natural gas market segments economically. Increasingly, the price of natural gas in many supply contracts between suppliers and local distribution companies, including APGA members, is determined based upon monthly price indexes closely tied to the monthly settlement of the NYMEX futures contract. Accordingly, the futures market serves as the centralized price discovery mechanism used in pricing these natural gas supply contracts. Generally, futures markets are recognized as providing an efficient and transparent means for discovering commodity prices.\2\ However, any failure of the futures price to reflect fundamental supply and demand conditions results in prices for natural gas that are distorted and do not reflect its true value.\3\ This has a direct affect on consumers all over the U.S., who as a result of such price distortions, will not pay a price for the natural gas that reflects bona fide demand and supply conditions. If the futures price is manipulated or distorted, then the price consumers pay for the fuel needed to heat their homes and cook their meals will be similarly manipulated or distorted.--------------------------------------------------------------------------- \2\ See the Congressional findings in section 3 of the Commodity Exchange Act, 7 U.S.C. 1 et seq. (``Act''). Section 3 of the Act provides that, ``The transactions that are subject to this Act are entered into regularly in interstate and international commerce and are affected with a national public interest by providing a means for . . . discovering prices, or disseminating pricing information through trading in liquid, fair and financially secure trading facilities.'' A further question with respect to whether other speculative strategies, or excessively large speculative positions is also distorting market prices by pushing prices higher than they otherwise would be. \3\ The effect of Amarath's trading resulted in such price distortions. See generally PSI Report. The PSI Report on page 3 concluded that ``Traders use the natural gas contract on NYMEX, called a futures contract, in the same way they use the natural gas contract on ICE, called a swap. . . . The data show that prices on one exchange affect the prices on the other.''--------------------------------------------------------------------------- Today, the CFTC provides generally effective oversight of futures exchanges and the CFTC and the exchanges provide a significant level of transparency. And under the provisions of the Title XIII of the farm bill, the CFTC has been given additional regulatory authority with respect to significant price discovery contracts traded on exempt commercial markets, such as ICE. This is indeed a major step toward greater market transparency. However, even with this additional level of transparency, a large part of the market remains opaque to regulatory scrutiny. The OTC markets lack such price transparency. This lack of transparency in a very large and rapidly growing segment of the natural gas market leaves open the potential for a participant to engage in manipulative or other abusive trading strategies with little risk of early detection; and for problems of potential market congestion to go undetected by the CFTC until after the damage has been done to the market. Equally significant, even where the trading is not intended to be abusive, the lack of transparency for the over-all energy markets leaves regulators unable to answer questions regarding speculators' possible impacts on the market. For example, do we know who the largest traders are in the over-all market, looking at regulated futures contracts, significant price discovery contracts and bilateral OTC transactions? Without being able to see a large trader's entire position, it is possible that the effect of a large OTC trader on the regulated markets is masked, particularly when that trader is counterparty to a number of swaps dealers that in turn take positions in the futures market to hedge these OTC exposures as their own.Regulatory Oversight NYMEX, as a designated contract market, is subject to oversight by the CFTC. The primary tool used by the CFTC to detect and deter possible manipulative activity in the regulated futures markets is its large trader reporting system. Using that regulatory framework, the CFTC collects information regarding the positions of large traders who buy, sell or clear natural gas contracts on NYMEX. The CFTC in turn makes available to the public aggregate information concerning the size of the market, the number of reportable positions, the composition of traders (commercial/noncommercial) and their concentration in the market, including the percentage of the total positions held by each category of trader (commercial/noncommercial). The CFTC also relies on the information from its large trader reporting system in its surveillance of the NYMEX market. In conducting surveillance of the NYMEX natural gas market, the CFTC considers whether the size of positions held by the largest contract purchasers are greater than deliverable supplies not already owned by the trader, the likelihood of long traders demanding delivery, the extent to which contract sellers are able to make delivery, whether the futures price is reflective of the cash market value of the commodity and whether the relationship between the expiring future and the next delivery month is reflective of the underlying supply and demand conditions in the cash market.\4\--------------------------------------------------------------------------- \4\ See letter to the Honorable Jeff Bingaman from the Honorable Reuben Jeffery III, dated February 22, 2007.--------------------------------------------------------------------------- Title XIII of the 2008 Farm Bill, empowered the CFTC to collect large trader information with respect to ``significant price discovery contracts'' traded on the ICE trading platform. However, there remain significant gaps in transparency with respect to trading of OTC energy contracts, including many forms of contracts traded on ICE. Despite the links between prices for the NYMEX futures contract and the OTC markets in natural gas contracts, this lack of transparency in a very large and rapidly growing segment of the natural gas market leaves open the potential for participants to engage in manipulative or other abusive trading strategies with little risk of early detection and for problems of potential market congestion to go undetected by the CFTC until after the damage has been done to the market, ultimately costing the consumers or producers of natural gas. More profoundly, it leaves the regulator unable to assemble a true picture of the over-all size of a speculator's position in a particular commodity.Greater Transparency Needed Our members, and the customers served by them, believe that although Title XIII of the 2008 Farm Bill goes a long way to addressing the issue, there is not yet an adequate level of market transparency under the current system. This lack of transparency has led to a growing lack of confidence in the natural gas marketplace. Although the CFTC operates a large trader reporting system to enable it to conduct surveillance of the futures markets, it cannot effectively monitor trading if it receives information concerning positions taken in only one, or two, segments of the total market. Without comprehensive large trader position reporting, the government will remain handicapped in its ability to detect and deter market misconduct or to understand the ramifications for the market arising from unintended consequences associated with excessive large positions or with certain speculative strategies. If a large trader acting alone, or in concert with others, amasses a position in excess of deliverable supplies and demands delivery on its position and/or is in a position to control a high percentage of the deliverable supplies, the potential for market congestion and price manipulation exists. Similarly, we simply do not have the information to analyze the over-all effect on the markets from the current practices of speculative traders. Over the last several years, APGA has pushed for a level of market transparency in financial contracts in natural gas that would routinely, and prospectively, permit the CFTC to assemble a complete picture of the overall size and potential impact of a trader's position irrespective of whether the positions are entered into on NYMEX, on an OTC multi-lateral electronic trading facility which is exempt from regulation or through bilateral OTC transactions, which can be conducted over the telephone, through voice-brokers or via electronic platforms. APGA is optimistic that the enhanced authorities provided to the CFTC in the provisions of the CFTC reauthorization bill will help address the concerns that we have raised, but recognizes that more needs to be done to address this issue comprehensively.Additional Potential Enhancements in Transparency In supporting the CFTC reauthorization bill, we previously noted that only a comprehensive large trader reporting system would enable the CFTC, while a scheme is unfolding, to determine whether a trader, such as Amaranth, is using the OTC natural gas markets to corner deliverable supplies and manipulate the price in the futures market.\5\ A comprehensive large trader reporting system would also enable the CFTC to better detect and deter other types of market abuses, including for example, a company making misleading statements to the public or providing false price reporting information designed to advantage its natural gas trading positions, or a company engaging in wash trading by taking large offsetting positions with the intent to send misleading signals of supply or demand to the market. Such activities are more likely to be detected or deterred when the government is receiving information with respect to a large trader's overall positions, and not just those taken in the regulated futures market. It would also enable the CFTC to better understand the overall size of speculative positions in the market as well as the impact of certain speculative investor practices or strategies on the future's markets ability to accurately reflect fundamental supply and demand conditions.--------------------------------------------------------------------------- \5\ See e.g. U.S. Commodity Futures Trading Commission v. BP Products North America, Inc., Civil Action No. 06C 3503 (N.D. Ill.) filed June 28, 2006.--------------------------------------------------------------------------- Accordingly, APGA supports proposals to further increase and enhance transparency in the energy markets, generally, and in the markets for natural gas, specifically. APGA supports greater transparency with respect to positions in natural gas financial contracts acquired through bilateral transactions. Because bilateral trading can in fact be conducted on an all-electronic venue, and can impact prices on the exchanges even if conducted in a non-electronic environment, it is APGA's position that transparency in the bilateral markets is critical to ensure an appropriate level of consumer protection.Electronic Bilateral trading One example of the conduct of bilateral trading on an all-electronic trading platform was ``Enron On-line.'' Enron, using its popular electronic trading platform, offered to buy or sell contracts as the universal counterparty to all other traders using this electronic trading system. This one-to-many model constitutes a dealer's market and is a form of bilateral trading. This stands in contrast to a many-to-many model which is recognized as a multi-lateral trading venue. This understanding is reflected in section 1a(33) of the Commodity Exchange Act, which defines ``Trading Facility'' as a ``group of persons that . . . provides a physical or electronic facility or system in which multiple participants have the ability to execute or trade agreements, contracts or transactions by accepting bids and offers made by other participants that are open to multiple participants in the facility or system.'' On the Enron On-line trading platform, only one participant--Enron--had the ability to accept bids and offers of the multiple participants--its customers--on the trading platform. Section 1a(3) continues by providing that, ``the term 'trading facility' does not include (i) a person or group of persons solely because the person or group of persons constitutes, maintains, or provides an electronic facility or system that enables participants to negotiate the terms of and enter into bilateral transactions as a result of communications exchanged by the parties and not from interaction of multiple bids and multiple offers within a predetermined, nondiscretionary automated trade matching and execution algorithm . . . .'' This means that it is also possible to design an electronic platform for bilateral trading whereby multiple parties display their bids and offers which are open to acceptance by multiple parties, so long as the consummation of the transaction is not made automatically by a matching engine. Both of these examples of bilateral electronic trading platforms might very well qualify for exemption under the current language of sections 2(g) and 2(h)(1) of the Commodity Exchange Act. To the extent that these examples of electronic bilateral trading platforms were considered by traders to be a superior means of conducting bilateral trading over voice brokerage or the telephonic call-around markets, or will not fall within the significant price discovery contract requirements, their use as a substitute for a more-regulated exempt commercial market under section 2(h)(3) of the Act should not be readily discounted.Non-Electronic Bilateral Trading Moreover, even if bilateral transactions are not effected on an electronic trading platform, it is nonetheless possible for such direct or voice-brokered trading to affect prices in the natural gas markets. For example, a large hedge fund may trade bilaterally with a number of counterparty/dealers using standard ISDA documentation. By using multiple counterparties over an extended period of time, it would be possible for the hedge fund to establish very large positions with each of the dealer/counterparties. Each dealer in turn would enter into transactions on NYMEX to offset the risk arising from the bilateral transactions into which it has entered with the hedge fund. In this way, the hedge fund's total position would come to be reflected in the futures market. Thus, a prolonged wave of buying by a hedge fund, even through bilateral direct or voice-brokered OTC transactions, can be translated into upward price pressure on the futures exchange. As NYMEX settlement approaches, the hedge fund's bilateral purchases with multiple dealer/counterparties would maintain or increase upward pressure on prices. By spreading its trading through multiple counterparties, the hedge fund's purchases would attract little attention and escape detection by either NYMEX or the CFTC. In the absence of routine large-trader reporting of bilateral transactions, the CFTC will only see the various dealers' exchange positions and have no way of tying them back to purchases by a single hedge fund. Given that the various segments of the financial markets that price natural gas are linked economically, it is critical to achieving market transparency that traders holding large positions entered into through bilateral transactions be included in any large-trader reporting requirement. As explained above, by trading through multiple dealers, a large hedge fund would be able to exert pressure on exchange prices similar to the pressure that it could exert by holding those positions directly. Only a comprehensive large-trader reporting system that includes positions entered into in the OTC bilateral markets would enable the CFTC to see the entire picture and trace such positions back to a single source. If large trader reporting requirements apply only to positions acquired on multi-lateral electronic trading platforms, traders in order to avoid those reporting requirements may very well move more transactions to electronic bilateral markets or increase their direct bilateral trading. This would certainly run counter to efforts by Congress to increase transparency. APGA remains convinced that all segments of the natural gas marketplace should be treated equally in terms of reporting requirements. To do otherwise leaves open the possibility that dark markets on which potential market abuses could go undetected would persist and that our current lack of sufficient information to fully understand the impact of large speculative traders and certain trading strategies on the markets will continue, thereby continuing to place consumers at risk.Derivatives Markets Transparency and Accountability Act of 2009 As stated previously, APGA supports proposals to further increase and enhance transparency in the energy markets, generally, and in the markets for natural gas, specifically. APGA commends Chairman Peterson for drafting the Derivatives Markets Transparency and Accountability Act of 2009. This legislation would significantly enhance market transparency and would provide the CFTC with additional needed resources to help ensure that the ``cop on the beat'' has the tools needed to do its job. Specifically, this legislation would provide greater transparency with respect to the activities of the Index Funds by requiring them to be separately accounted for in the CFTC's Commitment of Traders Reports. APGA strongly supports provisions in the legislation that would provide greater transparency to the CFTC with respect to bilateral swap contracts. Another provision in the bill that APGA strongly supports is the requirement that the CFTC appoint at least 100 new full time employees. The CFTC plays a critical role in protecting consumers, and the market as a whole, from fraud, manipulation and market abuses that create distortion. It is essential that the CFTC have the necessary resources, both in terms of employees but also in terms of information technology, to monitor markets and protect consumers from attempts to manipulate the market. This is critical given the additional oversight responsibilities the CFTC will have through the market transparency language included in the 2008 Farm Bill and the additional transparency requirements that APGA is proposing to the Committee. Over the last several years, trading volumes have doubled while CFTC staffing levels have decreased. In fact, while we are experiencing record trading volumes, employee levels at the CFTC are at their lowest since the agency was created. Further, more complex and comprehensive monitoring practices from the CFTC will require the latest technology. It is critical that CFTC have the necessary tools to catch abuses before they occur. APGA is concerned that if funding for the CFTC is inadequate, so may be the level of protection.Conclusion Experience tells us that there is never a shortage of individuals or interests who believe they can, and will attempt to, affect the market or manipulate price movements to favor their market position. The fact that the CFTC has assessed over $300 million in penalties, and has assessed over $2 billion overall in government settlements relating to abuse of these markets affirms this. These efforts to punish those that manipulate or abuse markets or to address those that might innocently distort markets are important. But it must be borne in mind that catching and punishing those that manipulate markets after a manipulation has occurred is not an indication that the system is working. To the contrary, by the time these cases are discovered using the tools currently available to government regulators, our members, and their customers, have already suffered the consequences of those abuses in terms of higher natural gas prices. Greater transparency with respect to traders' large positions, whether entered into on a regulated exchange or in the OTC markets in natural gas will provide the CFTC with the tools to answer that question and to detect and deter potential manipulative or market distorting activity before our members and their customers suffer harm. The Committee's ongoing focus on energy markets has raised issues that are vital to APGA's members and their customers. We do not yet have the tools in place to say with confidence the extent to which the pricing mechanisms in the natural gas market today are reflecting market fundamentals or the possible market effects of various speculative trading strategies. However, we know that the confidence that our members once had in the pricing integrity of the markets has been badly shaken. In order to protect consumers the CFTC must be able to (1) detect a problem before harm has been done to the public through market manipulation or price distortions; (2) protect the public interest; and (3) ensure the price integrity of the markets. Accordingly, APGA and its over 700 public gas system members applaud your continued oversight of the CFTC's surveillance of the natural gas markets. We look forward to working with the Committee towards the passage of legislation that would provide further enhancements to help restore consumer confidence in the integrity of the price discovery mechanism. ______ Statment Submitted by Steve Suppan, Senior Policy Analyst, Institute for Agriculture and Trade Policy The Institute for Agriculture and Trade Policy (IATP) is a 501(c)(3) organization headquartered in Minneapolis, MN with an office in Geneva, Switzerland. IATP, founded over 20 years ago, works locally and globally to ensure fair and sustainable food, farm and trade systems. IATP is grateful for the opportunity to comment on a bill that is crucial for ensuring that commodities exchange activities contribute to the orderly functioning of markets that enable food and energy security. In November, IATP published ``Commodity Market Speculation: Risk to Food Security and Agriculture'' (http://www.iatp.org/iatp/publications.cfm?accountID=451&refID=104414). The study found that commodity index fund speculation in U.S. commodity exchanges distorted prices and induced extreme price volatility that made the futures and options market unusable for commercial traders. For example, one market consultant estimated that index fund trading accounted for about 30 percent of the nearly $8 a bushel price of corn on the Chicago Board of Trade at the height of the commodities bubble in late June. Until the bubble burst, many country elevators, unable to assess their risk in such volatile markets, had stopped forward contracting, endangering the cash flows and operations of many U.S. farms. The spike in developing country food import bills and increasing food insecurity, both in the United States and around the world, is partly due to the financial damage of deregulated speculation. While researching this study, I monitored the Committee hearings that contributed to H.R. 6604, ``Commodity Exchange Transparency and Accountability Act of 2008.'' IATP congratulates the Committee for the intense and expedited schedule of hearings and legislative drafting that resulted in the passage of H.R. 6604 and revisions to it in the draft ``Derivatives Markets Transparency and Accountability Act of 2009'' (hereafter ``the Act''). Due to the complexity of the legislation, our comments will only concern a small portion of the Act's provisions.Section 3. Speculative limits and transparency of off-shore trading and Section 6. Trading limits to prevent excessive speculation U.S. commodity exchanges have a dominant international influence over both cash and futures prices for many commodities. Because of the affects of that influence on food security and agriculture around the world, it is crucial that U.S. regulation and oversight of commodity exchanges be exemplary for the regulation of other markets. However, incidents of off-shore noncommercial traders benefiting from U.S. commodity exchanges while claiming to be beyond the jurisdiction of the Commodity Exchange Act (CEA) have resulted in the need for the prudent measures of section 3. The Committee and its staff are to be congratulated for the work undertaken since the passage of H.R. 6604 on September 18 to improve the bill. Particularly noteworthy are the visits of Chairman Peterson and Committee staff to regulatory authorities in London and Brussels both to explain H.R. 6604 and to learn how it might be improved. Section 3 would do by statute what the Commodities Futures Trading Commission's (hereafter ``the Commission'') memoranda of understanding with other regulatory authorities have failed to do: to ensure that foreign traders of futures, options and other derivatives cannot trade on U.S. exchanges unless they submit completely to the authorities of the CEA. Section 6 is so drafted as to avoid the possibility of a trade dispute ruling against the United States for ``discrimination'' against foreign firms in the peculiar trade and investment policy sense of that term. However, the World Trade Organization negotiations seek to further liberalize and deregulate financial services, particularly through the Working Party on Domestic Regulation of the General Agreement on Trade in Services (GATS).\1\ The members of the Financial Leaders Group that has lobbied effectively for GATS and U.S. deregulation (and particular regulatory exemptions for their firms) are major recipients of taxpayer bailouts through the Troubled Asset Relief Program.--------------------------------------------------------------------------- \1\ Ellen Gould. ``Financial Instability and the GATS Negotiations.'' Canadian Centre for Policy Alternatives. July 2008. http://www.tradeobservatory.org/library.cfm?refID=103596. --------------------------------------------------------------------------- The Committee should invite testimony from the Office of the U.S. Trade Representative (USTR) concerning U.S. GATS commitments, to ensure that those commitments and/or USTR positions advocated at the GATS negotiations not conflict with sections 3 and 6 or leave them vulnerable to WTO challenge. Furnished with that testimony and documents relevant to it, legislative drafting may be tightened to avoid the possibility of a WTO challenge. As the Committee is well-aware, the number of contracts held by noncommercial speculators far outweighs those of bona fide physical hedgers. The overwhelming dominance of purely financial speculation has induced price volatility that can be neither explained nor justified in terms of physical supply and demand, bona fide hedging by commercial traders and/or the amount of purely financial speculation required to clear trades. For example, in May, The Brock Report stated, ``no [commercial] speculator today can have a combined contract position in corn that exceeds 11 million bushels. Yet, the two biggest index funds [Standard and Poors/Goldman Sachs and Dow Jones/American Insurance Group] control a combined 1.5 billion bushels!'' \2\--------------------------------------------------------------------------- \2\ ``A Big Move Lies Ahead.'' The Brock Report. May 23, 2008.--------------------------------------------------------------------------- Section 3 of the Act seeks to close the regulatory exemption granted to Wall Street banks that enabled this massive imbalance between bona fide hedging on physical commodities and contracts held purely for financial speculation. However, closing that loophole will not suffice to begin to repair the damage wrought by the speculative position exemption. In 2004, the Security Exchange Commission granted for just a half dozen investment banks an exemption to prudential reserve requirements to cover losses, thus freeing up billions of dollars of speculative capital and handing the chosen banks a huge competitive advantage.\3\ These two regulatory exemptions enabled the asset price bubbles that began to burst in July, with dire consequences for the entire financial system and the global economy. The Act should authorize the Commission to work with the SEC to close all exemptions to prudential capital reserve requirements.--------------------------------------------------------------------------- \3\ Stephen LaBaton. ``Agency's `04 Rule Let Banks Pile Up New Debt, and Risk.'' The New York Times. October 3, 2008.--------------------------------------------------------------------------- Despite the commodities price collapse, Goldman Sachs, whose then CEO Henry Paulson lead the successful campaign to exempt his firm and other paragons of risk management from prudential capital reserve requirements, is estimated to have made $3 billion in net revenue in 2008 from its commodities division alone. The average bonus for a commodities trading managing director is estimated to be $3-$4 million in 2008, down 25 percent from 2007.\4\ Hence, there is little trader disincentive to exceed whatever speculative position limits that are agreed as a result of the deliberations of the Position Limit Agricultural and Energy Advisory Groups (stipulated by section 6. 4a). The Act provides for no advisory group for base and precious metals, which suggests that those components of the index funds may continue without speculative limits. The Act can readily be amended to provide for a Position Limit Metals Advisory Group. Given the financial service industry incentives structure, there is much to be done in the Act to provide strong disincentives for firms and individual traders to exceed the agreed speculative position limits.--------------------------------------------------------------------------- \4\ Ann Davis. ``Top Traders Still Expect the Cash.'' The Wall Street Journal. November 19, 2008.--------------------------------------------------------------------------- One of the responsibilities of the advisory groups is to submit to the Commission a recommendation about whether the exchanges themselves or the Commission should administer the position limit requirements ``with enforcement by both the registered entity and the Commission'' (lines 10-12, p. 15). While IATP agrees that the exchanges may have a role to play in administering the position limits requirement, we fail to understand why enforcement is not exclusively the Commission's prerogative. We urge the Committee to modify this provision to remove any suggestion of exchange enforcement authority.Section 4. Detailed Reporting and Disaggregation of Market Data and Section 5. Transparency and Record Keeping Authorities The provisions in these sections will help regulators monitor the size, number and value of contracts during the reporting period ``to the extent such information is available'' (Sec. 4(g)(2)). It is this qualifying last clause that worries IATP, since the Commission's ability to carry out its statutory obligations depends on complete and timely reporting of index fund data that disaggregates the agricultural, energy, base metal and precious metal contract components of these funds. The duration of agricultural futures contracts are typically 90 days, while energy and metals futures are for 6 months to a year. Both sections should stipulate that disaggregation not only concern contract positions held by traders with a bona fide commercial interest in the commodity hedged versus contracts held by financial speculators. Disaggregated and detailed reporting requirements should also stipulate reporting data from all component commodities contracts of the index funds, taking into account the differences in typical contract duration. Furthermore, the Act should authorize the Commission to stipulate that the reporting period for the disaggregated and detailed data be consistent with the duration of the index funds' component contracts, rather than with the reporting period of the index fund itself. The Act should further stipulate that the privilege to trade may be revoked or otherwise qualified if that trader's reporting does not provide sufficient information for the Commission to determine whether the trader is complying with the CEA as amended. Section 5 anticipates that traders will exceed the speculative position limits set by the Commission and provides for the terms of a special call by the Commission for trading data to determine whether the violation of the position limit has lead to price manipulation or excessive speculation, as defined in the CEA. Although IATP finds these provisions necessary for prudential regulation, we believe that the Act should stipulate how the Commission should seek to obtain the documents requested in the special call, when the trading facilities are located outside the United States. The Act wisely provides a ``Notice and Comment'' provision concerning the implementation of the reporting requirements for deals that exceed the speculative position limits. We anticipate that this ``Notice and Comment'' period will be used and guide the Commission's implementation of section 5 reporting requirements.Section 7. CFTC Administration IATP believes that the increase in Commission staff, above that called for in H.R. 6604, is well warranted. The Committee should consider adding to this section a provision for a public ombudsman who could take under consideration evidence of misuse or abuse of the Act's authorities by Commission employees and evidence of damage to market integrity that may result from non-implementation or non-enforcement of the Act's provisions.Section 9. Review of Over-the-Counter Markets Because of the prevalence of over-the-counter trades in commodities markets, and the damage to market integrity caused by lack of regulation of OTC trades, the need for speculative position limits on those trades seems all but self-evident. However, the Committee is wise to mandate the Commission's study of the OTC market given the heterogeneity, as well as the sheer volume of OTC contracts. We would suggest, however, that the study not be limited to transactions involving agricultural and energy commodities, but should also include base and precious metals.Section 10. Study Relating to International Regulation of Energy Commodity Markets IATP is very disappointed that section 10 has dropped the study of agricultural commodity markets called for in H.R. 6604. The Commission will be better able to carry out its responsibilities if it understands how agricultural commodities are regulated or not on exchanges outside of the United States. While U.S. exchanges are dominant in determining futures and cash prices for many agricultural commodities, there are other influential exchanges for certain commodities. The Commission should study these exchanges to find out whether there are best practices from which U.S. exchanges could benefit. IATP urges the Committee to restore the provision for a study of the international regulation of agricultural commodity markets to section 10.Section 13. Certain Exclusions and Exemptions Available Only for Certain Transactions Settled and Cleared Through Registered Derivatives Clearing Organizations We confess to not understanding these amendments to the CEA and to skepticism about the need for the exclusions, exemptions and waivers, in light of the exclusions, exemptions, and waivers whose abuse has helped bankrupt both financial institutions and individual investors. IATP suggests that the Committee add a ``Notice and Comment'' provision to this section, so that the public has an opportunity to argue for or against individual provisions of this section.Section 14. Treatment of Emission Allowances and Off-Set Credits This addition to H.R. 6604 may be premature, as the efficacy of emissions trading for actual reduction of global greenhouse gas emissions is under debate in the negotiations for a new United Nations Framework Convention on Climate Change. IATP believes that the Committee should await the results of the Framework Convention negotiations in December in Copenhagen before deciding whether to add this amendment to the CEA. If the Committee decides to retain this section, it should consider whether the current amendment should be limited to carbon sequestration or whether it should cover other green house gas emissions. Again, I thank the Committee for the opportunity to submit testimony. I congratulate the Committee on moving forward on this important work. I'm available to answer any questions concerning this testimony. FOMC20060510meeting--100 98,MR. POOLE.," Okay. Anyway, he said that their construction costs—for a store, I guess—have come in 27 percent above expectations. Their construction costs are even higher in the Gulf Coast area. He also said that Wal-Mart is in the process of raising starting wages in about 700 stores. This is the first time in eight years of talking with him that I’ve heard any comment like that. He said that some of the raises are part of the Wal-Mart, I’ll call it “social/political,” agenda because of all the controversy about Wal-Mart. But he said about 125 of these were market driven, that they have plenty of labor in rural areas and in urban areas, but they are developing a labor supply problem for their stores in suburban areas. Suburban areas are strong. I have received some unsolicited e-mail messages—well, I guess to be fair they’re sort of solicited. [Laughter] These are from two directors: “Heavy construction industry is really hot. In the past month, I have received reports of a second round of capital cost increases of 25 to 40 percent in the refining industry, and the same for construction of large power plants. These estimates follow similar increases last summer.” Another message discussed pressures on the cost of construction materials. I won’t read the whole thing. It says, “We believe we are now on the front side of a real surge in prices that will mainly affect highly volatile commodity building products—steel, copper, aluminum, and zinc. However, if it is sustained, it will ripple across a broad range of more-manufactured products.” Now, very briefly, I’ve made a list of what I think are classic inflation warning signs, and I’ll just rattle these off very quickly. Inflation expectations—we’ve talked about that. Dollar depreciation. Commodity prices are really breaking out of a trading range that has prevailed for about fifteen years— if you look at the chart in the Greenbook Part 2, you’ll see that. The surge in construction costs—I think there is a building boom indicating business confidence, and, of course, a direct source of aggregate demand. Relatively low risk spreads, making it easy for firms to raise capital. Strong stock market. Strong corporate profits. From our anecdotal information, some increase in pricing power. And a worldwide boom. There is growth in almost every region of the world, and, of course, that translates to some extent into price pressures everywhere, including goods that we import and goods that we export, at least eventually. I’ll stop there. Thank you." FinancialCrisisReport--164 The Levin-Coburn memorandum contained joint findings of fact regarding the role of federal regulators in the Washington Mutual case history. Those findings of fact, which this Report reaffirms, are as follows. 1. Largest U.S. Bank Failure. From 2003 to 2008, OTS repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, and asset quality, but failed to force adequate corrective action, resulting in the largest bank failure in U.S. history. 2. Shoddy Lending and Securitization Practices. OTS allowed Washington Mutual and its affiliate Long Beach Mortgage Company to engage year after year in shoddy lending and securitization practices, failing to take enforcement action to stop its origination and sale of loans with fraudulent borrower information, appraisal problems, errors, and notoriously high rates of delinquency and loss. 3. Unsafe Option ARM Loans. OTS allowed Washington Mutual to originate hundreds of billions of dollars in high risk Option Adjustable Rate Mortgages, knowing that the bank used unsafe and unsound teaser rates, qualified borrowers using unrealistically low loan payments, permitted borrowers to make minimum payments resulting in negatively amortizing loans ( i.e. , loans with increasing principal), relied on rising house prices and refinancing to avoid payment shock and loan defaults, and had no realistic data to calculate loan losses in markets with flat or declining house prices. 4. Short Term Profits Over Long Term Fundamentals. OTS abdicated its responsibility to ensure the long term safety and soundness of Washington Mutual by concluding that short term profits obtained by the bank precluded enforcement action to stop the bank’s use of shoddy lending and securitization practices and unsafe and unsound loans. 5. Impeding FDIC Oversight. OTS impeded FDIC oversight of Washington Mutual by blocking its access to bank data, refusing to allow it to participate in bank examinations, rejecting requests to review bank loan files, and resisting the FDIC recommendations for stronger enforcement action. 6. FDIC Shortfalls. The FDIC, the backup regulator of Washington Mutual, was unable to conduct the analysis it wanted to evaluate the risk posed by the bank to the Deposit Insurance Fund, did not prevail against unreasonable actions taken by OTS to limit its examination authority, and did not initiate its own enforcement action against the bank in light of ongoing opposition by the primary federal bank regulators to FDIC enforcement authority. 7. Recommendations Over Enforceable Requirements. Federal bank regulators undermined efforts to end unsafe and unsound mortgage practices at U.S. banks by issuing guidance instead of enforceable regulations limiting those practices, failing to prohibit many high risk mortgage practices, and failing to set clear deadlines for bank compliance. 8. Failure to Recognize Systemic Risk. OTS and the FDIC allowed Washington Mutual and Long Beach to reduce their own risk by selling hundreds of billions of dollars of high risk mortgage backed securities that polluted the financial system with poorly performing loans, undermined investor confidence in the secondary mortgage market, and contributed to massive credit rating downgrades, investor losses, disrupted markets, and the U.S. financial crisis. 9. Ineffective and Demoralized Regulatory Culture. The Washington Mutual case history exposes the regulatory culture at OTS in which bank examiners are frustrated and demoralized by their inability to stop unsafe and unsound practices, in which their supervisors are reluctant to use formal enforcement actions even after years of serious bank deficiencies, and in which regulators treat the banks they oversee as constituents rather than arms-length regulated entities. CHRG-109hhrg23738--78 Mr. Greenspan," Well, Congresswoman, it depends not only on the level of prices but on the pace of change, and the reason I say that is, what we seem to do with gasoline consumption, and probably diesel as well, is: When prices go up, we consume just the same amount of gasoline, largely because we do not curtail our travel very much. If you look at the aggregate amount of motor gasoline consumption in the face of this very sharp rise in price, you will be hard-pressed to find any reduction. Yet what we do know from experience is that while people do not cut their mileages down very much, they do tend, when prices go up, to buy cars and trucks with much better fuel efficiency. And so over time, if prices stay up, what is going to happen is that the amount of gasoline consumed is going to go down, and indeed it could go down quite considerably. People will be traveling in lighter cars, more fuel-efficient, maybe more hybrids. One thing about Americans is that our cars are critical to our day-by-day existence, and they do notice when gasoline prices go up; and it probably does curtail other forms of spending. Indeed you can see it in certain income groups, where high gasoline prices lead to less purchases elsewhere. But what they do not do is drive fewer miles. At least that is what the data suggests. Ms. Hooley. I would like to take just a different tact, very shortly, and talk a little bit about the currency prices in China. Sixty percent of China's economists think they should allow the country's currency to increase in value sometime this year. Would you advocate a gradual increase in the value of Chinese currency; and what would be the impact on both the American and global economy; and if China refuses to increase the value of their currency significantly, would you advocate imposing punitive tariffs against China's imports? " FOMC20080109confcall--38 36,MS. PIANALTO.," Thank you, Mr. Chairman. I, too, am troubled by the weakness in the real economy data that we are seeing. Our Beige Book contacts confirm the weakness, and my business contacts to whom I have been talking report more weakness than they did before our December meeting. However, they are not flashing signals about a recession. Next week we will learn more about just how weak the fourth quarter was through the retail sales and industrial production releases for December. Next week we are also going to get the December CPI report. In my view, the October and November reports were very disappointing. In November, 60 percent of the CPI market basket prices increased at rates of 3 percent or greater. On learning of today's meeting, I was concerned about making a large policy move ahead of the December CPI report for fear that we would be damaging some of our credibility on price stability, so I did not want to make a move at today's meeting. However, I can support a 50 basis point reduction at our meeting at the end of the month if we are regarding that reduction--and regarding our cumulative policy actions--as just offsetting the decline in the equilibrium real rate and we are not being aggressively accommodative. That would be, in my view, appropriate policy given my concerns about inflation. But the public could interpret our actions as being aggressively accommodative and that we are downplaying inflation risks. So I hope, Mr. Chairman, that you will be able to communicate your thinking on this, as you have with us today, in some of your upcoming public statements. Thank you, Mr. Chairman. " fcic_final_report_full--585 East 2005,” September 20, 2005, pp. 5–7. 9. Alan Greenspan, “The Economic Outlook,” testimony before the Joint Economic Committee, 109th Cong., 1st sess., June 9, 2005. 10. Christopher Mayer, written testimony for the FCIC, Forum to Explore the Causes of the Financial Crisis, day 2, session 5: Mortgage Lending Practices and Securitization, February 27, 2010, pp. 5–6. 11. Antonio Fatás, Prakash Kannan, Pau Rabanal, and Alasdair Scott, “Lessons for Monetary Policy from Asset Price Fluctuations Leaving the Board,” International Monetary Fund, World Economic Out- look (Fall 2009), chapter 3. 12. James MacGee, “Why Didn’t Canada’s Housing Market Go Bust?” Federal Reserve Bank of Cleve- land. Economic Comment (December 2, 2009). 13. Morris A. Davis, Andreas Lehnert, and Robert F. Martin, “The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied Housing,” Federal Reserve Board Working Paper, May 2005, p. 2. 14. Price data from CoreLogic CSBA Home Price Index, Single-Family Combined. Rent data is Bu- reau of Labor Statistics, metro-level Consumer Price Index (CPI-U), Owners’ Equivalent Rent for Pri- mary Residence; all index figures are adjusted so that Jan. 1997=1. Methods follow from Federal Reserve Bank of San Francisco Economic Letter, “House Prices and Fundamental Value,” Number 2004–27, Oc- tober 1, 2004. 15. National Association of Realtors Housing Affordability Index, accessed from Bloomberg as com- posite Index (HOMECOMP). The index began in 1986. 16. The index also assumes that the qualifying ratio of 25%, so that the monthly principal & interest payment could not exceed 25% of the median family monthly income. More about the methodology can be found at National Association of Realtors, Methodology for the Housing Affordability Index. 17. Ben Bernanke, letter to FCIC Chairman Phil Angelides, December 21, 2010, p. 2. 18. Kristopher S. Gerardi, Christopher L. Foote, and Paul S. Willen, “Reasonable People Did Disagree: Optimism and Pessimism about the U.S. Housing Market Before the Crash,” Federal Reserve Bank of Boston Public Policy Discussion Paper No. 10-5, August 12, 2010. 19. Donald L. Kohn, “Monetary Policy and Asset Prices , ” speech delivered at “Monetary Policy: A Journey from Theory to Practice,” a European Central Bank Colloquium held in honor of Otmar Issing, Frankfurt, Germany, March 16, 2006. 20. Richard A. Brown, “Rising Risks in Housing Markets,” memorandum to the National Risk Com- mittee of the Federal Deposit Insurance Corporation, March 21, 2005, pp. 1–2. 21. Board of Governors, memorandum from Josh Gallin and Andreas Lehnert to Vice Chairman [Roger] Ferguson, “Talking Points on House Prices,” May 5, 2005, p. 3. 22. Missal, p. 40. 23. William Black, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Miami, Florida, session 1: Overview of Mortgage Fraud, September 21, 2010, transcript, p. 78; and email from William Black to FCIC, December 12, 2010. 24. Reply of Attorney General Lisa Madigan (Illinois) to the FCIC, April 27, 2010, p. 7. 25. Chris Swecker, Assistant Director Criminal Investigative Division Federal Bureau of Investigation, statement before the House Financial Services Subcommittee on Housing and Community Opportunity, 108th Cong., 2nd sess., October 7, 2004. 26. Florida Department of Law Enforcement, “Mortgage Fraud Assessment,” November 2005. 27. Wilfredo Ferrer, testimony before the FCIC, Hearing on the Impact of the Financial Crisis— Miami, Florida, session 3: The Regulation, Oversight, and Prosecution of Mortgage Fraud in Miami, Sep- tember 21, 2010, transcript, pp. 186–87. 28. Ann Fulmer, supplemental written testimony for the FCIC, Hearing on the Impact of the Finan- cial Crisis—Miami, Florida, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 2; Fulmer, testimony, transcript, pp. 80–81. 29. Ed Parker, interview by FCIC, May 26, 2010. 30. David Gussmann, interview by FCIC, March 30, 2010. 31. William H. Brewster, interview by FCIC, October 29, 2010. 32. Henry Pontell, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis— FOMC20050630meeting--286 284,CHAIRMAN GREENSPAN., I’m really surprised. I mentioned that in a speech recently; the spread between the six-year futures price and the spot price has closed. And no one has picked that up. It’s unbelievable. CHRG-110hhrg44901--204 Mr. Perlmutter," That was the time the market realized that housing prices weren't always going to go up. That is the way I would describe it. A lot of it was just based on increased housing prices over time. " CHRG-111shrg57320--12 Mr. Rymer," Yes, sir, I do. I really can see no practical reason from a banker's perspective or lender's perspective to encourage that. That is just, to me, an opportunity to essentially encourage fraud. Senator Levin. Now, on the Option ARMs issue, OTS allowed Washington Mutual to originate hundreds of billions of dollars in these Option Adjustable Rate Mortgages, these Option ARMs. OTS was also allowing the bank to engage in a set of high-risk lending practices in connection with the Option ARMs. Some of these high-risk lending practices included low teaser rates as low as 1 percent in effect for as little as a month to entice borrowers; qualifying borrowers using lower loan payments than they would have to pay if the loan were recast; allowing borrowers to make minimum payments, resulting in negatively amortizing loans; approving loans presuming that rising housing prices and refinancing would enable borrowers to avoid payment shock and loan defaults. Now, it was the Option ARM loans in 2008 that was one of the major reasons that investors and depositors pulled their money from the bank, and did those Option ARMs, particularly when connected with those other factors, raise a real safety and soundness problem at WaMu? Mr. Thorson. " FOMC20081029meeting--263 261,CHAIRMAN BERNANKE.," Okay. Thank you. Let me try to summarize all that I heard today and yesterday, and then I'll try to add some new comments to that. The outlook for economic growth appears to have deteriorated quite significantly since the last meeting. Data on consumer spending, production, and employment had weakened more than expected even before the recent intensification of the financial crisis. Over the past six weeks or so, however, financial conditions have greatly worsened, and risk aversion has increased, despite actions here and abroad to stabilize the banking system. Equity values have declined sharply amid conditions of low liquidity and extraordinary volatility. Credit market conditions have improved modestly since the global actions to recapitalize banks and guarantee their deposits, assisted also by additional central bank liquidity actions. However, in almost all credit markets, spreads remain much wider, maturities shorter, and availability more constrained than was the case before the intensification of the crisis. Firms face continued funding risk and rollover risk. Banks have probably not reserved sufficiently for the credit losses to come, and hedge funds will be hitting their net asset value triggers in greater numbers, forcing them to liquidate assets. The duration of future financial turmoil is hard to judge, but it could be lengthy. The worst thing is that financial conditions appear already to have had a significant and remarkably quick effect on activity and consumer and business expectations and plans. Most Committee participants see us in or entering a recession and have marked down significantly their expectations for near-term growth or for the pace of the recovery. The difficulty of predicting the course of the crisis or its effects on the economy has also increased forecast uncertainty. In particular, the ultimate effects of some major policy actions, such as the creation of the TARP and the bank guarantee, are not yet known. Uncertainty about future policy actions, as well as uncertainty about the economy, has affected behavior in markets and the broader economy. Consumer spending has weakened considerably and probably fell sharply in the third quarter, reflecting in part a recessionary psychology. Consumer durables, such as automobiles and discretionary expenditures, have been particularly hard hit. This weakness reflects the same set of negative influences on consumption that we have been seeing for a while, now compounded by losses of equity wealth and confidence effects on prices, although lower oil prices may provide some relief. The labor market continues to decline, with many firms reporting that they are cutting back workers. The housing sector has not been noticeably worse than expected, and reports are somewhat mixed. But on a national basis, the contraction is continuing, and recent developments in the economy and credit markets are likely to have adverse effects. Inventories of unsold new homes remain high, putting pressure on prices. Nonresidential construction continues at a moderate pace; but backlogs are falling, and the sector is looking increasingly vulnerable to weakening fundamentals and tighter credit conditions. Whether a new fiscal stimulus package will be passed and to what extent such a package would be helpful remain open questions. Manufacturing production has weakened significantly as have expectations of demand, including export demand. Credit is becoming more of a problem for many firms and their customers. Spending on equipment and software appears to have slowed, reflecting greater pessimism and uncertainty. Falling commodity prices may reduce mining activity and cool the boom in agriculture. On the plus side, firms are reporting fewer cost pressures, and inventories do not appear excessive. Deterioration in global growth expectations has been marked. Industrial economies had already shown signs of slowing, and they have been hit hard by recent financial developments. Emerging market economies, until recently evidently not much affected by the U.S. slowdown, have in recent weeks also been hit hard by the spreading financial crisis. Together with the stronger dollar, these developments are likely to restrain future growth of U.S. exports. Inflation risks have declined materially, reflecting the fall in the prices of energy and other commodities, the stronger dollar, and the prospect of considerable economic slack. Firms report much reduced pricing power and lower markups. Inflation expectations have come down, both in the surveys and in the TIPS market, though it wasn't noted--but I will note--that the TIPS market is distorted by illiquidity and other problems there. Most participants see both overall and core inflation moderating in the coming quarters toward levels consistent with price stability, with some seeing a risk of undesirably low rates of inflation. Some note, however, that financial dislocations affect aggregate supply as well as aggregate demand and may reduce the extent to which slower growth damps inflation. So that's just my sense. Any comments? Additions? Let me make just a few additional comments, none of which will be radically different from what we have already discussed. I do think it is overwhelmingly clear that we are now in a recession and that it is going to be a severe one. To give some sense of perspective, the postwar record for duration is 16 months. If the NBER sets this experience as having begun early this year, I think we have a reasonable chance to break that record. The largest increase from peak to trough in unemployment rate was in 1981. It was 3.6 percentage points. Starting from 4.4 percent, I think we have a chance to come close to that number. Yesterday's drop in consumer confidence in one month from 61 to 38 shattered the previous low of 43 in December 1975. So I think we are talking about an episode here that could easily be among the largest postwar recessions. We don't know how things would have evolved without the developments in September, but obviously we have to deal with that reality. It was just a few weeks ago that we were dealing with what might have been a true systemic crisis, in the week leading up to the G-7 and IMF meeting. I think it has been very fortunate that Europe, the United States, and other countries have adopted vigorous responses to that, including bank capitalization, bank guarantees, and other measures. That has been very important in calming the situation somewhat and reducing the systemic aspects of investor concerns. That being said, concern about counterparties remains very strong. Risk aversion is intense, spreads remain high, and I think that this has now become really pervasive. It isn't just a question of junk bonds and weak borrowers or weak credit histories. The spreads on GSE debt, on high-grade corporate debt, and other areas have also widened, leading to a very broad based tightening in credit conditions. So I think that, overall, any reasonable reading of financial conditions suggests that the tightening of credit or financial conditions in the last six weeks or so has been quite substantial and overwhelms the effects of our coordinated rate cut. Now, normally you would expect to see a tightening of credit conditions affect the economy with some lag. It takes time for people to borrow money and to use the money they borrow to make expenditures. But compared with that prediction, we have instead seen a sudden stop--a remarkable and very rapid effect on economic activity. It is possible this is due less to the direct effects of credit availability and more to the psychological impact of these events. One possible analogy is the 1980 Carter credit controls, when the government announced what seemed to be a tightening of credit. There was a very sharp response in economic activity, probably based more on expectations than on actual credit availability. Unfortunately, the credit controls could be removed by government fiat; we are not able to do that today. One interesting development is that the labor market has not yet shown as much weakness as one would expect. Unemployment insurance claims and other indicators do not yet show a marked deterioration. I expect that we will see more deterioration of the labor market. Besides the intensification of the financial crisis that has markedly increased the restrictiveness of financial conditions, I think the other very important development since our last meeting has been the internationalization of the crisis. We had already seen weakening in Europe before the most recent intensification, but it has become much more severe. There is little doubt that the United Kingdom and Europe are in or about to enter recession. My sense is that their monetary policy responses will be stronger than what the Greenbook anticipates. I believe they will be very aggressive in responding to that. A new and particularly worrying development is the fact that the crisis has now spread beyond the industrial countries to the emerging markets. The G-7 weekend was quite an interesting one. It was a striking experience. I heard over and over again from the Indians, from the Brazilians, and from all over the world that, until the middle of September we were fine, we were not being much affected, we didn't see much effect on our trade flows, and suddenly everything changed; and now we are under severe stress. We are seeing tremendous outflows. Our currencies are plummeting. Commodity price declines are hurting many countries. I think that is going to be a very significant development as we go forward. Just to give some data, in just a few weeks the EMBI spread, the emerging market sovereign debt spread, went from 280 basis points to 850 basis points; and the emerging market equity index has fallen about 40 percent since the last meeting. It is not obvious that these changes were justified by economic fundamentals. Many of these countries are very well run and had shown a lot of progress in their domestic policies and their domestic economies. Instead, I think they are suffering contagion from us mostly. Unfortunately, the implications of this will be not only the usual trade and commodity price type of implications but also, and even more important, financial implications. We are now seeing that the adverse feedback loop, which we've been talking about for a long time in the United States, is becoming a global phenomenon. In particular, European banks are very heavily exposed to emerging market debt. So we are going to see yet more of this interaction between the financial markets and the broader economy, except at a global rather than a national level. These developments, obviously, are very disturbing and don't bode well for U.S. growth or now for global growth. Somewhat ironically, all of this deterioration in the global outlook has led the dollar to appreciate very sharply, which is interesting to say the least. For us that obviously also has important implications for inflation, and as Governor Kohn mentioned, it means that we will be less a recipient of foreign strength and more a supporter of foreign weakness than we have been until now. On inflation, I know there is some discomfort in talking about a 1 percent policy rate and promising to keep it low for a protracted period--and all those things. We have seen this movie before, and I think we all have to recognize the importance of watching the implications of that for our economy and for asset prices and to take quite seriously the responsibility for removing accommodation in a timely fashion once the crisis has begun to moderate. That being said, I don't think that there is really any case in the near term to be worrying very much about inflation--or, perhaps even less so, the dollar--as we look at our policy. Pricing power is evaporating. And given what is happening in the global economy, I don't see a commodity price boom any time soon, although I think as the economies do begin to recover in the next year or so that we might see some recovery in commodity prices. So I think that, as everyone has indicated, this is a very worrisome situation. I don't think we have control of it. I don't think we know what the bottom is, so we have to remain very flexible and very open to new initiatives as they become necessary. There has been some comparison of this to the Japanese situation. I'm beginning to wonder if that might not be a good outcome. The advantage of the Japanese was, first of all, that they were isolated. The rest of the world was doing okay, and they were able to draw strength from their exports and the rest of the global economy. Although they had very slow growth, they never really had a deep recession or big increases in unemployment. I think we are looking at perhaps a much sharper episode, and our challenge will be to make sure that it doesn't persist longer. I do think that one lesson of both Japan and the 1930s as well as other experiences is that passivity is not a good answer. We do have to continue to be aggressive. We have to continue to look for solutions. Some of them are not going to work. Some of them are going to add to uncertainty. I recognize that critique. I realize it's a valid critique. But I don't think that this is going to be a self-correcting thing anytime soon. I think we are going to have to continue to provide support of all kinds to the economy. Let me stop there and, unless there is any question or comment, ask Brian to introduce the policy round. " CHRG-111hhrg48868--46 Mr. Campbell," Thank you, Mr. Chairman. There will be lots of discussion about how we got here, but we also need to spend some time on what we are going to do next. I have a lot of concerns about whether there will be any business left from which the taxpayers can recoup any money. A question I would like to know the answer to is that in September, AIG had $450 billion of exposure on credit default swaps. What is that number today? AIG's commercial property and casualty business was down 22 percent in the fourth quarter and there is evidence that it retained the remainder of its business by substantially reducing prices. What is happening to that property and casualty business? It would appear it is in some kind of a death spiral. Have there been some, even in the money market fund that AIG had, some puts and other riskier assets put into that which should not have been put into that and if the systemic risk is in the life insurance business, where does that stand right now? Thank you, Mr. Chairman. I yield back. " FOMC20061025meeting--231 229,MR. KROSZNER.," I support no change at this time. As many people have said, we’ve had very little new information to change our views from the last meeting, and I think that the position that we’re in is consistent with growth a tad under trend potential, whatever word we might want to use. I share Rick’s caution about being too explicit about that because I think there’s a lot of controversy about what that precisely means, and I don’t think we want to get into that in this statement or at least not at this point. Also, we have seen some inflationary pressures come off. Inflation has been evolving a bit as I expected. I was talking about the temporary factors versus the more-permanent factors. The key temporary factor seems to have been a temporary elevation in owners’ equivalent rent and the way we put that into our core CPI and PCE; so some of it is a measurement issue. Some of it is a transition in the housing market away from purchases toward rental. That seems to have come off a bit, and so going forward, it does seem as though we’re unlikely to have that continuing at elevated levels. My concern, as I mentioned yesterday, is that I don’t understand the path or the dynamics going forward. Certainly we have some simulations in the Bluebook which are very, very sticky. Inflation seems to evolve very slowly, or very little seems to affect it. Part of that seems to be, if we look at the data, that the energy price run-up appears not to have pushed much on inflation, so I don’t think we can rely on the energy price decline to give us much benefit in terms of core. Recent data on output gaps don’t seem to suggest that there’s much empirical evidence that a change in the cyclical behavior of the economy is going to have an important effect on inflation. Expectations certainly potentially have a very important effect, and I think we have seen a reduction in inflation expectations and inflation compensation, both in survey measures and in TIPS spreads or other market-based measures. But as I mentioned yesterday, that is a very fragile thing. The process is something that I don’t fully understand. Obviously, our credibility is very important, and our statements are very important. But it does seem as though the minutes and speeches have helped to clarify what our position is. If you look at the evolution of the expected fed funds rates in Vince’s exhibit 1, you see that not much change has been expected over quite a bit of time now and maybe 25 basis points is expected a year hence. That position is different from our position a few months ago. I think it’s an appropriate position given our discussions. It leaves us a lot of flexibility to respond either to surprisingly strong growth, to surprisingly strong inflation numbers, or to surprisingly weak housing. So I think that market expectations are in a reasonably good position in the near term. We do have to think about the longer-term issues that President Lacker has raised and that may come up in our discussions of communications. Speaking of communications, in particular the statement—we’ve been talking a lot about how the Committee is focused on data and the role of data and our forecasts. Because not much data have come in and our views have not changed a lot, I think we should not be changing the statement much. That is consistent with our view that we are really focusing on the data. In particular, I don’t like speculating about a particular number, especially when that number is going to be revealed in a few days, for three reasons. One is the potential embarrassment factor if we’ve missed the number. The second is that, even if we have very high confidence that we have gotten the number roughly right, getting it right only feeds the view that a lot of market participants have— and I’m sure you’ve all heard this—that we know something the rest of the world doesn’t, that we know these data before the rest of the world. I don’t—maybe some of you guys do [laughter]—at least the staff has not revealed any of that to me. Third, what we’ve been trying to say is that we look at a mosaic of data; we don’t look at any one piece, and to emphasize one piece is problematic. So that said, obviously the type of approach that Don was discussing is one that I would support. But I do think it is very important to make sure that we have a good understanding, in the context of that statement, of what “moderate” would be interpreted as. Obviously it will be very important in the minutes to make very clear what that is, and obviously with our blackout period, it will take us a while before we can make explicit statements if there’s confusion in the market. So I do think we need to think about the interpretation of “moderate.” However, I like the idea of conveying that the economy is likely to be coming back, perhaps not at the robust pace that we’ve seen in the past but at a reasonable or moderate pace. Given that energy prices and commodity prices have come down, we should be taking out that energy prices and commodity prices are pushing up inflation or seem to be sustaining inflation pressures. Also given that we have not seen much change in the data or have not made much change in our approach, there’s really no reason to change the assessment-of-risk discussion, particularly as the markets seem to be interpreting our assessments roughly where we think is reasonable considering the risks going forward. If the markets were interpreting things as they had been interpreting them a month or two ago, we may have wanted to change our statement, but I see no reason to do that now." FOMC20080625meeting--32 30,MR. MADIGAN.," 3 I will be referring to the separate package labeled ""Material for Briefing on FOMC Participants' Economic Projections."" The top two sections of table 1 show the central tendencies and ranges of your current forecasts for the first and second halves of 2008; central tendencies and ranges of the projections published by the Committee this past April are shown in italics. To facilitate comparisons, the Greenbook projections are shown in the bottom section. In your forecast submissions, most of you indicated that you saw appropriate monetary policy as entailing a path for the federal funds rate that lies above that assumed in the Greenbook. As shown in the first row, first column, of table 1, the central tendency of your real growth forecasts for the first half of 2008 has been marked up substantially since April. However, a number of you noted that recent upside surprises to consumer and business spending are likely to prove transitory and that falling house prices, tight credit conditions, and elevated energy prices will probably restrain growth over the remainder of 2008. Accordingly, some of you revised down a touch your growth expectations for the second half of this year (the second column) especially those of you who had previously anticipated the briskest 3 The materials used by Mr. Madigan are appended to this transcript (appendix 3). growth rates, as indicated by the downward revision to the upper end of the range shown in the middle section. Most of you think the economy will skirt recession. Nonetheless, your projections for the speed of recovery over the second half exhibit considerable dispersion: Four participants are projecting growth rates of real GDP between 2 and 2� percent, whereas an equal number are calling for growth at an annual rate of only around � percent, a pace similar to the one projected in the Greenbook, with many of you attributing the tepid growth partly to financial headwinds. The tendency for some clustering of your second-half growth forecasts at the extremes can be seen by noting the similarity between the central tendency and the range. As shown in the second set of rows in the top panel, your projections for headline PCE inflation in the second half of 2008 have been revised up more than 1 percentage point, to around 3� to 4� percent, largely as a result of the surge in prices of energy and agricultural commodities. However, in view of better-thanexpected news on core PCE inflation, the central tendency of your projections for core inflation during the second half (shown in the third set of rows) revised up only 0.1 percentage point. Looking ahead to 2009 (table 2, the middle column), you continue to expect growth to pick up as the drag from the housing sector dissipates and credit conditions ease. The midpoint of the central tendency of your forecast for real GDP growth next year is 2.4 percent, the same as in April and the same as the staff's current forecast. Your growth forecasts for 2010 (the third column) are a shade lower than in April, and the central tendency of your forecasts for the unemployment rate is a touch higher, perhaps because a number of you assumed more policy tightening over the forecast period in order to counter heightened inflation pressures. The midpoint of the central tendency of your projections for the unemployment rate edges down from about 5� percent in 2009 to about 5� percent in 2010. Your commentaries suggest that many, albeit not all, of you view those rates as a quarter-point to a half-point above your estimates of the NAIRU. The third and fourth sets of rows indicate that most of you see overall and core inflation staying above 2 percent next year; but by 2010, the extended period of economic slack and the assumed leveling-out of energy prices push down overall and core inflation to around 1� to 2 percent; for core inflation, the central tendency and range are a touch higher than you forecasted in April. For the first time since you started these projections last October, the upper end of the range of your projection of total inflation in 2010 exceeds 2 percent, albeit marginally. Thus, many of you project that, at the end of the forecast period, the economy will still be operating with some slack and real output growth will be slightly above the growth rate of potential. The continued presence of slack suggests that you anticipate that inflation will continue to edge lower in 2011 and, given the assumption of appropriate monetary policy, implies that you typically anticipate that inflation will still be a bit higher in 2010 than you see as consistent with price stability. Exhibit 3 presents your views on the risks and uncertainties in the outlook. As shown by the green bars in the top two panels, a large majority of you continue to perceive the risks to growth as weighted to the downside (the left panel), and many judge that the degree of uncertainty regarding prospects for economic activity is unusually high (the right panel), although the number of you seeing uncertainty about growth as elevated has declined slightly over the first half of the year. In your narratives, you attributed the downside risks primarily to the potential for steeper declines in house prices and persisting financial strains, which through a further tightening of credit conditions could exert an unexpectedly large restraint on household and business spending. Although your views of the risks regarding growth have shifted only modestly, the distribution of your perceptions of the risks regarding inflation (shown in the bottom two panels) has changed significantly so far this year. As shown in the lower left panel, about three-quarters of you now see the risks to the outlook for overall inflation as skewed to the upside. In your commentaries, you typically pointed to continued increases in energy and food prices and an upward drift in inflation expectations as the main reasons for the upside risks to inflation. In addition, as shown to the right, the number of participants who perceive the degree of uncertainty regarding the inflation outlook as larger than usual has risen considerably. Turning to exhibit 4, as I noted, your projections suggest that you do not see the economy as having fully settled into a steady state by 2010. The dynamics of the economy evidently are such that, following moderately large shocks, it can take quite a few years to converge back to steady state, a view that is captured by many econometric models such as FRB/US and is also reflected in the current Greenbook forecast. Thus, the three-year forecast horizon currently used by the Committee does not necessarily allow your forecasts to reveal fully your views of the steady-state characteristics of the economy and your views of the rate of inflation consistent with the dual mandate. Recognizing this, the Subcommittee on Communications recently sent the Committee a memo outlining several possible approaches to providing longer-term projections. The approaches are summarized in the lower panel. One option would be for participants to extend their entire set of projections out to, say, five years. Under this option, participants would be asked to submit projections for economic variables in year 4 as well as in year 5. You would also expand your individual forecast narratives to explain the trajectory of the economy and inflation over the five-year projection period. This approach would have the advantage of providing the basis for a complete presentation of the Committee's medium-term and long-term views. The principal disadvantage of this option is the relatively heavy burden it places on Committee participants to make projections covering five years. Another disadvantage is that in some circumstances--that is, following a very large shock--the economy still may not be in a steady state after five years. A second option is for participants to continue to submit economic projections and narratives out to three years as now but also to provide estimates of the values of output growth, unemployment, and inflation in year 5 under the assumption of appropriate monetary policy. Under this approach, you might wish to collect and publish long-term projections only for output growth, unemployment, and total inflation, and not for core inflation, in order to emphasize that total inflation rather than core inflation is the appropriate metric for the longer-run goal of price stability. This second approach presumably places less demand on your time than the first but it would make for a less integrated presentation. It would also suffer from the same defect as the first approach, in that the figures you submit might not reveal the steadystate characteristics of the economy after a large shock. In a third approach, you would augment your three-year projections with projections of the average values for output growth, unemployment, and total inflation over the period five to ten years ahead. This approach would have the advantage of more directly revealing your estimates of the key operating characteristics of the economy--that is, the parameters related to productive capacity and your inflation objective. It might also be less demanding of your time in the sense that you would need to project fewer time periods than in the first option. On the other hand, it might be more difficult in that you would need to consider likely trends in demographic variables and productivity further ahead than is ordinarily necessary for monetary policy making. Moreover, it is possible that some of the parameters you would be supplying for the period five to ten years ahead might take on different values than would apply to the medium term that is relevant for monetary policy. In your comments in the upcoming economic go-round, you may wish to express your views on whether you support publication of longer-run projections and, if so, which of the approaches you prefer. You might also wish to comment on the desirability of conducting a trial run with long-term projections--say, in October-- before going live with long-term projections, perhaps in January. That concludes our prepared remarks. " FOMC20070628meeting--113 111,MR. STERN.," Thank you, Mr. Chairman. Regarding the national economy and real growth, it seems to me that recent developments are unfolding to a considerable extent largely as anticipated. Growth was positive but subdued over the four quarters ending in the first quarter of this year. It apparently snapped back discernibly in the current quarter, and my forecast is for sustained growth around trend going forward. In examining the twelve-month period spanning the last three quarters of last year and the first quarter of this year, it is apparent that the slowing of aggregate demand went beyond the housing sector and, in fact, was fairly broadly based. To be sure, residential construction activity contracted persistently and substantially over those four quarters. In addition, spending on equipment and software barely advanced, federal government outlays were soft in real terms, and there was a significant inventory correction. In most cases, with the likely and perhaps obvious exception of residential construction, there are reasons to believe, based on some of the indicators that David Wilcox covered this afternoon as well as materials distributed before the meeting, that these components of demand—that is, spending on equipment and software, federal government outlays, and inventories—will strengthen going forward. I thought it was particularly heartening, as noted in Part 2 of the Greenbook, that apparently the inventory overhang in construction supplies and in autos has been worked off, which suggests that we should see improvement in those sectors going forward. As I have commented before at recent meetings, I think the outlook for nonresidential construction, for net exports, and for consumer spending remains positive, although not unduly exuberant. All of this fits reasonably well with my view of what we should expect from productivity gains going forward, as well as increases in employment and hours worked. So, overall, I think the outlook for the real economy is promising and favorable. As to inflation, there has been, as everybody has noted, some moderation in the core measures recently. I expect this performance to continue, not necessarily on a month-by-month basis but over time. Overall, my reading of monetary policy is that it is moderately restrictive. As a consequence, that should feed into a further, gradual diminution of inflation along with ebbing of some of the transitory factors that pushed it up for a time. I would add that anecdotes from our business contacts don’t suggest any changes in pricing power or acceleration of inflation at this point. Now, of course, risks to the outlook abound, as they always do, and many have already been mentioned. Several relate, of course, to housing—construction activity, home prices, mortgage-related paper, and so forth. Then, you can add uncertainty associated with energy prices, the run-up in long-term interest rates that has already occurred, and I am sure a few things that I haven’t enumerated. I wouldn’t want to sound overly complacent or sanguine, but I would observe that many of these risks are not new. Many of them are already built into the Greenbook or other forecasts. In any event, if one of them were to occur in isolation, I would doubt that it would have a profound effect on the outlook that I have described. Thank you." CHRG-111shrg54589--148 RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED FROM ROBERT G. PICKELQ.1. Are there differences between the SEC and CFTC's approaches for regulating their respective markets and institutions that we should take into consideration when thinking about the regulation of the OTC derivatives markets.A.1. There are differences in both the traditional roles and approaches to regulation between the SEC and CFTC that warrant consideration as Congress contemplates oversight of the OTC derivatives markets. The former primarily serves an investor protection role; the latter a market regulatory role. Generally, the SEC relies on rule-based regulation and enforcement actions, while the CFTC relies on principle-based regulation.Q.2. The Administration's proposal would require, among other things, clearing of all standardized derivatives through regulated central counterparties (CCPs). What is the best process or approach for defining standardized products? How much regulatory interpretation will be necessary?A.2. The industry strongly supports the clearing of OTC derivatives contracts and believes that clearing should be encouraged wherever feasible. In identifying those derivatives that are standardized and therefore clearable, we suggest the Federal regulators look to apply certain criteria or a framework of conditions to ensure that required clearing of standardized derivatives promotes economic efficiency, fungible treatment of cleared contracts, clearinghouse interoperability, choices among clearinghouses, and consistency with international standards. In particular, the Federal regulators should consider whether: 1. One or more regulated clearing organizations are prepared to clear the contract in accordance with U.S. regulatory requirements and will have the necessary resources, capacity, operational competence, experience, risk management infrastructure and governance structure to clear the contract in a prudent manner and mitigate systemic risk, taking into account the size and specific characteristics of the market for the relevant contract; 2. The contract is traded with sufficient frequency and volume that the risks associated with outstanding positions in the contract are significant with respect to the market as a whole; 3. Liquidity in the contract is sufficient to provide reliable price sources for the regulated clearing organization(s) to calculate collateral requirements consistent with prudent risk management; and 4. The contract is traded in the OTC market on terms and trading conventions that are sufficiently standardized to facilitate clearing without basis risk to be regulated clearing organization(s). The clearing rules applicable to the contract are consistent with the OTC market's trading terms and conventions. To the extent that mandatory clearing requirements for OTC derivatives contracts are adopted and implemented, they should apply only to OTC derivatives transactions between professional intermediaries within Tier 1 Financial Holding Companies and other systemically significant persons and should ensure broad-based participation among the covered participants active in the relevant market.Q.3. Are there key areas of disagreement between market participants about how central counterparties should operate? For example, what are the different levels of access these central counterparties grant to different market participants? What are the benefits and drawbacks of different ways of structuring these central counterparties?A.3. An important consideration facing market participants regarding how CCPs operate is the segregation and portability of CDS positions and associated initial margin. A related consideration is a CCP's criteria for clearing member (CM) status. ISDA, as part of an ad hoc group comprising both buy-side and sell-side constituents, prepared a report to the supervisors of the major OTC derivatives dealers (the Report), which analyzes the following proposed clearing solutions: CME Clearing, ICE Trust U.S. LLC, Eurex Clearing AG, ICE Clear Europe, LCH.Clearnet Limited/NYSE Liffe and LCH.Clearnet SA. The Report is available at www.isda.org/credit/buy-side-access.html. The Report explores the rights of ``customers''--e.g., buy-side and other market participants proposing to clear CDS through CMs of a CCP--in regard to the segregation and portability of CDS positions and associated initial margin. The Report also contains each CCP's response to a questionnaire, which, among other things, contains detailed information on the CCP structure and criteria for CM status. The Report also suggests legislative and regulatory reforms that may be particularly helpful in paving the way for effective clearing. The industry recognizes that clearing is an important public policy consideration and that it can provide many benefits to the market, including helping to identify systemic risk. It is also worth noting that along with the widespread recognition of the benefits of clearing, there is also widespread acknowledgement that there is a continued need for customized OTC derivatives. Establishing a clearing framework that maximizes the benefits of clearing while avoiding unnecessary costs requires the consideration of many factors. A recent paper authored by Darrell Duffie and Haoxiang Zhu entitled ``Does a Central Clearing Counterparty Reduce Counterparty Risk?'' analyzes many of these factors, including whether a CCP can actually reduce netting efficiency and thereby lead to an increase in collateral demands and average exposure to counterparty default and the effect of requiring multiple clearinghouses. Regarding the latter point, the authors' conclude that whenever a single CCP reduces average counterparty exposures, relative to bilateral netting, it is never efficient to introduce another central clearing counterparty for the same class of derivative. This observation is particularly significant in light of regulatory proposals that would ostensibly require clearing of the same product across multiple CCPs, whether such requirement is based on jurisdictional considerations or otherwise. Such a requirement may not only undermine the benefits of clearing, it would also impose considerable real costs for market participants. The industry does not oppose multiple clearing solutions and allowing the market to determine which should succeed but requiring compatibility with multiple CCPs will impose significant costs and may undermine the benefits that clearing provides.Q.4. One key topic touched on at the hearing is the extent to which standardized products should be required to be traded on exchanges. What is your understanding of any areas of disagreement about how rigorous new requirements should be in terms of mandating, versus just encouraging, exchange trading of standardized OTC derivatives?A.4. There is no simple division between standardized OTC derivatives and those that are not; instead, OTC derivatives occupy points on a continuum ranging from completely customized and unique to completely standardized. An example of the former would be a credit default swap used to transfer credit risk in a synthetic collateralized debt obligation (CDO); such a contract might not even be executed under an ISDA Master Agreement, and would reference a specific portfolio of credits in the securitization issue. Moving slightly along the continuum, one might find an option on the spread between the crude oil price and a basket of refined product prices based on the output mix of a specific refinery; this ``crack spread'' option would be executed under the ISDA Master Agreement but would involve, at least for the refined product prices, a unique basket of prices. Moving still further on the continuum, one would find interest rate caps on bond issues or bank loans. None of the three products described would generate sufficient volume to trade on an exchange, nor are they sufficiently standardized to trade on an exchange. As a general matter, standardization is a necessary but not sufficient condition for trading on an exchange: Standardized derivatives can be traded on an exchange only when a product has sufficient volume and liquidity to support reliable price discovery for the product. If sufficient volume and liquidity do not exist, it would be preferable to trade the products over-the-counter, that is, execute trades privately, and then book the trade with a clearinghouse. Policy discussions frequently confound exchange trading--which means that all trades must be negotiated and executed through a central venue--with clearing--which means that trades must be booked with a central counterparty that serves as the counterparty to all cleared transactions. Exchange trading is possible without clearing, although most exchanges involve clearing as well; and clearing is compatible with both exchange trading and over-the-counter trading. Exchanges and clearinghouses both make use of standardization, but for different reasons. Exchange trading involves extensive standardization because it makes a product easier to trade, which leads to higher liquidity. But as a product becomes more standardized, it attracts a narrower range of traders, which leads to lower liquidity. As a result of these conflicting effects, only products that inherently appeal to a large number of traders are likely to succeed on an exchange; more specialized products generally lack liquidity and consequently do not trade successfully on an exchange. Clearinghouses also rely on standardization, not to make trading easier but to facilitate valuation for the purposes of margin setting. Although cleared products need to be substantially standardized, they need not be highly liquid; all that matters is that the clearinghouse can calculate contract values and required margin in a timely manner. Clearinghouses are therefore suitable to both OTC and exchange-traded products. We see no compelling public policy rationale for mandating, as opposed to encouraging, exchange trading or clearing. To the extent there is a consensus in favor of some mutualization of counterparty credit risk, however, we believe that encouraging clearing should be sufficient.Q.5. Can you share your views on the benefits of customized OTC derivatives products? About how much of the market is truly customized products?A.5. A liquid, functioning OTC market requires the existence of both customized and relatively standardized derivatives. Customized derivatives are necessary in order to provide efficient and safe risk management for clients. Relatively standardized, known commonly as ``vanilla'' derivatives, are necessary for dealers to trade among each other and other market professionals in order to maintain a liquid, price efficient market. Further, the vanilla part of the market is likely to be substantially larger than the customized part because continuous trading is necessary to maintain liquidity. But the relatively low numbers of customized derivatives does not make them any the less important to the market. As a general rule, hedgers prefer flexible, customized OTC derivatives, while purely financial traders, including speculators, prefer the ease of trading standardized, transparent products. Customized OTC derivatives are most important to nonfinancial corporations seeking to manage the financial risks encountered in the course of business activities, as well as investment managers managing specific portfolios. An American manufacturing company that exports overseas, for example, encounters foreign exchange risks in its activities; because the cash flows do not correspond with exchange settlement schedules, the firm would need a customized derivative. Another example is an oil refinery that transforms crude oil into refined products; because each refinery has a unique product mix, only customized derivatives can fill the needs of the refiner. In both cases, requiring the use of standardized, margined products would make hedging more costly and possibly less likely because such companies do not routinely keep sufficient cash balances to ensure that margin calls can be met; instead, they often collateralize their OTC derivatives along with other banking relationships such as loans. ISDA has only indirect, rough estimates of the proportion of the market that is highly customized. According to a poll of ISDA Board member firms, an average of 58 percent are with dealers, 27 percent with nondealer financial counterparties (e.g., regional banks and hedge funds), and 6 percent are with end users (e.g., nonfinancial corporations); for interest rate options, 65 percent are with dealers, 28 percent with nondealer professionals, and 7 percent with end users. For credit default swaps, the proportions are 75 percent with dealers, 25 percent with nondealers professionals, and less than one percent with end users. The primary users of the more standardized instruments are likely to be dealers and hedge funds; the primary users of the more customized instruments are likely to be regional banks and corporation. Finally, a high proportion of equity derivatives are customized, especially those based on single equity issues.Q.6. The Administration's proposal would subject the OTC derivatives dealers and all other firms whose activities in those markets create large exposures to counterparties to a ``robust and appropriate regime of prudential supervision and regulation,'' including capital requirements, business conduct standards, and reporting requirements. What legislative changes would be required to create margining and capital requirements for OTC derivative market participants? Who should enforce these requirements for various market participants? What are the key factors that should be considered in setting these requirements?A.6. Prudential oversight of the OTC derivatives markets should ensure the availability of both customized OTC derivatives and more standardized derivatives as risk management tools. A vibrant and healthy derivatives market plays a crucial role in today's credit markets. Imposing capital requirements on OTC derivatives would require policy makers to find the equilibrium between the need for effective regulation of risk-taking and the need for effective risk-management. Therefore, we respectfully suggest that the setting and enforcement of capital requirements for OTC derivatives be left to the appropriate regulators.Q.7. One concern that some market participants have expressed is that mandatory margining requirements will drain capital from firms at a time when capital is already highly constrained. Is there a risk that mandatory margining will result in companies choosing not to hedge as much and therefore have the unintended consequence of increasing risk? How can you craft margin requirements to avoid this?A.7. This concern is valid because nonfinancial corporations, which make extensive use of customized derivatives, are not geared up to routinely post cash margin as required by clearinghouses. Instead, they customarily collateralize as part of their overall banking relationship. If margin were made a matter of law or regulation, the cost of funding margin might be sufficient to lead corporations to reduce their hedging activities and thereby increase their financial risk exposures. We respectfully suggest that margin requirements be left to clearinghouses and their regulators to determine, as they do now, for cleared products.Q.8. Is there a risk that regulating the OTC derivatives markets will dramatically alter the landscape of market participants or otherwise have unintended consequences we aren't aware of?A.8. Yes. OTC derivatives offer significant value to the customers who use them, to the dealers who provide them, and to the financial system in general by enabling the transfer of risk between counterparties. It is important that any changes to the OTC derivatives market maintain the continued availability and affordability of these important tools. The recent market turmoil and today's tight credit environment may be attributed, at least in part, to a lapse in risk management. It is difficult to determine unintended consequences ex ante, however, changes that would reduce the availability of credit or restrict the ability to manage risk, for example by restricting the ability of businesses to hedge their unique risks via customized derivative products, would be particularly problematic. ------ FOMC20081007confcall--47 45,MR. PLOSSER.," Thank you, Mr. Chairman. I'd just like to make a couple of observations and perhaps ask a question and make maybe one observation about language. As a general proposition, I do not like intermeeting cuts. I think they signal more panic than they do stability. On the other hand, I think this is an opportunity, given what the other central banks are doing, that might prove to be an exception to that. So I am reluctantly or modestly comfortable with this, however you want to characterize it, because I don't think that anything that we do today--cutting the funds rate 50 basis points or whatever--is going to make the next couple of months in terms of the overall economy any less painful. They won't be felt in the real economy for some time to come. They may provide some solace to the markets. I hope that they will. I wouldn't bet the ranch on that, but I do think that the coordinated effort might be helpful. I like in the statement the stressing of the point that, as you put it, this is based on a deteriorating economic outlook, and I think it is very important that we continue to emphasize that point as opposed to just volatility in the financial markets. So I feel that's very helpful. I have one question. President Yellen alluded to this, and I would like your thoughts on this, Mr. Chairman. Obviously, as we have been experiencing over the last year, things have seemed to change very rapidly at times, sometimes in surprising ways and in ways that we couldn't anticipate. But I have stressed in past meetings the importance for us of thinking not just about a funds rate decision on any given day or at any given meeting but about what we think the path should look like. So rather than just considering our action today, we obviously have a scheduled meeting coming up in a few weeks. Do you think that this is the precursor, as President Yellen suggested, to perhaps additional cuts, and where do you think a likely path might take us going forward, given that this is an intermeeting cut? My last comment has to do with the language, and I'd just like to make an observation about the sentence on inflation. It reads, ""Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have materially reduced the upside risks to inflation."" I guess I would make two observations, Mr. Chairman. One, that seems to be a much stronger statement about the reduction in the prospects for inflation than actually you gave in your speech today, where you emphasized that it had been reduced but that there continues to be lots of uncertainty and inflation continues to need monitoring. I would put on the table for discussion that we change the phrase ""materially reduced"" to these things have ""mitigated near-term upside risks to inflation."" Clearly commodity and oil prices have both mitigated the expectational channel for inflation in the near term. But I'm not necessarily convinced--and it's very model dependent--as to what inflation might do in the latter part of '09 and so forth. So I think that we should emphasize that the inflation risks for the near term have been mitigated as our rationale there. Thank you, Mr. Chairman. " CHRG-110hhrg41184--180 Mr. Bernanke," It is very difficult to know and we have been wrong before. But given how much construction has come down already, I imagine that by later this year, housing will stop being such a big drag directly on GDP. Prices may decline into next year, but we don't really know. The useful thing to appreciate, I guess, is that as house prices fall, they are self-correcting in a way because part of the reason that prices peaked and began to come down was that housing had become unaffordable. The median family couldn't afford a median home. As prices come down and incomes go up, you get more affordability and therefore more people come into the market. " CHRG-111hhrg51698--537 Mr. Kaswell," Thank you, Mr. Chairman. Mr. Chairman, Ranking Member Lucas, and Members of the Committee, I am Stuart Kaswell, Executive Vice President and General Counsel, Managed Funds Association. MFA appreciates the opportunity to testify before you today. MFA represents the majority of the world's largest hedge funds and is the primary advocate for sound business practices and industry growth for professionals in hedge funds, funds of funds, and managed funds, as well as the industry service providers. MFA appreciates the opportunity to share its views with the Committee regarding the proposed Derivatives Markets Transparency and Accountability Act of 2009. As participants in our nation's markets, MFA's members share your concerns regarding the challenges in those markets and the difficulties facing our economy. We commend this Committee for considering measures which, in seeking to strengthen the regulatory framework, can help restore stability and confidence in our markets and the economy they serve. The DMTAA has a number of provisions that MFA generally supports. These provisions would strengthen and codify the information that the CFTC receives to ensure that its decisions are well informed. For example, we support section 4, which would improve reporting of positions of index funds and require the CFTC to issue a rule defining and classifying index traders and swap dealers for data reporting. We also view sections 9 and 10 of the legislation as useful provisions which should provide the Committee and regulators with greater information about the OTC derivatives markets and international energy commodity markets. Our members also support the provisions included in section 3, which would codify the CFTC's authority to set conditions on the access of foreign boards of trade to the United States. While we support these provisions and the Committee's commitment to promoting greater transparency and a more sound regulatory structure, we are concerned about certain other aspects of the legislation. Section 6 would direct the CFTC to set position limits for all commodities. We believe this provision is unnecessary. The exchanges currently perform this important function and are in a better position to establish and enforce position limits. Moreover, we believe that position limits are more appropriate for the spot month of physical delivered commodities than for the back months of such contracts. We also view the language in section 11 as problematic, as it; first, effectively mandates that the CFTC set position limits on OTC derivatives; and second, is premature given the lack of understanding about this market. As the Committee knows, section 9 of the bill seeks more detailed information about this market, which we believe is an important predicate before Congress takes further action. Finally, we believe that section 16, which seeks to eliminate the so-called naked credit default swap transactions, would significantly damage the liquidity and price discovery process in the CDS market. Such an outcome would not only undermine the efficiency of this market, but would also have a negative impact on the real economy as it would increase the cost of capital, and potentially cause the cost of projects and business development to rise substantially. With respect to section 13, MFA strongly supports moving to a clearing system and a central counterparty for OTC products. In fact, we believe that the credit review and margin requirements attendant to central clearing would address many of the concerns that may have been the motivation for the section 16 language. While we strongly support central clearing, which has proven to help reduce risks in other commodity and financial markets, we believe that Congress should not mandate this requirement in the OTC market until such platform is fairly mature. Moreover, we believe that over time many OTC products should be standardized and centrally cleared. It would be inadvisable to require all OTC transactions to be centrally settled and cleared since customized products are an important risk management tool. Mr. Chairman, Ranking Member, although we have outlined certain concerns, MFA and our members are grateful for the opportunity to testify and we appreciate the bipartisan approach you have taken in fashioning this legislation. We appreciate your willingness to consider the views of all interested parties. We welcome the opportunity to work with you. I do have one request. I would like to add to the record a letter that MFA sent to the Federal Reserve Bank of New York, the SEC and the CFTC to supplement my written statement. [The prepared statement of Mr. Kaswell follows:] Prepared Statement of Stuart J. Kaswell, Executive Vice President and General Counsel, Managed Funds Association, Washington, D.C. Managed Funds Association (``MFA'') is pleased to provide this statement in connection with the House Committee on Agriculture's hearing on the ``Derivatives Markets Transparency and Accountability Act of 2009'' (the ``Derivatives Act'') to be held February 2, 2009. MFA represents the majority of the world's largest hedge funds and is the primary advocate for sound business practices and industry growth for professionals in hedge funds, funds of funds and managed futures, as well as industry service providers. MFA's members manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies around the world. MFA appreciates the opportunity to express its view on the Derivatives Act and the important issues that it raises. MFA members are active participants in the commodities and over-the-counter (``OTC'') derivatives markets and have a strong interest in promoting the integrity of these markets. MFA consistently supports coordination between policy makers and market participants in developing solutions to improve the operational infrastructure and efficiency of the OTC credit derivatives markets. We are supportive of the Committee's goals to: (1) enhance transparency and reduce systemic risk; (2) promote a greater understanding of the OTC markets and their interaction with exchange-traded and cleared markets; (3) ensure equivalent regulatory oversight in the international regulatory regime for energy commodities and derivatives and provide for greater information sharing and cooperation among international regulators; and (4) provide additional resources to the Commodity Futures Trading Commission (``CFTC''). Nevertheless, we have significant concerns with several provisions of the Derivatives Act, including, in chronological order, Section 6 ``Trading Limits to Prevent Excessive Speculation'', Section 11 ``Over-the-Counter Authority'', Section 12 ``Expedited Process'', Section 13 ``Clearing of Over-the-Counter Transactions'', and Section 16 ``Limitation on Eligibility to Purchase a Credit Default Swap''. We believe these provisions would have the effect of reducing market participants' hedging and risk management tools, and negatively impact our economy by raising the cost of capital and reducing market transparency and efficiency in capital markets. We would like to work with the Committee in addressing these issues. We respectfully offer our suggestions in that regard.Trading Limits To Prevent Excessive Speculation As a general matter, greater market liquidity translates into more effective price discovery and risk mitigation, especially in physically-settled contracts. We are concerned that Section 6 ``Trading Limits to Prevent Excessive Speculation'' will impose upon the CFTC a new obligation that historically has been left to the exchanges in deference to their greater expertise respecting the various factors that affect liquidity in these markets. We are concerned that section 6 implements an overly rigid structure for establishing speculative position limits. We urge that the markets are best served by placing the CFTC in an oversight role. Currently, the exchanges, as part of their self-regulatory obligations, are involved daily in monitoring the activities of market participants. They frequently engage in soliciting the views of speculators and hedgers in their markets. Also, they are more closely engaged in watching deliverable supply. Because position limits may have an impact on price, we believe speculative position limits are best determined by a regulatory authority, rather than market participants through position limit advisory groups. For these reasons, we believe that the exchanges, subject to their regulatory obligations under the Commodity Exchange Act (``CEA''), should propose the size of the speculative position limits following the processes they now employ with their energy and other markets. Section 6 would require the CFTC to convene a Position Limit Agricultural Advisory Group and a Position Limit Energy Group, consisting of industry representatives, exchanges and electronic trading facilities, to provide the CFTC with position limit recommendations. While, as stated, we believe the exchanges, subject to the CFTC's oversight, should determine and administer speculative position limits, we are concerned that the make-up of these advisory groups is not well-balanced and therefore does not provide a mechanism for obtaining the views of all parties active in these markets. For example, noncommercial participants add vital liquidity to these markets through investment capital and are necessary to the success of a market. Thus, we believe that each advisory Committee should have the same number of noncommercial participants as there are short and long hedgers. We support the setting of speculative limits in spot months for physically-delivered energy and agriculture commodities for two reasons. First, physically-delivered futures contracts are more vulnerable to market manipulation in the spot month, because the deliverable supply of the commodity is limited and, thus, more susceptible to price fluctuations caused by abnormally large positions or disorderly trading practices. Second, the commodity is likely delivered by the contract owner during the spot month and has a closer nexus to the end-price received by consumers. On the other hand, we believe that requiring speculative position limits for all months and for aggregate positions in the energy markets, in particular, has the capacity to distort prices. Commercial hedgers often enter into long-dated energy futures (for example, a contract with an expiration date 7 years into the future) to hedge specific projects. Speculators typically take the other side of these contracts. The markets for contracts in these distant (or back) months are less liquid as there are fewer buyers and sellers for long-dated contracts. We are concerned that by setting position limits for all months, including the less liquid, back months, the speculative position limit will reduce liquidity in these distant months and distort the market price for these contracts. We note that the CFTC already has at its disposal several tools, including position reporting and accountability levels, which serve effectively in ensuring market integrity without the inflexibility of speculative position limits. Cash-settled commodities do not raise the same market manipulation concerns as do physically-delivered commodities in that the ability to impact the futures price by controlling deliverable supply is absent. Cash-settled commodities (particularly financial futures) tend to have deep and liquid markets, are primarily used for hedging and risk mitigation by commercials, do not contribute to price discovery which is usually set in the cash markets and therefore have little or no impact on consumers. The CEA, as amended by the CFTC Reauthorization Act of 2008, provides that any contract that has a significant price discovery function on an exempt commercial market, is subject to greater CFTC regulation and oversight. We are concerned that imposing speculative position limits on cash-settled commodities will have the effect of depressing liquidity and thereby increase the cost of using these back months. It would appear that Congress has already addressed this issue in section 4a of the CEA which grants to the CFTC broad authority to impose limits on trading and to curb excessive speculation. In MFA's view it would be advisable for all interested parties to work together to address concerns about excessive speculation, rather than having Congress mandate a process that could result in negative consequences. As market participants, we have a strong interest in promoting fair and orderly markets. To this end, we believe the CFTC should be afforded regulatory flexibility, which the current framework provides, in addressing excessive speculation and policing the markets.Over-the-Counter Authority and Central Clearing MFA supports the requirement in Section 9 ``Review of Over-the-Counter Markets'' that the CFTC study and analyze the effects of OTC trading and aggregate limits across the OTC markets, designated contract markets and derivative transaction execution facilities. We applaud this effort in conjunction with the additional authority Congress seeks to provide to the CFTC through Section 4 ``Detailed Reporting and Disaggregation of Market Data'' and Section 5 ``Transparency and Recordkeeping Authorities''. We believe these provisions will provide the CFTC with better information to understand the OTC markets and how best to regulate these markets. However, we believe that the CFTC should be authorized to determine position limits under Section 11 ``Over-the-Counter Authority'' only after the study has defined the existence of risks that are appropriately controlled by the imposition of such limits. In other words, the results of such study should be the predicate for taking further legislative or regulatory action. We are concerned that section 11 creates a test that can only result in the CFTC concluding that all fungible OTC agreements must be subject to position limits. Section 11 requires the CFTC to determine whether fungible OTC agreements have the potential to disrupt market liquidity and price discovery functions, cause severe market disturbance, or prevent prices from reflecting supply and demand. It would be extremely difficult for the CFTC to find that OTC agreements have absolutely no potential for disruption under any circumstances, whether currently known or unknown. Thus, section 11 may be interpreted to automatically provide the CFTC with the authority to impose and enforce position limits for anyone trading in fungible significant price discovery agreements. We recognize that the bill would leave to the CFTC the discretion to use its authority as to the size of the position limits it imposes. Nonetheless, we think the grant of authority is too broad. With regard to Section 13 ``Clearing of Over-the-Counter Transactions'', we strongly support the concept of central clearing and believe that it offers many potential market benefits. We greatly appreciate the urgent attention of Federal regulators and Congress in addressing this important matter. The private sector, working in conjunction with the Federal Reserve Bank of New York (``NY Fed''), has made strong progress in standardizing credit default swap (``CDS'') contracts and establishing a central clearing house for these contracts. There is also a private sector initiative to develop exchange trading for CDS contracts. As investors in the OTC derivatives markets, we would like to see greater contract standardization and a move toward central clearing for other OTC derivatives instruments, including interest rate, foreign exchange, equity and commodity derivatives. MFA shares Congress' desire to expedite the establishment of central clearing platforms covering a broad range of OTC derivative instruments. We believe a central clearing platform, if properly established, could provide a number of market benefits, including: (1) the mitigation of systemic risk; (2) the mitigation of counterparty risk and protection of customer collateral; (3) market transparency and operational efficiency; (4) greater liquidity; and (5) clear processes for the determination of a credit event (for CDS). In fact, MFA and its members have been actively involved in the establishment of CDS central clearing platforms. Congress, regulators, and the private sector should promote central clearing of OTC derivative products. However, while we urge Congress and regulators to stay engaged in the process and development of establishing central clearing platforms for OTC derivatives products, we do not believe that Congress should mandate clearing for all OTC derivatives by a certain date. As a step in this direction, Congress should simplify regulatory procedures and remove obstacles to prompt approval of central clearing for OTC products. For example, in view of the support shown by many spokespeople for different sectors of the agricultural industry, we believe Congress should allow agricultural swaps to be centrally cleared without the need to first obtain an exemption from the CFTC. Our concern with section 13 mandating central clearing of all OTC derivatives transactions is twofold. First, as central clearing platforms for financial derivatives are still in development, there remain many undetermined and unresolved operational factors that could limit the value of central clearing. Among the operational factors are: most importantly, protection of customer collateral; central counterparty governance and dispute resolution; the most appropriate formats for clearing; and the optimum fee structure. To the point on protection of customer collateral, we are especially concerned that early discussions on central clearing operations will not protect customer assets through segregated accounts. As noted in our December 23, 2008 letter to the NY Fed, the Securities and Exchange Commission (``SEC'') and the CFTC (attached hereto), the current collateral management mechanism used by banks do not adequately protect a participant's pledged collateral, and as such, contributes to systemic risk. For example, because pledged collateral at Lehman Brothers was not segregated, once the company was placed in bankruptcy, pledgors became general creditors of the company. With respect to central counterparty governance, we believe a central counterparty should be an established independent body led by a board reflecting balanced representation of all market participants. Similarly, a central counterparty should have an independent, fair and efficient dispute resolution process. Second, central clearing is not readily attainable for the majority of OTC derivatives because these products are not standardized. We appreciate the Committee's attempt to address the issue of non-standardized, highly unique (individually-negotiated or bespoke) contracts by providing the CFTC with the authority to exempt a transaction from the section 13 clearing requirement. We note that as part of a regulatory framework that maximizes the ability of market participants to mitigate risk and encourage product innovation, it is important to provide market participants with the ability to engage in non-standardized, highly unique contracts. However, in view of the number of OTC derivative contracts that would have to rely on an exemption and the delays that occur when an agency must staff a new mandate, we are concerned that the implementation of section 13 would be highly disruptive to the marketplace. In contrast to other OTC derivatives, the CDS market has quickly become more standardized for various reasons. When the CDS markets began to develop in 1997, only a few of the major derivatives dealers traded these products. Since these dealers were similarly positioned in the market and traded these contracts as both buyers and sellers, they were able to negotiate and develop standardized templates for CDS contracts. These template contracts, with some modifications, have remained relatively unchanged and are currently used by all market participants that trade CDS. This standardization is a major reason why CDS contracts are highly liquid and attractive products. Conversely, derivatives dealers are generally the sellers of other OTC derivatives and will negotiate and structure different terms with each counterparty. As a result, other OTC derivatives are not as fungible or liquid as CDS. The fungibility and liquidity of CDS contracts have caused them to reach a certain level of standardization and efficiency, which have made them ripe for centralized clearing. The same can be said for certain interest rate, energy and agricultural commodity derivatives. By way of comparison, the majority of OTC derivatives markets, including those trading interest rate, foreign exchange, and equity derivatives, are nowhere near the level of standardization of the CDS markets. The CDS markets account for roughly 8% to 9% of the notional volume of the OTC derivatives market. As stated above, these other OTC derivative instruments are not interchangeable between buyers and sellers, and are generally sold by banks or dealers to market participants other than banks or dealers. MFA fully supports collaborative industry-wide efforts and partnerships with regulators, like the NY Fed, SEC and CFTC to develop solutions to promote sound practices and to strengthen the operational infrastructure and efficiency in OTC derivatives trading. MFA is an active participant in the Operations Management Group (the ``OMG''), an industry group working towards improving the operational infrastructure and efficiency of the OTC derivatives markets. The goals of the OMG are: Full global use of central counterparty processing and clearing to significantly reduce counterparty credit risk and outstanding net notional positions; Continued elimination of economically redundant trades through trade compression; Electronic processing of eligible trades to enhance T+0 confirmation issuance and execution; Elimination of material confirmation backlogs; Risk mitigation for paper trades; Streamlined trade lifecycle management to process events (e.g., Credit Events, Succession Events) between upstream trading and confirmation platforms and downstream settlement and clearing systems; and Central settlement for eligible transactions to reduce manual payment processing and reconciliation. In recent years, the OMG and other industry-led initiatives have made notable progress in the OTC derivatives space. Some of the more recent market improvements and systemic risk mitigants have included: (1) the reduction by 80% of backlogs of outstanding CDS confirmations since 2005; (2) the establishment of electronic processes to approve and confirm CDS novations; (3) the establishment of a trade information repository to document and record confirmed CDS trades; (4) the establishment of a successful auction-based mechanism actively employed in 14 credit events including Fannie Mae, Freddie Mac and Lehman Brothers, allowing for cash settlement; and (5) the reduction of 74% of backlogs of outstanding equity derivative confirmations since 2006 and 53% of backlogs in interest rate derivative confirmations since 2006. MFA supports the principles behind section 13, but, as discussed, has concerns with how these principles will be implemented. Although central clearing is not appropriate for all OTC derivative contracts, we firmly believe that greater standardization of OTC derivative contracts and central clearing of these more standardized products would bring significant market benefits. Indeed, we believe that central clearing offers substantially greater opportunity to address concerns about systemic risk, than other alternatives, such as section 16 of the legislation. To this end, MFA is committed to continuing its collaboration with the major derivatives dealers and service providers to prioritize future standardization efforts across OTC derivatives and other financial products. MFA also understands Congress's desire to have greater oversight of these markets and believes there is an important role for the NY Fed, CFTC and SEC to play in monitoring and guiding industry-led OTC derivatives solutions. We believe it would be more appropriate at this stage to require the applicable regulatory authorities to work with market participants towards the principles espoused in section 13 and to provide the Committee with frequent progress reports.Expedited Process Section 12 ``Expedited Process'' provides the CFTC with the authority to use emergency and expedited procedures. While we do not object to this authority, we strongly urge Congress and the CFTC to use the notice and comment process whenever possible. We believe the notice and comment process is more likely to protect the public interest, minimize market disruptions and unintended consequences, and result in better regulation.Limitation on Eligibility To Purchase a Credit Default Swap Credit derivatives are an important risk transfer and management tool. Market participants use credit derivatives for hedging and investment purposes. We believe both are legitimate uses of the instrument and are equally important components of a liquid and well-functioning market. Section 16 would make it a violation of the CEA for a market participant to enter into a CDS unless it has a direct exposure to financial loss should the referenced credit event occur. We appreciate that it is the goal of the provision to add stability to the CDS market by reducing excess speculation. Nonetheless, this provision would severely cripple the CDS market by making investment capital illegal and removing liquidity providers. Without investment capital in the market, market participants wishing to hedge their position through a CDS would find few, if any, market participants to take the other side of the contract. As a result, the CDS market could cease functioning for lack of matching buyers and sellers. Market participants that risk their own capital provide depth and liquidity to any market, and the market for CDS is no exception. Because the provision would eliminate such market participants, the CDS market would have much less price transparency and continuity. This outcome is particularly troubling given the benefits the CDS markets provide to the capital markets and to the overall economy. CDS contracts have improved our capital markets by enhancing risk transparency, price discovery and risk transferal, with the effect of reducing the cost of borrowing. Market participants use the CDS market as a metric for evaluating real-time, market-based estimates of a company's credit risk and financial health; and it is in this way that the CDS markets provide risk transparency and price discovery. Market participants find that CDS market indicators are a superior alternative to relying on credit rating agency scores. CDS contracts also provide banks, dealers and other market participants with a tool to mitigate or manage risk by dispersing credit risk and reducing systemic risk associated with credit concentrations in major institutions. Take the following scenario, which section 16 would prohibit, for example: Bank A owns a $1 billion loan to Company X. Bank B owns a $1 billion loan to Company Y. Both banks would be better off from a risk management perspective, assuming that Companies X and Y have comparable credit worthiness, if they each had a $500 million Company X loan and a $500 million Company Y loan. The loans, however, are not transferable. Through CDS contracts, Bank A is able to buy Company X protection and sell Company Y protection, and Bank B is able to do the opposite. In this way, market participants use CDS contracts to manage risk. Financial markets benefit overall from the reduction in systemic risk. Accordingly, these products reduce an issuer's cost of borrowing from banks, dealers and other market participants by enabling these entities to relay existing risk and/or purchase risk insurance against a particular issuer. Simply put, CDS markets facilitate greater lending and support corporate and public finance projects. By reducing the depth and liquidity of the CDS market, the cost of capital would rise. As a consequence, new investment in manufacturing facilities and other private sector projects and public works efforts would be more expensive. If market participants could not hedge their market risk through CDS contracts, the risk premium on debt would increase significantly. We do not believe this is advisable, especially in light of the troubled state of the U.S. economy and the Congress' current stimulus package deliberations. To our knowledge, Congress has never before imposed a trading restriction such as is proposed in section 16 on any type of commodity or financial instrument, and for good reason. Congress has previously recognized in section 3 of the CEA that we have a national public interest in providing a means for managing and assuming price risks, discovering prices or disseminating price information. Shutting out investors from the CDS market would be contrary to the public policy interests enumerated in the Act. As noted below, we believe that there are more effective alternatives for addressing concerns about the CDS markets.All Commodities Are Not Equal Finally, we are concerned with the expansion of the bill to all commodities. Physically-delivered, cash-settled and OTC commodities each trade in distinct markets and have different characteristics. We believe the rationale behind certain requirements, such as spot month speculative limits and aggregate position limits, are not applicable to financial futures or their OTC derivatives. Legislation that attempts to regulate all commodity and financial markets in an identical manner will fail to take into consideration the different needs of these markets and important functions they serve. Specifically, we refer to sections 6, 11 and 13, which we believe attempts to uniformly regulate these distinct markets. Moreover, such legislation will risk affecting liquidity and the opportunity for innovation that have made these markets so widely used and integral to the economy.Conclusion As Congress, including this Committee, considers ways to restore stability and confidence to our markets and to address the recent economic downturn, we believe it is important to recognize the important role the OTC derivatives markets have played. These products allow market participants to contribute vital market liquidity, mitigate risk, support lending and project finance, and facilitate economic growth. In considering ways to promote enhanced risk management and greater transparency in the marketplace, we urge you to resist any efforts which, while well-intended, could prove harmful to these important markets and our broader economy. These markets have played a pivotal role with respect to the development of our financial markets and the growth of our nation's economy. This success is attributable to the innovation and sophistication of our financial markets and the participants of these markets. It is also a testament to the competency of the underlying regulatory framework. MFA would like to thank the Committee for allowing us the opportunity to share our views on these important issues. MFA, and our members, are committed to working constructively with this Committee, the Congress, and the Administration over the coming weeks and months as this legislation and the broader dialogue regarding financial regulatory reform progresses. Thank you. AttachmentDecember 23, 2008Timothy F. Geithner,President,Federal Reserve Bank of New York;Hon. Christopher Cox,Chairman,U.S. Securities and Exchange Commission;Hon. Walter Lukken,Acting Chairman,U.S. Commodity Futures Trading Commission. Dear President Geithner, Chairman Cox and Chairman Lukken: Recently, Managed Funds Association (``MFA'') \1\ and its members met with the Federal Reserve Bank of New York (the ``NYFRB'') to discuss and provide comments regarding the state of the credit default swap (``CDS'') market, including our feedback on current proposals to establish a central clearing counterparty for the CDS market. As part of our ongoing commitment to proactively work with regulators on topics that pose significant market or systemic risk concerns, we wish to direct your attention to the protection and safeguarding of customers' initial margin that they deposit with dealer financial institutions in connection with the trading of all over-the-counter (``OTC'') derivatives.--------------------------------------------------------------------------- \1\ MFA is the voice of the global alternative investment industry. Its members are professionals in hedge funds, funds of funds and managed futures funds, as well as industry service providers. Established in 1991, MFA is the primary source of information for policy makers and the media and the leading advocate for sound business practices and industry growth. MFA members include the vast majority of the largest hedge fund groups in the world who manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies. MFA is headquartered in Washington, D.C., with an office in New York. For more information, please visit: www.managedfunds.org.---------------------------------------------------------------------------Effects of Current Collateral Management Practices By way of background, the default of Lehman Brothers, a major OTC derivatives counterparty, and the resulting market concerns about the viability of other major dealers, has caused significant volatility in the capital markets. These concerns demonstrate that current mechanisms for collateral management, outside of the context of broker-dealer accounts covered by Exchange Act Rule 15c3-3, do not adequately protect the pledgors of collateral and can contribute to systemic risk in several important respects: The purpose of initial margin is to provide dealers with a cushion against the potential counterparty risk they assume when entering into an OTC derivatives contract with a customer. However, since such margin is not typically segregated from the dealers' other unsecured assets, what is supposed to be a credit mitigant for the dealer instead subjects the customer to actual credit risk on the posted amounts. If a dealer becomes insolvent, initial margin posted by customers that is not so segregated is treated in bankruptcy as a general unsecured claim of the customer. As a result, customers who are counterparties to that dealer stand to incur significant losses, regardless of the current value of their derivatives contracts. Investment managers have fiduciary duties to their investors. When a dealer experiences difficulties, the risk to initial margin may cause managers to seek to hedge counterparty exposure to such dealer (either through the CDS market or by trying to close-out or assign derivatives trades away from such dealer). These hedging actions can have a further destabilizing impact on such dealer and the market generally, thereby increasing systemic risk. In addition, given that dealers are able to freely use posted collateral, they have come to rely on initial margin, a fluctuating source of cash, to fund their business activities. As trades are closed-out or assigned, dealers are required to return initial margin to their customers. The return of margin constricts dealers' liquidity and, as recent events demonstrate, the inability of the dealers to access cash has potentially severe market consequences. We highlight that the aforementioned counterparty risks related to customer initial margin have been greatly exacerbated over the last few months as dealers as a whole have significantly increased their demands for initial margin. These risks are in turn further compounded by the general weakening of the financial sector as a whole.Enhanced Customer Segregated Accounts As you are aware, the segregation of initial margin is a key component of the central clearingparty initiatives for the CDS market, and we understand that the NYFRB, SEC and CFfC have stipulated this condition to be a prerequisite for regulatory approval. We agree that segregation of initial margin is crucial to the success of these clearing initiatives, but also believe that the protection of customer initial margin should be implemented more broadly for all OTC derivatives, irrespective of the launch of any CDS central counterparty because it is critical in order to promote broader market stability and to mitigate counterparty risk. Protection of customer initial margin with respect to all bilaterally negotiated OTC derivatives could be incorporated into the existing transaction structure through dealer use of a segregated account, in the name of, and held for the benefit of, the customer (e.g., at a U.S. depository institution or a regulated U.S. broker-dealer), whereby the dealer would not be permitted to rehypothecate the initial margin held in such an account. This would promote broader market stability and mitigate counterparty risk. Given that dealers will be required to provide initial margin segregation as part of the clearing initiatives, they should be capable of offering this to customers on a broader basis. However, to date the dealer community, as a whole, has been resistant to such efforts by MFA's members and other investment managers. * * * * * We recognize the efforts of regulators to collaborate on mitigating risk and promoting market stability. We appreciate the constructive working relationship fostered by each of you as well as the opportunity to share the views of our members on this important topic. We welcome the opportunity to discuss this issue further with each of your staffs. If we can provide further information on this topic, or be of further assistance, please do not hesitate to contact us at [Redacted]. Yours Sincerely,[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Richard H. Baker,President and Chief Executive Officer.cc:Hon. Ben Bernanke,Chairman,Board of Governors, Federal Reserve System;Patrick M. Parkinson,Deputy Director,Division of Research and Statistics, Board of the Federal Reserve System;Ananda Radhakrishnan,Director,Division of Clearing and Intermediary Oversight, Commodity Futures Trading Commission;Theodore Lubke,Senior Vice President,Bank Supervision Group, Federal Reserve Bank of New York;Erik R. Sirri,Director,Division of Trading and Markets, U.S. Securities and Exchange Commission. " FinancialCrisisInquiry--598 ROSEN: I’m Ken Rosen. I want to thank Chairman Angelides and Vice Chairman Thomas, and the commission for having me here. I want to not read my testimony since you have it. But I’m going to talk a little bit about what I think is the epicenter of the crisis—where this started, how it got there, and where we are today, which is the housing market—the housing and residential mortgage market. Excessively easy credit, extremely low interest rates created a house price bubble. And the house price bubble when it burst has really caused a significant part of the problems that we had—at least the—initially. And of course it caused—helped cause the great recession where we have lost over eight million jobs. I think the most important thing to say is how did we get here. And I would say that low interest rates is part of the blame, but really it’s the poorly structured products that came about in this environment. Innovative products are important, and a good thing. And I’ve written papers on—on this in the 1970s and 80s while we needed innovative mortgage products. And they’re good for some people—some households. Subprime— there is a need for having that. But not to the market share it got. Low down payment loans – Alt-A loans, option arms. All those made some sense for a portion of the population. What happened is we layered all these risks. We went from a conservatively written subprime loan to a subprime loan that had no down payment, and didn’t document someone’s income or employment. So we made a mistake from what was a good idea by financial institutions became a bad idea for the entire overall market. And then we combine that with a second component which was I thought bad underwriting. We lowered underwriting standards dramatically. We started this in California, and it spread everywhere. We—we do this sometimes. Liars loans which are stated income loans, and there was rampant fraud at the consumer level. We’ve heard discussion of this at the institutional level, but I think the consumer basically really did this so they could qualify for the loan. There was some complicity on January 13, 2010 the part of brokers and originators. I think—I do not think this was at the high level institutions, but it’s at the individual originator level. And then we had wide-spread speculation. And I submitted an article to you as a commission, which I wrote in 2006 that was published in 2007. Nearly 30 percent of all home sales in the hot markets were just speculators. And this is not a bad thing, but the speculators put down almost no money. They were flipping houses. And our mortgage system was not able to distinguish between a homeowner and a speculator. And I think we really need to do a much better job of that in the future. We already are trying to. We’re— nothing wrong with speculating, but you’ve got to put down hard money -- 30 percent down. Some big number so they’re not destroying the market for the people who want to own and live in houses. There was a regulatory failure, and everybody knew this was happening. Everybody in the country knew this was happening by the middle of 2006 -- late 2006. One of the unregulated institutions—New Century—a mortgage broker—went bankrupt in early 2007. Everybody knew this, but it kept on going on. I tried very hard and others as well to talk to regulators about this—inform them of this—and within institutions—the Fed in particular. There was a big debate going on. Should they do something about it? And it was decided not to. They didn’t think they had the power. They didn’t really believe it was as bad as it was. But there was a big debate with board members about doing something about this. I think really the whole system of a non-recourse loan in both commercial and residential while desirable by the people borrowing has really created this problem. That there is a belief that it’s a—a put option. Things go well, great. If not, I can give it back. And this misalignment of interest at this level—the consumer level, the borrower level—and the misalignment of—of interest throughout the entire system where risk and rewards are disconnected is really how we’re going to fix this. So if I were to summarize I would say too much leverage, poor underwriting and lax regulation. But I want to take you through some of the charts I have. I know I’ve got January 13, 2010 about five more minutes, but tell you where we are today. And I think you have these at the end of the testimony. They’re figures. And let’s take the first one, which is the housing bubble. It says, “Figure One—U.S. Housing, Single Family Starts.” You can see here that we had—hopefully you have it, but if not I’ll describe the numbers. We were producing in single-family starts about 1.1 million a year on average. That’s roughly the average level of single-family starts. And that’s the demographic demand. During the peak moments here, we produced 1.7 million. So we were producing about -- we produced during this whole bubble about a million more new starts then demographic demand would have you produced. And one of the reasons for that was that these—basically people were able to put down $1,000 or $2,000 or $3,000 to control a $100,000 to $200,000 house. It was a—basically a call option. And homebuilders sold them this house. They took an order, and of course they didn’t have to fulfill that order. If prices went up, they take the order and flip the house. So we built about a million too many. We are now building about 500,000 houses, and as you know in many markets this has led to lots of layoffs. I think roughly 15 percent of the decline in employment is in the construction industry. So this is a—a very big negative. But we’ve begun to come back a little bit, and my guess is we’ll slowly recover. I would agree with Mark. It’s going to take three to four years to get recovery here. Maybe a little bit longer. If we skip to this figure three—there was some reference to this earlier—is the house price bubble, which is on the second page there. And the house price bubble I think is really why we’ve had all this fallout. House prices went up in nominal terms dramatically. And in real terms also very dramatically. We’ve had big house price inflations before. In the late 70s we had that happen. But that was accompanied by overall inflation. This time house prices went up, and we did not have overall inflation. So real house prices went up dramatically. And only one other period of time have we ever seen a—a January 13, 2010 drop in house prices that was in a big way, and that was in the 1930s. It really didn’t happen in the post-war period. But we’ve seen a cumulative price decline based on realtor data of about 21 percent based on another index Kay short about 30 percent. So this bubble bursting is what’s caused I think the bad loan issues in the financial sector with mortgages being a big part of it. The chart below that though is what was referred to by Mr. Bass earlier—key thing—housing became unaffordable during 2003, 4 and 5. The affordability—that is the income relative to the payments you had to make wasn’t there. And so that is why we had these new mortgage instruments come about. Because people could not afford to buy the house. And so they had to find an instrument that allowed them to make a lower initial payment. This would not have been a bad thing if they had fully verified the person’s income, they’d have laid down 20 percent, did all the things that made sense. Unfortunately we layered these risks, and that did not happen. So it was the affordability problem that really and partly caused the bubble. But because the bubble itself made people go to these instruments that were at least much more risky. From the investment community side, of course as you said earlier, that people wanted to get higher yields. They weren’t getting them cause the interest rates were so low. So they—investor also wanted these instruments. The fall out is figure five, which is unfortunately not over. In a way you’re investigating what caused this, but we’re still in the middle of this crisis from the point of view of the consumer, and—and Main Street. Wall Street feels great, but Main Street does not feel great. And this just shows you that the delinquency and foreclosure the total non-performing loans continue to mount for all of the—both the risky loans, and also for non-risky loans. Remember, there’s $11 trillion of mortgages. There are about $3 trillion of the risky category. There’s $7 trillion of what is called prime mortgages. And those are going bad January 13, 2010 because house prices have dropped so much, people have lost their jobs, and there’s no end in sight of this. I think 2010 is going to be a bigger year than 2009. And then of course our friends at Fannie Mae and Freddie Mac. Again you can see delinquency rates are rising there dramatically. They are much lower than the—the risky mortgage types even though after some time these numbers are going to continue to rise as far as we can see. The next figure on figure seven shows you the same thing is happening with FHA. Big rises in delinquencies in the FHA mortgage program. So to summarize, we’re not done by any means. The cost to the government so far has been large with the bailouts. But I think that we—we see continual further losses over the next year, year and a half, in the residential mortgage market. So we’re not at all done. I do have some other data which we’ll be able to take in questions. But I— I’m hoping that I will be able to give you some advice in how this happened, and how it—we can make it not happen again. Thank you very much. FOMC20081007confcall--23 21,MR. SHEETS.," Since the last Greenbook, the economic indicators for the foreign economies have generally surprised us on the downside, notwithstanding the fact that our expectations in the Greenbook for foreign growth were already pretty grim. In the euro area, measures of consumer and business sentiment have continued to retreat. Industrial production has moved down, and retail sales have been soft. Recent data for the United Kingdom have continued to point to a mild contraction during the second half of this year, and notably house prices there continue to fall. In Japan, industrial production plummeted in August, recording its biggest monthly decline in more than five years, and survey data point to further declines in business and consumer confidence. Finally, in the emerging market economies, industrial production has fallen in a broad set of countries, and exports have softened significantly. In light of these data, we now see foreign growth in the second half of this year as likely to come in at a little less than 1� percent, down � percentage point from our last forecast, with these markdowns spread about evenly between the advanced economies and the emerging market economies. We have reduced our projections for growth in 2009 almost as much. This weakening outlook for global activity has been largely driven, as Bill has described, by a marked deterioration in financial conditions in both the advanced and the emerging market economies. Since the last FOMC meeting, equity markets have fallen sharply in numerous countries. Risk premiums on many types of assets have risen, and conditions in short-term funding markets have worsened further. These difficult financial conditions threaten the outlook for foreign growth going forward both by weighing on sentiment in financial markets and by potentially limiting the flow of credit to the economy. If there is any good news for me to report, it's that the softening outlook for global growth has continued to put downward pressure on the price of oil and other commodities. Oil prices have been extraordinarily volatile over the last month, lurching up and down in response to a number of factors, including the effects of the two hurricanes, shifting expectations regarding global growth, and financial turbulence. On net, as Larry mentioned, the price of WTI is down about $13 a barrel since the Greenbook and down over $55 per barrel from its peak in mid-July. Prices for many nonfuel commodities have fallen sharply since the FOMC meeting, including price declines of more than 10 percent for copper, nickel, and rubber, and more than 20 percent for corn and soybeans. Headline inflation remains elevated in the advanced foreign economies. Notably, U.K. inflation in August reached 4� percent, a 15-year high. In contrast, the most recent CPI data for the euro area hint at some deceleration, with inflation moving down from over 4 percent in July to 3.6 percent in September. Going forward, there are good reasons to expect inflation in these economies to abate, given the recent sharp decline in commodity prices and emerging slack in their economies. Inflation rates in the emerging market economies appear to be cresting for similar reasons. In the midst of these events, the dollar has remained quite resilient, rising about 3 percent since the last FOMC meeting. In our view the currency markets earlier this year had priced in expectations that the major foreign economies would remain largely resilient despite U.S. slowing. As the growth prospects for the foreign economies have deteriorated, the relative attractiveness of the dollar has increased. This, along with the sustained demand for dollar funding in global financial markets, seems to have buoyed the dollar of late. Finally, given the weaker path of foreign activity and the stronger dollar, we now expect export growth to be somewhat less robust than was the case in our previous forecast and, consequently, net exports to be less supportive of U.S. economic growth over the next two years. Nevertheless, net exports are still expected to contribute a positive 0.5 percentage point to growth in the second half of this year and about 0.3 percentage point in 2009. We are happy to take your questions now. " FOMC20071211meeting--39 37,MR. STOCKTON.," Thank you, Mr. Chairman. We had a great deal to contend with over the intermeeting period, and the forecast has changed in some important ways. Nevertheless, the basic story underlying our projection remains largely unchanged. The fallout from the slump in the housing sector, the ongoing turbulence in financial markets, and elevated energy prices result in subpar growth over the next several quarters. With some further easing of monetary policy, a leveling-off of oil prices, and a gradual improvement of financial conditions, growth picks back up toward potential in 2009. The gap in resource utilization that opens up over the next several quarters, in combination with the anticipated flattening-out of energy prices, puts total and core inflation on a mild downtrend over the longer haul. Overall, our forecast could admittedly be read as still painting a pretty benign picture: Despite all the financial turmoil, the economy avoids recession and, even with steeply higher prices for food and energy and a lower exchange value of the dollar, we achieve some modest edging-off of inflation. So I tried not to take it personally when I received a notice the other day that the Board had approved more- frequent drug-testing for certain members of the senior staff, myself included. [Laughter] I can assure you, however, that the staff is not going to fall back on the increasingly popular celebrity excuse that we were under the influence of mind- altering chemicals and thus should not be held responsible for this forecast. No, we came up with this projection unimpaired and on nothing stronger than many late nights of diet Pepsi and vending-machine Twinkies. While our basic story hasn’t changed much, the events of the past six weeks have resulted in a considerable darkening of our outlook for activity over the next year. In particular, the incoming data have been weaker than expected, the projected path of household net worth has been revised down owing to lower prices for both equities and houses, oil prices average about $7 per barrel higher than in our previous forecast, and the brief improvement in financial conditions that we experienced in September and October has been reversed in recent weeks. As a consequence, we now project that real GDP will be about flat in the current quarter after having increased at an annual rate of 5 percent in the third quarter. Although the sharp swing in activity from the third to the fourth quarters is exaggerated by some wide fluctuations in inventory investment, we are reading the incoming data as suggesting that there has been a greater downshift in the underlying pace of growth than we had previously anticipated. Furthermore, we expect activity to remain sluggish next year, growing 1¼ percent, nearly ½ percentage point less than in our October projection. In 2009, real GDP is projected to grow at a 2.1 percent pace, a touch below our previous forecast. Most of the disappointing news that we have received over the past six weeks has centered on the household sector, most especially on residential construction. Single- family housing starts came in a bit below expectations, and permits plunged, suggesting some further intensification of the decline in construction activity in the months immediately ahead. Moreover, substantial downward revisions to estimates of new home sales for earlier months indicate that housing demand has been weaker than we previously thought. Meanwhile, conditions in mortgage markets have deteriorated further and appear likely to remain impaired longer than we had projected in October. Nonprime markets remain moribund, spreads on jumbo mortgages have widened further, and spreads on conforming mortgages to Treasuries have increased. These developments along with the weaker incoming data on sales and starts led us to mark down our housing forecast once again. We now expect that sales and starts will post a further drop of nearly 10 percent by early next year. Moreover, we have delayed our projected recovery in starts until 2009. As a consequence, the contraction in residential investment is now expected to subtract over ½ percentage point from the growth of real GDP next year, about ¼ percentage point more than in our October projection. In addition to these softer readings on housing activity, the incoming data on consumer spending also have surprised us to the downside. Real outlays are now estimated to have been nearly flat between August and October, rather than increasing modestly as had earlier appeared to be the case. That subdued pace seems consistent with the slump in consumer sentiment that has followed in the wake of the increased financial turbulence. We now project that real PCE increased at a 1¼ percent pace in the current quarter, 1 percentage point less than in the October Greenbook. I don’t want to overstate the strength of our case that a noticeable slowing in consumer spending is under way. Light motor vehicle sales ran at a 16.2 million unit pace in November, an observation that creates a bit of tension with the survey reports of bummed-out consumers. Moreover, it wouldn’t take much more than a few modest upward revisions to earlier months or a pop in spending in December to undermine this part of our story. That said, the picture doesn’t seem likely to us to brighten much soon. The recent jump in oil prices, coupled with a restoration of currently narrow gasoline margins, points to steep increases in retail energy prices that will take a bite out of the purchasing power of household incomes and further restrain overall consumer spending in coming months. Furthermore, with the lower level of the stock market and a downward revision to our house-price forecast, household net worth is expected to exert more of a drag on consumer spending over the next two years than in our previous forecast. While we don’t expect a dramatic shift, we are anticipating that households will face tighter standards and more-expensive terms for consumer credit. All told, we are projecting real PCE to increase 1½ percent in 2008, about ¼ percentage point less than in our October projection. In contrast to the almost uniformly weaker-than-expected data on the household sector, the information that we have received on business spending has been more mixed. Investment in high-tech equipment has been well below our expectations, especially for communications equipment. That observation squares with some reports we have heard that orders for high-tech gear from financial institutions have fallen off. Other equipment spending has come in close to our expectations, with the recent data on orders and shipments consistent with our projection for some modest slowing in capital spending. The data also have been mixed for nonresidential structures. As I noted at the last meeting, the GDP data for the third quarter pointed to stronger drilling activity than we had earlier anticipated, and we have revised up our projection for this category in response to both the incoming data and the higher projected path for energy prices. For nonresidential buildings, the October data for construction put in place were a bit below our expectations, and we have lowered our near-term projection of activity in this sector. Beyond the near term, we have reduced our forecast for both equipment spending and nonresidential investment. Most of that revision reflects an expected endogenous response of investment to the slower growth of final sales and business output in this projection. But we also have made some small allowance for what we expect to be less favorable financing conditions and greater uncertainty over the next year. Taken as a whole, the spending data have clearly fallen short of our expectations. It might appear that, like the spending data, last week’s labor market report was also a downside surprise for us; after all, we noted in the Greenbook that we had penciled in an increase of 100,000 for private payrolls in November. However, we did that only grudgingly after seeing the ADP survey last Wednesday morning, and basically we did not allow that change to alter any other important aspect of our forecast. In fact, the payroll employment figures are slightly stronger than we expected at the time of the October Greenbook. Indeed, I still see the generally firm conditions in labor markets as suggesting some upside risk to our view that the economy is in the process of slowing sharply. Let me now turn to the inflation forecast. Total PCE prices are projected to increase at an annual rate of 3½ percent in the current quarter, about ¾ percentage point above our previous forecast. Most of that revision reflects higher retail energy prices. But we have also raised our projection of core PCE prices for the third and fourth quarters by ¼ percentage point. That adjustment resulted from the upward revisions made by the BEA to nonmarket prices in earlier months. As you know, we had been consistently surprised by the mild increases in nonmarket prices that had been reported since the spring. As a concession to those persistent errors, a couple of forecast rounds ago, we pushed off the reacceleration of those prices into 2008. Well, we should have stuck with our earlier story because the revised data now show that those prices picked back up in late summer and early fall. Our slight upward revision to core PCE prices in 2008, from 1.9 to 2.0 percent, reflects the indirect effects of the higher oil prices in this projection. We continue to believe that the pass-through of energy prices is small, but not zero. The other major influences on our price projection have remained relatively tame. Although the exchange value of the dollar has fallen a bit, global prices for non-oil commodities have revised down as well, leaving the forecast for core non-oil import prices roughly unchanged. Increases in labor compensation remain subdued. And taken as a whole, readings on inflation expectations have not changed much. The Michigan survey measures of inflation expectations are up some, the Survey of Professional Forecasters was flat, and inflation compensation as inferred from TIPS has edged down slightly. With some slack emerging in labor and product markets in the second half of next year and with energy and import prices projected to decelerate, we are forecasting a slight drop in core price inflation from its projected pace of 2 percent this year and next to 1.9 percent in 2009. In contemplating our forecast, you might be concerned that our relatively benign muddle-through scenario is increasingly looking like the average of two considerably less benign outcomes—one in which the economy proves considerably more resilient, growth bounces back more quickly, and inflation picks up by more than we are projecting and another in which we drop below stall speed and the economy experiences outright recession. While I would readily acknowledge those risks, I still see something like our forecast as the more plausible outcome at this point. At the September meeting, I quoted from the Greenbook of March 1999, in which we had raised the white flag of surrender on our story that the financial turbulence of the autumn of 1998 would significantly restrain the growth of the economy. We could be making that mistake again, but it seems less likely to me now. In particular, one important feature of the episode of the late 1990s was that we were almost immediately fighting the incoming data, much of which came in well above our expectations over the final months of 1998 and early 1999. By contrast, as I have noted today, the recent data seem to be lining up comfortably with our projection of slower growth ahead. I also noted in September the possibility that we could be facing a situation similar to the fall of 2000, when we were forecasting a period of muddling through but were, in fact, on the brink of a mild recession. Again, this possibility certainly can’t be ruled out. But here, as well, there are some noteworthy differences from that earlier episode. In particular, through the fall of 2000, we were receiving increasingly grim stories, especially from manufacturers, about the dismal state of order books and a sharp shift in business psychology. At the time, we didn’t have the conviction to embrace those anecdotes given the strength of the official data. I’ll be interested to hear your reports today, but my sense is that the anecdotes from businesses, while mixed, are not sharply at variance with the data at present. Both seem to be pointing to slower growth but not to a serious retrenchment in activity. For these reasons, we are inclined to stick with our muddle-through story for now. Nathan will continue our presentation." CHRG-111hhrg53234--149 Mr. Mishkin," It is a great pleasure to be here to discuss what is a very important issue, which is what role the Federal Reserve should have as a systemic risk regulator. I want to boil this down to three questions, even though we were asked four, but I think three that are quite relevant to these issues. And the first question is the essential one, which is, should the Fed be the systemic risk regulator? And I am going to answer yes to that question, and there are four reasons that I take that view. The first is that the Federal Reserve is involved in daily interaction with the market, and in terms of being a systemic risk regulator, that kind of information or that contact is extremely useful. The second is that there is a synergy between thinking about macroeconomic stability and financial stability, and that is, I think, extremely important in terms of performing the appropriate analysis to do systemic risk regulation in the best way possible. The third is that there is a synergy between the actions that are required in terms of promoting macroeconomic stability and financial stability. And so we have seen this, of course, in very major ways during this recent crisis. This involves the role of the Federal Reserve as a so-called lender of last resort, providing liquidity to the financial system to, in fact, make sure that macroeconomic stability is preserved. And, finally, the Federal Reserve is one of the most independent of government agencies. In order to be an effective systemic risk regulator, the kind of independence the Fed has had in the past and has used in the past would be also very helpful in this regard. So when I look at this issue of the Fed being a systemic risk regulator, I think that, from my viewpoint, it really is the appropriate logical choice when we think about the nature of this role. The second issue is should the Fed relinquish some of its other roles if it became the systemic risk regulator? And I think the answer here is yes. In particular, the Treasury plan has suggested that the Federal Reserve no longer be a consumer protection regulator, and I concur with this view. There are three reasons why I think that the Fed should no longer be involved in this activity if, in fact, it is handed these additional responsibilities. The first is that being a consumer protection regulator is not at the core mission of what the Federal Reserve does, where I actually do see macroeconomic stability and financial stability is part of that core mission. The second is that it uses a very different skill set. And so in the context of thinking about the synergies, I do not see them to be nearly as relevant. And the third, I think, is really the most important, which is that consumer protection regulation is very political. Everybody cares about it. In the past I testified on credit cards. Everybody has issues in terms of their dealing with the credit card companies. In that context, the possibility of there being more pressure, political pressure, put on the Federal Reserve system is, in fact, greater. And so again I think that this is another reason why having something that is not in your core mission which is, in fact, something that tends to get more political could be harmful to the independence of the Fed, something that I am going to turn to later. The third question is, are there dangers from the Federal Reserve taking on this role of systemic risk regulator? And I think the answer is yes. There are three dangers that do particularly concern me. I will argue, however, that even though these dangers exist, that the Federal Reserve still should be the risk regulator, systemic risk regulator, and there are steps that the Congress can take to, in fact, ensure that the Federal Reserve can do its job adequately both in terms of monetary policy and in terms of promoting financial stability. So the first danger is that the Federal Reserve might lose its focus on price stability. Clearly there are concerns in the marketplace about this issue about the credibility of the Fed as an inflation fighter and steps that it needs to take in terms of making sure that inflation is not too high. And in this context I have argued elsewhere, both when I was a Governor at the Federal Reserve and also afterwards in op eds, that one way of dealing with this would be to have the Federal Reserve to have an explicit numerical objective in terms of inflation, something that it does not have at the current time. The second issue is, could systemic risk regulation interfere with the independence of the Fed? And I think there is some danger here. The danger, of course, is that systemic risk regulation, particularly in the context of having to deal with an institution which has to be reined in, could actually mean that there is some pressure put on the Federal Reserve in that context. And so I think that there is some danger here. But, again, I think that the issue here is that the Congress has to be aware that the independence of the Federal Reserve is very much in the national interest. Indeed, this is a very major concern that I have right now, given concerns about the Federal Reserve's independence and people who have been saying the Federal Reserve needs to be reined in, I think it actually is something that can damage the Federal Reserve's ability to maintain price stability and also macroeconomic stability. But, furthermore, I think that there is also an issue that--in that context that we could actually have even problems currently with concerns about Fed's credibility, which is actually something that can raise interest rates, something that I think has indeed happened. The third issue is something that is not really discussed as much as I would like to see discussed, which is the Federal Reserve's resources have been stretched to the limit by this crisis. And this is particularly true of the Board of Governors. I saw this as a member of the Board of Governors where the staff was working extremely long hours and was exhausted. And I left in September of 2008, before the crisis really got bad. So there are issues in terms of the Fed having enough resources and the support of the Congress for the Fed to acquire the resources that it needs. And I think, again, that is something that is quite important. So the bottom line here for me is that one of the important lessons from this crisis is that we absolutely desperately need a systemic risk regulator. And then I look at the issue about who can do that the best, and my view is that the Federal Reserve is, in fact, best positioned to do so. On the other hand, there are some dangers here, but this is why I think the Congress needs to, in fact, support the Federal Reserve in its independence in terms of the resources that it needs to do this job. And as a result, I think that we would be better served having the Fed pursue this role. Thank you very much. [The prepared statement of Dr. Mishkin can be found on page 83 of the appendix.] " FOMC20050322meeting--140 138,CHAIRMAN GREENSPAN., The critical word is “notably”—that the rise in energy prices has not notably fed through to core consumer prices. It’s not saying that the pass-through is zero. FOMC20080724confcall--17 15,MR. DUDLEY.," If you won an option, you would lock in with certainty the ability to borrow at the TSLF for a fixed price--so you would be locking in your place in the queue, and you would also be locking in your price. " CHRG-110hhrg41184--176 Mr. Bernanke," Whether they price it in dollars, euros, or something else, the exchange rate is known, and so they can always calculate the value. I don't think they misunderstand the fact that they are getting a very high price for their oil. " FOMC20050809meeting--130 128,MR. WILCOX.," Yes. Our price projection has moved up. The best measure of that may be what has happened to the core PCE price index. Let’s see, now that I’m looking at the numbers I’m about to eat my words. In 2002, on the revised figures, core PCE inflation was at 2.2 percent and we now have it at 2.0. So if one takes as the trend last year and the first half of this year, I guess I’m going to have to reverse myself and say that the core PCE price index has been about flat. It has been running in the neighborhood of 2 percent or a little above. It has been higher than we thought because of the oil price." FinancialServicesCommittee--51 You can see at 13:46 p.m., the market had had time to attract liquidity and rebalance, and the E-Mini led the recovery, leading the Dow Jones to recover 400 points in 3 minutes. Moving to chart 2, this graph shows price movement in the E- Mini S&P futures as well as 3M stock. As you can see, the price of 3M stock declined much more rapidly, starting at 13:45 while the E-Mini S&P 500 was hitting a low at 13:45 and 50 seconds, at which time you can see the market and the E-Mini reverses, while the 3M stock continues to decline. Market integrity is of the utmost importance to CME Group. We have developed systems that maintain integrity in all our markets, including a number of controls to protect market users. For example, CME is the only exchange in the world that re- quires pre-execution credit controls. As Chairman Gensler men- tioned, CME Globex maintains functionality that causes the match engine to pause when orders, if they were executed, would exceed predetermined levels. Following the 5-second pause, new orders would come into the market. This is a critical point. We believe this functionality and these protocols do not exist in the cash market. If they did, it would have been highly effective in eliminating price dislocations in 3M and Procter & Gamble. Fur- thermore, CME Globex electronic trading infrastructure incor- porates numerous risk protection tools. They provide added safe- guards to customers and clearing firms, including stop price logic functionality, price banding and circuit breakers. As I mentioned earlier, stop price logic functionality helps to mitigate market spikes that can occur because of the continuous triggering or the election of trading of stop orders. This is what happened last week with the E-Mini and S&P futures, allowing li- quidity to come into the market and ultimately leading to the rally in the equities market. We believe the focus of your review should be on the national market system. We support Chairman Schapiro’s recommendation regarding harmonization across these platforms. We have seen no evidence that high-frequency or other specific trading practices in any way magnified the decline on May 6th. In fact, we believe that high-frequency traders in our market provided liquidity on both sides of the market on this extraordinary day. We do, however, recognize that changes should be considered to avoid a repeat of the events of May 6th. We would make the fol- lowing recommendations. As Chairman Schapiro pointed out, circuit breakers, including circuit breakers for individual stocks, such as those implemented by the NYSE, must be harmonized across markets. We also believe that stop logic functionality should be adopted across markets on a product-by-product basis to prevent cascading downward market movements. The circuit breaker levels of 10, 20, and 30 percent and the duration of the halt and time of day at which triggers are applicable should be reevaluated in light of cur- rent market conditions to determine whether any changes are war- ranted. Any such changes must be implemented across all market venues. I thank the committee for the opportunity to share CME’s views, and I look forward to answering your questions. [The prepared statement of Mr. Duffy can be found on page 70 of the appendix.] FOMC20060510meeting--74 72,MR. REINHART.," I’m not sure I have that expertise. Perhaps the evolution of inflation expectations is asymmetric, as President Moskow suggested. Perhaps it’s also what we look at at a high frequency. Inflation compensation doesn’t exactly map into inflation expectations—it includes an inflation risk premium. We think that some of the rise in inflation compensation is due to an unwinding of something we couldn’t explain—that is, a term premium that was very low by historical standards. To the extent that it’s the term premium rising, it could get packed into that measure of inflation compensation. I would also note that, as Dave said, in the Michigan survey of households, longer-term inflation expectations ticked up. In the Blue Chip consensus forecast that’s released today, longer-term inflation expectations are actually unchanged over the last month, and that covers the span of the rise in energy prices and the whiff of inflation jitters that we saw in financial markets." CHRG-110shrg50414--161 Mr. Bernanke," This is one of the reasons, you know, in response to Senator Bennett, you know, if we narrow--if we keep the range of participants too narrow, only failing institutions, for example, then we will not have a robust, competitive auction. The more participants we have, the more people who are involved in offering these assets, we will have a competition. And auctions are good at producing, you know, relevant prices, even if individuals have an incentive to underprice. Senator Menendez. Well, let me ask you this: I have heard you both make statements today and in the past that would lead one to believe that, at the end of the day, there is minimal risk to the taxpayers here. And, in fact, I have heard you say that there are some who argue that, in fact, we could make money. Can you both look at me in the eye and tell me that, as we increase the debt limit of the United States by $700 billion, which basically means about $2,333 for every man, woman, and child in this country, that this will not cost the taxpayers anything if we pursue what you want us to do? " CHRG-111shrg57322--9 Mr. Birnbaum," Good morning, Mr. Chairman, Members of the Subcommittee, my name is Josh Birnbaum. Thank you for offering me this opportunity to discuss my work in the Mortgage Department at Goldman Sachs in 2006 and 2007, when I was a Managing Director in the Structured Products Group. I began working at Goldman shortly after my graduation from the Wharton School at the University of Pennsylvania in 1993. I worked at Goldman until March 2008, when I left to start my own advisory firm, Tilden Park Capital Management. I take great pride from having worked for Goldman Sachs for almost 15 years and greatly admire the firm's integrity, commitment to client service, and ethics.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Birnbaum appears in the Appendix on page 205.--------------------------------------------------------------------------- During 2006 and 2007, I worked on the Asset-Backed Securities (ABS), Desk in the Structured Products Group. My job was to make markets for Goldman clients who sought long or short exposure to the market for residential housing asset-backed securities and to assist in hedging investments made by other parts of the Mortgage Department. The primary products I traded and risk-managed were the then newly created Asset-Backed Securities Index (ABX), and credit default swaps (CDS) in individual securitizations, also known as single-name CDS. As a market maker, we were continuously asked to provide liquidity for customers, which frequently required the firm to participate on the other side of transactions on a ``principal'' basis. For example, when a client wanted to buy protection on a particular securitization, we would offer a price to sell that protection. If the client chose to execute the transaction at that price, we would take the other side of the trade. We would then have a decision to make whether to offset that risk through a transaction with another client who wanted to sell that protection to us or keep it on our book for some period of time as part of our inventory. From time to time, as a result of client-driven trades, our team's book accumulated long and short positions. For example, from the inception of the ABX Index in January 2006 through November 2006, customers interested in selling the ABX Index outnumbered buyers. The trades we made to meet client demands during that period naturally caused the book to develop a long position in the ABX Index and a smaller short position in the single-name CDS. As part of our management of our own inventory, we had the discretion to hedge positions through trades with other clients or keep them on our book in accordance with the limits set by the risk management department. Whenever our inventory got significantly long or short, risk management directed us to cut our risk and ``get closer to home,'' or to ``flatten the book.'' For example, when our net position became long in late 2006, we were told to offset our risks, which we did through a combination of selling off some of the long ABX position and buying more single-name CDS protection. And when our inventory expressed a short bias at times in 2007, we were directed to cover our short positions to reduce risk, and we did so. In late 2006 and into early 2007, I developed a negative view on the likely direction of the subprime market. Traders on desks like ours often develop a short or long bias based on their personal views of the market. Not everyone in the Mortgage Department--or the firm, for that matter--agreed with my view at the time. In fact, there was a vigorous debate as to the future direction of the market. In line with my view, our desk began to accumulate short positions, purchasing protection on individual securities through credit default swaps, largely from external CDO managers who asked us to bid for these positions. There was, of course, risk involved in accumulating short positions, as no one could be certain which direction the market would go. These positions became profitable as the market deteriorated. When those short positions bumped up against the risk parameters for our book during the spring and summer of 2007, my group was instructed to cover them. On both occasions, I expressed my belief that the market would continue to deteriorate and that the better, more profitable trade was to maintain the short position on our book, but the firm insisted that we reduce our position, and we did so. No one from senior management told me to make a directional bet against the subprime market. Rather, during 2006 to 2007, regardless of whether our books were long or short, the consistent theme from management was get smaller, reduce risks, and get closer to home. I am very proud of the accomplishments of the ABS Group during my tenure there. We provided significant liquidity to our clients in a difficult and challenging market while also managing to post a profit during this period. Thank you for inviting me to testify here. I am happy to answer any questions Subcommittee members may have. Senator Levin. Thank you very much, Mr. Birnbaum. Mr. Swenson. TESTIMONY OF MICHAEL J. SWENSON,\1\ MANAGING DIRECTOR, STRUCTURED PRODUCTS GROUP TRADING, THE GOLDMAN SACHS GROUP, CHRG-111shrg57322--323 Mr. Birnbaum," Well, typically when people are talking about the housing market declining or going up, they are talking about housing prices. So we all have publicly available information on housing prices that is released, typically monthly, sometimes quarterly, and if that is what you are referring to---- Senator Tester. So the housing decline was based on housing prices around the middle to end of 2006. It was not based on subprime or--it was based on that pattern. I am not trying to set you up for anything. " CHRG-110hhrg45625--69 Mr. Bachus," Chairman Bernanke, let me ask you the same question. How do you structure this program or how is it structured to ensure that the taxpayers are protected? I know that Chairman Frank and I have been working on some assurances or guidelines in the legislation to make sure that either by auction or covenant or some mechanism, that that price is pretty much guaranteed. And I know it is hard to guarantee, but you have also mentioned the difference between a fire sale price and a hold to maturity price. Would you go into that? " CHRG-111hhrg51698--69 Mr. Duffy," I agree with Mr. Cota, what he said. Again, from our standpoint, liquidity, as we talked about it earlier, is critically important to our participants. What we had seen throughout some of the increase in prices is really the credit prices affecting our clients where they weren't able to get credit to finance the hedges they had on the books of the exchanges, and in return they had to liquidate those positions. So that is one of the things we have seen. But it is not so much a fundamental flaw of the price or the product; it is the fundamental flaw in the credit. We could not get the credit. " FinancialCrisisReport--477 On February 14, 2007, Mr. Sparks wrote some notes to himself: “Bad week in subprime collateral performance on loans was poor – we took a write-down on second lien deals and on the scratch and dent book last week ... Synthetics market got hammered – around 150 [basis points] wider ... Originators are really in a bad spot. Thinly capitalized, highly levered, dealing with significant loan putbacks, some with retained credit risk positions, now having trouble selling loans above par when it cost them 2 points to produce. What is the next area of contagion.” 2013 That same day, February 14, 2007, Mr. Sparks exchanged emails with Goldman’s Co- President Jon Winkelried about the deterioration in the subprime market: Mr. Winkelried: “Another downdraft?” Mr. Sparks: “Very large – it’s getting messy. ... Bad news everywhere. Novastar bad earnings and 1/3 of market cap gone immediately. Wells [Fargo] laying off 300 subprime staff and home price appreciation data showed for first time lower prices on homes over year broad based.” 2014 On February 26, 2007, when Mr. Montag asked him about two CDO 2 transactions being assembled by the CDO Origination Desk, Timberwolf and Point Pleasant, Mr. Sparks expressed his concern about both: Mr. Montag: cdo squared–how big and how dangerous Mr. Sparks: Roughly 2bb, and they are the deals to worry about. 2015 2012 2013 2014 2/8/2007 email from Daniel Sparks, “Post,” Hearing Exhibit 4/27-7. 2/14/2007 email from Daniel Sparks to himself, “Risk,” GS MBS-E-002203268. 2/21/2007 email exchange between Daniel Sparks and Jon W inkelried, “Mortgages today,” GS MBS-E- 010381094, Hearing Exhibit 4/27-10. 2015 2/26/2007 emails between Tom Montag and Daniel Sparks, “Questions you had asked,” GS MBS-E-019164799. FOMC20060808meeting--82 80,CHAIRMAN BERNANKE.," Thank you. Let me briefly summarize what I’ve heard and add a few comments. I think one thing we can conclude is that this is not getting any easier. [Laughter] Starting with the data, which are not cooperating, the NIPA revisions show that potential growth may be less than we thought and, therefore, we may have to have more of a slowdown, if we believe in the Phillips curve, to begin to contain inflation. The small bit of comfort I take is that the slowdown in potential and productivity appears to be coming from capital rather than from multifactor productivity; so at least that technological component still seems to be with us. The question is whether we are, in fact, slowing to potential or to slightly below potential. I agree with most of what I heard around the table, which is that there is evidence of slowing but, except for the residential construction sector, it is not yet at all definitive that we are falling below potential growth rates. For example, the staff estimated that GDP growth in the second quarter was 3 percent. The staff also estimated that the slower rate of job creation we saw in the second quarter is still fairly close to what is needed to keep the unemployment rate constant. We are certainly seeing areas of strength in the economy, as a number of people noted. That includes the industrial sector—which will grow 0.7 or 0.8 percent, something like that, overall in July—and nonresidential construction, which has been strong enough that so far there has not been a net decline in construction jobs in the United States. So there certainly are some strong elements of the economy. I’d like to talk about the very important housing sector, in terms not of the expected level but of the variance of our forecast, which I think we must think about given our risk-management approach. At least three dimensions of the housing sector provide significant uncertainty as we look forward. The first is the extent to which sales, starts, and permits will decline. The correction in the housing market so far appears to be fairly substantial. In 2005, we had 1.72 million starts. For June, the number of adjusted permits was 1.45 million. We already have a 15 percent decline in the level of construction. As Governor Kroszner pointed out, the curve doesn’t look as though it’s flattening out; it looks as though it’s heading directly south. We have heard anecdotally that cancellations are up very sharply. Inventories are rising significantly, and I note that, just since the last meeting, the GDP contribution estimated by the staff for housing construction went from minus 0.3 percent to minus 0.6 percent. So there is, I think, a lot of uncertainty about where that sector is going to level out. Second, associated with that consideration is a lot of uncertainty about housing prices. Again, as Governor Kroszner noted, we don’t really have much information on what the “true price” of housing is at this point because of the way this market works: People leave things on the market for a long time; they take them off the market; they provide incentives; and so on. So we don’t really see the transaction prices in any kind of quality-adjusted or reliable way for some time after the decline begins. The prices are significant, of course, both because they affect the profitability of future construction and because they are, at this point, an important component of household wealth; we know that these factors are likely to affect spending. Finally, a third element of uncertainty as we look into the forecast is what I would call parameter risk, which is that the staff assumes that the effect of housing wealth on consumption spending is, through the standard wealth effect, about four cents on the dollar. I happen to think that is a good estimate. I think the econometric calculations are persuasive. Nevertheless, there is the possibility that the effect is somewhat greater, perhaps operating through liquidity effects. There may be buffer stock effects. If people see their equity falling, they may become more cautious about spending in order to avoid eliminating their buffer of reserves. Thus there is the possibility that housing will have a stronger effect on consumption than we now expect. I don’t know what the expected growth rate is. If I had to take a guess, I would say that we’re going to be close to or slightly below potential going forward, but I simply want to point out that our forecast may have a higher variance now than it does under normal circumstances. Let me say just a few words about inflation. I heard a lot of concern about inflation around the table. I certainly share that concern, and I don’t expect any near-term improvement, if for no other reason than that these things tend to be highly inertial. I also agree with the general observation that the pickup is fairly broad based, as I discussed in the meeting last time. One indicator of that is the share of goods that have price increases or price increases above a certain level. I tried a somewhat different exercise, and I didn’t do it in any way as an apologist for inflation—I want to be very clear. But I think it’s useful to look at inflation from a different approach, which is to ask what share of the inflation acceleration is attributable to different components. So I asked for a look at the past three months versus the past twelve months to examine the acceleration between those two periods. In a sort of growth-accounting exercise, how can we distribute that acceleration among different components? I have just a few observations from that exercise. First, the shelter component really does play a big role. For example, in this particular calculation, which is somewhat sensitive to sample period, of the 71 basis point increase in the core CPI between twelve months and three months, 48 basis points were associated with the shelter increase. So that component is significant, and our views on where it will go and how that relates to the developments in the housing market need to be thought about. A second observation is that we are seeing energy pass-through, a good example being air fares, which have jumped significantly and which by themselves contribute 19 basis points to the acceleration. So energy pass-through is real. A somewhat more subtle point, which was made in the Greenbook and which I think is interesting, is that there’s a little different behavior between inflation in goods and inflation in non-energy, nonshelter services. Inflation in services has been generally flat. In goods, however, we have seen a bit of acceleration, from a negative number in ’05 to a slightly positive number in ’06. Examples would be the rise in prices in apparel and, more recently, in used cars. In just examining clues, I think that acceleration might say something about international competition, the effects of the declining dollar, and the possibility that import competition has weakened to some extent and is allowing prices of tradable goods to rise a bit more quickly. One theme that is consistent regarding the energy pass-through and the perhaps slightly greater inflation in tradable goods is that an important component of the inflation is product market tightness as opposed to labor market tightness. That suggests that, as we go forward, we should pay a lot of attention to final demand and consumption and see how they are affecting the product markets. My own guess is that unit labor costs and wages will be somewhat lagging; and I think that, if the product markets slow and the slowing reduces pricing power, as we call it, those effects will ultimately have effects on the markup that will offset some of the wage effects. So those are just a few observations about the economy. To summarize, I agree with the sentiment around the table that there is a lot of uncertainty going forward, particularly in the housing sector, but that the inflation risks at this point are still dominant and that our policy action and statement should reflect the greater concern with inflation. On the subject of policy, let me now turn to Brian, who will present the policy options." FinancialCrisisInquiry--118 To solve this OTC derivatives problem—I heard a few of the—of the potential solutions this morning. But I’ll go over the three that I think are absolutely mandatory to fix this problem. One is—is the key issue—is homogeneous minimum collateral requirements. All participants in the derivatives marketplace—do not bar the dealers from this— should be required to post initial capital based upon some formulaic determination of the risk by the appropriate regulatory body. Two, centralized clearing and mandatory price reporting of all standardized CDS, FX and interest rate derivatives—we believe close to 90 percent of these derivatives are standardized. Centralized data repository for all cleared and non-cleared derivatives trades—essentially there must be some place where every single transaction is recorded and monitored. As of today, that still doesn’t exist. It’s hard for me to believe that where we are today that that doesn’t exist. The second thing I’d like to talk about is bank leverage. And this is just the fundamental tenants of the U.S. banking system. Under current regulatory guidelines, banks are deemed to be well- capitalized with 6 percent tier one capital and adequately capitalized with 4 percent tier one capital based upon risk weighted assets. As an aside, the concept of risk weighting in assets should also be reviewed. This in turn means that a well-capitalized bank is leveraged 16 times to its capital, much more to its tangible common equity. And an adequately capitalized bank is—or a minimum capitalized bank—sorry—is 25 times levered to its tier one capital. I don’t know how many prudent individuals or institutions can possibly manage a portfolio of assets that is 25 times levered when we hit a crisis. But—but I surely can’t. Unfortunately, the answer so far has been not many of the other banks have been able to manage these risks either. Of the 170 banks that have failed during the crisis to date, the average loss to the FDIC and the taxpayer is well over 25 percent of their assets. When you think about that, that means they’ve lost more than six times their equity, of the banks that have gone down so far. fcic_final_report_full--600 Special Comment, September 23, 2010. 69. Ben Bernanke, closed-door session with the FCIC, November 17, 2009. 70. Vikas Shilpiekandula and Olga Gorodetsky, “Who Owns Residential Credit Risk?,” September 7, 2007, p. 1. The Lehman analysts pegged ultimate subprime and Alt-A losses at $200 billion. Those fore- casts were based, the analysts said, on a scenario in which house prices fell an average of 30% across the country. For the securitization figures, see Inside Mortgage Finance, The 2009 Mortgage Market Statisti- cal Annual, vol. 2, The Secondary Market. 71. IMF, “Financial Stress and Deleveraging: Macro-Financial Implications and Policy,” Global Finan- cial Stability Report, October 2008, p. 78; IMF, “Containing Systemic Risks and Restoring Financial Soundness,” Global Financial Stability Report, April 2008. 72. FCIC staff estimates, based on Moody’s Investor Service, “Default & Loss Rates of Structured Fi- nance Securities: 1993–2009,” Special Comment, September 23, 2010, and analysis of Moody’s Structured Finance Default Risk Service. 73. Ben Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 2, ses- sion 1: The Federal Reserve, September 2, 2010, transcript, p. 54. Chapter 12 1. FCIC staff calculations using data in worksheets Markit ABX.HE. 06-1 prices and ABX.HE. 06-2 prices, produced by Markit; Nomura Fixed Income Research, CDO/CDS Update 12/18/06 . The figures re- fer to the BBB- index of the ABX.HE. 06-2. 2. Nomura Fixed Income Research, CDO/CDS Update 12/18/06 , p. 2. 3. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” internal memo to Erik Sirri and others, January 4, 2007. 4. Jim Chanos, interview by FCIC, October 5, 2010. 5. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” memo, January 4, 2007. 6. Fed Chairman Ben S. Bernanke, “The Economic Outlook,” testimony before the Joint Economic Committee, U.S. Congress, 110th Cong., 1st sess., March 28, 2007. 7. Henry Paulson, quoted in Julie Haviv, “Bernanke Allays Subprime Fears as Beazer Faces Probe,” Reuters, March 28, 2007. 8. David Viniar, written testimony, Wall Street and the Financial Crisis: The Role of Investment Banks, Senate Permanent Subcommittee on Investigation, 111th Cong., 2nd sess., April 27, 2010, pp. 3–4. 9. Michael Dinias, email to David Viniar and Craig Broderick, December 13, 2006, Senate Permanent Subcommittee on Investigations, Exhibit 2. 10. Viniar, written testimony, Permanent Subcommittee on Investigation, pp. 3–4; Daniel Sparks, email to Tom Montag and Richard Ruzika, December 14, 2006, Senate Permanent Subcommittee on In- vestigations, Exhibit 3. 11. Kevin Gasvoda, email to Genevieve Nestor and others, December 14, 2006, Senate Permanent Subcommittee on Investigations, Exhibit 72. 12. David Viniar, email to Tom Montag, December 15, 2006, Senate Permanent Subcommittee on In- vestigations, Exhibit 3. 13. Stacy Bash-Polley, email to Michael Swenson and others, December 20, 2006, Senate Permanent Subcommittee on Investigations, Exhibit 151. 597 14. Tetsuya Ishikawa, email to Darryl Herrick, October 11, 2006, Senate Permanent Subcommittee on Investigations, Exhibit 170c; Geoffrey Williams, email to Ficc-Mtgcorr-desk, October 24, 2006, Senate Permanent Subcommittee on Investigations, Exhibit 170d. 15. Fabrice Tourre, email to Jonathan Egol and others, December 28, 2006, Senate Permanent Sub- committee on Investigations, Exhibit 61. 16. Daniel Sparks, email to Tom Montag, January 31, 2007, Senate Permanent Subcommittee on FOMC20060510meeting--159 157,MR. STONE.," Thank you, Mr. Chairman. Given that I see the risk to growth as reasonably balanced and the risk to inflation as slightly more to the upside, I support raising the funds rate 25 basis points. With resource utilization at high levels and core inflation near the top of the range I consider consistent with price stability, any positive aggregate demand shock could result in inflation higher than we would like. So I think that we should take some action today to lean against this possibility, and I see that 25 basis points would do that. I don’t sense right now that we’re behind the curve and that we need to do more. I think the funds rate is approaching the level that’s consistent with stable inflation and growth at potential, but I’m not sure whether today’s move will be the last or when the next move will be required. That will depend on what the incoming data tell us about where the economy is headed and our assessment of the risk to that forecast. There has been a perception by some, and it’s been discussed around the table, that the FOMC often makes one or two moves too many. At the last meeting, I said I would rather accept the risk of taking one or two moves too many than of coming up short. The risk associated with this would be magnified if it proved difficult for the FOMC to reverse itself, should it perceive ex post that rates have been raised too high. We recently did a study to look at our past behavior, and the staff analysis shows that there have been numerous episodes in which the FOMC has paused and then continued along the policy path and even paused and reversed course. So that gives me some comfort that we have the flexibility to take the appropriate actions based on incoming data. Turning to the language, I had about three pages worth of material, most of which I can throw away. I think alternative B comes very close to the language that I think appropriate. I have some sympathy with President Lacker’s and President Moskow’s comments that leaving the phrase about inflation expectations the way it was in the last meeting does not fairly represent the tenor of the discussion today. Balancing that a little is the change in the language in row 4, which now addresses the inflation issue more head-on and thus shows the change in the tenor of the discussion a bit. But we certainly would not want the markets to perceive a lower policy path by reading that in the language, and maybe the inflation expectations phrase might do that. That concludes my comments." FOMC20080318meeting--42 40,MR. STOCKTON.," President Fisher, I will just basically reiterate what I said earlier and amplify many of the same things that Nathan just said in terms of the influences on our headline forecast. We revised up � percentage point as well, and that really is coming from higher energy prices, higher food prices, and higher commodity prices, all of which we think are already showing through to some extent and we expect to continue to show through to headline inflation. Despite the fact that we run with a much larger output gap in this forecast, we haven't revised down our forecast for 2009 because of the lingering effects of the run-up in commodity prices that we are expecting. As I indicated, we think there has probably been some small deterioration in inflation expectations as well. " CHRG-109hhrg31539--224 Mr. Pearce," Really affect the price of gasoline if we were to drill in ANWR in the outer continental shelf, if we were able to get those things through legislative bodies in this town, might affect the price of gasoline in some way. " FOMC20070321meeting--83 81,MR. LACKER.," Thank you, Mr. Chairman. Overall, economic activity in the Fifth District expanded modestly in recent weeks, though performance across sectors remains uneven. Growth is centered in the services sector, where moderately positive readings continue. Real activity has recovered somewhat in recent weeks, and big-ticket sales have posted modest gains after two months of quite weak readings. In manufacturing, our survey respondents continue to report a downward drift in activity. They remain optimistic about their future prospects, however, though many comment on generally weak current demand. Labor markets remain tight in most jurisdictions, with the standard reports of spot shortages of skilled workers, but wage pressures are reported to be moderate. We continue to hear of some reasonably firm housing activity in a number of District localities. Home prices remain generally flat, though builders are offering more incentives to buyers. Inflation pressures appear to have moderated in March according to our latest survey, but manufacturers and service providers expect price pressures to increase modestly over the next six months. On the national level, risks seem to have risen lately, but my sense is that prospects are still reasonably sound. Subprime mortgages, obviously, have dominated the financial news in recent weeks. Concerns about the welfare of families suffering foreclosure are quite natural, and anecdotes about outright fraud suggest some criminality. But my overall sense of what’s going on is that an industry of originators and investors simply misjudged subprime mortgage default frequencies. Realization of that risk seems to be playing out in a fairly orderly way so far. Mortgage-backed securities have lost value as risk spreads have widened, and there have been insolvencies among firms that specialized in this sector. The updating of risk estimates in light of recent experience will lead to higher borrowing costs in the affected market segments, and at the margin this increase could shift some households from homeownership to renting. But in my judgment, that isn’t likely to affect the net demand for housing units. Notably, we have not seen broader risks to credit availability in other markets or to the financial safety net. Perhaps the greatest economic risk posed by recent subprime developments is legislation that impedes the availability of credit or that provides financial support ex-post that was unanticipated ex-ante but affects private decisionmaking henceforth, somewhat like ad hoc disaster relief. Housing construction continues to contract, of course, and inventories remain elevated. The choppy winter data make it hard to gauge the descent, but overall home sales seem to be holding steady, and we haven’t heard anything locally that suggests a renewed contraction in demand. So the housing outlook hasn’t changed much for me. However, the recent weakness in business investment has been disappointing. One would expect soft patches related to housing, autos, and the new truck regulations, but the broader sluggishness is a bit at odds with the generally favorable fundamentals. I still expect this investment to pick up ultimately, although I have to admit that the recent data have left me a bit less certain, especially about when. The outlook for consumer spending remains fairly healthy, though. Real disposable income growth has been powered by continuing gains in employment and firmer wage growth. So all in all, I still think the current episode of below-trend growth is fundamentally a transitory phenomenon that will most likely be behind us by the end of the year, although the recent weakness in business investment suggests more downside risk than before. Core inflation continues to firm, and it now seems clear that the fourth quarter’s energy- induced lull is over. We have yet to see much sign of the long-awaited easing in resource utilization. It’s not obvious that we will be getting any help from labor costs any time soon, and inflation expectations remain centered at or above 2 percent. So to me, the prospects for moderation in inflation remain tenuous. I continue to believe that, by summer, growth concerns are likely to be behind us, and we will want to act to reduce inflation, which we recognize is higher than we want. Thank you." FOMC20080318meeting--65 63,MR. SAPENARO.," Thank you, Mr. Chairman. Eighth District economic conditions have softened, but with considerable variability across industries and local areas. The outlook for District agriculture is very strong in the context of high commodity prices. This prospect is reflected in prices of agricultural land, which in areas within the District have risen at a rate of 20 to 25 percent over the past year in active markets. Production of agricultural equipment for the 2008 crop season is fully booked, and prices of used equipment are at or very close to prices of new equipment. There was major activity in the District energy industry, with significant construction projects of coal-fired generation facilities and rapidly developing exploration and production in the Fayetteville Shale play in Arkansas. Total natural gas production from this source roughly quadrupled during 2007. In a recently published study, it is estimated that the direct impact on Arkansas output from exploration and production will average about $2.5 billion per year for the next five years. For perspective, this is about 2.8 percent of the 2006 Arkansas gross state product. Overall activity in the Evansville, Indiana, metropolitan area is particularly strong. The unemployment rate there has declined year over year from 4.6 to 4.2 percent, and nonfarm employment has grown 1.4 percent from January '07 to January '08. A major investment in the auto parts industry is in the works for this area. Activity in housing markets in the District is soft, with building permits in the four largest metro areas down on average 16.8 percent during 2007. Nevertheless, house prices in the District have held up much better than the national experience. In 21 District metropolitan areas, house prices increased an average of 2.5 percent in 2007, with decreases in house prices reported in only 3 metro areas. However, in contrast to other parts of the nation, these areas did not experience major house-price inflation before 2007. From 2000:Q4 through 2006:Q4, the average annual price inflation in these areas was only 5.3 percent. Foreclosures have increased in 2007 in three of the four largest District metro areas but at much lower rates than nationally, and 2007 foreclosure rates are at or below national averages in three of these four areas. I solicited information on the national economy from a number of sources. Contacts in the air and ground cargo industry report significant cost pressures from higher energy prices. These affect everything from fuel costs to the cost of snow removal. Respondents indicate that these cost increases are significantly but not completely passed through to their prices. International cargo traffic is reported to show strong growth, but with some customers substituting sea for air shipment and choosing less rapid delivery service to reduce cost. Year-over-year traffic out of Asia to both Europe and North America has grown at double-digit rates. One contact indicated that volume appears to have bottomed out in the first half of 2007 and has slowly but steadily improved since. In contrast, a contact in the over-the-road trucking industry reported that there was not much change in the past two months. In his view, the industry has been in recession since December 2006. He sees improvement for his firm going forward not because of increased demand but because of small competitors exiting the industry through bankruptcy. Excluding fuel surcharges, freight prices are flat to down. A contact at a major credit card bank reported that their credit card activity indicates that retail sales, excluding autos, were flat in February and are likely to be flat to down in March. These February data were confirmed by the advance retail sales report last week. He also reported that a smaller percentage of customers are making full payment on their credit cards and that a larger percentage are making only the minimum required payment. He sees delinquencies spreading to credit cards. A contact at a major software producer indicates that revenue growth was robust prior to the first quarter of 2008 and, while remaining strong, has slackened since the beginning of the year. He reports strong retail sales, but that was possibly influenced by reductions in prices. He sees business IT spending in the United States remaining strong and no deterioration in the collection of receivables. Nevertheless, he is less optimistic about the industry outlook now than in January. Finally, a contact in the quick service restaurant industry, or fast food, sees business as stable at the moment, not getting worse but not getting better. He notes that while historically this industry is affected least when the economy slows down, this particular time he sees gasoline prices as a significant factor, with many consumers making fewer trips to purchase low-ticket items. He also views financial markets as closed to all but the largest and most highly rated nonfinancial corporations. In his words, there is no market for deals. The national economy certainly appears headed for a weaker first half of 2008 than seemed likely at the January meeting. A model estimated by our staff economists for forecasting recessions suggests a probability in the neighborhood of 60 percent that the NBER dating committee will label the current experience an official recession. Unlike some, I am not an optimist on the effect of the fiscal stimulus program on consumer demand. Economic theory and past experience with such oneoff stimulus programs do not provide a basis for assuming a strong response. In the current situation, with many consumers heavily leveraged, it is likely that the stimulus to consumption will be less than historical averages. Notwithstanding the February CPI report, the inflation situation is deteriorating and appears likely to continue deteriorating. Beyond the immediate issue of containing systemic risk, the most important issue is the subsequent economic recovery. We have eased aggressively already. We must not lose focus on the lagged effect of current policy actions on that recovery. We must preserve the credibility of our commitment to low and stable inflation. The greatest danger is a relapse into a period of higher inflation, which then promotes a policy response that could generate a future recession and start a vicious cycle of increasing inflation and increasing unemployment. Thank you, Mr. Chairman. " FOMC20050630meeting--25 23,MR. GALLIN.," Okay. I can tell something from the tone of your voice. [Laughter] In any event, the idea there was to look at house prices and construction costs and to try to back out as a sort of mechanical operation—not an easy one—the value of the land. He shows that land prices have increased very rapidly and that the land share of the property values has gone up over time. As you mentioned, we know something about farm prices. But besides those two things, there really aren’t—" FOMC20070628meeting--82 80,MR. STOCKTON.," We do indeed forecast it to continue to decline over the next year or so, in large measure because, as David shows in his chart, we still think this house price adjustment has to proceed further before we get into a better equilibrium. Our assumption on the stock price, of course, is pretty neutral because we have it going up pretty close to the overall rate of nominal income, so I think the downward tilt is being driven mostly by the house price story." CHRG-111shrg53176--156 PREPARED STATEMENT OF RICHARD BAKER President and Chief Executive Officer, Managed Funds Association March 26, 2009 Managed Funds Association (``MFA'') is pleased to provide this statement in connection with the Senate Committee on Banking, Housing, & Urban Affairs hearing, ``Enhancing Investor Protection and the Regulation of Securities Markets--Part II'' held on March 26, 2009. MFA represents the majority of the world's largest hedge funds and is the primary advocate for sound business practices and industry growth for professionals in hedge funds, funds of funds and managed futures funds, as well as industry service providers. MFA's members manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies around the world. MFA appreciates the opportunity to express its views on the important subjects of investor protection and the regulation of securities markets. In considering theses issues, it is important to remember that vibrant, liquid markets are important to investors and that for these markets to work, financial institutions need to be able to perform their important market functions. Hedge funds play an important role in our financial system, as they provide liquidity and price discovery to capital markets, capital to companies to allow them to grow or turn around their businesses, and sophisticated risk management to investors such as pension funds, to allow those pensions to meet their future obligations to plan beneficiaries. Hedge funds engage in a variety of investment strategies across many different asset classes. The growth and diversification of hedge funds have strengthened U.S. capital markets and allowed investors means to diversify their investments, thereby reducing their overall portfolio investment risk. As investors, hedge funds help dampen market volatility by providing liquidity and pricing efficiency across many markets. Each of these functions is critical to the orderly operation of our capital markets and our financial system as a whole. In order to perform these important market functions, hedge funds require sound counterparties with which to trade and stable market structures in which to operate. The recent turmoil in our markets has significantly limited the ability of hedge funds to conduct their businesses and trade in the stable environment we all seek. As such, hedge funds have an aligned interest with other market participants, including retail investors, and policy makers in reestablishing a sound financial system. We support efforts to protect investors, manage systemic risk responsibly, and ensure stable counterparties and properly functioning, orderly markets. Hedge funds were not the root cause of the problems in our financial markets and economy. In fact, hedge funds overall were substantially less leveraged than banks and brokers, performed significantly better than the overall market and have not required, nor sought, federal assistance despite the fact that our industry, and our investors, have suffered mightily as a result of the instability in our financial system and the broader economic downturn. The losses suffered by hedge funds and their investors did not pose a threat to our capital markets or the financial system. Although hedge funds are important to capital markets and the financial system, the relative size and scope of the hedge fund industry in the context of the wider financial system helps explain why hedge funds did not pose systemic risks despite their losses. With an estimated $1.5 trillion under management, the hedge fund industry is significantly smaller than the U.S. mutual fund industry, with an estimated $9.4 trillion in assets under management, or the U.S. banking industry, with an estimated $13.8 trillion in assets. According to a report released by the Financial Research Corp., the combined assets under management of the three largest mutual fund families are in excess of $1.9 trillion. Moreover, because many hedge funds use little or no leverage, their losses did not pose the same systemic risk concerns that losses at more highly leveraged institutions, such as brokers and investment banks, did. A study by PerTrac Financial Solutions released in December 2008 found that 26.9 percent of hedge fund managers reported using no leverage. Similarly, a March 2009 report by Lord Adair Turner, Chairman of the U.K. Financial Services Authority (the ``FSA''), found that the leverage of hedge funds was, on average, two or three-to-one, significantly below the average leverage of banks. Though hedge funds did not cause the problems in our markets, we believe that the public and private sectors (including hedge funds) share the responsibility of restoring stability to our markets, strengthening financial institutions, and ultimately, restoring investor confidence. Hedge funds remain a significant source of private capital and can continue to play an important role in restoring liquidity and stability to our capital markets. The value of hedge funds (and other private pools of capital) as private investors has been recognized by Treasury Secretary Geithner in his proposals for the recently announced Public Private Partnership Investment Program (the ``PPIP'') and implementation of the Term Asset-Backed Securities Loan Facility, each of which is dependent on private investor participation to be successful. In addition to providing liquidity, managers of private pools of capital have significant trading and investing experience and knowledge that can assist policy makers as they continue to contemplate the best way to implement the Administration's Financial Stability Plan. MFA is supportive of the new PPIP. We share Secretary Geithner's commitment to promote efforts that will stabilize our financial markets and strengthen our Nation's economy. MFA and its members look forward to working with Secretary Geithner, Congressional leaders, and members of President Obama's economic team on this and other important issues in order to achieve the shared objective of restoring stability and investor confidence in our financial markets. Regulatory reform also will be an important part of stabilizing markets and restoring investor confidence, but it will not, in and of itself, be sufficient to do so. The lack of certainty regarding major financial institutions (e.g., banks, broker dealers, insurance companies) and their financial condition has limited the effectiveness of government intervention efforts to date. Investors' lack of confidence in the financial health of these institutions is an impediment to those investors' willingness to put capital at risk in the market or to engage in transactions with these firms, which, in turn, are impediments to market stability. The Treasury Department's plan to conduct comprehensive stress tests on the 19 largest bank holding companies is designed to ensure a robust analysis of these banks, thereby creating greater certainty regarding their financial condition. Treasury's announcement that it plans to involve private asset managers in helping to value illiquid assets held by banks as part of the PPIP recognizes the beneficial role that private asset managers can play in helping provide that certainty. We believe that, to achieve this certainty, it is also important for policy makers and regulators to ensure that accounting and disclosure rules are designed to promote the appropriate valuation of assets and liabilities and consistent disclosure of those valuations. Though ``smart'' regulation cannot, in and of itself, restore financial stability and properly functioning markets, it is a necessary component of any plan to achieve those ends. ``Smart'' regulation would include appropriate, effective, and efficient regulation and industry best practices that better monitor and reduce systemic risk and promote efficient capital markets, market integrity, and investor protection. Regulation that addresses these key issues is more likely to improve the functioning of our financial system, while regulation that does not address these key issues can cause more harm than good. We saw an example of the latter with the significant, adverse consequences that resulted from the SEC's bans on short selling last year. A smart regulatory framework should include comprehensive and robust industry best practices designed to achieve the shared goals of monitoring and reducing systemic risk and promoting efficient capital markets, market integrity, and investor protection. Since 2000, MFA has been the leader in developing, enhancing and promoting standards of excellence through its document, Sound Practices for Hedge Fund Managers (``Sound Practices''). As part of its commitment to ensuring that Sound Practices remains at the forefront of setting standards of excellence for the industry, MFA has updated and revised Sound Practices to incorporate the recommendations from the best practices report issued by the President's Working Group on Financial Markets' Asset Managers' Committee. Because of the complexity of our financial system, an ongoing dialogue between market participants and policy makers is a critical part of the process of developing smart, effective regulation. MFA and its members are committed to being active, constructive participants in the dialogue regarding the various regulatory reform topics.I. Systemic Risk Regulation The first step in developing a systemic risk regulatory regime is to determine those entities that should be within the scope of such a regulatory regime. There are a number of factors that policy makers are considering as they seek to establish the process by which a systemic risk regulator should identify, at any point in time, which entities should be considered to be of systemic relevance. Those factors include the amount of assets of an entity, the concentration of its activities, and an entity's interconnectivity to other market participants. As an Association, we are currently engaged in an active dialogue with our members to better understand how these factors, among others, may relate to the systemic relevance of all financial market participants--including our industry and its members. MFA and its members acknowledge that at a minimum the hedge fund industry as a whole is of systemic relevance and, therefore, should be considered within the systemic risk regulatory framework. We are committed to being constructive participants in the dialogue regarding the creation of that framework.A. Central Systemic Risk Regulator Under our current regulatory structure, systemic risk oversight is the responsibility of multiple regulatory entities, or worse, no one's responsibility. For systemic risk oversight to be effective, there must be oversight over the key elements of the entire financial system, across all relevant structures, classes of institutions and products, and an assessment of the financial system on a holistic basis. We believe that a single central systemic risk regulator should be considered to accomplish this goal. This central regulator should be responsible for oversight of the structure, classes of institutions and products of all financial system participants. MFA is engaged in discussions with its members with respect to which regulatory entity, whether new or existing, would be best suited for this role. We believe that having multiple regulators with responsibility for overseeing systemic risk likely would not be an effective framework. Jurisdictional conflicts, unintended gaps in regulatory authority, and inefficient and costly overlapping authorities likely would inhibit the effectiveness of such a regulatory framework. Moreover, in a framework with multiple systemic risk regulators, no one regulator would be able to assess potential systemic risks from a holistic perspective, as no regulator would oversee the entire system.B. Confidential Reporting to Regulator MFA and its members recognize that for a systemic risk regulator to be able to adequately assess potential risks to our financial system, that regulator needs access to information. We support a systemic risk regulator having the authority to request and receive, on a confidential basis, from those entities that it determines (at any point in time) to be of systemic relevance, any information that the regulator determines is necessary or advisable to enable it to adequately assess potential risks to the financial system. In considering the appropriate scope of this authority, we believe that it is important for the systemic risk regulator to have sufficient authority and flexibility to adapt to changing conditions and take a forward-looking view toward risk regulation. Attempting to pre-determine what information a regulator would need would not provide sufficient flexibility and likely would be ineffective as a tool to address potential future risks. We believe that granting the systemic risk regulator broad authority with respect to information gathering, along with ensuring that it has the appropriate resources and capabilities to effectively analyze that information, would be a more effective framework. While we support a systemic risk regulator having access to whatever information it deems necessary or advisable to assess potential systemic risks, we believe that it is critical for such information to be kept confidentially and granted full protection from public disclosure. We recognize the benefit of a regulator having access to all important data, even potentially sensitive or proprietary information from systemically relevant entities. A systemic risk regulator can fulfill its mandate to protect the financial system without publicly disclosing all the proprietary information of financial institutions. We do not believe that there is a public benefit to such information being publicly disclosed. Moreover, public disclosure of such information could be misleading, as it would likely be incomplete data that would be viewed by the public outside of the proper context. Public investors may be inclined to take action based on this data without fully understanding the information, which could lead to adverse consequences for those investors, for the investors in systemically relevant entities, and for the stability of the financial system as a whole. Public disclosure of proprietary information also harms the ability of market participants to establish and exit from investment positions in an economically viable manner. Such disclosure also could lead to systemically relevant entities being placed at an unfair competitive disadvantage compared to nonsystemically relevant entities, as sensitive and proprietary information of only the systemically relevant entities would be publicly available.C. Mandate To Protect the Financial System Setting a clear and specific mandate is important for any regulator to be effective. This is particularly true in a regulatory framework that has multiple regulatory entities, as a lack of clarity in the mandates of regulators can lead to gaps in oversight, or costly and inefficient overlapping regulation. We believe that the systemic risk regulator's mandate should be the protection of the financial system. Investor protection and market integrity should not be part of its mandate, but should instead be addressed by other regulatory entities. Congress should be clear in stating that the risk regulator should collect information only for its mandate to protect the financial system, and should not use that authority for other purposes. To fulfill its mandate to protect the financial system, we recognize that the regulator would need to take action if the failure of a systemically relevant firm would jeopardize broad aspects of the financial system. Absent such a concern about broad systemic consequences, however, the systemic risk regulator should not focus on preventing the failure of systemically relevant entities. Systemically relevant market participants do not necessarily pose the same risks or concerns as each other. There likely are entities that would be deemed systemically relevant for purposes of reporting information, but whose failure would not threaten the broader financial system. For this reason, we believe that the systemic risk regulator should focus on preventing failures of market participants only when there is concern about the consequences to the broader financial system, and should not focus on preventing the failure of all systemically relevant entities. Consistent with this mandate, the systemic risk regulator should not equate systemically relevant entities with entities that are too big, or too interconnected, to fail. An entity that is perceived by the market to have a government guarantee, whether explicit or implicit, has an unfair competitive advantage over other market participants. We strongly believe that the systemic risk regulator should implement its authority in a way that avoids this possibility and also avoids the moral hazards that can result from a company having an ongoing government guarantee against its failure.D. Scope of Regulatory Authority The last part of systemic risk regulation that I would like to address in my testimony is the scope of authority that a systemic risk regulator should have to fulfill its mandate to protect our financial system. There are a number of suggestions that various people have made as to the type of authority a systemic risk regulator should have. We continue to discuss with our members what the appropriate scope of authority should be for such a regulator. We believe that whatever authority the regulator has should ensure that the regulator has the ability to be forward-looking to prevent potential systemic risk problems, as well as the authority to address systemic problems once they have arisen. The systemic risk regulator's authority must be sufficiently flexible to permit it to adapt to changing circumstances and address currently unknown issues. An attempt to specifically define the regulator's authority must avoid unintentionally creating gaps in authority that would prevent the systemic risk regulator from being able to fulfill its mandate to protect the financial system in the future. We do believe that the systemic risk regulator needs the authority to ensure that a failing market participant does not pose a risk to the entire financial system. In the event that a failing market participant could pose such a risk, the systemic risk regulator should have the authority to directly intervene to ensure an orderly dissolution or liquidation of the market participant. The significant adverse consequences that resulted from the failure of Lehman Brothers, Inc. this past fall is an example of what can happen when there is not an intervention to prevent a disorderly dissolution of such a market participant. The continuing market disruption caused by the failure of Lehman Brothers also demonstrates the importance of ensuring that there is a coordinated global effort with respect to such interventions. Whatever the scope of authority that a systemic risk regulator has, its implementation of that authority will be critical to the effectiveness of any regulatory regime. We believe that the systemic risk regulator should implement its authority by focusing on all relevant parts of the financial system, including structure, classes of institutions and products. Because systemic risk concerns may arise from a combination of factors, rather than from the presence of any particular factor, a holistic approach is more likely to successfully identify and assess potential systemic risks. Recent coordinated efforts between the Federal Reserve Bank of New York (the ``New York Fed'') and industry participants provide a good example of how a systemic risk regulator could address systemic risk concerns posed by structural issues in our markets. In recent years, the New York Fed, working with MFA and other industry participants through the Operations Management Group (``OMG'') and other industry-led initiatives has made notable progress in addressing concerns related to the over-the-counter (``OTC'') derivatives market. Some of the more recent market improvements and systemic risk mitigants have included: (1) the reduction by 80 percent of backlogs of outstanding credit default swap (``CDS'') confirmations since 2005; (2) the establishment of electronic processes to approve and confirm CDS novations; (3) the establishment of a trade information repository to document and record confirmed CDS trades; (4) the establishment of a successful auction-based mechanism actively employed in 14 credit events including Fannie Mae, Freddie Mac and Lehman Brothers, allowing for cash settlement; and (5) the reduction of 74 percent of backlogs of outstanding equity derivative confirmations since 2006 and 53 percent of backlogs in interest rate derivative confirmations since 2006. In addition to these efforts, MFA, its members and other industry participants have been working with the New York Fed to expedite the establishment of central clearing platforms covering a broad range of OTC derivative instruments. We believe a central clearing platform, if properly established, could provide a number of market benefits, including: (1) the mitigation of systemic risk; (2) the mitigation of counterparty risk and protection of customer collateral; (3) market transparency and operational efficiency; (4) greater liquidity; and (5) clear processes for the determination of a credit event (for CDS).II. Prudential Regulation We recognize that, in addition to systemic risk regulation, some policy makers, regulators and authors of various reports (e.g., the Group of 30, Government Accountability Office and Congressional Oversight Panel) have contemplated the notion of a prudential regulatory framework, including mandatory registration for private pools of capital. There are a great many issues that should be considered in determining what, if any, such a framework should look like. As an Association, we are currently engaged in an active dialogue with our members on these critical issues and we are committed to being constructive participants as discussions on these issues progress. While many of the details regarding reform initiatives have yet to be proposed, we would like to share some initial thoughts with you on some of the key principles that we believe should be considered by Congress, the Administration and other policy makers as you consider prudential regulatory reform. Those principles are: The goal of regulatory reform should be to develop intelligent regulation, which makes our system stronger for the benefit of businesses and investors. Prudential regulation should address identified risks or potential risks, and should be appropriately tailored to those risks. Regulators should engage in ongoing dialogue with market participants. Any rulemaking should be transparent and provide for public notice and comment by affected market participants, as well as a reasonable period of time to implement any new or modified regulatory requirements. This public-private dialogue can help lead to more effective regulation and avoid unintended consequences, market uncertainty and increased market volatility. Reporting requirements should provide regulators with the right information to allow them to fulfill their oversight responsibilities as well as to prevent, detect and punish fraud and manipulative conduct. Overly broad reporting requirements can limit the effectiveness of a reporting regime as regulators may be unable to effectively review and analyze data, while duplicative reporting requirements can be costly to market participants without providing additional benefit to regulators. I would add that it is critical that any reporting of sensitive, proprietary information by market participants be kept confidential. As discussed in the section above on reporting to a systemic risk regulator, public disclosure of such information can be harmful to members of the public that may act on incomplete data, increase risk to the financial system, and harm the ability of market participants to establish and exit from investment positions in an economically viable manner. We believe that any prudential regulatory construct should distinguish, as appropriate, between different types of market participants and different types of investors or customers to whom services or products are marketed. While we recognize that investor protection should not be limited only to retail investors, we believe that a ``one-size fits all'' approach will likely not be as effective as a more tailored approach. Lastly, we believe that industry best practices and robust investor diligence should be encouraged and viewed as an important complement to prudential regulation. Strong business practices and robust diligence are critical to addressing investor protection concerns.III. Short Selling One issue in particular which has been the focus of a great deal of discussion recently is short selling, specifically the role of short selling in capital markets. Short selling, as recognized by the Securities and Exchange Commission (the ``SEC''), ``plays an important role in the market for a variety of reasons, including providing more efficient price discovery, mitigating market bubbles, increasing market liquidity, facilitating hedging and other risk management activities and, importantly, limiting upward market manipulations.'' \1\ Similarly, the FSA has noted that short selling is, ``a legitimate investment technique in normal market conditions,'' and ``can enhance the efficiency of the price formation process by allowing investors with negative information, who do not hold stock, to trade on their information.'' In addition, short selling can ``enhance liquidity by increasing the number of potential sellers,'' and increase market efficiency. \2\ We strongly agree with the SEC and the FSA that short selling, along with derivatives trading, provides capital markets with necessary liquidity and plays an important role in the price discovery process. Markets are more efficient, and securities prices are more accurate, because investors with capital at risk engage in short selling.--------------------------------------------------------------------------- \1\ Statement of Securities and Exchange Commission Concerning Short Selling and Issuer Stock Repurchases, SEC Release 2008-235 (Oct. 1, 2008). \2\ Temporary Short Selling Measures, FSA Consultation Paper 09/1 (Jan. 2009), at page 4.--------------------------------------------------------------------------- Short selling and other techniques, including listed and over-the-counter derivatives trading, are important risk management tools for institutional investors, including MFA members, and essential components of a wide range of bona fide cash and derivatives hedging strategies that enable investors to provide liquidity to the financial markets. We are concerned that requirements that investors publicly disclose short position information, or that create the potential for public disclosure, would negatively reduce overall market efficiency by undermining the important role that short selling plays in providing liquidity and price discovery to markets. The risk of public disclosure could cause investors, including pension plans and endowments, with billions of dollars of assets to withdraw capital and further disrupt already stressed capital markets. In the long-term, pension, endowment and foundation investors would forego diversification and risk management benefits provided by alternative investment vehicles. We believe that concerns which have led some to propose public disclosure of short positions could be substantially mitigated through effective, comprehensive reporting of short sale information by prime brokers and clearing brokers. Regulators could require short sales and short position information to be provided by brokers on an aggregate basis. A regulator could request specific information as to short sales and short positions of individual investors if it suspected or became concerned about manipulation of a particular security. Such reporting also would provide regulators with a more effective means by which to identify manipulative activity.Conclusion Hedge funds have important market functions, in that they provide liquidity and price discovery to capital markets, capital to companies to allow them to grow or turn around their businesses, and sophisticated risk management to investors such as pension funds, to allow those pensions to meet their future obligations to plan beneficiaries. MFA and its members acknowledge that smart regulation helps to ensure stable and orderly markets, which are necessary for hedge funds to conduct their businesses. We also acknowledge that active, constructive dialogue between policy makers and market participants is an important part of the process to develop smart regulation. We are committed to being constructive participants in the regulatory reform discussions and working with policy makers to reestablish a sound financial system and restore stable and orderly markets. MFA appreciates the opportunity to testify before the Committee. I would be happy to answer any questions that you may have. ______ FOMC20080916meeting--158 156,CHAIRMAN BERNANKE.," Thank you very much, and thanks, everyone, for very helpful comments. Let me try to summarize, and I will just make some comments, and then we can turn to the statement and policy. The group indicated, of course, that economic growth has slowed and looks to be quite sluggish in the second half. I didn't hear a great deal of change in the general profile, with most people still viewing growth as being slow in the near term but perhaps recovering somewhat in 2009. But obviously there is a lot of uncertainty surrounding that judgment. The ongoing problems in housing and the financial system are, of course, the downside risks to growth. Another factor, which is becoming more relevant, is the slowing global economy, which together with the stronger dollar may mean that U.S. export growth will be somewhat less. Despite the tax rebate, consumer spending seems likely to be weak in the near term, reflecting a variety of factors that we noted before, including housing and equity wealth, credit conditions, and particularly perhaps the ongoing weakness in the labor market. The labor market is deteriorating, with unemployment up, although UI programs may play some role in the unemployment rate. It is somewhat difficult to predict the peak of the unemployment rate, given the upward momentum we are seeing. Declines in energy prices, however, will improve real incomes and help consumer sentiment--so that is a potentially positive factor. The housing sector continues to be the central concern in the economy, in both the real and the financial sides. There are no clear signs of stabilization, although obviously regional conditions vary considerably. The government action regarding the GSEs has lowered mortgage rates and may be of some assistance. Credit conditions have tightened, though, in other areas as well, including nonresidential construction. Firms are continuing to struggle with weaker demand, higher uncertainty, and high costs. Manufacturing has been relatively stable to weaker, but we had at least one report of a survey that in the medium term the outlook is looking a little better. Inventories appear to be relatively well managed. Credit conditions for business vary, but there are indications that some firms are finding it very difficult to attract capital. Financial markets received a lot of attention around the table. Conditions clearly have worsened recently, despite the rescue of the GSEs, the latest stressor being the bankruptcy of Lehman Brothers and other factors such as AIG. Almost all major financial institutions are facing significant stress, particularly difficulties in raising capital, and credit quality is problematic, particularly in residential-related areas. One member noted that it is not evident that markets are clearly differentiating between weaker and stronger firms at this point. Deleveraging is continuing, and securitization markets are moribund. Credit terms and conditions are quite tight and may be a significant drag on the economy. However, the mediumterm implications of the recent increases in financial stress for the economy are difficult to assess. We may have to wait for some time to get greater clarity on the implications of the last week or so. On the inflation front, recent core and headline numbers have been high, reflecting earlier increases in the prices of energy and raw materials. There are positive factors, including the significant intermeeting declines in the prices of oil and other commodities, which, if maintained, would bring headline inflation down rather notably by the end of the year or next year. The dollar has also strengthened. Generally speaking, inflation expectations, though noisy, have improved. We have seen a decline in TIPS breakevens and some decline in survey expectations as well. But it was noted that the five-by-five TIPS breakeven remains above a level consistent with long-term price stability. Nominal wage growth has remained subdued so far, slack is increasing, productivity has been strong, and therefore, unit labor costs are well controlled. Again, all of these factors are positive in terms of a better inflation picture going forward. On the other hand, recent declines notwithstanding, the cumulative increases in commodity prices over the past year or so do remain large, and there is some evidence that these cost increases are being passed through into core prices. Commodity prices are extremely volatile, which makes inflation very difficult to forecast and makes the inflation outlook, therefore, quite uncertain. Wages could also begin to rise more quickly as the economy strengthens. For all these reasons, inflation risks are still in play and remain a concern for the Committee. Some participants reiterated their concern that maintaining rates too low for too long risks compromising our credibility and stimulating inflation over the medium run. That is a very quick survey of the comments. Are there any comments or questions? If not, let me just make a few comments. Personally, I see the prospects for economic growth in the foreseeable future as quite weak, notwithstanding the second quarter's strength. I think what we saw in the recent labor reports removes any real doubt that we are in a period that will be designated as an official NBER recession. Unemployment rose 1.1 percentage points in four months, which is a relatively rapid rate of increase. The significance of that for our deliberations is, again, that there does seem to be some evidence that, in recession regimes, the dynamics are somewhat more powerful and we tend to see more negative and correlated innovations in spending equations. So I think that we are in for a period of quite slow growth. That is confirmed by what we are seeing in consumption, which probably would be quite negative if it weren't for the remainder of the fiscal stimulus package. Other components of demand are, likewise, quite weak. We are all familiar with the housing situation. Some other factors that were supportive in Q2 are weakening--a number of people have noted the export growth. Actually, it is net exports--which is important--not just exports, and we are seeing both slowing growth in exports and some forecast of increased growth in imports. A factor that we haven't talked about much is the fiscal side. That has been supportive and may be less supportive going forward. Generally speaking, though, I do think--and I have said this for a long time--that the credit effects will be important. They operate with a lag. It is very difficult to judge the lag. But my strong sense is that they are still some distance from their peak; that they will begin to be felt outside of housing, in nonresidential construction, for example, in consumer spending, and in investment; and that this is going to be independent of last week's financial developments. I think that is going to be a major drag, probably well into next year. There are a few positives, which give some hope of some improvement next year. We have talked about energy and commodity prices as they relate to inflation, but of course, the decline in energy and commodity prices is also a plus for consumers and raises real incomes and would be supportive of sentiment, as we have already seen. There are a few positive indications here and there on the housing market, a few glimmers of stability, particularly in some regions. I think that the GSE stabilization is going to be very important. It has already lowered mortgage rates. It suggests that there will be a market for securitized mortgages, and I think that is positive. So if I wanted to outline an optimistic scenario, it would involve stronger indications of stabilization in housing, which in turn would feed into more confidence in the financial sector and would lead over time to improvement in the broader economy. I do think that financial conditions are a major concern. The situation right now is very uncertain, and we are not by any means away from significant systemic risk. Even if we avoid a major systemic event, the increase in risk aversion, the pullback from all counterparties, the deleveraging, the sale of assets--all of these things are going to continue for some time and are going to make the financial sector very stressed, which obviously will have effects on the economy. I have been grappling with the question I raised for President Lacker, and I would be very interested in hearing other views either now or some other time. The ideal way to deal with moral hazard is to have in place before the crisis begins a well-developed structure that gives clear indications in what circumstances and on what terms the government will intervene with respect to a systemically important institution. We have found ourselves, though, in this episode in a situation in which events are happening quickly, and we don't have those things in place. We don't have a set of criteria, we don't have fiscal backstops, and we don't have clear congressional intent. So in each event, in each instance, even though there is this sort of unavoidable ad hoc character to it, we are trying to make a judgment about the costs--from a fiscal perspective, from a moral hazard perspective, and so on--of taking action versus the real possibility in some cases that you might have very severe consequences for the financial system and, therefore, for the economy of not taking action. Frankly, I am decidedly confused and very muddled about this. I think it is very difficult to make strong, bright lines given that we don't have a structure that has been well communicated and well established for how to deal with these conditions. I do think there is some chance--it is not yet large, but still some chance--that we will in fact see a much bigger intervention at the fiscal level. One is tempted to argue that by doing more earlier you can avoid even more later, but of course that is all contingent and uncertain. So we will collectively do our best to deal with these very stressful financial conditions, which I don't think will be calm for some time. With respect to inflation, I accept the many caveats around the table. I have to say that I think, on net, inflation pressures are less worrisome now. The last two meetings have been very positive in that respect. The declines in energy and commodity prices are quite substantial. Natural gas, for example, has reversed all of its gains of the year. Steel scrap is down 40 percent in two months. We are seeing many other indications that commodity prices really have come down quite a bit. The dollar's increase is also quite striking, and we have talked about wages, TIPS, and other factors. So I think overall I see at least the near-term inflation risk as considerably reduced. I do agree, though, with the points that were made that we may well see pressure on core inflation for a while longer, despite this morning's reasonably benign number. The increases in commodity costs, although they have been partially reversed, have not been entirely reversed. Certainly over the last year to year and a half there is still a net substantial increase, which will show up as firms begin to pass through those costs. It is also the case, of course, that we have seen a very, very sharp movement in commodity prices and the dollar. Therefore, there is no logical reason why that couldn't be reversed. Clearly, one problem we face is that the uncertainty about forecasting commodity prices is so large that it makes our forecasting exercises extraordinarily uncertain and means that we need to be somewhat more careful than we otherwise would be if we were back in the days of the Texas Railroad Commission, when we knew the price of oil six months in advance. We don't have that privilege anymore. So I think core inflation may be elevated for a while. It may take a while for inflation to moderate. Everything I say is contingent on the dollar and commodity trends not being strongly reversed. But if those things are not reversed, I think we will see some improvement in inflation in the near term. I also agree with those who say that, when the time comes, we do need to be prompt at removing accommodation. It is just as much a mistake to move too late and allow inflation, and perhaps even financial imbalances, to grow as it is to move too early and be premature in terms of assuming a recovery. I think that is a very difficult challenge for us going forward, and I acknowledge the importance of that, which a number of people have noted. So that is a quick summary of my views. Let me just turn briefly, then, to policy. Do we have the statement? Let me just preview. I talked with Governor Warsh, and he gave me now during the break some of those suggestions he made. As they fit closely with other things that people said around the table, we have made a version here that incorporates them. I'll discuss that in just a minute. 3 First, as a number of people have said, let me just say that I thought the memo that the staff prepared over the intermeeting period was extraordinarily helpful. We have been debating around the table for quite a while what the right indicator of monetary policy is. Is it the federal funds rate? Is it some measure of financial stress? Or what is it? I think the only answer is that the right measure is contingent on a model. As President Lacker and President Plosser pointed out, you have to have a model and a forecasting mechanism to think about where the interest rate is that best achieves your objectives. It was a very useful exercise to find out, at least to some 3 The statement referred to here is appended to this transcript (appendix 3). extent, how the decline in the funds rate that we have put into place is motivated. In particular, the financial conditions do appear to be important both directly and indirectly--directly via the spreads and other observables that were put into the model and indirectly in terms of negative residuals in spending equations and the like. The recession dynamics were also a big part of the story. I hope that what this memo does for us--again, I think it's extraordinarily helpful--is to focus our debate better. As President Plosser pointed out, we really shouldn't argue about the level of the funds rate or the level of the spreads. We should think about the forecast and whether our policy path is consistent with achieving our objectives over the forecast period. I am sympathetic to the general view taken by the staff, which argues that those recession dynamics and financial restraints are important, that we are looking at slow growth going forward, and that inflation is likely to moderate. Based on those assumptions, I think that our policy is looking actually pretty good. To my mind, our quick move early this year, which was obviously very controversial and uncertain, was appropriate. Their analysis also suggests that the amount of insurance that we have is perhaps limited, given that they take a risk-neutral kind of modeling approach. Having said that, I think they have also clearly set out the conditions and the framework in which we can debate going forward exactly where we should be going. To the extent that those around the table disagree with the model or with the projection, then that is the appropriate way, it seems to me, to address our policy situation. So, again, I do very much appreciate that. It helped me think about the policy situation. As I said, I think our aggressive approach earlier in the year is looking pretty good, particularly as inflation pressures have seemed to moderate. Overall I believe that our current funds rate setting is appropriate, and I don't really see any reason to change. On the one hand, I think it would be inappropriate to increase rates at this point. It is simply premature. We don't have enough information. There is not enough pressure on inflation at this juncture to do that. On the other hand, cutting rates would be a very big step that would send a very strong signal about our views on the economy and about our intentions going forward, and I think we should view that step as a very discrete thing rather than as a 25 basis point kind of thing. We should be very certain about that change before we undertake it because I would be concerned, for example, about the implications for the dollar, commodity prices, and the like. So it is a step we should take only if we are very confident that that is the direction in which we want to go. Therefore my recommendation to the Committee--and I will open it up for comment in a moment--is to keep the funds rate at its current level. I listened very carefully to the conversation around the table in terms of the statement. I think it was President Lockhart, President Stern, and Governor Warsh, among others, who talked about strengthening the language on financial markets. So the draft statement that you have in front of you is an attempt to make that change. It has two changes relative to existing alternative B. First, as Governor Warsh suggested, it reverses the first two sentences and so focuses in the first sentence on ""Strains in financial markets have increased significantly and labor markets have weakened further,"" and then the rest of it is basically the same as it was. The other change, which is in the last paragraph in the risk assessment, is pretty small, but it is probably worth considering. The word ""closely"" has been added to suggest, obviously, that we understand that the situation is changing rapidly and that we are carefully following conditions as they evolve. Kevin, we took your word ""market"" there--what was the rationale for it? " CHRG-109shrg21981--178 Chairman Greenspan," The intial benifit is thereafter indexed by inflation, so that the real benefit doesn't change after retirement, whether it is at 62 or 65. And trying to get the average wage as the index creates a much higher initial benefit than were you to use prices retrospectively and the reason is that wages will reflect productivity increases, whereas prices will not. If you, however, now substitute prices for wages in creating the initial benefit, you will have essentially a benefit which, whereas now its ratio to your previous income has been stable, will begin to fall through time. And if you make a full adjustment going from a so-called wage-adjusted initial benefit to a price-adjusted initial benefit---- " FOMC20060920meeting--148 146,MR. KROSZNER.," Thank you very much. Unfortunately, I think we find ourselves in an uncomfortable position like that of six weeks ago, with a continuing mix of inflationary pressures and decelerating economic growth at the same time. I think the fundamentals are in place for a continued moderation of growth but not a contraction, much as the Greenbook describes. Obviously, housing is a risk that everyone has talked about. But the key, as many people have also mentioned, is maintaining contained inflation expectations, and that comes down to thinking about whether some of the factors that we’ve been seeing have been more transitory or more persistent. Let me first talk about growth and go through the C plus I plus G plus net exports. I would agree with the staff’s characterization that world economic growth is not quite as strong as some others have put forward. I don’t think we’re going to be seeing an enormous export boom. Also, as briefly mentioned, I see very little on the government stimulus side. Tax revenues, as Governor Warsh mentioned, were very high. Spending is being kept relatively tight. On investment, we’re seeing some strength in capital spending. My concern is, if consumption goes as low as the Greenbook suggests, what the return on this capital spending will be. Is it going into the right areas? I was a little concerned when President Poole mentioned that the air freight company is expanding rapidly but the on-the-ground delivery company is not expanding at all. So are they going to have to invest in parachutes to get these in? [Laughter] But that is precisely the concern that I have—that capital spending may not conform perfectly to what consumption demand is going to be. We certainly saw this in the late 1990s and early 2000s. I’m just a bit worried about that now, especially given the potential tension between slowing consumption and robust investment growth. Now, regarding consumption—we’ve talked about the potential support from lower energy prices and some positive wealth effect from stronger equity markets, but obviously housing is one key here. It’s a key partially in overall investment but also in the uncertainty that it causes in consumers’ minds. Housing is one of the worst areas for data. It’s very difficult for us to have any concept of what prices are doing because it’s not a market like any other. We do have the Case-Schiller index, and we do have some better indexes that people are now betting on, but they’re still very poor indicators of prices relative to the indicators we have in other markets. We also know that there can be queues and that extras can be thrown in, so there’s a lot of uncertainty with respect to where prices are going. That concerns me quite a bit because I think we just don’t have a good handle on it. Permits and starts have continued to come down from where they were at our last meeting and are now at levels of the beginning of 2003 or even starting to slip into 2002. If they flatten out there, the housing sector is still historically reasonably good. But there’s no indication that we’re necessarily at a turning point and that things are going to flatten out. There is the wealth effect, the direct effect on people’s consumption behavior of lower wealth going forward, and also the confidence effect. We don’t have a perfect analogy with the previous times in which we’ve seen these housing downturns— we have a different context in that the economy is broadly more robust—and so I think it’s less likely that we’re going to see a major housing problem. But I think it is a real risk, and we have to be sensitive to it. On the inflation outlook, we have to come back to transitory versus more-persistent components, as many people have mentioned in the discussion. Obviously, people are heartened that energy prices have come down, but I certainly would not put the same bet on the energy markets that one trader did in a hedge fund that got into a little trouble recently because we know that energy prices can move in ways we don’t expect. So I don’t want to take too much from that. I think it’s appropriate in the Greenbook to use the market’s expectations. What measure do we have other than market expectations? If we did have a better measure, then we’d be running one of those hedge funds. However, there’s a lot of uncertainty around that measure. So I certainly don’t want to bet on better inflation going forward just because we’ve suddenly seen a 15 percent decline in oil prices over the past six weeks. That said, it’s heartening that energy prices are unlikely to lead to greater inflationary pressures going forward than those when we paused six weeks ago. The rise in compensation is obviously troublesome—not if you are an employee receiving the higher compensation, but from our point of view. However, a lot of tension is in those data because we have the compensation numbers versus the ECI. There’s a big statistical discrepancy between gross domestic income and gross domestic product. It’s possible that some of the increase in compensation will be revised away, and we’ll see actually higher productivity growth. We just don’t know, and it may be a while before we see it. Also, as we discussed a lot last time but not this time, the continuing fairly wide margins that businesses are experiencing may come under more pressure and may absorb some of the increases in labor compensation. How much is uncertain, but that may be one potential offset. As many people have said, we can’t become complacent. Inflation expectations have behaved reasonably well since we paused at the last meeting, which is heartening in that the markets believe that inflation is reasonably under control in the near to medium term and even in the longer term. It’s hard to find evidence of increases in inflation expectations, but as many people have said, that does not mean that we don’t have to worry. We have to worry a lot because the key is keeping those expectations well contained. I think we’re in a situation in which we can do that. Slowing growth is not going to give us more of a benefit. The flatness of the Phillips curve, which people have talked about, is what the data have been over the past ten to fifteen years in the United States and most other countries. So even if there is a bit more slowdown, we are not necessarily going to get the potential benefit in significantly lower inflation pressures—maybe a little but not very much. So we still have to worry about the upside on inflation, and that’s why maintaining our credibility is of utmost importance." FOMC20051213meeting--28 26,MS. JOHNSON.," This is the time of year when folks young and old look forward to receiving a pleasant surprise or two—and not necessarily something that can fit inside a single stocking. We in the International Division have found ourselves pleasantly surprised by the strength of global economic activity during the third quarter, which is now evident in the data, and the indications that some of that strength is continuing. Accordingly, we have revised up our estimate of foreign real GDP growth for 2005 to near 3½ percent, about the pace we were projecting early last year. The baseline forecast this time calls for economic activity abroad to continue expanding at about that pace through the end of 2007. The greater-than-expected buoyancy of the global economy was widespread and does not appear to be explained by one or two special developments that have limited implications for future growth. Among the industrial countries, the strong performers such as Canada had another good quarter, with Canadian Q3 real GDP growth at 3.6 percent. But more sluggish regions, for example the euro area, also did moderately well, at 2.6 percent real growth. Labor markets have either continued to improve or remained solid. And German and Canadian orders data portend continued solid expansion. Among the Asian emerging-market economies, China, Taiwan, Hong Kong, Korea, the ASEAN countries, and India all performed well in the third quarter. In Latin America, a sharp rebound in Mexican GDP growth raised the average for the region despite a very weak quarter in Brazil. December 13, 2005 14 of 100 in the recent data. In contrast, in the major regions of the global economy, inventories do not appear excessive and in need of reduction. Private fixed investment has shown vitality in Japan, the euro area, the United Kingdom, Canada, China, and Mexico. These elements suggest the expansion will prove durable. In most foreign economies, financial conditions remain very favorable for growth. Equity prices, in particular, have risen substantially over the year, providing support for both private investment and consumption. Since the end of last year, equity prices have recorded double-digit increases in the foreign G-7 countries, with the more than 30 percent gain in Japan being particularly noteworthy. Among the emerging Asian countries, stock prices in Korea have surged over the year. In Latin America, Mexican and Brazilian stock prices have risen very sharply. Except for Canada, the major foreign industrial countries have all experienced expansionary depreciations of their currencies on balance over the year. For these countries, long-term interest rates remain low, ranging from about 1½ percent in Japan to 4¼ percent in the United Kingdom. We interpret the positive surprise in the pace of third-quarter activity as indicating somewhat greater fundamental economic momentum abroad than we recognized in the previous Greenbook. That momentum, in combination with the generally supportive foreign financial conditions, should sustain foreign real GDP growth, and we have accordingly raised our forecast for 2006 slightly. We expect that this continued moderate real output growth will be accompanied by little change, on average, in inflation abroad as the flat path projected for global crude oil prices over the forecast interval should result in some shifts down in headline inflation. Of course, risks of an acceleration in consumer prices abroad, owing to second-round effects from previous oil price rises, remain. Both the Bank of Canada and the ECB raised policy rates during the intermeeting period to counter any upward drift in inflation pressures or in inflation expectations. We expect further policy tightening in Canada in the next few quarters, more limited additional action by the ECB, and an end of the Bank of Japan=s policy of quantitative easing some time in 2006. December 13, 2005 15 of 100 deficits could increase. This feature of the December forecast is not such a pleasant surprise. Given today=s prices for energy, perhaps we would be better off with a lump of coal. David and I would be happy to answer any questions." FOMC20051213meeting--92 90,MS. BIES.," Thank you, Mr. Chairman. I want to echo Dave Stockton’s analogy of tidings of great joy in this forecast. I think the upward revision in growth and the downward revision in inflation are developments that we all welcome at this point in the economic expansion. As I tried to assess some of the information to see where I would want to come out on policy, I tended to take an approach similar to the one President Yellen took, in saying: Where do we stand at this point in our effort to remove accommodation, and where are we going as we move forward? In the alternative scenarios laid out in this Greenbook, there is really only one where long-term inflation expectations lose their anchor and which therefore gives me much concern. As I looked at where we are on inflation, I was struck that there is some good news and some bad news and that there are currently risks on both sides. Last year we saw inflation coming up from extraordinarily low levels— moving up from 1 percent to over 2 percent. It rebounded quickly, and I was one who was quite concerned by how quickly inflation had moved up. In the last six months, though, it has been 1.6 percent, which sounds like a fairly good area for it to be in. But the fact that it rebounded so fast clearly indicates that we always have to be very alert to developments on that front, because prices can move rapidly. The energy pass-through, I think, is a risk for higher inflation. I’d love to see the analysis that December 13, 2005 60 of 100 think we could see real concerns about disruptions and risks to the economy going forward—as a consequence, for example, of believing that energy prices are going to stay in a high range for several years or seeing the possibility of outright shortages in areas like natural gas. We’ve also seen that other central banks in the world are now expecting stronger growth and higher inflation in their economies. The ECB [European Central Bank], as was mentioned earlier, finally raised its policy rate, and even the Bank of Japan is coming out of a zero rate world. So some of the cushion we’ve had worldwide may be moderating, and that could produce more risks on the upside on inflation. On the other hand, when I look at what has been happening with jobs growth and labor compensation, I continue to be struck by how moderate the growth in compensation has been. The productivity story is clearly one reason for this. The numbers continue to amaze me at this point in the cycle. It’s easy to achieve productivity gains in a company early on when you have excess capacity. But this many years into an expansion, it really takes a ton of attention and effort. Another thing that often comes up in my conversations with business executives is this: They are sitting at very high levels of profit and cash flow generation; and when you ask them about their main challenges, they still say their primary challenge is to maintain profit growth. If you start to dig into that, you find that it’s beyond just managing wage costs and looking at capital. The lessons they learned in the ’90s in terms of really changing the way business processes are run are continuing to play a role in all of the decisions they’re making on issues like inventory management—not tying up capital either in inventory stored or in warehouse capacity. As I looked at last month’s numbers, inventory-sales ratios hit record lows. So clearly, businesses are continuing to learn more and more about how to keep inventory levels very, very December 13, 2005 61 of 100 through better information systems and better order management systems. They also are focusing a great deal on quality control, particularly in services and retail businesses, and in business services where that is a key differentiator with the competition. But better quality also has major cost benefits because it reduces errors and the need to redo work and it focuses on the timeliness of delivery. And these are the kinds of values beyond prices that customers are rating as increasingly important. So firms get both greater efficiency and value added for their customer base more than in the past. And finally, outsourcing—and I’m talking not internationally but simply outside of the core enterprise—is a business practice that evolved in the ’90s and has proven to be very important. In the old days when you ran a big corporation that was vertically integrated, there were cost centers throughout the organization and it was very hard for CFOs to get a handle on controlling costs. Now that the culture has become “if it isn’t a core function, you ought to try to outsource it,” the process of renegotiating with the contractors annually or semi-annually or every three years and of going out for other bids puts continual pressure on attaining productivity improvements and a favorable cost payback. But when the function was embedded in the bigger organization, the social politics sometimes got in the way and made it difficult to wring out the costs. The fact is that firms now try not to do everything, and to outsource functions unrelated to their core business. That this has become an ingrained practice in many companies is another theme I’m hearing. So, in short, I’m finding that changes in business practices are the focus of a lot of companies. And they believe that despite higher costs, they are going to be able to improve the value with modest price increases going forward. Pulling all of that together, I tend to think that we are very close to the end of the increases in interest rates that we need to implement. There are risks on both sides, but it strikes me, based on the December 13, 2005 62 of 100 a minute ago, according to the Bluebook, the real fed funds rate that we would have with a 25 basis point increase today is at the midpoint of the range of the staff’s estimates of equilibrium. Also, it’s above the funds rate derived from the policy rules for all of the alternatives. So we are close to where I think we need to be, given the forecast. As a result, I think we really do need to talk about how to make this transition and change our communication." FOMC20050630meeting--169 167,MR. RUDEBUSCH.," With regard to equity prices and bond prices, the reason I included that comparison was to make a couple of points. For one, the comment is often made that we can’t second-guess financial markets or financial market participants. It seems as if that may be true for equity market participants but less true for bond market participants. There I take “inflation scare” or “credibility gap” or “conundrum” all to be another term for a situation in which we have an idea of where the fundamentals are and we’re not sure what bond market participants are thinking. Now, it’s true that there’s a difference in that you have a clear idea about the reaction June 29-30, 2005 56 of 234 with transparency regarding your notion of fundamentals. So there is a clear difference between the markets. The housing market is different from both the bond and the equity markets, and the question is: Where can we draw the lessons? The regional disparity is completely different from both markets, and that’s just a separate issue. In any event, one reason behind the housing price appreciation, perhaps, is that we have very low long rates. This is a bond rate conundrum. Perhaps the misalignment in bond prices is leading to this misalignment in housing prices. So, one could perhaps make the argument that it’s the bond price experience in 1994 that may be the relevant one for today. I think I’ll stop there and leave it at that." FOMC20080430meeting--188 186,MR. HOENIG.," Mr. Chairman, I'm glad that reasonable people can differ. I do continue to hold the view that easing policy today is a mistake. If I were voting on it, I would vote to hold where we are. With the fed funds rate at the level it currently is, I think that continuing to ease policy in an environment of rising inflationary pressures gives serious erosion to our long-run credibility. We are seeing increasing signs that inflation expectations are rising. I see it constantly, as the public's inflation psychology is changing as well. This change reflects the large, sustained now, increases in food, energy, and other commodities and accelerating import prices. I am concerned that maintaining at this highly accommodative policy level for an extended period, while it may bring some short-run stimulus into the economy, increases inflationary risk to an unacceptable level, which will, over the not-too-distant future, begin to distort long-run investment decisions and continue to increase the risk of financial instability and imbalances in the longer-run. Finally, on the psychology of the markets, holding rates constant, although it might disappoint some on Wall Street, will please many, many on Main Street. I judge that it will confirm to the world that we are turning our attention to these longer-run issues, and I'm disappointed that we're not seizing the opportunity to make that statement. Thank you " FOMC20060808meeting--22 20,MS. YELLEN.," Thank you. I have a question for David and Karen, and it picks up on President Poole’s. My question has to do with what, if anything, we can learn about the role of energy-price increases as a factor raising core inflation here from the experience of other countries. Since we’re not the only country experiencing increases in energy and other commodity prices, my question is whether or not there is some econometric or other evidence that pertains to the degree of energy-price pass-through into core inflation in other developed economies. I’m thinking particularly of economies in which inflation expectations are reasonably well anchored—for example, the United Kingdom, Canada, and the euro area. What do we know about energy-price pass-through into core inflation? Is there evidence of that?" FOMC20060629meeting--151 149,MR. GUYNN.," Thank you, Mr. Chairman. Given our recent disappointing inflation experience and, more important, our forecast that suggests that inflation is likely to move at least somewhat higher over the forecast period, I’m solidly in favor of a 25 basis point move today. Like some others, I am less sure about the need for further increases at subsequent meetings. As yesterday’s discussion highlighted, our near-term policy decisions look to have become somewhat harder. There is the possibility that output may be slipping to below potential, and inflation has yet to respond in any convincing way to the tighter policy. Like others, even given that possible problem, I am more concerned about the upside inflation risk, given what I consider to be the greater consequences of an unwelcome development on the inflation side. Despite that leaning, I would emphasize the increased uncertainty we now face and the need to maintain some flexibility with regard to our subsequent policy actions. I want to go back to the last point I made, or tried to make, in yesterday’s discussion—the possible policy corner into which we may have unwittingly painted ourselves. Let me explain what I mean by that. In an effort to underscore our individual commitments to low inflation, many—and I think perhaps most—of us have over the last couple of years expressed a numerical range of price inflation that we would consider acceptable over the longer term. While those ranges have not all been the same, 1 to 2 percent on the core PCE price measure has been the most often mentioned and the range many outside commentators have picked up as what they believe us to consider as our informal target. The problem that we now face in my view is that our forecast for inflation over at least the near term, and perhaps extending into the intermediate term depending on how one defines that time period, does not have inflation moving down even to the upper end of that range. I was struck by the tabulations of the forecasts we turned in for the upcoming congressional testimony. Those showed a central tendency of 2¼ to 2½ percent core PCE inflation this year and 2 to 2¼ percent next year. The staff forecasts were even higher, at 2.4 percent this year and 2.2 percent next year. Using the confrontational language of one of my grandkids, I will say, “So?” In other words, what are we going to do about it? I think it’s reasonable to expect that people are going to be asking that question of us more and more. More important, we should be asking that question of ourselves. I find it interesting to think back as to how we may have individually hit upon 1 to 2 percent core PCE inflation as reasonable and achievable. I think it was substantially influenced by our very favorable experience during the 1996 to 2003 period, when we did have the measure comfortably within that range. But a decomposition of core PCE inflation for that period suggests that such a benign experience may have been an aberration. During that period, we experienced significant declines in goods prices, due largely to sharply lower worldwide demand and the persistent downward pressure on goods prices resulting from the emergence of China and other developing economies as goods producers. That pattern of goods price deflation has now changed, and goods prices in the aggregate are now not making a large negative contribution to overall inflation. In other words, it’s hard to attribute that brief historical period of low core inflation to our domestic monetary policy—it may have simply been good luck—and I think it’s a weak reed upon which to base our longer-run policy response and preference. The scenario in the Greenbook that has below-trend growth, unemployment above 5¼ percent, and near-term inflation accelerating underscores the difficult policy choices we may face. And the Bluebook’s modeling of what will be required to get inflation back under 2 percent is sobering. Yet if we continue to espouse a target range of 1 to 2 percent and do not behave in a way that seems to move us decisively in that direction, then I think we run the risk of a substantial loss of policy credibility. Finally, alternative C in today’s Bluebook table 1 hints at the kind of action and statement language that would seem to be consistent with a commitment to get back well within a range of 1 to 2 percent. I would not advocate that we go there today, but I think that construct serves to remind us of the need to begin to have such a discussion around this table. With regard to today’s statement, I like the way the various drafts have evolved, and I am generally comfortable with the latest alternative B language that we have before us. I was very uncomfortable with earlier language that toyed with the notion of commenting on and forecasting several very specific variables. I would urge us not to use the statement to elaborate on a rationale for our actions or to highlight a particular data series. I believe that’s best left to the minutes. Thank you, Mr. Chairman." FOMC20050920meeting--74 72,MS. JOHNSON.," Let me take it in two halves. I’ll talk a little about global energy use, and then we’ll come to the import price part. We model energy demand, energy consumption, energy production, and the implied change in inventories on a global basis. And we do it using all of the information we can muster. But it is understood by the people in that world that there is a lack of good information. There has been an outcry for more transparency about energy production and energy capacity than now exists. Some of the volatility that President Fisher was speaking to derives from the fact that when the IEA makes an announcement of a change in their estimate of what demand was last year it will move the market. So, the quality of the information that is available for the global market is certainly far from ideal. And some of the countries involved, of course, are in rather troubled political areas where being transparent about anything is not in their interest, so they don’t provide data. So that adds to the complexity. But we have an oil model and we use a lot of judgment—the add factors that David was talking about—and we attempt to account for total oil production in essence by country. It’s not that we think any individual number in that mix is going to be right in any sense, but we try to be consistent through the story. So we start with the futures curve for WTI, and we make some judgments about the spreads on things like Dubai and other oils that loom large in the global market, and we use the model to infer what the balance of supply and demand would have to be. And given that we have relied on the futures markets—basically for want of a view that we could do better than the futures market—supply becomes the residual. So we have forecasts of global demand of GDP. And we have different weights that apply to those that are the oil-using September 20, 2005 32 of 117 Now, part of your question was how often we change those weights and how sensitive we are to the shifts in production that are taking place in the world. I can’t speak to that specifically, but in general we revise our weights every year. It’s not as if we have weights from 1970 and we just keep cranking away using those weights. We’ve gone to this variable weight approach as in the GDP and everything else. So, we specifically do at least attempt to take account of how different countries use energy versus how other things happen. We have a set of energy-using weights that we apply to world GDP, and that gives us, in essence, a different aggregate for world growth than if we were doing it for some other purpose, which we do. So we’ve got a price and we’ve got demand, and we back out supply; supply becomes the residual. For example, two years ago when prices seemed to us to be rather high, we were inferring a need for supply to pull back in order to sustain those prices. And OPEC has played that role—Saudi Arabia, in particular. Go back and read Greenbooks from two to three years ago, and we had a story about expecting supply to contract in certain places in order for futures curve prices to be realized, as oil suppliers target prices, and so forth. That has not been so true lately. Indeed, we’ve been tapping capacity increasingly over the last two years. And the notion that global supply was more than enough to explain the prices we were seeing has flipped to become a question of where we are going to get the extra supply. For a time Russia and the FSU [Former Soviet Union] were a big source of extra non-OPEC supply. That seems to have changed more recently. So, there is a supply story that tries to take these things into account that matches demand and the futures curve to give a crude oil picture. September 20, 2005 33 of 117 contradiction there, we would have to go back and say something to ourselves about our assessment of demand. We take that picture, and for the United States—particularly this time more so than most—we have to ask questions about domestic capacity to supply the residual part. Would that have to be imported? And what would be the mix of those imports? So we try to make all of that fit. That leaves us then with an oil import price which can move differently than global crude prices because of the mix factor. And the oil import price is what feeds into the domestic economy and then drives the elements of pass-through and domestic production and so forth. Now, in our forecast of import prices the oil price portion is distinct from the non-oil portion, and it is non-oil import prices that in the projection come down. Those prices have been kicked around hugely by natural gas and by non-oil primary commodities. We have now internally, but we don’t put it in the Greenbook, import prices less natural gas as a check on whether we are fully incorporating what we think is happening to natural gas. But we don’t have a comparable setup for the supply and demand balance of natural gas that we have for oil, and the natural gas that would be relevant, obviously, is for North America as an almost isolated market. There is liquefied natural gas on the margin. There are some imports on the margin. But we are thinking that we might have to do something about the quantity of natural gas because it’s a hidden uncertainty in the overall non-oil import price, and it’s uncomfortable that we haven’t been able to have a better control over that. Even so, the non-oil, non-energy primary commodities have been the big story in import prices; they caused the import prices to move up. And the fact that those futures markets are September 20, 2005 34 of 117 that import prices are decelerating yet again—and to very low levels in 2006 and into 2007. That outlook is really a combination of what we think the non-energy futures markets are telling us about commodity prices and the maintained assumption we make about the dollar. Either of those things could change, and the forecast is completely conditional on them, with the added wrinkle of this role of natural gas that is embedded in non-oil import prices, but which probably should be separated out. Now, at least in terms of the work we do, we try to do that partially but maybe we should do it more explicitly." FOMC20050630meeting--170 168,MR. WILLIAMS.," In fact, the third scenario that I considered involved trying to emphasize that point—namely that, at least by some measures that people have come up with, there is a big difference in where bond rates are relative to standard estimates of fundamentals. It’s actually a much bigger problem for the economy than just the house-price effect directly, at least according to the FRB/US model. More importantly, it could be one of the factors driving a big part of the house- price appreciation. In terms of needing strong house prices to keep the economy moving, the way I view your third question is that if it weren’t for the house-price run-up, monetary policy would need to be easier, given current economic conditions. And I think that’s absolutely right. One way to think about my scenarios is just to reverse the signs, especially in scenarios 1 and 2, and think about it as this as the positive stimulus we’ve gotten from a 20 percent appreciation of housing prices and this is the positive effect we’ve gotten from some other factors. Especially scenario 1, I think you can see that way. The reason I mentioned the misallocation of resources toward housing-related activities in June 29-30, 2005 57 of 234 is that they actually lead to, as Glenn mentioned, a misallocation of resources. Therefore, these gaps between fundamental prices and actual prices should appear in the policymaker’s objective function, in addition to inflation, output and employment. So there is a notion here that that’s just another problem that you would want to balance off if you could. Now, I’d like to emphasize in my closing remarks that the assumption that you could affect the bubble is very problematic. As Josh himself mentioned, these relationships between housing prices and interest rates are just not as strong as one would think and not as strong as economic theory would suggest." FOMC20081216meeting--140 138,MR. STOCKTON.," We are looking for about minus 0.5 percent in December and minus 0.1 in January. We are also not expecting the core figures to remain as low as they have been running for the past month or two. We do think that they have been held down by some very significant declines in air fares. That could continue for another month or two--again, as the energy price pass-through works. They have also been held down by some very large declines in lodging away from home, which is a volatile series, and it is not likely to sustain this level. Despite the fact that we don't see them as low as they have been the past two months--that is, declining to flat--we are expecting some fairly small increases going forward. We have core inflation heading down, and all of these exhibits have shown a significant reduction in price pressures coming from import prices, from energy prices, and from broader commodity prices as well as the increase in slack that, as Stephanie pointed out, is keeping a real lid on labor costs. " FOMC20070321meeting--79 77,MR. HOENIG.," Mr. Chairman, I’ll spend a little time on the District. I think you can describe it as almost robust, recognizing that we are a District that exports a lot of raw materials and byproducts of raw materials. We have had solid job gains led by further tightening in our labor markets, and recent revisions suggest that 2006 job growth was stronger than we had previously thought. Mining led the job growth, but we also saw strong gains in professional and business services and in leisure and hospitality. In fact, our ski season this year was a record, as the snow was also a record. Besides shortages of skilled labor, of which we are constantly getting reports, we are seeing also shortages of some lower-skilled workers as well—in the temporary employment area, for example. It is also noteworthy that our manufacturing activity has been strengthening. We have received good reports from our directors and advisory council members that it actually strengthened in February. Lower inventories of finished goods led to a surge in order backlogs, and most industries reported robust activity led by machinery and high-tech equipment production. In addition, plant managers expressed greater optimism about the outlook for employment and capital spending as they look forward, not as they’re looking right now. Turning to real estate, housing activity may have stabilized. We have suffered like the rest of the country in that area, especially in our Denver market, where we have had record levels of foreclosure. But beyond that—and even there—we have seen some stabilizing in our housing market, and our commercial activity remains really quite solid. Housing permits and the value of new residential construction held steady in February. In addition, the buildup of home inventories has actually slowed, and District contacts expect inventories to decline gradually in the coming months, as they are now seeing things turn. Nonresidential construction remains strong, with absorption of office space increasing in most cities and vacancy rates continuing to decline throughout our region. Commercial real estate contacts expect more new construction in the months ahead. They are actually seeing it come on the drawing board. They also reported that office prices and rents increased further, even though sales were somewhat flat over the last month or so. Farm financial conditions have improved overall, with increased crop prices that are being driven by the expanded ethanol production. USDA forecasts that net farm income will rise about 10 percent this year. Strong income prospects have boosted land prices—significantly, I might add, in some parts—and solidified farm balance sheets. One piece of information I would note is that ethanol is a boom industry right now in the region—not in just our region but in the area around Nebraska and Iowa. In that area, 100 plants are producing; there are 50 on the drawing boards, but we are seeing some backing away from that. Three projects have been pulled back in Oklahoma recently, and one more in Kansas. But still, a lot are going forward, and it gives me some pause because it has the tone of too much, too quickly, and the real economy will suffer if it backs away from that development. Anyway, on balance, the regional economy is very strong right now. Turning to the national outlook, I would say that, on balance, although I have revised my outlook down somewhat in 2007, I still have it projected as growing on the whole for the year better than 2½ percent. So my outlook is more optimistic than that of the Greenbook. There are some reasons for that, at least that we’re thinking through. Like others, we see housing stabilizing, perhaps taking a little longer to come back, but inventories seem to have stabilized. As those inventories are worked off through the first half of this year, we think housing should improve through the rest of the year, at least given where the fixed interest rates lie. We’re also seeing that the secondary effects of the slowing of the housing market seem contained at the moment, so that slowing is not spilling over, and the containment is being strengthened by the facts that personal incomes are actually continuing to improve and that we have a good labor market. So those factors are important. Also, as we discussed earlier, foreign demand is strong, and the outlook seems to be good. Finally, federal spending—the fact is that we’re fighting a war, and you tend to spend more over the course of a war—is picking up I think. Coffers are strong, and states are spending at a fairly rapid rate. So a lot of factors are affecting demand, and therefore I think that this economy will pick up as the year goes on. I recognize very clearly that there are some risks to keep in mind. One is that the housing market could worsen, and there could be further spillovers. I’m very mindful of that. But on the other side, I do share some of the concerns raised by others in terms of the inflation outlook. Inflation has not come down as much as we had hoped, although I’m still projecting that it will so long as we keep the rates at their current levels. But there are some upside risks with the tighter labor market and strong demand, and we could see energy prices putting more pressure on it. So it’s a mixed bag perhaps with, on balance, some upside risk as well as downside risk to this economy. Thank you." FOMC20050322meeting--97 95,MR. HOENIG.," Mr. Chairman, looking at the economy, we expect growth will be in line with what others have said—in the 4 percent range this year and slightly above 3½ percent next year. With trend growth of about 3¼ percent, obviously the output gap and labor market slack are diminishing. There are a whole host of reasons for that, which Dave already outlined, and I won’t repeat them. I will say that from the Tenth District perspective, our information supports this more robust March 22, 2005 28 of 116 addition, travel and tourism continued to improve, as the dollar has helped to increase ski visits and hotel occupancy in the mountain states. Labor markets remain strong, with hiring announcements exceeding layoffs by about a 1¼-to-1 ratio since our previous FOMC meeting. And, finally, District manufacturing continues to expand strongly. Production, new orders, and employment all rose in February. Moreover, firms remain optimistic about future activity and plan moderate increases in employment and capital spending going forward this year. I’ll make most of my comments on the inflation outlook, because I do have some concern about that. I was struck by David’s point that, as for inflation breaking out, he would put it in terms of a “not yet” statement. But as I view the outlook, I expect, even with the fed funds rate rising as we currently are projecting, that inflation will increase and perhaps could accelerate in 2005 and 2006. Here are some reasons for that. First, we have been in an accommodative mode of policy for an extended period of time now—years, not quarters—with the fed funds rate below most estimates of neutral over much of that period. Core inflation, by whatever measure you pick—core CPI or PCE or the market-based core PCE—drifted higher last year. Not only did core inflation drift higher, it was unexpectedly higher than earlier projections. This unexpected increase is notable because it occurred even though real GDP growth was as expected and the fed funds rate was being increased. If inflation could increase that much last year in the presence of sizable slack and a rising fed funds rate, I am concerned that, with less slack in the economy this year, we will end up with yet higher inflation. In addition, a number of indicators suggest continuing inflationary pressures. For example, we have higher cost pressures resulting from higher commodity prices, which we mentioned, and March 22, 2005 29 of 116 in unit labor costs that may not be dramatic yet, but they are increasing. Wage pressures are emerging in our District. About a quarter of the employers we contacted said that they’ve had to raise wages more than normal, particularly for skilled workers. We are also seeing evidence of increased pricing power in the Tenth District, as firms have more confidence in their ability to raise output prices even without an increase in input costs. For example, we asked our survey participants a special question about whether their ability to raise prices had improved since the beginning of just this year. Of 77 responses, more than half said clearly yes. The final reason I see an upside risk for inflation is that monetary policy does, in fact, remain accommodative. The federal funds rate is currently below most estimates of the neutral rate. Even with the Greenbook’s assumptions of tighter policy, the fed funds rate will end the year below or at the lower end of estimates of the medium-run neutral rate. This poses a significant upside risk to inflation, because it is likely that much of the slack in the economy will have been eliminated by the end of the year. With output close to potential and core inflation elevated, I think we should aim to be comfortably within the range of neutral by the end of the year, not at the lower end. Overall, with growth above trend, I am concerned that there is an upside risk to inflation even with the funds rate path consistent with the projections we are seeing currently. I believe we should begin moving more aggressively to bring the fed funds rate closer to the long-run neutral rate sooner. I would submit that, as long as the funds rate remains significantly below neutral, the risk that we will need to raise it 50 basis points can be managed. Now, I say that, but I also realize that a 50 basis point increase, while it could be justified, would surprise financial markets. So perhaps we should begin to signal the market that a more aggressive return to neutral is at least possible. But March 22, 2005 30 of 116 prefer to shorten it and drop any reference to measured pace. After reading the minutes in three weeks, markets will know that a more aggressive policy is possible. In other words, we don’t have to provide a long explanation today. And in fact, in testimony you gave earlier, I think you dropped the “measured” language; therefore, I don’t think changing that part of the statement would surprise the markets at all. Thanks." CHRG-109hhrg31539--202 Mr. Bernanke," Then you are going to have a lot of power of firms to pass through their cost because high demand means that they will have the power to raise their prices. What we want to make sure is that those high energy prices-- " FOMC20050630meeting--34 32,MR. STOCKTON.," Mr. Chairman, we have, in fact, looked at farmland values and at the data that are collected by the Reserve Banks, and there has been an appreciable acceleration in June 29-30, 2005 25 of 234 Francisco District or the Richmond District, where the interface of the urban expansion into agricultural areas probably is greater, we’ve seen a much more pronounced acceleration than, for example, in the Dallas District. As we put that all together, it is true that we don’t have a good series broken down by regional land prices per se. But it’s very difficult to believe that the acceleration we’ve seen in residential property prices doesn’t reflect to a very significant degree an increase in land prices. While it may be difficult to do Morris’s type of calculation, we just haven’t seen anything like the acceleration in basic construction costs that would suggest anything other than a substantial increase in land values. And when we looked at those farmland prices to see if there was some confirmation of that impression in the agricultural land prices, it seemed pretty clear that we were seeing that. Again, that doesn’t necessarily mean that the farmland is overvalued. I think the same questions are open on the agricultural land prices as they are in Dick’s and Josh’s debate about whether or not housing is overvalued, but there has been a substantial step-up in recent years." FOMC20060510meeting--54 52,MS. JOHNSON.," On the international side, two major developments during the intermeeting period merit some further discussion this morning: the rapid and sizable run-up in global prices for crude oil and the significant depreciation of the exchange value of the dollar in the second half of the period. Those developments occurred against a background of continued strong global growth, with some economic indicators again surprising us on the positive side for some countries. As a result, we are still expecting moderately strong foreign real GDP growth at an annual rate of 3½ percent over the forecast period, with inflation projected to remain contained although upside risks are a concern. When we finalized the March Greenbook forecast, the spot price of WTI was just over $60 per barrel. Last week, as we completed the forecast for this meeting, that price reached about $75 per barrel before partially retracing. The intervening seven weeks had witnessed almost daily tales of woe of higher prices, with the supply problems in Nigeria proving more persistent and serious than earlier thought and tensions over the nuclear program of Iran adding to heightened pressures on energy prices. In addition, outages of U.S. crude production as a result of the hurricanes continue, as do issues regarding supply from Iraq and Venezuela. Events in Bolivia have also rattled the energy market. As a result, and consistent with the shift in futures prices for the rest of this year and next, we raised the projected path of the U.S. oil import price about $10 per barrel. As in March, that path rises slightly through the end of this year and then is about flat in 2007. One significant and direct consequence of the higher oil prices is an increase in the U.S. oil import bill from that forecast in March. In the baseline forecast, the value of oil imports has been revised up $34 billion for this year and $48 billion for next. As a consequence, of the approximately $150 billion widening of the U.S. nominal trade balance that we now project from the fourth quarter of last year to the final quarter of 2007, just about one-third is accounted for by the enlarged oil bill. The overall trade deficit is now expected to be about 6½ percent of GDP at the end of next year. A second consequence of higher global oil prices is that the revenues to the world’s oil exporters have significantly increased. This positive change to the external revenue of these countries has raised a number of questions about their propensities to import and from whom and their decisions about how to hold the funds that they have received and have not as yet spent on goods and services. Data on the portfolio allocation of oil revenues by many exporting countries are sparse; in many cases, the funds are held by national oil companies or in special stabilization funds, neither of which are likely to be included in reports of foreign official reserves. Moreover, officials in some of these countries tend not to reveal detailed information about their holdings. A case can be made that increased revenue flows to these countries over recent years likely added to overall global net saving and contributed to low long-term interest rates globally. It is still uncertain whether their behavior has had or will in the future have a systematic influence on exchange rates. From U.S. TIC data, we have some limited information about some categories of dollar holdings that are current through March of this year. As was reported in Part 2 of the Greenbook, inflows of foreign official assets in the United States held by OPEC countries were quite strong in the fourth quarter of last year and in January. However, in February and March those inflows dropped sharply, as did aggregate official inflows from other non-G-10 countries. For total portfolio inflows to the United States that combine public and private investors, funds from oil exporters (including the Middle East, Mexico, Russia, and Norway) were more than $25 billion in the first quarter—a pace comparable with that in 2005. The $25 billion inflow compares with estimates of the net oil revenues of the oil exporters of about $200 billion in the first quarter. Again, the monthly data show a sizable step-down in the size of inflows after January. Among the oil exporters, there is some variation across countries in their inflows into the United States. After showing positive inflows in the previous two years, net outflows were recorded for both Russia and Venezuela in the first quarter. In contrast, inflows from Middle East oil exporters, Mexico, and Norway were strong. All told, although total inflows for oil exporters remained near rates in 2005, there are some hints of possible diversification away from assets held in the United States by some oil-exporting countries, especially in more recent months. I should note that these countries may hold dollar assets outside the United States; changes in such holdings are not captured by the TIC data and may give rise to entries for countries such as the United Kingdom that are the location of major global financial intermediaries. We have only extremely partial data for U.S. financial inflows in April, so it is not possible to relate the recent sharp depreciation of the dollar to any pattern in such data. The exchange value of the dollar fell significantly against all the currencies of our index of major industrial country trading partners as well as against the currencies of Brazil, Korea, Chile, and most other Asian emerging-market economies. This broad-based decline reflects a significant change in preferences on the margin among at least some global investors and may alter expectations of some of those holding large amounts of dollar assets. Over the intermeeting period, U.S. long-term nominal interest rates moved up nearly 40 basis points. But rates rose 20 or more basis points in most foreign industrial countries. Real long-term interest rates taken from inflation-indexed, sovereign securities in Japan and the euro area also rose about 20 basis points, comparable to the change in U.S. inflation-indexed rates. A significant decrease in the market value of the dollar with no evident change in relative real rates of return on comparable fixed-income securities could indicate an increase in the risk premium attached to holding dollars, or it could signal a change in perceptions of the long- run real exchange value of the dollar. Even given lags in the underlying relationships, the weaker projected path of the dollar does show through in our forecast. For real exports of core goods, the drop in the level of the dollar to date and the slightly faster pace we now project for real dollar depreciation imply that relative prices will boost growth of these exports about 1 percentage point more over the remainder of the forecast period than we thought in March, based on our model. For real exports of services, the story is similar. For core import prices, our equations imply a positive effect, concentrated in this year. However, when incoming data and other factors are taken into account, our projection for import price inflation is only a little above that in the previous Greenbook, and so the net effect on real imports is negligible. For real imports of services, a negative effect from higher relative prices is evident in the baseline projection. For the nominal measures at the end of the forecast period, total exports are revised up, but total imports are up more. The enlarged oil bill accounts for virtually all of the upward revision to nominal total imports. As a consequence, the trade deficit has been revised to a somewhat larger figure. That change is significantly offset by the effects of the lower dollar on projected investment income. The lower dollar is positive for investment income as it translates earnings abroad of U.S. firms into more dollars. In addition, in our forecast those earnings are directly boosted by higher oil prices. All told, our outlook for the current account deficit is for more-rapid deterioration this year than we previously thought but a deficit at the end of 2007 that is only slightly larger than we had been expecting in March. David and I would be happy to answer any questions." CHRG-111hhrg56766--250 Mr. Bernanke," I have not heard anything to the contrary. I guess you would have to ask the investors. To respond to your earlier point, I think mark-to-market can be very useful in terms of information, but I think for banks, which have long-term loans on their books, often it is very difficult, because there is no liquid market, it is very difficult to get an accurate price of what a long-term loan might be worth, and even a large commercial real estate loan might be very hard to price accurately. For capital and regulatory purposes, I think you do need to look at the hold to maturity prices as well as the mark-to-market prices. Mr. Miller of North Carolina. I will yield back the little bit of time I have left. " FOMC20051101meeting--123 121,MR. GUYNN.," Thank you, Mr. Chairman. Let me first share some thoughts on recent economic developments in our Southeast region. As you would expect, we’ve continued to assess the regional and national implications of Hurricane Katrina, and now Hurricanes Rita and Wilma, which have added to our woes. The recent employment statistics serve as a real-time barometer of the hit our region has taken. Across the states involved, through September our District has lost approximately 300,000 jobs from the storms. Ironically, businesses in the affected areas trying to restart their operations November 1, 2005 46 of 114 downtown New Orleans, one sees help wanted signs on every corner. The inability to get evacuees from the area back into local housing has clearly slowed the process of business recovery. In fact, if one thing related to the storms now stands out, it’s the lingering uncertainty on several fronts and what now looks to us to be a longer rebuilding and recovery period. Indications are that it could well be several more months before oil and gas production and processing return to near normal. The latest reports from our contacts indicate that almost 7 percent of U.S. daily oil production and 9½ percent of U.S. natural gas production remain shut in. The assessment of damage and the repairs to pipeline and production facilities in the Gulf continue to be hampered by equipment and labor shortages. Louisiana refineries are slowly coming back on line, but by current estimates up to 6 percent of total U.S. refining capacity will remain off line until at least early next year. And U.S. refineries are reportedly now operating at only about 80 percent of capacity. The situation with respect to natural gas is even less clear than for refined products, and there remains widespread concern that potential shortages over the winter could keep natural gas prices elevated for a while. At the time of our last meeting, I expressed concern about the impact of the storms on shipping and port facilities. It now appears that activity is slowly returning to the Port of New Orleans, constrained by labor availability and access to land transportation. By and large, ships that were inbound to New Orleans were diverted to other ports, so there wasn’t as much disruption to the nation’s imports as there was to those exports that depended upon the Mississippi River and Louisiana ports. At the last meeting I also indicated that while we expected a significant regional hit to output, that would quickly be replaced by spending on cleanup and rebuilding. This is generally happening, November 1, 2005 47 of 114 year when insurance assessments have been completed and comprehensive plans are put in place. Commercial contractors note that there was a strong backlog of work prior to the hurricanes; and this, coupled with labor shortages, will constrain the pace of rebuilding at least for a while. At the national level, I agree with the Greenbook’s assessment that despite our heartaches along the Gulf Coast, the national economy seems to have remained relatively strong. And this was reinforced by last Friday’s initial reading of third-quarter real GDP. I view the economy as continuing on a path of about trend. However, I continue to wonder how the consumer will respond to higher energy prices. So far, the impact hasn’t been great, but there may be some important substitution effects when the consumer is faced with substantially higher heating costs during the winter on top of still-elevated gasoline prices. Spending may not decline, but more household funds may be allocated to energy and less to other goods and services, and this could cause second-round effects in terms of cutbacks in production and investment. In addition, we do know that auto sales dropped early in the fourth quarter, due in part to energy concerns but also due to a retreat from employee pricing. I’ve gotten some recent and interesting anecdotal information that is consistent with my concern about consumption and consumer substitution effects. Last week I chatted with a major wholesale supplier of groceries who has seen a significant recent pickup in business. He noted that core wholesale grocery sales are notoriously steady and boring, and he attributed the measurable pickup in recent weeks to the fact that more people were likely eating in and, hence, were buying more groceries. Similarly, an Atlanta director who is president of a major building materials and consumer products firm noted that his away-from-home product sales—staples like paper towels and toilet tissue sold to restaurants—were slowing and that retail home product sales were up. He November 1, 2005 48 of 114 This same director, however, also commented on how serious the price pressures were due to energy and freight costs. His company experienced a substantial earnings decline in the third quarter, as he wasn’t able to pass on all of his cost increases to his customers. Taken together, recent data and these kinds of anecdotes suggest to me that downside risks to consumer spending still remain elevated. This brings me to the inflation risk, which is my major concern. As already noted by a number of people, we experienced a significant increase in both headline CPI and PPI inflation last month, which was expected. This was largely due to energy and, in my view, is likely to be temporary. At the same time, the core measures remained relatively stable, but the anecdotes about growing price pressures and actual or intended price increases seem to be at odds with this continuing, going forward. I note, too, like others, that the Greenbook has built in more of a pass- through of energy and other price increases into core inflation next year. There are some possible explanations that we’ve all given at one time or another for this seeming disconnect, including the fact that the economy is relatively more energy-efficient and that we are evolving into a more service-oriented economy so that energy is a much less direct component of consumption. And perhaps most importantly, there’s the fact that intense competition is limiting the ability to pass input price increases through to customers—for instance, the difficulty I noted earlier that the consumer products firm was having in passing on energy costs. A large athletic apparel manufacturer in our District, the Russell Corporation, attributed a large share of their third-quarter earnings decline to higher costs for poly-cotton blends that could not be passed on, very specifically because of intense foreign competition. But these questions about pricing power are not, in my view, reasons to be complacent about November 1, 2005 49 of 114 in the system, and significant fiscal spending associated with hurricane-related rebuilding has yet to come on stream. My concern is that deviating from our path of gradually removing policy accommodation at this time could signal that we are less concerned about inflation and, therefore, cause some deterioration in inflation expectations. It is this threat that I think we need to guard against. I view the cost of ratcheting down inflation expectations, should they get out of hand, as being great. So I’d argue that we need to continue on our current path, at least for a while longer, including raising our fed funds target rate by 25 basis points today. As several of us have said today and in previous recent meetings, deciding what to say following today’s meeting may be more difficult than deciding what to do. Realizing that our discussion of the statement often gets truncated, I also want to put down a brief marker. Given my concern about keeping inflation expectations in check, I would prefer a statement that is somewhere between Bluebook alternatives B and C. I’m concerned that “C” is too strong, but I am particularly uncomfortable with the balance of risk characterization in option B. President Yellen has just offered some attractive statement language for us to consider, and I think it’s terribly important that we make time at this meeting or at some other meeting in the near future to begin to talk about that seriously. Thank you, Mr. Chairman." CHRG-110hhrg44901--25 Mr. Bernanke," Congressman, I couldn't agree with you more that inflation is a tax and that inflation is currently too high, and it is a top priority of the Federal Reserve to run a policy that is going to bring inflation to an acceptable level consistent with price stability as we go forward. I would make one distinction, which is that what the Federal Reserve can control is the increase in prices on the average, over the overall basket of consumer goods and services. The enormous jumps in oil prices and other commodity prices are to some extent at least due to real factors out of the control of the Federal Reserve. The Federal Reserve cannot create another barrel of oil. It is the global supply and demand conditions which are affecting those particulars things to the most significant extent, but to the extent that the Fed does have influence on the overall inflation rate, you are absolutely right that it is very important to maintain price stability, and I take that very seriously. Dr. Paul. But if the oil prices were going up for another reason other than monetary reasons, other prices would have to come down because there would be a limit in the money supply. I think--and the prices are going up today, like I indicated in my opening statement, not necessarily because of the monetary policy of the last year but maybe for the last 15 or 20 years and the fact that we were able to export, so to speak, our inflation. Now it is coming home. Those people who have been holding these dollars are not wanting to buy them as readily. Fortunately, foreign central banks are still not dumping them but even the other central banks might not be as cooperative. So I still see tremendous pressure. I don't see any signs that you are able to do very much because all we hear about is more inflation. You know, it is not so much that they are too big to fail. It just means that everybody needs to be propped up. Congress participates in it. And all the pressure is put on the dollar. It is a dollar bubble. And I think what we are seeing is the unraveling of a dollar bubble that had been building for more than 35 years. " FOMC20070509meeting--90 88,MR. REINHART.,"3 Thank you, Mr. Chairman. I’ll be referring to the materials that were passed around during the coffee break. For the past few years, the Committee has taken a “belt and suspenders” approach to providing guidance to financial markets by characterizing both the likely direction of interest rates and the risks to its dual objectives. In March, you loosened the belt a few notches by replacing the reference to “additional firming” with more-balanced language but retained the macroeconomic assessment that inflation risks were the more serious concern. The top left panel of your first exhibit provides one way to score the immediate market consequences of that change. The black and red bars, respectively, plot the changes in two- and ten- year Treasury yields in the one-and-a-quarter-hour window bracketing the 2:15 p.m. release of statements for the past two years. As some of you predicted, market participants saw particular significance in the March announcement that the Committee was apparently no longer presuming that its next action would be a firming, and two- and ten-year yields fell 10 and 5 basis points, respectively, the biggest moves in the sample shown. After a bit of confusion about what the statement really meant, markets ultimately got the message, aided in part by Chairman Bernanke’s testimony, your speeches, and the minutes. I take from this the sense that the wording of the statement is important [laughter], but that there are also other opportunities to provide a more-nuanced policy message. The message that market participants got both from you and from the incoming data, on net over the intermeeting period, is seen in the top right panel by the shift from the dotted red to the solid black line depicting the path of the 3 Material used by Mr. Reinhart is appended to this transcript (appendix 3). expected federal funds rate. Futures quotes now imply a consensus that policy will be kept on hold today and at the June meeting but then will be eased ¾ percentage point by the end of next year. This modest upward repricing of money market futures yields accompanied a reemergence of remarkably benign financial conditions, the subject of the three middle panels. Corporate bond spreads (at the left) and implied volatilities on equities and money market futures (in the middle) retraced much of the run-up of late February to end the period at relatively low levels by historical standards. Equity prices, at the right, gained 7 percent to reach new highs. As you’ll see a little later, this addition to household wealth pushed up estimates of the equilibrium real federal funds rate and may importantly influence your thinking about near-term economic prospects. In the bottom left panel, I trot out the usual suspects for why stock prices rose. First-quarter earnings reports were solid, so higher share value may just be a bet on rising domestic and foreign profits—the latter seeming especially more secure in light of the apparent vigor of the global economy. Our estimates of the equity premium— one of which is shown at the bottom right as the spread between the forward earnings-price ratio and the long-term real interest rate—narrowed a bit, suggesting that investors were more accepting of risk. Also, investors may see less risk, as in answer C. Potentially bad things that seemed palpable as the subprime market melted down did not go bump in the night—that is, downside risks to the outlook appeared to ease. What is the right answer to this multiple choice test? I think (D), all of the above, in that the world’s growth prospects seem a little more assured and, as a result, investors see fewer risks and are more willing to take them on. That backdrop leads naturally to a discussion of policy choices, which begins by examining the case for alternative B, which is in your next exhibit. The last time that you sat at this table to consider the setting of policy, you chose to keep the federal funds rate at 5¼ percent. The way the staff has filtered the flow of information since March has produced only minor changes to their outlook for real GDP growth, the top left panel, and core PCE inflation, the top right panel. So, if you were content in March, would you not be so in May? Keeping the nominal funds rate at 5¼ percent is consistent, as plotted in the middle panel, with the real federal funds rate, the solid black line, rising to continue to match the Greenbook-consistent measure of its equilibrium value, the dotted green line. If you believe that framework, this stance of policy should return the level of output to its potential within three years. Some of you might argue that such an outcome is not good enough. With core PCE inflation lingering above 2 percent, a more forceful working down of inflation—perhaps even at the cost of creating some slack—may be required for acceptable economic performance. While that may be a relevant consideration, risk-management issues may tug in the opposite direction. In particular, and as shown by the solid line in the bottom panel, the staff forecast puts real GDP growth in the neighborhood of 2 percent for the next six quarters. Times in which economic growth has been at or has dipped below 2 percent—the dashed horizontal line—have often been followed by recession—the shaded regions. Concern that the economy would be flying close to stall speed may stay your hand from dealing more aggressively with inflation. Indeed, concerns about growth may incline you to believe that your next policy action will be an easing—the subject of the left column of charts in exhibit 3. As has been true for some time, the case for alternative A rests importantly on your assessment of the housing market. New-home sales, the solid black line in the middle panel, have taken another step down, further elevating the months’ supply of unsold new homes, the dotted red line. This inventory correction will impose a drag on residential investment for some time—and could get worse if the availability of funds tightens some more in light of the woes in the subprime mortgage market. You also might now harbor doubts that businesses will step up their spending, which would otherwise have cushioned any slowing in the growth of aggregate demand. While the latest readings on orders and on shipments of capital goods, plotted as the solid black and dotted red lines, respectively, in the bottom left panel, were encouraging, you might dismiss those as one month’s noisy signal around a downward-pointing trend. In addition, you might see financial markets as ripe to correct, once investors come to appreciate that earnings prospects are as tepid as in the Greenbook forecast. But risks to economic growth are not the Committee’s sole concerns. In March you identified the failure of inflation to moderate from its current elevated level to be the predominant concern. The case for alternative C, presented in the right panels, probably hinges on the view that inflation is not clearly on a downward trend, seen in the middle panel by inflation as measured by the core PCE price index (the solid black line) and the market-based core PCE index (the dotted red line). In addition, the outlook for inflation may now be seen as less favorable than in March, given the run-up in the prices of oil and other commodities. As shown in the bottom right panel, futures-market participants have revised up their forecasts for the prices of these items well into the future. If the pace of moderation of core inflation turns out to be even slower than previously anticipated, you might be concerned that long-run inflation expectations will drift up, making for difficult policy choices going forward. The prevailing expectations of inaction, shaped in part by official comments, may take alternatives A and C off the table for today. But any inclination to favor the arguments in either the right or the left columns should influence your choice of language in the statement, the subject of your last exhibit. This exhibit is just table 1 repeated from the Bluebook with no emendation. I note that, in the discussion of communications, the Committee thus far has been reluctant to specify an inflation goal consistent with its dual mandate. However, by describing current inflation as “somewhat elevated,” as was the case in March, you are implicitly characterizing the upper limit of your tolerance for inflation, just as you delimited its lower bound in the summer of 2003 with talk of “unwelcome disinflation.” Market participants will read much into your choice of words when the time comes to change that characterization. So, at some point, you will have to come to terms with your preferred specification of your inflation goal, either directly through deliberations on communication policy or indirectly through the wording of the statement. That concludes my prepared remarks." CHRG-111hhrg52397--132 Mr. Price," Yes. " CHRG-110hhrg46596--451 Mr. Price," How do you know? " CHRG-111hhrg54868--139 Mr. Price," That is my concern. " CHRG-109hhrg28024--212 Mr. Price," Thank you. " CHRG-111hhrg54867--233 Mr. Price," Thank you. " CHRG-111hhrg48868--153 Mr. Price," Could they have been used more wisely? " CHRG-111hhrg48674--226 Mr. Price," I didn't-- " FOMC20050630meeting--212 210,MR. GALLIN.," If you look at the pattern of the green line, the constant-quality and the cost line move roughly together. Obviously, the constant-quality price index has increased more rapidly recently, because that index does capture partially, I think, increases in land prices. But I think that the gaps between the three lines are telling us quite a bit about what’s going on with regard to the price of land sitting under the entire stock of housing." CHRG-111hhrg63105--55 Mr. Johnson," Back in the heartland, a lot of people believe, rightly or wrongly, that prices don't always reflect supply and demand. I think you have expressed that too. I have a question and then kind of an unrelated comment. In your judgment, either witness's judgment, do you think the level of prices that ag commodities are at today is a result of the supply and demand factors and/or speculation? And how would you allot each in terms of what impact you think those respective forces are having in our market prices? " FOMC20080130meeting--335 333,VICE CHAIRMAN GEITHNER.," Thank you. I agree with President Poole and President Yellen about the need to focus on compensation structures and incentives, but just two observations. One is that, if you look at compensation practices among the guys who actually look as though they did pretty well against those who didn't do so well--I'm not talking about in a mortgage-origination sense but in the major global financial institutions--the structure of compensation doesn't vary that much. What varies a lot is how well people control for the inherent problems in the basic compensation structures. Remember Raghu's presentation was mostly about hedge fund compensation, and I think he is mostly wrong when you think about that and the incentive structure. The difference really is how you design your limits to make sure that your traders' incentives are more aligned with the incentives of the firm as a whole. The biggest errors and differences are in the design of the process of the checks and balances to compensate for the inherent problems in the compensation structure. That's important to know because a lot of these things, if you look at the formal attributes of the risk-management governance structure across these firms, don't look that different. What distinguishes how well the guys did is much more subtle around culture, independence, and the quality of judgment exercised at the senior level, and this is important because, when you think about what you can do through supervision and regulation, to affect that stuff is hard. I have a question for Pat. Pat, not to overdo this, but where do you put in your diagnosis of contributing factors the constellation of financial conditions that prevailed during the boom and what those did to housing prices? You know, there's a tendency for everybody to look at regulation and supervision and the incentives that they have created or failed to mitigate, but there is a reasonable view of the world that you wouldn't have had the pattern of underwriting standards of mortgages without the trajectory of house prices that occurred. Sure, maybe what happened in the late stage of the mortgage-origination process contributed to the upside, but if you look at a chart, the rate of house-price appreciation started to decelerate about the time you had the worst erosion in underwriting practices. Anyway, my basic question is, Where do you put the constellation of financial conditions, not so much just what the Fed was doing but what was happening globally that affected long rates, expectations of future rates, et cetera? " CHRG-111hhrg52397--236 Mr. Sprecher," Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, my name is Jeff Sprecher, and I am the chairman and chief executive officer of IntercontinentalExchange, which is also known by our New York Stock Exchange ticker symbol as ICE. I very much appreciate the opportunity to appear before you today to testify on the over-the-counter derivatives regulation. And, Congressman Scott, thank you for your kind introduction earlier today. In the mid-1990's, I was a power plant developer in California, and I witnessed the State's challenge in launching a market for electricity. Problems arose from a complex market design and partial deregulation, and I was convinced that there was a more efficient and transparent way to manage risks in the wholesale markets for electric power and natural gas. Therefore, in 1997, I purchased a small energy trading platform that was located in Atlanta, and I formed ICE. The ICE over-the-counter platform was designed to bridge a void that existed between a bilateral, voice-brokered over-the-counter market, which were opaque, and open up futures exchanges, which were inaccessible or they lacked products that were needed to hedge power markets. ICE has grown substantially over the past decade, and we now own three regulated futures exchanges and five regulated clearinghouses. Yet, we still continue to offer the over-the-counter processing along with futures markets. In discussing the need for the over-the-counter regulation, it is important to understand the size of the over-the-counter derivatives market and their importance to the health of the U.S. economy. In this current credit crisis, derivatives have been commonly described as complex, financially engineered products transacted between large banks. However, in reality, an over-the-counter derivative can encompass anything from a promise of delivery in the future between a farmer and his grain elevator, to a uniquely structured instrument, like an exotic option, and much of the Nation's risk management occurs in between these two extremes. Derivatives are not confined to large corporations. Small utilities, farmers, manufacturing companies and municipalities all use derivatives to hedge their risks. Providing clearing, electronic execution and trade processing are core to ICE's business model. As such, my company would clearly stand to benefit from legislation that required all derivatives to be traded and cleared on an exchange. However, forcing all OTC derivatives onto an exchange would likely have many negative and unintended consequences for our markets as a whole. In derivative markets, clearing and exchange trading are separate concepts. At its core, exchange trading is a service that offers order matching to market participants. Listing a contract on an exchange does not necessarily mean it will have better price discovery. Exchange trading works for highly liquid products, such as the Russell 2000 or standardized commodity contracts that appeal to a whole host of a broad set of market participants. However, for many other markets, exchange trading is not the best solution as the market may be illiquid, with very wide bid offer spreads, leading to poor or misleading price signals. Nonetheless, these illiquid products can still offer value to hedgers and thus they have a place in the over-the-counter deliberative market. Turning to clearing, this technique gracefully reduces counterparty and systemic risk in markets where you have standardized contracts. However, forcing unstandardized contracts into a clearinghouse could actually increase market risk. Where the market depth is poor or the cost of contracts are not accurate for price discovery, it is essential that the clearinghouse be operated so that it can see truly discovered value. So while ICE certainly supports clearing as much standardized product as is possible, there will always be products which are either non-standard nor sufficiently liquid for clearing to be practical, economic or even necessary. Firms dealing in these derivatives should nonetheless have to report them to regulators so that regulators have a clear and a total view of the market. ICE has been a proponent of appropriate regulatory oversights of markets and as an operator of global futures and over-the-counter markets, we know the importance of ensuring the utmost confidence, which regulatory oversight contributes to. To that end, we have continuously worked with regulatory bodies in the United States and abroad to ensure that they have access to relevant information that is available from ICE regarding trading activity in our markets. We have also worked closely with Congress and regulators to address the evolving oversight challenges that are presented by complex derivatives. We continue to work cooperatively to seek solutions that promote the best marketplace possible. Mr. Chairman, thank you for the opportunity to share our views with you, and I will be happy to answer any questions that you may have. [The prepared statement of Mr. Sprecher can be found on page 182 of the appendix.] " FOMC20060328meeting--164 162,CHAIRMAN BERNANKE.," Thank you. I would like now to summarize these views and add a few comments of my own. At that point, if there are additional comments or questions, they will be welcome. We have had, I think, a fairly upbeat group here the last couple of days, which is of course good, both in terms of views of economic activity and in terms of keeping inflation well controlled. The economy appears to be quite strong, but my sense is that most people feel that risks on that score are relatively balanced, which I take to imply that, after being strong in this quarter, growth will slow to something closer to a more-sustainable pace in the remainder of the year. Perhaps the leading source of uncertainty on the output side is the housing market, but I was reassured to hear that most participants think that a decline in housing will be cushioned by strong fundamentals in terms of income, jobs, and continuing low interest rates. The labor market is clearly continuing to strengthen, but I heard not too many concerns about increasing wage pressures. There was some discussion about shortages of more highly skilled workers, which presumably might affect wages at some point but apparently has not so far; and there was additional discussion of productivity gains, which are helping to keep unit labor costs down and to support growth. On the inflation side, I have not been in this conversation for a while, but I was impressed at least relative to a year ago that the angst about inflation seems to have declined. Clearly, inflation expectations are well anchored. Margins are high, and the sense of the group was that pass-through to consumer inflation was likely to be limited. Still, I took from the group some sense of at least a slight upside risk to inflation, reflecting the increasing resource utilization; the fact that inflation is somewhat on the high side of what many people describe as their comfort zone; and the fact that, if inflation does rise, there will be costs to bringing it back down and maintaining our credibility. So that is my overall summary of the Committee discussion. My own views, you will probably not be surprised to hear, are not radically different from what we have heard around the table. I would point out, first, that except for housing, the economy continues to be very strong. One might be tempted to average the expected rate of growth of the first quarter at about 4½ percent with the 1½ percent of the fourth quarter and say we’re at a pace of about 3 percent, but then I would remind you that we had 4.1 percent in the third quarter despite Katrina and about 3.7 percent average growth in the first three quarters of ’05. We have a strengthening world economy. We have consumption that looks likely to be well supported by income and jobs. Several people have talked about the strength of investment in nonresidential construction. Job creation at about 200,000 a month is clearly above the long-run sustainable rate. So except for housing—and that is, of course, a critical sector—it looks as though the economy is, if anything, growing more quickly than potential. Housing is the crucial issue. To get a soft landing, we need some cooling in housing. So far there is a good bit of evidence that there has been a peak, but we do not know a great deal more than that. So obviously we are going to have to watch carefully. The range of possible outcomes is quite wide. I agree with most of the commentary that the strong fundamentals support a relatively soft landing in housing. A pessimist might point out that the expectation of future price increases is itself an important part of the user cost of housing. A sea change in people’s views about what is going to happen to house prices in the future might significantly affect their perceived cost of owning a house and lead to lower prices and to weaker activity. On the other side, residential investment is, of course, only about 6 percent of GDP, and so long as consumption is well maintained by incomes, jobs, and other factors, I think it would take a very strong decline in the housing market to substantially derail the strong momentum for growth that we are currently seeing in the economy. What we might see in the next few quarters is some quarter-to-quarter variation. We may not have the stability of growth that we have had the last couple of years. If that happens, we should be willing to accept it. I might offer a very rough analogy to the way we think about energy prices and core inflation. With core inflation, our goal is to accommodate energy prices but to make sure that they do not get into the underlying rate of inflation. Again, this might be a rough analogy, but if the housing market moves significantly, we should perhaps not try to upset that movement but rather just try to ensure that the resources that are released are deployed in the rest of the economy and that the rest of the economy remains on a stable path. Again, I think we are unlikely to see growth being derailed by the housing market, but I do want us to be prepared for some quarter-to- quarter fluctuations. So, broadly speaking, I agree with the Committee that we should see some cooling for the remainder of the year and that we should approach a more-sustainable pace of growth. But I think there is some upside volatility risk, if you will, because of the fluctuations in residential investment. On inflation, like most of you, I am struck by how well behaved core inflation has been. Indeed, in 2005, core inflation was even slightly lower than it was in 2004, and we have all pointed to a number of explanations, including well-anchored inflation expectations, international competition, productivity growth, and since I wasn’t here, I can say good Fed policy. [Laughter] One area of uncertainty in trying to look forward is unit labor costs. Remarkably, unit labor costs in the nonfarm business sector grew only 1.3 percent in 2005, but as was already mentioned in the staff presentation, I think that understates the trend because it is coming off the surge in the fourth quarter of ’04 in bonuses, stock options, and other types of one-time compensation. If you smooth through that bulge, it looks as though the underlying trend of unit labor costs is more like 1.7 percent, and perhaps that may have some upward bias. There is certainly a lot of uncertainty about that, though. We have seen some indicators, such as average hourly earnings, rising. Other indicators, such as the employment cost index, are slowing. I just point this out as a significant source of uncertainty, given how difficult it is to forecast both compensation and productivity going forward. So, again, the stability of inflation in the last couple of years is very reassuring. I would note, however, that over the past three years, since 2003, we have seen a pickup in inflation. That was, of course, by design, but I think it is important for us to think about why that happened. There’s something of an identification problem here. To the extent that the increase in inflation over the last two to three years reflected the pass-through of energy costs and commodity prices, that is actually good news in a sense because, to the extent that those factors soften and flatten in the coming year, we should see some reduction in inflation in ’06 and ’07. To the extent that inflation increases in the last two and a half years reflected increased resource utilization, the strength in the economy, and the return of pricing power, however, there is a bit of concern that we may see some additional updrift of inflation in the next few quarters. Like most of you, I am not at all alarmist about inflation. I think the worst that is likely to happen would be 20 or 30 basis points over the next year. But even that amount is a little disconcerting for me. I think it is very important for us to maintain our credibility on inflation and it would be somewhat expensive to bring that additional inflation back down. So my bottom line on inflation is that there is a very modest upside risk. Again, I think it’s not a large risk but one that we probably should pay attention to. Are there any comments or questions to close our round on the economic outlook? If not, we can move to the policy round. In a moment I’m going to turn to Vincent to introduce the policy options in the statement. Before I do that, I just want to note that we have left unresolved the discussion about the ownership of the statement—in particular, what we are voting on when we vote at the end of the meeting. Currently we vote on the action, on the directive, and on the risk assessment but not on the rationale. The rationale has, however, been largely a consensus paragraph worked out by the Committee. My sense is that this decision is not entirely separable from a wide range of other issues we may want to talk about over the next few quarters concerning the content of the statement, its structure, whether we use forward-looking language, and whether we consider adopting some kind of numerical guidepost for inflation. And so what I would like to do, if it is okay with the Committee, is to maintain the status quo for today in terms of our voting in this statement. By the next meeting, in May, I will come back to the Committee with a proposal for a process by which we can address this whole range of issues over a period of time, and on the top of the agenda for that process will be the ownership of the statement. Is that acceptable? All right. Seeing assent, we will maintain the status quo on the statement just for today. Vincent, whenever you are ready." FOMC20060920meeting--121 119,MS. YELLEN.," Thank you, Mr. Chairman. Since our last meeting, the data bearing on the near-term economic outlook suggest both slower economic growth and a bit less core price inflation going forward. In terms of economic activity, the recent news has been uniformly negative, resulting in a significant downward revision to growth in the Greenbook. Indeed, compared with the outlook of other forecasters, the Greenbook’s projection of real GDP growth for the second half of this year is quite pessimistic; it would now rank in the lower 5 percent tail of the distribution of individual Blue Chip forecasters. I think this pessimism is not completely unfounded, however, largely because of my worries about the housing sector. The speed of the falloff in housing activity and the deceleration in house prices continue to surprise us. In the view of our contacts, the data lag reality, and it seems a good bet that things will get worse before they get better. A major homebuilder who is on one of our boards tells us that home inventory has gone through the roof, so to speak. [Laughter] He literally said that. With the share of unsold homes topping 80 percent in some of the new subdivisions around Phoenix and Las Vegas, he has labeled these the new ghost towns of the West. In fact, he described the situation at a recent board meeting in Boise. He had toured some new subdivisions on the outskirts of Boise and discovered that the houses, most of which are unoccupied, are now being dressed up to look occupied—with curtains, things in the driveway, and so forth—so as not to discourage potential buyers. The general assessment is that this overhang of speculative inventory implies that permits and starts will continue to fall. Inventory ratios will rise, and the market probably will not recover until 2008. So far, builders remain hesitant to cut prices, fearing that doing so will cause a surge in cancellation rates on sold but unfinished homes. However, builders now routinely offer huge incentives, and price cuts appear inevitable. We have been following the Case Schiller house-price index, which is based on house-price data in ten large urban markets, three of which are in California. Beginning in May of this year, futures contracts on this price index also began trading; they suggest that house prices will be falling at an annual rate of about 6 percent by the end of this year. Of course, trading in this new futures market is still somewhat thin, but it is a signal that we need to keep a very close eye on the incoming data and watch whether the housing slowdown is turning into a slump. Turning to inflation, core measures of consumer price inflation remain well above my comfort zone, but the latest readings on consumer prices have been modestly better. Unlike the Greenbook, I think the outlook for inflation has actually improved a bit since our last meeting largely because of the recent drop in commodity and crude oil prices. The relief on energy prices is, of course, very welcome, but we do have to be careful not to overestimate the extent to which past energy price pass-through has been boosting core inflation. For example, airfares might seem like an obvious case in which outsized consumer price increases reflect energy price pass-through. However, our staff recently calculated the share of jet fuel costs to total airline operating expenses and estimated that the jump in those costs likely accounted for less than half the rise in airfares this year. Instead, airfares may reflect strong demand and constrained capacity as indicated by very high airline passenger load factors. Still it seems likely that energy pass-through has played at least some role in the run-up of core inflation this year, so any energy price pressure on core inflation is likely to dissipate over time. Now, as David noted, the Greenbook has completely offset the favorable effects on core inflation from lower energy prices by boosting the growth rate of labor costs. In contrast, I attach a little less weight to the recent data on compensation per hour. My guess is that most of the difference between hourly compensation and the ECI does relate to profit-linked items like bonuses and stock options, and that suggests to me that marginal costs of production are not rising significantly faster. Even if they are, it remains true that markups are high. So with sufficient competitive pressures, firms have room to absorb cost increases without fully passing them into prices. Finally, I want to add my compliments to those of others to the Board’s staff for a very interesting analysis of inflation dynamics and monetary policy. As I mentioned at our last meeting, it may be unduly pessimistic to assume that the recent rise in inflation will be highly persistent. Over the past ten years, estimated reduced-form models suggest that core inflation generally returns to its sample average after several quarters. Recently our staff examined persistence at a more disaggregated level and found that the same general pattern also holds for each of the major components of the core PCE price index, with price inflation for durables only slightly more persistent than price inflation for nondurables and services. In the current situation, this suite of regressive models indicates that core PCE inflation should fall to just below 2 percent by the middle of next year. I am not quite as optimistic as these simple models, but on balance my concerns about the inflation outlook have been slightly alleviated by recent developments." FOMC20071031meeting--75 73,VICE CHAIRMAN GEITHNER.," As the Chairman said at the Economic Club of New York, it is likely to emerge stronger. I think the outlook looks about the way it did in September. Just a few quick points. Financial market conditions are substantially better than during the peak of the panic in mid-August; but the improvement, as many of you said, is still quite limited and uneven. Sentiment is still quite fragile, and I think we still seem likely to face a protracted period of adjustment ahead as the markets work through the substantial array of challenges remaining. Growth in the United States and in the world economy in my view seems likely to slow— more here, of course, than elsewhere. Here, even though the nonhousing, non-auto parts of the U.S. economy don’t yet show significant evidence of a considerable slowdown of actual or expected demand, I think that still seems likely. In our central scenario, though, housing construction weakens further. Housing demand slows further because of the tightening of credit conditions. Prices fall further. Consumer spending slows a bit, and businesses react by scaling back growth in hiring and investment, and this produces several quarters of growth modestly below trend. I think that growth outside the United States is likely to slow a bit. It will slow toward potential, if not all the way to potential, in those economies that have been growing above potential. Although the world is larger in relative terms and somewhat less vulnerable to a U.S. slowdown than it once was, it seems to me very unlikely that domestic demand in the rest of the world will accelerate as domestic demand slows in the United States. So the risks to this outlook for U.S. growth still seem to lie to the downside. The magnitude of the downside risks may be slightly less than in September, but they remain substantial. I think the main source of this downside risk to growth is the interaction between expectations of recession probability and the credit market dynamics. Each feeds the other. As the outlook for housing deteriorates and the recession probability stays elevated, financial institutions and investors stay cautious. That caution, in turn, slows the pace of recovery in markets—in asset-backed, securitization, and structured-credit markets—and in credit growth more broadly. As expectations adjust to anticipate a longer, more-substantial period of impairment in markets, then recession probability at least potentially increases. I think that the underlying inflation numbers and the measures we use to capture underlying inflation do not suggest any meaningful acceleration in underlying inflation, and we still expect the core PCE to run at a rate below 2 percent over the forecast period. In some ways, though, the inflation outlook now feels a bit worse. It feels worse because of the modest rise in breakevens that we saw following our last meeting and because of sentiment in markets around gold, commodity and energy prices, and the dollar. The fact that breakevens at long horizons have risen or failed to fall as monetary policy expectations have shifted down is not the most comforting pattern out there. So I think we need to be very careful not to encourage any sense in markets that we’re indifferent to those potential risks. Having said that, I think the risks to that inflation forecast are roughly balanced. The range of tools we have for measuring equilibrium combined with what you see in financial market expectations suggests that monetary policy, to assess the real short-term interest rate, is at or above most estimates of neutral and, therefore, is still exerting some modest restraint on growth. The expectations now built into markets imply too much easing over the next eighteen months, more than I think we’re likely to have to do. But I think the appropriate path of monetary policy lies under the Greenbook’s assumption. Thank you." CHRG-110shrg50369--111 Mr. Bernanke," On your second concern, I think we are better off now than we were in the 1970s in that there is a much broader recognition of the importance 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 is likely to go. The Federal Reserve has emphasized the importance of maintaining price stability and has indicated that we will watch very carefully and make sure that we do not 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---- Senator Schumer. But do you believe if you miscalculate and inflation starts coming out of the box more quickly than you think, do you have tools to deal with that or is that still a very difficult area, once inflation rears its head, it is very hard to put the genie back in the bottle? Or are we much better at it now than we were 20 years ago? " FinancialCrisisReport--542 On May 11, 2007, Mr. Sparks notified Goldman senior executives that marking down the value of the unsold CDO securities so that, internally, the firm understood their current market value had become a “real issue”: “Cdo positions and market liquidity and transparency have seized. I posted senior guys that I felt there is a real issue. ... We are going to have a very large markdown – multiple hundreds. Not good.” 2385 That same evening, Mr. Lehman sent out a “Gameplan” to colleagues in the Mortgage Department announcing that Goldman was going to undertake a detailed valuation of its CDO 2 securities using three different valuation methods, and would also take “a more detailed look” at the values of the assets in the CDO warehouse accounts and in Goldman’s own inventory. 2386 Also on May 11, Chief Credit Officer Craig Broderick sent an email to his team to set up a survey of Goldman clients who might encounter financial difficulty if Goldman lowered the value of the CDO securities they had purchased. 2387 As explained earlier, some Goldman clients had purchased their CDO securities with financing supplied by Goldman that required them to post more cash margin if the financed securities lost value. Other clients had invested in the CDO securities by taking the long side of a CDS contract with Goldman and also had to post more cash collateral if the value of the CDO securities declined. All of these clients would also have to record a loss on their books due to the lowered valuations. With respect to the CDO securities that had yet to be sold, Goldman senior executive Harvey Schwartz raised another issue related to lowering the values of the CDO securities Goldman was selling to clients: “[D]on’t think we can trade this with our clients andf [sic] then mark them down dramatically the next day. ... Needs to be a discussion if that risk exists.” 2388 In an email to Mr. Sparks, Mr. Montag, and Mr. Schwartz, Goldman senior executive Donald Mullen acknowledged concerns “about the representations we may be making to clients as well as how we will price assets once we sell them to clients.” 2389 The executives also agreed, however, not to “slow or delay” efforts to sell Timberwolf securities if they got “strong bids.” 2390 The CDO valuation project generated many comments on how to price the firm’s unsold CDO securities, including Timberwolf. One Goldman employee, who was applying Goldman’s most common valuation method to Timberwolf, wrote that the price should be dramatically lower: 2385 5/11/2007 email from Daniel Sparks to Richard Ruzika, GS M BS-E-019659221. Mr. Sparks also noted that he had a meeting with David Viniar, Don Mullen, and Gary Cohn to discuss the issue. 2386 5/11/2007 email from David Lehman, GS MBS-E-003361238. For more information on this CDO valuation project, see Section C(5)(a)(iii)BB, above. 2387 84. 2388 2389 2390 5/11/2007 email from Craig Broderick, “CDO ’s - Mortgages,” GS MBS-E-009976918, Hearing Exhibit 4/27- 5/11/2007 email from Harvey Schwartz to Daniel Sparks, Tom Montag, and others, GS MBS-E-010780864. 5/11/2007 email from Donald Mullen to Daniel Sparks, GS MBS-E-010780849, Hearing Exhibit 4/27-103. Id. at GS MBS-E-010780848-49. “Based on current single-A CDO marks, the A2 tranche of Timberwolf would have a price of 72 cents on the dollar.” 2391 He also noted: “Based on a small sample of single-A CDOs for which we have a complete underlier marks, we believe that the risks of the RMBS underliers are frequently not fully reflected in the marks on the CDOs. If the trends in this small sample are extrapolated, the fair spread on the CDOs could even be double where they are marked now; if that were the case, the price of the A2 tranche of Timberwolf would actually be 35-41 cents on the dollar, depending on the correlation.” 2392 fcic_final_report_full--125 In the end, companies in subprime and Alt-A mortgages had, in essence, placed all their chips on black: they were betting that home prices would never stop rising. This was the only scenario that would keep the mortgage machine humming. The ev- idence is present in our case study mortgage-backed security, CMLTI -NC, whose loans have many of the characteristics just described. The , loans bundled in this deal were adjustable-rate and fixed-rate residen- tial mortgages originated by New Century. They had an average principal balance of ,—just under the median home price of , in .  The vast major- ity had a -year maturity, and more than  were originated in May, June, and July , just after national home prices had peaked. More than  were reportedly for primary residences, with  for home purchases and  for cash-out refinancings. The loans were from all  states and the District of Columbia, but more than a fifth came from California and more than a tenth from Florida.  About  of the loans were ARMs, and most of these were /s or /s. In a twist, many of these hybrid ARMs had other “affordability features” as well. For ex- ample, more than  of the ARMs were interest-only—during the first two or three years, not only would borrowers pay a lower fixed rate, they would not have to pay any principal. In addition, more than  of the ARMs were “/ hybrid balloon” loans, in which the principal would amortize over  years—lowering the monthly payments even further, but as a result leaving the borrower with a final principal pay- ment at the end of the -year term. The great majority of the pool was secured by first mortgages; of these,  had a piggyback mortgage on the same property. As a result, more than one-third of the mortgages in this deal had a combined loan-to-value ratio between  and . Raising the risk a bit more,  of the mortgages were no-doc loans. The rest were “full-doc,” although their documentation was fuller in some cases than in others.  In sum, the loans bundled in this deal mirrored the market: complex products with high LTVs and little documentation. And even as many warned of this toxic mix, the reg- ulators were not on the same page. FEDERAL REGULATORS: “IMMUNITY FROM MANY STATE LAWS IS A SIGNIFICANT BENEFIT ” For years, some states had tried to regulate the mortgage business, especially to clamp down on the predatory mortgages proliferating in the subprime market. The national thrifts and banks and their federal regulators—the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC), respectively—resisted the states’ efforts to regulate those national banks and thrifts. The companies claimed that without one uniform set of rules, they could not easily do business across the country, and the regulators agreed. In August , as the market for riskier subprime and Alt- A loans grew, and as lenders piled on more risk with smaller down payments, reduced documentation requirements, interest-only loans, and payment-option loans, the OCC fired a salvo. The OCC proposed strong preemption rules for national banks, nearly identical to earlier OTS rules that empowered nationally chartered thrifts to disregard state consumer laws.  FinancialCrisisReport--132 A week later, on Sunday, February 25, 2007, Mr. Beck sent an email with the subject heading, “HFI Option Arms redirect to HFS,” to much of WaMu’s top management, including Mr. Schneider, Mr. Rotella, Mr. Casey, as well as the FDIC Examiner-In-Charge Steve Funaro, and others. The email indicated that a decision had been made to sell $3 billion in recent Option ARM loans, with as many as possible to be sold before the end of the quarter, which was four weeks away: “David [Schneider] and I spoke today. He’s instructed me to take actions to sell all marketable Option Arms that we intend to transfer to portfolio in 1Q[first quarter], 2007. That amounts to roughly 3B [$3 billion] option arms availab[l]e for sale. I would like to get these loans into HFS [the Hold for Sale portfolio] immediately so that [I] can sell as many as possible in Q1. John [Drastal], we are only targeting to sell Option Arms destined for portfolio since year end at this point. I’ll need direction from you on any special accounting concerns or documentation you will need to get these loans in the warehouse without tainting the HFI [Hold for Investment] book. 472 Michelle, I believe this action requires MRC [Market Risk Committee] approval. Please advise. This week I’ll work to get the necessary governance sign offs in place. Cheryl, please direct me on what form the approval request should take and what committees should review and authorize the request. I can pull all of the data. We continue to work with Cheryl and the credit risk team to analyze emerging credit risks in our prime portfolio and recommend actions to mitigate them. Thanks for your help, DJB” 473 Two days later, on Tuesday, February 27, 2007, Mr. Chen sent an email with the subject line, “HFI selection criteria changes,” to Michelle McCarthy, who was head of WaMu’s Market Risk Management department 474 as well as chair of both its Market Risk Committee and Asset Liability Committee. 475 The email was copied to Mr. Beck, Ms. Feltgen and others, and showed that the implementation of the plan was underway: 472 Loans in a bank’s Hold for Investment portfolio receive different accounting treatment than loans in the bank’s Hold for Sale portfolio, and generally accepted accounting principles (GAAP) frown upon frequent transfers between the two portfolios. The GAAP principles were a key reason for Mr. Beck’s instruction that the transfer of the Option ARM loans from WaMu’s HFI to HFS portfolios proceed “without tainting the HFI book.” 473 2/25/2007 email from David Beck to himself, David Schneider, Steve Rotella, Ron Cathcart, Tom Casey, Cheryl Feltgen, others, Hearing Exhibit 4/13-42b. 474 12/28/2007 WaMu internal report, “Disclosure Management,” JPM_WM02414318. 475 3/9/2007 WaMu Market Risk Committee Meeting Minutes, Hearing Exhibit 4/13-43. “After careful review with David and the teams, David suggested me to make the following recommendations to MRC [Market Risk Committee] on the existing prime HFI/HFS selection criteria 1. Effective March 7th 2007, modify the portfolio option ARM and COFI ARM retention criteria (see attached ‘existing HFI descriptions’, ‘section 1.01 to 1.11 and section 2.01 to 2.08’) to include only following loans for the portfolio (HFI) a. Super jumbo of size greater or equal to $ 3 MM (Risk based pricing applied, but difficult to sale) b. Advantage 90 (high LTV loans without MI, very little production as 80/10/10 gets popularity) c. Foreign Nationals (Risk based pricing applied, but difficult to sale due to FICO problems) d. FICO less than 620, except employee loans in which case FICO can be re- stated after closing. e. 3-4 units (excessive S & P level hit calls for portfolio execution) 2. Further more, we would like to request, transferring from HFI to HFS, all the MTA option ARMs and COFI ARMs, funded or locked between January 1st, 2007 to Mach [sic] 7th, 2007, and DO NOT fit the criteria listed above, and DO NOT fit the criteria section 3.02 to 4.07 in the attached ‘existing HFI descriptions’) CHRG-111shrg54589--108 Mr. Whalen," It may, and I am not sure that would not be inappropriate, and I am sure my colleagues will disagree with me. But let me just put it to you this way: I do not think at the end of the day that most people on Wall Street are competent to be a rating agency. And if you are talking about calculating the probability of default of a company or a security, that is not a trivial exercise. It takes a lot of work. And I do not think most people on Wall Street do it. They look at the Bloomberg terminal and by consensus they have all agreed that the spread on the Bloomberg terminal, when you put it in this model, is the price you are going to deal on, whether it is right or not. Senator Johanns. You know, and I would say to you, Mr. Whalen, listening to your testimony just from a sterile standpoint and saying, ``Well, you know, if it is that kind of risk maybe it should be out of business,'' that is probably OK unless that is the only regional airline in town. And when that one goes away, guess what? Air transportation for half of western Nebraska goes away. " CHRG-111hhrg52400--114 Mr. Price," Thank you, Mr. Chairman. I want to--and I appreciate the opportunity for this hearing. I think this has been an excellent panel, and the information that you have provided has been very, very helpful. I think it is important to appreciate that Federal regulation of insurance is different than instituting a systemic risk regulator for insurance, and I think it's important that we keep that in mind. And we are kind of sometimes combining apples and oranges here. I want to shift gears a little bit and talk about and get some response regarding the financial products consumer safety commission that has been bandied about by the Administration. And it appears to many of us to be a kind of a command and control apparatus for different industries, including the insurance industry. And I wonder--and I know oftentimes Congress and the Administration can go too far; in fact, that seems to be the order of the day, is going too far--I wonder if, starting with Mr. Spence and kind of heading on down the table, do you have any thoughts about what would be too far for the insurance industry, or what the effect of this would be on the insurance industry for a products consumer safety commission? " FOMC20080130meeting--276 274,MR. ROSENGREN.," Thank you, Mr. Chairman. I support alternative B, though I think a case can be made for alternative A. The Boston model indicates that even after a 50 basis point reduction, we still need more easing to return to an economy with both full employment and inflation below 2 percent. Taking out insurance against more-severe downside risks would imply even more easing than our baseline forecast. Given our recent move and the additional easing in alternative B, I am comfortable waiting to take more aggressive action only if incoming data warrant it. However, I will not be surprised if we find further action is indeed needed. What would be the arguments against taking an aggressive tack? Certainly, one argument might be that elevated oil and commodity prices and core inflation currently above 2 percent warrant a more restrained approach. However, I would note that in previous recessions the inflation rate has declined significantly, even in the 1970s, in the midst of historic surges in energy and food prices. Whether we skirt a recession or experience a recession, I expect core inflation to trend down. A potential second argument is that we have responded too slowly to the need for tighter policy in the past, so we should be more reluctant to ease in the present. While it may be true that we raised rates too slowly at the onset of previous expansions, I see no reason for this Committee to behave in a manner that it believes is suboptimal. As a Committee, we seem to have consensus on the importance of maintaining low inflation rates, and I am confident we have the will to raise rates with the same alacrity that we reduced them, should economic conditions warrant such action. " FOMC20060328meeting--88 86,MS. YELLEN.," Thank you, Mr. Chairman. May I say it’s a great pleasure to see you back at the table. And while I hesitate to wish your predecessor’s eighteen years of service on anyone, I look forward to many interesting and productive meetings under your leadership. The latest monthly data show significant strength in activity for the quarter just ending, and I agree with the Greenbook’s assessment that this strength represents a temporary catch-up after the weak fourth quarter. I anticipate that growth will likely settle back to trend as the year progresses, especially as the lagged effect of tighter financial conditions damps interest-sensitive sectors. The current risks to this scenario are by now a well-known litany—housing, energy prices, the saving rate, foreign demand, and term premiums. Overall, I judge the risk to the growth forecast to be pretty well balanced. I did want to comment briefly on the risks associated with housing. This is the sector that obviously bears close watching because it can represent the leading edge of the effects of the monetary tightening. Thus far, published data on housing starts and permits provide rather little evidence of a significant weakening in construction activity, although other indicators such as home-buying attitudes and new home sales, along with a growing amount of anecdotal evidence, suggest that tighter financing conditions are finally exacting a toll. I think one possible reason that starts and permits have remained so strong is that the inventory margin is taking up some of the slack in demand. Indeed, the stock of unsold homes on the market has now reached quite high levels. I noted a similar phenomenon in talking to a real estate developer in what has been the sizzling Phoenix housing market. In that market, demand has been so strong that builders couldn’t build houses fast enough to satisfy buyers. So delivery times for new homes were very long. And as the demand for new homes has slowed recently, we haven’t seen a noticeable change in building activity, but there has been a significant decline in delivery times. As this margin, like unsold inventories, returns to more historical norms, I think that we’ll see the moderation in demand show up in new construction numbers as well. Turning to inflation, I think it’s worth stressing how good recent readings have been. Over the past twelve months, core PCE prices are up 1.8 percent, the market-based component 1.5 percent, and the core CPI just 2.1 percent. As I’ve noted in previous meetings over the past six months, we have been more optimistic than the Greenbook about the prospects for core inflation during 2006. For quite some time now, we have been on the order of several tenths of a percentage point lower. And I continue to think that core PCE price inflation will come in at about 1.8 percent this year. As the Greenbook forecast drifts down, I think maybe my stubbornness is paying off. My relative optimism partly reflects my view, based on econometric evidence using data after the early 1980s, that there is little pressure for higher inflation coming from the pass-through of energy prices to labor compensation or core prices. Another important element in my optimistic inflation outlook is inflation expectations, which I consider to be well contained and unlikely to provide significant upward impetus to inflation. At the same time, I think it’s important not to ignore the potential adverse inflationary consequences from a resurgent economy. I realize the link between resource utilization and inflation is a contentious topic. Actually, the Philadelphia Fed’s Survey of Professional Forecasters asked its respondents whether they used the concept of a natural rate of unemployment in their macroeconomic projections, and the replies indicate a split of about 50–50. About half the economic forecasters, in other words, use such a rate, and the other half don’t. And my guess is that there is also a considerable difference of opinion around this table. Personally, I’m persuaded that excess demand in a market does tend to push up prices and that the domestic labor market is no exception to this rule. I think that the econometric evidence supports that view. President Fisher has been arguing, and perhaps some others would agree, that what matters is not just U.S. productive capacity but worldwide capacity. I do agree that the world—or, more accurately, the aggregate supply curve—has probably become flatter. But while globalization has had a profound impact on the U.S. economy in a number of ways, I think that there are a number of reasons to doubt that it will overturn, at least completely, the normal historical relationship between domestic labor market slack and inflation. The first point here is simply that many goods and most services still must be produced in the United States, and so foreign capacity isn’t an issue. The second point is that, in order to utilize productive capacity in foreign countries, we do need to run a trade deficit; in principle, such deficits eventually put downward pressure on our exchange rates, which tends to raise the prices paid for imports in the United States. I’m sure this is a topic we will be discussing in a lot more detail going forward. Of course, the measurement of aggregate excess demand or slack is difficult, and I’m sympathetic to the view that there is no bright red line for the unemployment rate that, once crossed, triggers higher inflation. But by examining a variety of indicators, I think it’s possible to get a useful notion of aggregate resource utilization. I would judge that these measures currently fall in a range from a modest amount of slack to a modest amount of excess demand. Specifically, the unemployment rate, the vacancy rate, the employment–population ratio, capacity utilization, and other measures are all within a few tenths, in unemployment rate terms, of full employment. Looking ahead, with the unemployment rate already at 4.8 percent, I think it’s logical to worry that wage and price inflation will rise over time if resource slack diminishes further. And with GDP growth forecast at 3¾ percent this year, a naïve calculation based on Okun’s law suggests that the unemployment rate could fall to 4½ percent by the fourth quarter. In contrast, the Greenbook assumes that the unemployment rate will remain unchanged. The Greenbook inflation projection is, accordingly, more optimistic than a forecast based on the naïve model. Now, given the importance of the behavior of unemployment to one’s forecast of inflation, my staff has been looking at the performance and fit of Okun’s law—namely, the relationship between output growth and the change in the unemployment rate. And I think their analysis provides support for the Greenbook assessment. Using a dynamic version of Okun’s law that fits exceptionally well after 1961, my staff finds evidence of an error correction between the output and the unemployment gaps. During 2005, unemployment declined substantially more than a simple version of Okun’s law would have predicted. And this dynamic model suggests that, even with fast economic growth, the unemployment rate will likely be pushed up a bit this year, as this unusual decline in 2005 is reversed. So to sum up, I see steady growth and few pressures for price acceleration." CHRG-109hhrg28024--30 Mr. Bernanke," That's an excellent question. And the Federal Reserve has given a great deal of thought to that question. Part of the answer is that the U.S. economy is less dependent on energy, on oil, than it was 30 years ago. The increase in prices we saw in the '70s did lead to increased efficiency and, therefore, less sensitivity to changes in oil prices. Secondly, the increase in energy prices, although substantial, with the exception of the hurricane period, has been generally less rapid than occurred in some episodes during the 1970s. Third, the economy is very resilient. It showed remarkable strength after the hurricanes. It showed remarkable strength after 9/11. So our economy does have a lot of staying power, a lot of ability to deal with shocks. But the final point that I'd like to make, and it relates to some comments I made in my testimony, is that a big difference between the 1970s and today is that inflation expectations are low and stable. The public has a great deal of confidence that the Federal Reserve will keep inflation low and stable. In the 1970s, that confidence did not exist, and when oil prices rose, wages and prices began to spiral upward. The Federal Reserve had to raise interest rates quite substantially, slowing the economy, in order to keep the inflation rate under control. 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. " FOMC20070628meeting--109 107,MR. LACKER.," Thank you, Mr. Chairman. The Fifth District’s economy has picked up since the last meeting. Retail sales rose briskly in June following several months of flatness, and shopper traffic increased more broadly as well. Of particular interest, building supply and furniture retailers report better sales. Big-ticket sales remain generally weak, however, with domestic brand automobile dealers continuing to note soft sales. Activity at District services firms added to an already healthy pace of growth, with revenues and employment expanding somewhat faster in June. In May, our manufacturing sector finally joined in the general manufacturing pickup that began a few months back in other regions. Our indexes for shipments and new orders swung well into positive territory after having spent the entire year well down in the negative region. This rebound appears to be broadly based, with most industries posting stronger readings. Housing sales and construction remain weak in most parts of the District, though home prices have been more resilient, with very modest gains reported in most areas and lower prices in only a few. In contrast, the commercial real estate sector appears to be fairly strong, with both leasing and construction looking solid. Regarding inflation, our survey measures suggest that price trends in the services sector remain moderate. Our manufacturing numbers, however, consistent with President Moskow’s report of anecdotal information, indicate significant price acceleration, on both the product and the input sides. At the national level, the new information on the real economy we have received since the last meeting has been fairly positive. In particular, I’m heartened by the recent reports on business investment and manufacturing, which appear to confirm our expectations that the softness we were seeing a few months ago would prove to be transitory. Consumer spending also continues to expand, although not as rapidly as earlier in the year. Housing, of course, continues to be the main drag on spending, and the most prominent source of uncertainty about the real outlook. My sense is that the uncertainty is receding, however. Construction numbers have more or less moved sideways since the beginning of the year, in contrast to the sharp fall we saw in the first three quarters of last year. So it looks to me as though we’re nearing a bottom in housing activity, albeit a bottom that may slope gently away from the steep cliff we descended last year. At this point, I think the risk of encountering another cliff has become relatively small. We have also received favorable readings on core inflation for the past three months. This has brought the twelve-month core PCE number down to 2.0 percent. While this news is good, we should react cautiously, of course. We have seen several months of favorable data before only to see several months of unfavorable numbers. Moreover, the Greenbook points to a number of special factors suggesting that the second quarter’s better inflation performance is likely to be transitory. I am inclined to agree with that assessment, and so I think we could well see core inflation rise again. Measures of near-term inflation expectations have not moved much in recent months. They all still point to PCE inflation expectations of 2 percent or so. Moreover, five-year, five-year-ahead inflation compensation has moved up ¼ percentage point, for whatever reason, since just before our last meeting. All this makes it hard to be confident that we are going to see a sustained decline of inflation below 2 percent anytime soon. The good news on the real side, however, suggests that we are making progress toward seeing downside risks diminish enough for us to do something about inflation. Thank you." FinancialCrisisReport--198 In mid-2005, an internal FDIC memorandum discussed the increased risk associated with the new types of higher risk mortgage loans being issued in the U.S. housing market: “Despite the favorable history, we believe recent lending practices and buyer behavior have elevated the risk of residential lending. Concerns are compounded by significantly increased investor activity and new loan products that allow less creditworthy borrowers to obtain mortgages. The new loan products of most concern include Option Adjustment Rate Mortgage (ARM) Loans, Interest Only (IO) Loans, and Piggyback Home Equity Loans.” 753 WaMu offered all three types of loans, in addition to subprime loans through Long Beach. In 2007, an FDIC memorandum again identified WaMu’s high risk home loans as its “primary risk,” singling out both its subprime and Option ARM loans: “SFR [Single Family Residential loan] credit risk remains the primary risk. The bank has geographic concentrations, moderate exposure to subprime assets, and significant exposure to mortgage products with potential for payment shock. … The bank’s credit culture emphasized home price appreciation and the ability to perpetually refinance. … In the past, the bank relied on quarterly sales of delinquent residential loans to manage its non performing assets. The bank’s underwriting standards were lax as management originated loans under an originate to sell model. When the originate to sell model collapsed in July 2007 for private and subprime loans, management was no longer able to sell non performing assets. Consequently, non performing assets are now mounting, and the bank’s credit risk mitigation strategy is no longer effective.” 754 From 2004 to 2008, the FDIC assigned LIDI ratings to WaMu that indicated a higher degree of risk at the bank than portrayed by the bank’s CAMELS ratings. LIDI ratings are intended to convey the degree of risk that a bank might cause loss to the Deposit Insurance Fund, with A being the best rating and E the worst. 755 The FDIC IG explained the difference between LIDI and CAMELS ratings as follows: “LIDI ratings consider future risks at an institution, where CAMELS rating, in practice, are more point-in-time measures of performance.” 756 As 753 7/5/2005 memorandum from FDIC Associate Director John H. Corston to FDIC Associate Director Michael Zamorski, “Insured Institutions’ Exposures to a Housing Slowdown,” FDIC_WAMU_000015114, Hearing Exhibit 4/16-51b. 754 FDIC Washington Mutual Bank LIDI Report, Q307, FDIC_WAMU_000014851, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 755 An A rating indicates a “low risk” of concern that an institution will cause a loss to the Deposit Insurance Fund, a B rating indicates an “ordinary level of concern,” a C rating indicates a “more than an ordinary level of concern,” a D rating conveys a “high level of concern,” and an E rating conveys “serious concerns.” See prepared statement of FDIC IG Rymer at 5 (chart showing FDIC LIDI ratings descriptions), April 16, 2010 Subcommittee Hearing, at 124 (showing FDIC LIDI ratings description). 756 Id. early as 2004, the FDIC viewed WaMu as having higher levels of risk than indicated by its CAMELS ratings. This chart shows the comparable ratings over time: FinancialCrisisInquiry--184 You can see here that we had—hopefully you have it, but if not I’ll describe the numbers. We were producing in single-family starts about 1.1 million a year on average. That’s roughly the average level of single-family starts. And that’s the demographic demand. During the peak moments here, we produced 1.7 million. So we were producing about -- we produced during this whole bubble about a million more new starts then demographic demand would have you produced. And one of the reasons for that was that these—basically people were able to put down $1,000 or $2,000 or $3,000 to control a $100,000 to $200,000 house. It was a—basically a call option. And homebuilders sold them this house. They took an order, and of course they didn’t have to fulfill that order. If prices went up, they take the order and flip the house. So we built about a million too many. We are now building about 500,000 houses, and as you know in many markets this has led to lots of layoffs. I think roughly 15 percent of the decline in employment is in the construction industry. So this is a—a very big negative. But we’ve begun to come back a little bit, and my guess is we’ll slowly recover. I would agree with Mark. It’s going to take three to four years to get recovery here. Maybe a little bit longer. If we skip to this figure three—there was some reference to this earlier—is the house price bubble, which is on the second page there. And the house price bubble I think is really why we’ve had all this fallout. House prices went up in nominal terms dramatically. And in real terms also very dramatically. We’ve had big house price inflations before. In the late 70s we had that happen. But that was accompanied by overall inflation. This time house prices went up, and we did not have overall inflation. So real house prices went up dramatically. And only one other period of time have we ever seen a—a drop in house prices that was in a big way, and that was in the 1930s. It really didn’t happen in the post-war period. But we’ve seen a cumulative price decline based on realtor data of about 21 percent based on another index Kay short about 30 percent. FOMC20070807meeting--94 92,MR. LACKER.," Thank you, Mr. Chairman. In the Fifth District we continue to see moderate economic growth, though it has been uneven across sectors in recent weeks. Manufacturing activity rebounded somewhat in June and July after several months of weakness, with our indexes showing increases in new orders and shipments. Activity at District services firms advanced at a steady pace, with solid revenue growth and a broader pickup in hiring. The retail sector, however, has lost much of the momentum reported last month, as softness in big-ticket categories continues to constrain revenue growth. On the employment front, District labor markets are increasingly taut, given steady hiring activity and slower labor force growth. In addition, in contrast to the Eighth Federal Reserve District, contacts continue to report rising wage pressures and difficulty finding qualified workers. Housing markets remain weak across much of the District. However, commercial real estate activity remains healthy, with steady demand reported for office and industrial space. Some contacts, however, have expressed concern about slower activity in the retail segment of that market. Turning to prices, our July surveys indicate increased inflation pressures. The average current rate of increase of manufacturers’ prices has moved up for both raw materials and finished goods over the past few months, reversing the decline seen earlier this year. Price pressures on the services side have picked up as well, though expectations for future prices eased somewhat in the July report. At the national level, we continued to receive fairly good news on inflation. After annualized rates of monthly core PCE inflation above 2 percent at the beginning of the year, we’ve now had four months of readings below 2. But there are still abundant reasons for caution, as President Moskow, for example, noted. I’ll mention the Greenbook, which cites transitory factors—apparel and owners’ equivalent rent, for instance—that have contributed to the recent moderation. The passing of these damping forces could well push core inflation back up in the near term. So although I think we have reason to take some comfort from recent inflation numbers, and I do, I want to wait to see more evidence, especially as growth moves back toward trend. I still think the prospects for a return to trend growth are reasonably good, and my assessment of trend is still a bit higher than the Greenbook’s, in part because I’ve not revised my estimate of productivity growth much in response to the GDP revisions. Obviously, there are downside risks to be concerned about, and financial market activity since the last meeting obviously raises some concerns. As far as we can tell at this point, the heightened turbulence of the past month is all pretty closely related to subprime and nontraditional mortgages and the leveraged financing of private equity buyouts in the corporate sector. These two market segments are relatively new, and they represent the latest manifestation of the broad, ongoing wave of financial innovation that we’ve been seeing over the past few decades. Because these two markets are so young, one would expect participants’ risk assessments to be more uncertain and thus be more sensitive to what is learned from market events and incoming news. That said, developments in the past month have certainly been quite dramatic, and it looks less like rapid learning than it does rapid unlearning of what was previously viewed as known—although that, too, is of course a form of learning. The implication of these revised risk assessments for the economic outlook and for policy depend on whether they affect business investment or household spending on consumption or new housing. At this point the answer to that question is not yet clear, but it’s worth noting that, by many measures, corporate credit quality seems to remain pretty good by historical standards, and the buyout movement, as President Poole just noted, seems to have been more about restructuring liabilities and governance arrangements and less about funding capital spending. So it’s not obvious why there should be dramatic effects on business investment. What about consumption? PCE was fairly soft last quarter, and this softness could be a harbinger of more-sustained weakness. The second-quarter softness may well be a one-time phenomenon, however, reflecting both the sharp rise in gasoline prices in the first five months of the year and some payback from the strong spending growth in Q4 and Q1. Moreover, the outlook for household income looks pretty good, with labor market conditions fairly firm and consumption gains showing no sign of slowing down. In addition, household net worth is coming off a relatively high base. Neither of these fundamentals seems likely to be seriously threatened by the repricing that’s in train. Housing, on the other hand, continues to be the predominant area of concern regarding real spending, and financial market developments have only heightened that concern. The Greenbook paints a fairly pessimistic picture. The decline in residential investment accelerates over the remainder of year and continues into next, and the inclusion of three “greater housing correction” alternative scenarios suggests that the staff is especially concerned, justifiably so in my view, with the downside risk to their outlook. But even though the housing market has definitely deteriorated, the outlook for housing is quite uncertain in my mind, and I continue to think that a more moderate decline is also possible and that housing could be somewhat less of a drag on growth than the Greenbook forecasts. At this point, however, the reassessment under way in secondary markets regarding housing-related credits still has a way to go, and until that process plays out, it’s going to be hard to gauge the resulting magnitude of repricing at the retail level. About all I conclude at this point is that the outlook for housing is still awfully uncertain right now. Thank you." FinancialCrisisInquiry--252 DIMON: I can’t move it any closer, but I’ll sit up here. I am saying, at no point in the market before the problem started were these firms priced like they were too big to fail. So if you look at what people lent money to at the firms, no, they were priced like there’s a potential for failure like any other company. Even after things started failing and the government—remember, they did allow firms to fail like Lehman. But there was Indy Mac, WaMu, virtual failures in Wachovia, Bear Stearns. Even after they let things fail, that was true, and even after the government did the stress tests and said they don’t want these things to fail, the market still priced them— their stock price and their debt—like they could fail. At our board level, we never had a conversation, ever, that we should rely on the government to do anything. FOMC20061212meeting--49 47,MR. STOCKTON.," Well, it is in the forecast. It’s just not so easy to see on a revision-by- revision basis because we’re also being surprised by the tightness of the overall labor market, by the decline of the dollar, and by somewhat higher import prices. So there have been other offsetting factors that are masking the underlying effect of the lower energy prices. We have built in those energy prices on the upside; we’re taking them out on the downside; and they are, I think, an important factor behind the contour that we’re projecting. It’s just that there are other factors operating." CHRG-111hhrg51698--223 Mr. Slocum," I am not discussing likes and dislikes. I am talking about an unprecedented rise and then collapse of crude oil prices; where any analyst examining it could see a wide disconnect between supply-demand fundamentals. When you have prices rise that quickly, demand does not collapse overnight. There were no new massive oil fields that appeared. This collapse in oil prices was directly the result of the inability of financial players who were betting on these markets---- " CHRG-110hhrg44901--134 Mr. Bernanke," Well, with respect to possible steps, as I indicated, the Federal Reserve is part of a task force being led by the CFTC, which is trying to get as much clarity as we can on exactly this question, and that includes right now we and the CFTC in particular has been gathering information from other petroleum futures exchanges like the ones in U.K., has been gathering information on the activities of swaps dealers and index traders who invest in these economies. We are trying to understand how these investments are made and how they relate to price movements, those sorts of things. So we are looking at that seriously. It is possible that the CFTC may decide, and, of course, it is their province to do so, that changes in the information requirements or in positions, limits or things of that sort might be justified under certain circumstances. There is a lot of evidence, though, on which I base my earlier statement in the testimony that makes it seem unlikely that speculation or, better termed, manipulation is driving up energy prices. I mentioned the absence of inventories. There are a number of other things. For example, there seems to be no empirical relationship between long, open positions by noncommercial traders and movements in prices. It is striking that there are many or at least some commodities which are not even traded on future markets which have had big price run-ups, like coal and iron ore, for example. So it doesn't seem to us to be the central issue. It does mean that energy prices in the very short run can respond quite sensitively to news that comes in because they begin to trade like a stock price, for example. But that is not necessarily a bad thing; that means that information is being incorporated into those prices, and that helps suppliers and demanders know how better to respond. Ms. Moore of Wisconsin. Mr. Chairman, thank you for that. Is the SEC a part of this committee that is looking at the commodities irregularities? " CHRG-111hhrg63105--154 Mr. Sprecher," Thank you, Chairman Boswell, Chairman Peterson, Ranking Member Moran. I am Jeff Sprecher. I am the Chairman and Chief Executive Officer of IntercontinentalExchange, which is known in our industry as ICE; and I am grateful for the opportunity to provide comments on the position limit rulemaking that is pending before the Commodity Futures Trading Commission. ICE has supported setting aggregate position limits across trading venues if administered in a fair and nondiscriminatory manner. In summary, ICE's position on this subject has been very clear. We believe that the CFTC should set aggregate position limits in economically equivalent markets; to avoid negatively impacting liquidity that is relied upon by commercial end-users to hedge their risk, aggregate position limits should be set at levels taking into account the volumes of both the existing futures markets and the broader over-the-counter markets; and financially and physically settled contracts should be treated differently at their expiration in a revised position limit regime. There have been exhaustive hearings by Congress and the Commission over the last several years, and they have concluded that economically equivalent contracts traded on separate exchanges operate as an aggregate market. Therefore, ICE agrees with Congress and believes that the Commission is the appropriate neutral authority to set and administer aggregate position limits for U.S. energy futures and for significant price discovery contracts. Only the Commission is in a position to view a market participant's positions across all venues and to administer aggregate position limits in an objective manner. However, we also believe that the position limit rulemaking should focus on implementing the core requirements of Dodd-Frank, and that is namely setting aggregate position limits across markets, and they should avoid the consideration of experimental rules, such as rules that would set concentration limits for each and every exchange and every swap execution facility. In setting aggregate limits, the Commission should take into account trading data from both futures markets and the broader over-the-counter swaps market. Failing to take into account accurate data from each of these markets risks setting aggregate position limits at levels that could negatively impact liquidity that is actually relied upon by the commercial users to effectively hedge their price risk. This would certainly be an unintended consequence, and it would be inconsistent with the goals of Dodd-Frank. Finally, in setting position limits in the expiration or the spot month, the Commission should treat financially and physically settled contracts differently as market participants use financial and physical contracts differently for different purposes. The Commission already recognizes there is a distinction between financial and physically settled contracts. These rules promote contract convergence and they eliminate the need for significant numbers of hedge exemptions that exist in the energy futures markets today. In conclusion, we are a strong proponent of open, competitive derivatives markets and of appropriate regulatory oversight; and, to that end, we are pleased to work with Congress to find solutions that promote the best marketplaces possible. Mr. Chairman, I would like to thank you for the opportunity to share our views with you here today. [The prepared statement of Mr. Sprecher follows:] Prepared Statement of Jeffrey C. Sprecher, Chairman and CEO, IntercontinentalExchange, Inc., Atlanta, GAIntroduction Chairman Boswell, Ranking Member Moran, I am Jeffrey C. Sprecher, Chairman and Chief Executive Officer of IntercontinentalExchange, Inc., or ``ICE.'' We are grateful for the opportunity to provide comments on the position limit rulemaking pending before the Commodity Futures Trading Commission (Commission). As background, ICE was established in 2000 as an over-the-counter (OTC) marketplace with the goal of providing transparency and a level playing field for the previously opaque, fragmented energy market. Since that time, ICE has grown significantly through organic growth fostered by product, technology and clearing innovation, and by acquisition of futures exchanges that have broadened its product offerings and risk management services. Today, ICE operates a leading global marketplace for futures and OTC derivatives across a variety of product classes, including agricultural and energy commodities, foreign exchange and equity indexes. Commercial market participants rely on our products to hedge and manage risk and investors in these markets provide necessary liquidity. ICE believes proper regulation is essential for ensuring that market participants--as well as the broader public--have confidence in the price formation process that takes place in our markets. This assurance of integrity lies at the heart of the futures exchange model. The U.S. energy futures markets, governed by the Commission's comprehensive-but-flexible regulatory structure, have permitted commercial and professional market users to hedge future price risk in an efficient and cost-effective manner.Position Limits The Dodd-Frank Wall Street Reform and Consumer Protection Act gives the Commission new authority to set aggregate position limits on both energy futures and swaps and to have those position limits apply across competing exchanges and trading venues. This authority was granted by Congress because economically equivalent contracts may vary only where they are listed for trading, or in how they are settled, and have repeatedly been shown to trade as a single market up until the final days of trading.\1\--------------------------------------------------------------------------- \1\ Excessive Speculation in the Natural Gas Markets, Staff Report, Senate Permanent Subcommittee on Investigations (June 2007), pgs. 36-38. http://hsgac.senate.gov/public/_files/REPORTExcessiveSpeculationintheNaturalGasMarket.pdf.--------------------------------------------------------------------------- ICE supports aggregate position limits across trading venues if administered by the Commission in a fair, non-discriminatory manner. In summary, ICE's position on this subject is clear: (1) Different sized position limits for different exchanges, or so- called ``concentration limits'', were considered and rejected by Congress, and should not form a part of the Commission's proposed rules because they are conceptually inconsistent with the ``single market'' theory and anti-competitively favor larger exchanges; and (2) To avoid negatively impacting liquidity that is relied upon by commercial end-users to hedge their risk, aggregate position limits should be set at levels taking into account both existing futures volumes and the broader OTC markets. The Dodd-Frank Act gives the Commission 180 days to implement the position limit provisions for energy. ICE believes that the position limit rulemaking would be easier and less costly to implement if the Commission focused its rulemaking on implementing the core requirements of Dodd-Frank, namely aggregate position limits across markets--and avoids consideration of experimental rules and such as single-exchange concentration limits that have already been rejected by Congress.Concentration Limits for Single Exchanges Were Rejected by Congress and Are Redundant and Anti-Competitive In the Commission's previous position limit rulemaking, which was withdrawn in anticipation of the passage of Dodd-Frank, the Commission proposed an aggregate position limit regime across markets, but with separate ``concentration limits'' for individual exchanges and trading venues. The concentration limit would be set at 30% of the given exchange or venue's open interest for all months, and 20% of open interest in any single month, with each percentage based on the exchange's open interest in the previous year. The Commission's rationale for the concentration limit was to prevent concentrated positions from causing abrupt price movements and distortions in a market, and to ``fragment'' the market to allow multiple traders to step in where a smaller number of traders may have existed previously. The theory rested upon the unproven assumption that large traders are crowding out smaller participants. ICE disagrees with setting exchange specific concentration limits in any new rulemaking as they ignore the premise that economically equivalent contracts operate as a single aggregate market, were expressly rejected by Congress in drafting Dodd-Frank; and may have significant anti-competitive implications.\2\ Exhaustive hearings by Congress and the Commission over the last several years have concluded that economically equivalent contracts traded on two separate exchanges operate as a single aggregate market. In testimony before this Subcommittee in September 2007, Dr. James Newsome, former Commission Chairman and then President of NYMEX, stated ``the two competing trading venues [ICE and NYMEX] are now tightly linked and highly interactive and in essence are simply two components of a broader derivatives market.'' \3\ This is because participants arbitrage between economically equivalent markets, causing prices to converge. As this Subcommittee is well aware, the one market concept was the impetus for provisions in the farm bill which mandate regulation of swaps determined to be Significant Price Discovery Contracts in an equivalent manner as futures. Thus, the idea of imposing concentration limits on an ``individual exchange'' basis is unnecessary given the aggregate limit, which will serve the same purpose.--------------------------------------------------------------------------- \2\ H.R. 4173, Section 3155. \3\ Testimony of Dr. James Newsome, Chief Executive Officer, New York Mercantile Exchange, before the Subcommittee on General Farm Commodities and Risk Management, United States House of Representatives (September 26, 2007).--------------------------------------------------------------------------- Importantly, Congress expressly rejected a concentration limit in Dodd-Frank when it dropped language in the Section 738 of the Act in the House version of the legislation \4\ requiring foreign boards of trade to set position limits based upon ``relative'' market size. In addition, having market specific concentration limits appears inconsistent with other parts of Dodd-Frank, which contemplates multiple competing Swap Execution Facilities with open access to central clearing houses where swap positions would be traded into on one SEF and out of on another SEF.\5\ It is not apparent how this could be accomplished with SEF-specific concentration limits based upon open interest at an open-access clearinghouse used by multiple platforms.--------------------------------------------------------------------------- \4\ See, supra note 1. \5\ Dodd-Frank Wall Street Reform and Consumer Protection Act, Section 723(3).--------------------------------------------------------------------------- Finally, a single exchange concentration limit is anti-competitive. The Commodity Exchange Act mandates that the Commission ``regulate the futures markets by the least anti-competitive means available.'' By design, a concentration position limit will impose smaller, or stricter, concentration limits in smaller markets. A smaller market with fewer market participants has its open interest concentrated in these market participants. Thus, applying a concentration limit for an individual exchange will inhibit competition by impeding liquidity, given that smaller markets are concentrated. This would effectively lock in the market share of existing exchanges. A nascent exchange with such restrictions would likely face insurmountable odds in establishing a market and competing with incumbents. In addition, large market participants will effectively be prevented from leaving one market for another that offers a competitive advantage due to its inability to carry a similar sized position on the second market due to the ``concentration limit.'' This would substantially curtail innovation and the choice that exists in today's markets. Slowly, over time, the dominant market will continue to gain market share, as liquidity attracts liquidity. In the end, concentration limits may create the opposite of what the Commission intends: a diverse, highly competitive market for execution of derivatives.Position Limits Across Futures and OTC Markets Should Be Set to Avoid Negatively Impacting Liquidity Available to Commercial Users of the Markets and Should Be Based Upon Data of Each Market In setting aggregate position limits across futures and OTC markets, the Commission should act only after taking into account trading data from both the futures markets and the broader OTC swaps markets. Failing to take into account accurate data from each market risks setting aggregate position limits at artificially low levels that could negatively impact the liquidity relied upon by commercial users to efficiently hedge their price risk. Dodd-Frank requires the Commission for the first time to regulate previously un-regulated OTC markets that have themselves been used by segments of the commercial market to hedge risk. Should the Commission not take into account the size of this market in setting speculative position limits in the now-combined market, liquidity could be adversely impacted with commercial end-users paying wider spreads to hedge their price risk. This would certainly be an unintended consequence and inconsistent with Dodd-Frank's broader goals.Conclusion ICE is a strong proponent of open and competitive derivatives markets, and of appropriate regulatory oversight of those markets. As an operator of global futures and OTC markets, and as a publicly-held company, we understand the essential role of trust and confidence in our markets. To that end, we are pleased to work with Congress to address the challenges presented by derivatives markets, and we will continue to work cooperatively for solutions that promote the best marketplace possible. Mr. Chairman, thank you for the opportunity to share our views with you. I am happy to answer any questions you may have. The Chairman [presiding.] We thank you. " Mr. Jones," STATEMENT OF ROBERT JONES, SENIOR VICE PRESIDENT, ABN AMRO CLEARING CHICAGO LLC; MEMBER, RISK FOMC20050322meeting--37 35,MR. STOCKTON.," Thank you, Mr. Chairman. By virtually all measures, the economy has been humming along at a very solid pace in recent months. We are estimating that real GDP expanded at a 4¼ percent annual rate in the fourth quarter of last year and is likely to grow at about that pace in the first quarter of this year. March 22, 2005 9 of 116 Although the pace of the expansion in real activity is much the same as that of a year ago, the character of the expansion now feels different. While I can easily imagine looking back on these words with regret [laughter], the persistent and widespread improvements that we are now witnessing certainly leave the impression that the expansion is more firmly established and less fragile with respect to adverse shocks than it was in early 2004. As you know from reading the Greenbook, we think that the recent greater momentum in real GDP will carry forward for a while. That greater momentum in activity and heightened upward pressures on inflation led us to raise the assumed path of the federal funds rate by 50 basis points beyond the very near term. As in past forecasts, tighter monetary policy, diminished impetus from rising equity values and house prices, and fading fiscal stimulus are expected to gradually put a brake on the pace of activity. In our projection, the economy reaches the end of next year with the funds rate in the neighborhood of neutral, output close to potential, and core inflation running around 1½ percent. Were it to occur, such an outcome would be very pleasant indeed. Of course, we know that our point forecast, like any point forecast, will occur with probability zero. So what should we worrying about? While my colleagues who attend our lengthy forecast meetings were not exactly thrilled by it, the removal of my arm from its sling in the past few weeks has allowed me, once again, to bring my principal value added to the forecasting process, and that is copious amounts of hand- wringing. [Laughter] In the remainder of my remarks, I=d like to focus on three difficult questions with which we had to wrestle in assembling this forecast: First, what should we make of the recent strength in capital spending and what are its implications for the outlook? Second, how should we balance some powerful crosscurrents at work on the supply side of the economy? And third, what is happening with inflation? I=ll take them each in turn, although there are some common threads that tie them together. March 22, 2005 10 of 116 So, little remains of our elegant story. Our calibrated vintage capital models failed us, and clearly finger-crossing has not proven a terribly robust forecasting technique. We even tried an approach gently suggested to us by Governor Olson at the time of our last forecast—you know, had we thought about trying common sense? [Laughter] We tried, but even that didn=t seem to work. In a conversation with our colleagues at Treasury that they asked remain confidential, they indicated having been surprised that an appreciable number of firms with taxable income have simply not taken advantage of partial expensing. Moreover, some firms have taken it for purchases of longer-lived assets, but not for shorter-lived assets. This pattern of behavior might suggest that administrative complexity may have loomed larger as a discouraging factor than we or others imagined. But the facts are likely to remain obscure for a long time, while the IRS tabulates the corporate income tax forms for recent years. For now, we=re raising the white flag of surrender and chalking it up as a defeat for models, luck, and logic. I wouldn=t drag you through this discussion if it were just a sideshow in the forecast. But the changes that we made here were of policy significance. We revised up the growth in real equipment spending by 10 percentage points in the current quarter, from a decline of 5 percent at an annual rate to an increase of 5 percent. Moreover, we had previously interpreted some of last year=s strength in capital spending as resulting from firms pulling forward outlays to take advantage of the tax break. If that was not the case, then underlying demand was likely stronger than we had previously recognized. As a consequence, we are projecting some of that additional strength to carry over into the first half of this year. After accounting for follow-on multiplier–accelerator effects, the revisions to our forecast of equipment spending boosted growth of real GDP by nearly 2 percentage point this year and by ¼ percentage point next year. These adjustments more than offset the downward revisions to our projection that were necessitated by the higher expected path of oil prices, which we estimate will trim about ¼ percentage point off the growth in real GDP in each of the next two years. The faster pace of capital spending incorporated in this projection also had implications for aggregate supply through its contribution to capital deepening. But that was just one of a number of changes we made on the supply side of our projection. As I noted earlier, we have had to contend with two strong crosscurrents in this aspect of our forecast: faster-than-expected growth of labor productivity, on the one hand, and slower-than-expected growth of the labor force, on the other. March 22, 2005 11 of 116 As you know, the surprising strength of productivity over the past few years has required us to take a stand on how much of the recent gains has reflected structural improvements that will persist going forward and how much has reflected the cautious hiring stance of businesses and their ability, at least for a time, to elicit greater effort from their workforces. In other words, we have had to parse these innovations into trend and cycle components. With positive surprises to productivity continuing, the story about caution-induced effort seemed to us to have diminishing plausibility. Both our models and our best judgment suggested raising our estimates of the structural component of productivity in recent years and correspondingly lowering the cyclical component. In addition to raising the level of structural productivity through the end of last year, we also nudged up our estimate of the growth of structural productivity going forward by about ¼ percentage point per year to about 3 percent per annum. About half of that upward revision reflected the larger contribution from capital deepening that followed from our stronger investment forecast. The other half reflects stronger projected growth of multifactor productivity. Businesses have been making substantial gains in technological and organizational efficiencies in recent years, and we anticipate more of that to continue over the next couple of years than was assumed in our January projection. While the revisions that we have made to structural productivity, all else equal, would have resulted in a noticeable upward revision to the projected growth of potential output, all else was not equal. Just as we have been surprised to the upside by productivity, we have been consistently surprised to the downside over the past year or so by the weakness in labor force participation. We had been expecting that, as the labor market began to give clearer signs of sustained improvement, more workers would be drawn back into the labor force. We still think that is likely to happen. March 22, 2005 12 of 116 On net, the upward revisions to productivity slightly exceeded the downward revisions to potential labor input, and we revised up the growth of potential output by 0.1 percentage point this year and next. These upward revisions were smaller than those we made to actual GDP, and, as a consequence, the GDP gap is a touch smaller in coming quarters than was the case in our January projection. A slightly tighter economy has added to a growing list of worries that would make any compulsive hand-wringer proud. That list would also contain higher oil prices, larger increases in non-oil import prices, a steep rise in commodity prices, a reemergence of price pressures from intermediate materials, some deterioration in near-term inflation expectations, and a disappointingly large increase in core PCE [personal consumption expenditures] prices in January. To our relief, this morning=s PPI for February did not add to this list. The increase in core finished goods—at 0.1 percent—and the increase in core intermediate materials—at 0.5 percent—were right in line with the Greenbook projection. But taken together, price developments over the intermeeting period have been troubling. The effects of higher oil prices are already being felt at the pump, and headline inflation measures will be up noticeably in February and March. Moreover, higher energy and materials prices are adding to business costs, and higher prices for imports are lessening competitive pressures on the pricing decisions of domestic producers. In response to these developments, we have raised the projected increase in core PCE prices to 1¾ percent in 2005 and 1½ percent in 2006—about ¼ percentage point higher than our previous projection in both years. Still, the basic contours of the inflation forecast remain the same. Such a modest revision might lead some to wonder if the staff should be doing a little more hand-wringing if we wish to avoid an eventual neck-wringing! But at this point, we believe that only a modest revision is warranted. As you know, for the prices of oil and other commodities, we take our cues from futures markets. And, as they have for much of the past year, those markets are suggesting that a flattening out of prices is just around the corner and that declines will occur by next year. Futures markets have not proven to be terribly reliable guides to prices over the past year, but we simply aren=t confident that we can outguess the markets in these areas. March 22, 2005 13 of 116 Moreover, the labor cost picture remains quite subdued. Growth in hourly labor compensation has basically moved sideways in recent quarters. Our projection incorporates some acceleration in wage inflation in response to higher price inflation this year and a gradual tightening of the labor market. But the faster projected growth of actual and structural labor productivity holds down the overall increase in unit labor costs. Indeed, the combination of slightly higher price inflation and lower unit labor costs resulted in an upward revision to the price markup in this projection, which already was above historical norms. In effect, greater pricing power is implicit in this forecast. As I see it, the most disquieting development on the inflation front has not been the run-up in energy and commodity prices, but has been the apparent rise in inflation compensation over the next three years—at least as best as we can judge by readings from the inflation swaps market. Should a deterioration in inflation expectations eventually come to be reflected in wage- and price-setting decisions, you would be facing a more substantial, persistent, and ultimately costly acceleration of labor costs and prices. As we showed in an alternative simulation in the Greenbook, those difficulties are amplified if monetary policy is slow to respond to heightened inflation expectations, and real interest rates are inadvertently eased. On the other hand, the most comforting development on the inflation front has been the continued exceptional performance of productivity. Although we have revised up our forecast for actual and structural productivity, we are still betting on a substantial slowdown of structural multifactor productivity. As we showed in another simulation, if that doesn’t occur, cost pressures could be considerably less than we are currently anticipating and inflation could drop to the low end of your comfort zone. Karen will continue our presentation. March 22, 2005 14 of 116 No one factor explains the run-up in prices since late January, but a major reason seems to be stronger demand in global markets—currently and prospectively, in the eyes of market participants. This stronger demand is arising from a global economy in which continued expansion at a reasonably robust pace seems likely, albeit with some variation across regions. Also, there are currently some supply risks in the usual trouble spots among oil-producing countries. But over the longer run, the issue seems to be how projected increases in demand will be met by increased supply. Of the 2.7 million barrels per day that global consumption increased during 2004, 30 percent, or 850,000 barrels per day, was accounted for by increased consumption in China. China is now the second-largest oil consumer on the globe; the United States is first. The staff continues to rely on futures markets for our projection of the spot WTI price. After the first couple of months, the futures curve slopes down and is the basis of our forecast that, by the end of 2006, that price will be somewhat below today=s price. However, we also need to forecast the U.S. oil import price, and for us the challenge is to project the spread going forward between WTI and the import price. That spread was quite variable last year, and in January of this year it jumped up again, to over $9 per barrel. We currently expect that the spread will narrow, on balance, over the forecast period, with the result that the U.S. price for imported oil will decline only slightly from current levels—noticeably less than the decrease embedded in the futures curve for WTI—by the end of next year. However, we could be surprised, and the behavior of that spread is one of the risks to the forecast. The general increase in global oil prices has been cited by many as a reason for rising inflation expectations and the move up in long-term interest rates across the major industrial countries during the intermeeting period. Ten-year sovereign rates in the major foreign industrial countries generally rose about 20 basis points since your last meeting, somewhat less than the increase in the U.S. rate. The smaller rebound in rates abroad is consistent with the perception that recent economic indicators suggest a more vigorous pace of expansion in the U.S. economy than in the other industrial economies. And foreign rates declined more sharply than did U.S. rates from the end of last June, when you began your current tightening cycle, to the turning point for rates in early February. However, it may be that the stronger price performance of bonds denominated in the major foreign currencies reflects some shift in portfolio preferences away from dollar assets toward those denominated in the other major currencies. Such an interpretation is consistent with the 1 percent net nominal depreciation of the foreign exchange value of the dollar in terms of the other major currencies over the intermeeting period and the fact that stock market indexes in the foreign industrial countries generally outperformed U.S. indexes over the same interval. March 22, 2005 15 of 116 widened nearly $90 billion from the third-quarter figure, with about $60 billion of that change accounted for by the increase in the trade deficit. Of that $60 billion, more than half represents the deterioration in the oil import bill. Relative to the figures we put in the Greenbook, net investment income surprised us in the positive direction. That surprise was entirely in net direct investment receipts, as net portfolio income came in about as expected, around $25 billion weaker than in the third quarter. Direct investment receipts were particularly strong, with the increase more than offsetting a small positive surprise in direct investment payments. The fourth- quarter increment in the current account deficit was financed by somewhat larger foreign official financial inflows and substantially larger foreign private net purchases of U.S. securities, particularly of agency bonds and corporate stocks. The rise in foreign inflows was sufficient to finance a small rise in U.S. net private acquisitions of foreign securities and an unusual but sizable increase from the third quarter of U.S. direct investment abroad. Looking forward, we expect the trade deficit to widen further both this year and next. With little change projected in the U.S. oil import price, the oil import bill should increase only slightly, and most of the deterioration in the trade balance is expected to occur within the core goods categories—that is, goods less oil, computers, and semiconductors. Accordingly, in real terms we are looking for net exports to make a small negative contribution to GDP growth in each of the two years. We expect the widening of the nominal trade deficit to be nearly matched by further reduction in the net investment income balance, as the negative change to net portfolio income substantially outweighs projected gains in net direct investment income. Accordingly, the current account deficit should widen to exceed $850 billion, or 6½ percent of GDP, by the end of next year. We also received February prices of internationally traded goods late last week. Prices for non-oil core imports increased a bit more than we were expecting. February price rises were concentrated in foods, feeds, and beverages and in non-oil industrial supplies; but for January and February combined, all categories of non-oil, core goods other than autos registered significant upward moves. These developments leave us with a projection for inflation of the core import price deflator in the first quarter of nearly 5 percent at an annual rate, higher than the January Greenbook figure and higher than our equations by themselves would suggest. We do not yet have sufficient evidence to conclude that the decline observed in past exchange rate pass-through is being reversed. With the effects of dollar depreciation in the second half of last year and the recent run-up in commodity prices likely to be felt through the end of this year, we expect core import price inflation to be about 2 percent at an annual rate during the rest of this year before slowing noticeably next year, consistent with our outlook for flat commodity prices and only modest further dollar depreciation. March 22, 2005 16 of 116" FOMC20080625meeting--79 77,MR. LACKER.," Thank you, Mr. Chairman. Economic activity in the Fifth District has remained soft in recent weeks. Our retailers report declining activity in June, especially in autos. We are still hearing scattered reports of delayed or canceled new construction projects, either because of a lack of financing or because demand is expected to decline. Our survey measure of manufacturing activity, which by the way covers a manufacturing sector bigger than the Philadelphia and the Empire indexes combined, [laughter] has edged lower in the last two months; but exports continue to be a bright spot with reports of robust outbound activity at area ports. Manufacturing contacts report some success in passing on rising energy and transportation costs to their customers, and their indexes of expected six-month-ahead manufacturing price trends, both for prices paid and prices received, reached new record highs for the 14-year history of those series. I, too, have heard scattered reports in the last couple of weeks of employers contemplating providing extra compensation boosts to their employees to make up for rising energy costs. On the whole, I think the risk of the national economy sinking into a serious recession has receded, and the growth outlook has edged up a bit. I was relieved by the strength in retail sales in May as well as the upward revisions for April and March. The ISM indexes have steadied at right around 50 over the past four months; and although the labor market has been weak, it has not yet shown the accelerating declines that I feared. The Greenbook projection for Q2 real GDP has been revised from minus 1.4 to plus 1.7, and we have made a similar adjustment in our own projection. There remain plenty of reasons for concern on the real side of the economy, of course. Real disposable income has suffered with the fall in employment over the last half-year, and the rising cost of gasoline is taking its toll as well. The continued fall in housing prices has cut into household net worth and could contribute to a rise in consumer saving. Stimulus checks might be playing an important role in supporting consumer spending right now; it is not clear how much. But I am concerned that, when the stimulus effects wear off later this year, we may find that the underlying trend in consumer spending is fairly soft. Commercial construction also remains a potential risk, I believe. There is a bit of a disconnect between the surprisingly strong data on nonresidential construction and the reports of slowing that we keep hearing from regional contacts. This suggests that the numbers reflect projects initiated before the beginning of the year and that commercial construction is likely to soften later this year and to be a drag next year. Despite all of these elements that could depress growth, I think the economic situation has undoubtedly turned out better than we expected at the April meeting because of the better-thanexpected consumer and business-investment numbers. Greenbook now forecasts a period of low but positive real growth, significantly better than the experiences of the last two fairly mild recessions, and I think that is about right. Inflation is a growing problem, though. CPI came in at an annual rate of 8 percent in May and has averaged 4.9 percent over the last three months. The core intermediate goods PPI is increasing at double-digit rates. Oil prices have risen 16 percent by my calculation since the last meeting. Retail gas prices are up 13 percent. Changes in inflation expectations since the last meeting vary with the measure that you choose. But my reading is that they continue to deteriorate. In any event, they are above levels consistent with price stability. The Michigan survey numbers for inflation expectations have risen notably, especially for the one-year horizon. The TIPS-based measure of expected one-year inflation five years forward has increased 30 basis points since the April meeting, and although the five-year, five-year-forward figure has been stable since then, it is still quite close to the highest value it reached at any point last year. It is popular, as many have noted around the table, to cite the stability of compensation gains as evidence that we are not seeing a wage�price spiral. I have done it myself recently. But I share the concerns expressed by President Evans and others around the table about that being a lagging indicator. I am concerned that, if we wait until we see rising inflation expectations showing up as wage pressures, we will have waited too long. I noted in just a casual glance at the data from the 1970s that, although wage acceleration was a prominent component of the acceleration of inflation in the late 1960s, it was largely absent in the accelerations that occurred in '74 and '79. I think monetary policy is quite stimulative right now. Using the Bluebook's standard approach of subtracting four-quarter lagged core inflation, the real funds rate now stands just below zero, about where it bottomed out in the '91 recession and a good deal above its trough in 2004. But I don't think lagged core inflation is the best estimate of overall inflation now. I am drawn to the Bluebook's real rate estimate, new in this edition, that uses the Greenbook's projection for headline inflation. Using that measure and going back and reconstructing it for the past, the real funds rate is now minus 1.3 percent, and that is substantially lower than its troughs in the last two recessions, which were right around zero. This is a lot of stimulus, arguably way too much given the improvement in the growth outlook, the reduction in downside risks, and the continuation of inflation pressures. I think withdrawing the stimulus is going to be challenging, however. About the extended projections, I am not convinced that the benefits exceed the cost. I don't think it is going to provide much help on communicating an inflation objective. I think it will show about as much dispersion as our third-year forecasts show now. In any event, I haven't noticed much of a decline in the volatility of inflation expectations since we began releasing projections on an accelerated calendar late last year. Moreover, I think those steadystate or longer-run projections are just going to tempt people to think that we have an unemployment rate target and a growth target. That some politicians have suggested that we actually adopt such makes it dangerous to engage in any exercise that seems to comply with that suggestion. Besides, I am not sure who cares about our steady-state growth forecasts besides maybe some business-cycle-model calibrators. But we are likely to get our steady-state growth forecasts from those people in any event, so I am not sure that is going to be very helpful. I don't think we should bother with these extended forecasts. Thank you, Mr. Chairman. " FOMC20080805meeting--110 108,MR. MISHKIN.," I think there's no question that headline inflation is very high right now. Clearly, when you get these kinds of increases in energy prices and food costs, you're going to have to reflect them in current prices. In fact, that's exactly what you need to have happen so that relative prices shift. The reality is that high oil prices have to mean that real wages fall. People have to conserve and not drive as much and so forth. So this is a normal process, and monetary policy does not control these relative price shifts. What I think is more critical is that, although there are some problems in terms of core, the effect has actually been quite limited given the incredible rise in energy prices. While it's important to think about headline in the long run, the information from core is very useful in terms of thinking about policy because it tells you whether this is spilling over into underlying inflation. One of my concerns about going to anecdotal information and why I think we need to use an analytic framework in thinking about what is really driving the inflation process is that we do need to focus on the longer-run because that's what monetary policy can control. I get a bit nervous about these anecdotal concerns, which I think can tell us something about headline. Then we have to ask what they tell us about the longer-run context but not put too much weight on them. That's one reason that I think some of the analytic frameworks that we've developed here are very useful for thinking about these things. Thank you. " FOMC20050630meeting--166 164,MR. KOHN.," Thank you, Mr. Chairman. I have three questions. The first one is on the price-to-rent ratio. We’ve been treating it as if most of the adjustment has come on prices. And I wanted to ask Josh particularly whether, as you’ve been looking at the micro data and thinking about this, the dynamics of some of these innovations that have led to a shift from renting to home ownership might have artificially depressed rents relative to prices. And I wondered, after that shift is over, if rents will start rising faster and close the gap that way—use up some of that 20 percent. My question is what you thought of that. And my observation is that that would present a much more difficult situation for us sitting around this table. It would be kind of like a supply shock because prices would be rising, inflation would be higher—and that homeowners’ equivalent rent June 29-30, 2005 54 of 234 if house prices fall. That’s a pure demand shock. But if rents start rising, that’s another matter. So I wondered if you’d comment on that. And then, while I have the floor, let me ask my questions of Glenn and John. Glenn, on the 1994 bubble analogy, I was surprised to see that classified as a bubble. I think there was some inflation scare then, but there was also a real rate adjustment at the same time. If you looked at any of the surveys, I think you wouldn’t have seen much of an increase in inflation expectations. I agree that we had to raise real rates in order to prevent that from happening. But that seems to me a very different animal than equity price changes or house-price changes because we are responsible for inflation. So if we see inflation moving, we’ve got to do something about that, whereas we’re not responsible for the relative prices of houses or equity and other things. So I wouldn’t have put 1994 on a list of situations we might think about as we’re looking at this issue of house-price gains. It seems to me very different. I’d like to hear your comment on that. And finally, my other question for John has to do with this point about the misallocation of resources. Doesn’t it matter what the state of the business cycle is? If we hadn’t had so many houses built and so much consumption over the last few years, we would have had more unemployment. So it’s not obvious that resources have been misallocated. The resources that went into building houses, furniture, and cars, and so forth might have been unemployed, especially if we had raised rates more in order to lean against the house-price increases. If we had, surely unemployment would be higher. So it seems to me that it’s one thing to talk about misallocating resources between two states of full employment, but it’s another thing to talk about a misallocation of resources where there would otherwise be slack in the economy. And the latter case I don’t think really is a misallocation of resources. There’s no opportunity cost. June 29-30, 2005 55 of 234 I’ve looked at the rent side of the picture. As to this idea that perhaps prices are getting too high relative to rents, I’d argue that they’re going to come back in line. Now, maybe rents are going to be doing some of the correcting, as it were. The work that I’ve done gives just a little hint of evidence that maybe rents do a bit of the correcting. So, what we might see going forward is rent growth slightly higher than it otherwise would have been. But statistically speaking, it’s basically no different from zero. Statistically, it doesn’t look like rents do any of the correcting. What really seems to be happening is that rents go up at some rate determined by economic conditions and then prices move around them." CHRG-111hhrg51698--333 Mr. Lucas," Mr. Taylor, along those lines, in Mr. Pickel's testimony he notes that supply and demand ultimately determine prices and that speculation does not increase prices. Would you care to offer some observations on that point? " FOMC20050630meeting--90 88,MR. GALLIN., We do have those data. There’s an index that gives price per square foot and rent per square foot for apartments nationally and in various cities. And it shows a marked increase in the price-rent ratio. CHRG-111hhrg63105--193 Mr. Conaway," You used a phrase which I thought was interesting. You said that basically the speculation--and you said it as a pejorative--are bets on higher prices. Is there a different reason to speculate than higher prices? Is that the side of the deal that is buy low, sell high? " CHRG-111hhrg53244--199 Mr. Bernanke," No. I agree it is very important, and I am surprised that we don't have much coverage. I think we certainly do put a lot of resources into projecting construction, house prices, land prices, and the like. And I agree, it is very important. " FOMC20080805meeting--102 100,MR. LOCKHART.," Thank you, Mr. Chairman. The contours and basic outcomes of Atlanta's forecast are similar to the baseline of the Greenbook forecast. So I want to focus my remarks this morning on the underlying assumptions in both forecasts--assumptions that I view as pivotal and if we miscalculate could result in a longer-term policy error. It seems that at every meeting there's great uncertainty around the outlook, and this juncture is no different. I perceive considerable uncertainty and debatable assumptions in the base-case scenario. As I see it, the key assumptions broadly are that housing stabilizes, perhaps as indicated by housing prices, in the second half of '09. Inflation pressures intensify in the near term but then abate because of economic slack and lower commodity prices and, as discussed, core import prices. Recent declines in oil prices stick, and prices remain more or less flat. Certainly since the Greenbook was published, we note the fluctuations just in the past few days that were referred to earlier, and I also can't dismiss geopolitical risks and the potential of a severe shock. Finally, financial market stress will persist for some months but diminish next year. These assumptions, using the respectable term ""assumptions,"" have the feeling to me of ""bets,"" not so respectable a term. The policy assumption integral to both the Greenbook and the Atlanta forecasts could be added to this, and that is that rate rises starting in 2009 won't choke off improving growth and will be enough to blunt remaining inflation pressures. So I'll devote my comments to input from regional and other contacts that either serve to confirm or cast doubt on these assumptions. We oriented this cycle's questions to our Atlanta and Branch directors to, first, evidence of wage pressures and pass-through of higher costs. In interpreting the feedback, we noted some confusion between a business's management of its labor costs versus general wage pressures. We heard that businesses are working to keep their total wage bills in check by raising wages for key talent but letting less critical employees go or cutting their work hours as an offset. The reduction in hours is attributed to some combination of weaker product demand and increased average productivity. Rising unemployment appears to be keeping wage demands in check. There are exceptions, such as the oil field services industry, for which qualified staff are in short supply, and certain skilled industrial and business trades in which local bottlenecks exist. In businesses enjoying strong export demand, some employers are utilizing bonuses rather than commitment to permanent wage increases. So our regional contacts did not indicate the development of broad-based underlying pressures on labor costs reflecting wage demands. As for inflation pass-through, our contacts reported widespread and growing efforts to pass through higher input costs. Pass-through efforts appear to be the rule rather than the exception. As one Branch director put it, people are passing through costs like crazy using high energy costs as cover. The reports of my supervision staff regarding banking conditions indicate a continuing decline in asset quality and a very nervous interbank funding market. Foreclosed properties, both single-family and condo, are making up the majority of house sales and slowing the absorption of the oversupply of new homes. Some contacts are very concerned about the prospect of a second wave of foreclosures as option ARM mortgage borrowers, mostly concentrated in large states like Florida and California--these are borrowers who are currently paying less than the accrued interest--run up against maximum loan-to-value ceilings. New, higher GSE standards are resulting in fewer borrowers being qualified, putting downward pressure on house prices and bringing more foreclosures. Virtually all comparables for Florida residential valuation are based on forced sales and foreclosures, we are told. Beyond the deterioration in real estate portfolios, banks are reporting growing problems in credits to food distributors, restaurants, trucking, and other petroleum fuel or input-intensive industries. Based on my calls with financial market contacts, it seems that--no surprise--much of the attention in financial markets has shifted from private fixed-income markets to Fannie and Freddie. Fixed-income markets for private securities appeared to have improved relative to their lows since the current financial turmoil began. Although significant concerns remain, it appears that leveraged-loan deals are getting done. Volume is down, spreads are up, and the deals are very conservative, but deals are getting done. That said, one of the patterns in my calls over the past year has been that, every time one concern abates, another seems to jump up and take its place. Although the recent legislation appears to have alleviated concerns about the Fannie and Freddie senior debt, my contacts indicate that there is widespread uncertainty about what will happen to junior securities if the Treasury injects funds. Furthermore, more than once I heard the view that foreign holders of GSE debt are concerned that their positions are not as safe as they believed. One contact mentioned that the 18-month term of the guarantee is reportedly affecting some holders' maturity choices. In response to my question about the relative weakness of European banks, one contact suggested that they have booked much of their troubled assets in the ""hold to maturity"" account, suggesting slower recognition of losses and difficulties ahead. We confirmed with one large regional bank CFO significant deterioration of HELOCs in their portfolio and, by implication, broadly among regional banks. The option ARM problem, by contrast, is perceived to be possibly the next shoe to drop but, as I said earlier, not uniformly distributed across the country. Finally, we heard the view that markets perceive banks as facing protracted difficulty raising capital. To conclude, the downside risks to growth have not diminished in my opinion. On the flip side, I agree that the upside risks to inflation are obviously a serious concern. In particular, I put a fair amount of weight on the possibility that inflation will not moderate sufficiently without a more substantial tightening of monetary policy than that projected in the Greenbook baseline. My intermeeting internal and external discussions make it difficult for me to dismiss some of the alternative scenarios in the Greenbook, specifically the ""severe financial stress"" scenario, the ""typical recession"" scenario, and the ""inflationary spiral"" scenario; and in a high-uncertainty environment, I don't view any of these scenarios as exclusive of another. That said, I see the risks to both the inflation and the growth objectives as very roughly in balance at this time. Thank you, Mr. Chairman. " CHRG-110hhrg38392--95 Mr. Bernanke," Well, first of all, we are unhappy with inflation, including energy and food prices running higher than we would like, so it is already a concern in that respect. Looking forward, I think the real issue for us is, if there are temporary bursts in prices of food and energy, will those higher prices somehow get embedded in the long-run, underlying trend of inflation. There are a couple of ways in which that could happen. One would be if say, higher crude costs, materials costs, were passed through by producers into the higher prices of other consumer goods, for example. The other possibility would be if consumers, having seen for many years very high increases in their food and energy costs, began to lose confidence in the Federal Reserve and to worry that inflation would be higher in the future. Their expectations of inflation would begin to move upward. Once that happens, it is much more difficult to keep inflation low, because people are building into their wage and price decisions higher expectations of inflation. So there are some concerns there, and it is part of the reason why I think we do have to be quite vigilant on inflation at this juncture. " CHRG-111shrg53085--105 Mr. Whalen," Nobody does not want to get paid. But Lehman Brothers to me is a classic example of why the good people in the U.S. Federal Bankruptcy Court should be the first folks you talk to about this. You do not need another layer of politics to deal with holding companies, because once the bank is gone, what do you have? You have a Delaware corporation that belongs in front of the U.S. Bankruptcy Court. The moment the FDIC becomes receiver of the banks, it is no longer a regulated entity. They are gone. The deposits are gone. The loans are gone. That is the point. Senator Warner. Let me come at this from a different way, and I am going to thank the Chairman for giving me a little more time. We look at size, we look at complexity. Another approach which I have been thinking about for some time is on the financial products end. Again, my premise is--and I would like to hear from a number of you, if you want to comment. And I spent 20 years around financing more in the venture capital end, but, you know, under the guise of innovation, it appears to me that over the last 10 years we have created a whole series of financial products that at some level have been argued that they have been about better pricing risk. I think on reflection it may be the marginal societal value of better pricing risk versus the type of systemic exposure that it has created and that many of these financial products may have been more about short-term fee generation than they have been about long-term value to the system. But if we were to--and I know Senator Schumer has mentioned an approach he has taken, and I would love to see what would be the--what kind of thinking any of you have done in terms of the criteria of how we might on a going-forward basis evaluate financial products. Is there an underlying theory? Is it just the risk they bring to the system? Would there be some effort to try to make an evaluation of a macrolevel societal value added for these new financial products? How do you do that, and how do you--you know, I am a little bit afraid that we closed the door on certain products from the last crisis, but with the amount of intellectual fire power going into financial engineering, how are we going to preclude the next generation of financial products kind of getting beyond our control or oversight? Ms. Hillebrand, or anyone else on that comment. Ms. Hillebrand. Thank you, Senator Warner. I think there are two things. One is the Financial Product Safety Commission would be charged not with minimizing all risk but with minimizing undue risk to consumers, including keeping up with those new practices and those new products, so that the consumer who overdraws by 85 cents does not face $126 in bank fees, as happened to a consumer who we talked to earlier this month, and keeping up, looking at the practices. This is not to say banks cannot charge fees, cannot do anything, but to try to watch the practices and to outlaw those products that just do not fit with the nature of the product. Your checking account should be a service you pay for and not a fee machine for the bank. We need to get back to that kind of common sense. We think a Financial Product Safety Commission could do it on the consumer financial product side. In the mortgage and credit area, we also need to create accountability structures so that everybody who has a piece of that loan has responsibility going forward. That means a suitability requirement for those who are selling, a fiduciary requirement for those who are advising, and as people talk about ``skin in the game,'' a responsibility going forward if there are later problems with that loan. That is a beginning. Senator Warner. Well, my time has expired. I know Senator Menendez--but I would like to hear from others, perhaps, if you could get back to us on what would be that--I still did not hear what would be the underlying theory of how we would evaluate financial products on a going-forward basis. We do not want to stem innovation and, clearly, some level of responsibility and higher minimum investment requires qualified investor criteria and other things I get. But what would be the underlying theory of how we should regulate or evaluate financial products. Thank you for allowing me a little additional time, Mr. Chairman. " CHRG-110shrg50369--16 Mr. Bernanke," Mr. Chairman, there are certainly some similarities with the 2001 experience, most obviously the sharp change in asset price. In the previous case, it was the stock market, the tech stocks; in this case, it is home prices. But there are some important differences as well, as you point out. The decline in home prices is creating a much broader set of issues, both for borrowers and homeowners, but also for the credit markets. And so we have a sustained disruption in the credit process which has gone on now since last August and is not yet near completion. That is a continuing drag on the economy and a continuing problem for us as we try to restore stronger growth. The other problem is that we do have greater inflation pressure at this point than we did in 2001, and that is coming from oil. In 2001, the price of oil was somewhere around $20. Today it is $100. " FOMC20060131meeting--89 87,MS. MINEHAN.," Thank you, Mr. Chairman. There’s not a lot new in New England. So I thought I’d just skip over my usual probably more-lengthy-than-necessary comments on the region. Let me just mention a couple of things, though. Employment growth is still slower, and income growth is still slower than that of the nation. Our regional unemployment rate went up rather than down over the past year, and we have seen some slowing in residential real estate markets. However, surprisingly enough, there seems to be a good deal of optimism in discussions we have had with people about business spending and about commercial real estate markets. So, for the first time in five or six years, we’ve actually had net absorption of space, both downtown and in the suburbs. That situation is making a big difference in the smiles on people’s faces around town. I hope it means that New England is getting back and moving along the same trajectory as the nation. Turning to the nation, we, like most observers, were surprised at the modest growth rate of the economy in the fourth quarter. But we, like almost everybody else, believe that the reduced pace of government spending and smaller-than-expected inventory investment that affected the fourth quarter are likely to be temporary and reflect issues of timing rather than overall economic strength. Thus, we, too, anticipate a slightly stronger first quarter this year than we had before. But our forecast takes the same basic trajectory over the balance of ’06 and ’07—that is, strength in the first half of ’06 and then moderation as the effect of tighter monetary policy, cooling housing markets, and less fiscal stimulus takes hold. This is the same trajectory as that in the Greenbook. However, as we look at GDP, our forecast for ’07 is slower—½ percent or a little bit less— than the forecast for ’06, reflecting an expected outright decline in housing investment. We also see inflation trending off both this year and next, with core PCE inflation never above 2 percent over the two-year period. I mean, not “never,” which is a strong word, but at the points we’re mapping. Some of this difference in price pressures is accounted for by a sense of a somewhat greater supply of labor resources, as reflected in a slightly lower NAIRU and a higher labor force participation rate. Looking at these forecasts and assessing all the data and anecdotal inputs I have received since the last meeting, I am struck by a couple of things. First, these forecasts, and the vast majority of those available from other sources, describe an almost ideal outcome. U.S. demand is strong but slowing, as consumers save more and borrow less. Fiscal stimulus diminishes, business spending remains solid, employment grows, inflation edges off, and foreign growth is spurred by domestic demand at last and acts to create some export growth, though we continue to have a widening current account deficit. If these forecasts were to be realized, it would truly be just about the best of outcomes, and I would agree with President Yellen—a major sweet spot as the Chairman hands over the reins. But that scenario sort of begs the question of risks, both large and small, and how they are balanced. We could certainly be surprised by new energy shocks or geopolitical events of such magnitude to cause financial turmoil and consumer and business retrenchment. We could also witness the turbulence that could accompany a sharp unwinding of the nation’s ever-growing external deficit. But you don’t have to focus on major upsets. Risks of a lesser proportion loom as well. We could very well be wrong about the remaining capacity in labor markets, and the resulting upward pressure on wages and salaries could create a more rapid pace of inflation, particularly given the solid pace of external growth and pressures on a range of commodity prices. To date, however, the growth of wages and salaries has been on the slow side, particularly relative to productivity, and there is little evidence that firms believe they have the pricing power to pass on much more than energy surcharges. Indeed, their profit margins suggest that they have a cushion against increases in input costs. Alternatively, the impact of a cooling housing market could take a larger bite out of consumption than we now expect and cause a greater-than-projected, though welcome, increase in personal saving. This would, of course, slow the economy from baseline and damp price pressures. We haven’t seen this yet either, but it could be just as likely as missing on the inflation side. Thus, as I look at both the upside and downside risks, they seem to me to be more balanced than they have been. As some evidence of this, both the Greenbook and the fed funds futures markets anticipate that policy is near a tipping point—move a bit more now and then retrench in late ’06 or early ’07. I also find myself beginning to wonder about the cost of being wrong. When policy was arguably much more accommodative, it seemed to me that letting inflation get out of hand might be harder to deal with and ultimately more damaging to the economy than if growth slipped a bit. That may still be true. But just as our credibility regarding price stability is important in setting market expectations so, too, is some sense that policy will be supportive of growth when the threat of rising inflation is less imminent. In short, we need to be credible about achieving both our goals. At this point, another nudge toward a policy rate that neither stimulates nor restrains the economy seems appropriate. But the need for further moves seems to me to be increasingly driven by the incoming data." FOMC20071031meeting--155 153,MR. KOHN.," Thank you, Mr. Chairman. I agree with President Hoenig that this is a difficult decision between staying where we are—and I would have downside risks to growth on that—or moving 25, but with more-balanced risks. I think it’s difficult—we are balancing a number of very difficult things here. On the one hand, the incoming data, as Dave has emphasized, have been, if anything, stronger than we anticipated on the real economy and include data for September and some hints for October in here. On the other hand, many members of the Committee, myself included, have a sense that the real interest rate is still a little to the high side of where it needs to be to promote full employment and stable prices over time. We expect the output gap to move over the next couple of quarters, as housing holds down growth relative to potential. We expect inflation to stay low and inflation expectations, if anything, perhaps to edge down as people realize that inflation is going to stay at 2 or below. I wonder whether the 50 basis points we did last time was enough to offset the tighter credit conditions that have developed and the market disruptions that are going to impede, particularly, the secondary markets for nonconforming mortgages for some time. This stuff isn’t going to go away soon, and it’s going to weigh on demand. Partly as a result of this sense, many of us think that the risks to growth are on the downside but are still worried about inflation expectations. The risks to growth on the downside are compounded, as the Chairman and Brian pointed out, by the sense that financial markets are still fragile and there is the tail risk of getting into the feedback spiral between concerns about the real economy and reactions in financial markets. Not the most likely outcome, but certainly a tail risk. As I tried to square several circles at the same time, I came down on alternative A: reducing 25 basis points but going to risks being roughly balanced. I see this as preemptive but not open ended. I think that combination of preempting some of the tail risk, getting a little ahead of the possibility, and buying this insurance is helpful. But going to roughly balanced risks takes out the open-ended sense that we’re on a path toward ever-lower interest rates. I see the incoming data for inflation as consistent with this. Inflation has been low even with today’s data. I think the core PCE has been low; the CPI is up a little but not much. I found the ECI data kind of interesting this morning. I have been a little concerned about labor costs creeping up, which you could see from some of the compensation data. But the ECI is a good, consistent measure over time. It is not totally comprehensive. Also, the fact that there is no increase in the growth rate of the ECI to me is pretty encouraging that underlying cost pressures are not building. By emphasizing our concerns about inflation—that the risks are roughly balanced—we are signaling that we are not buying into the full extent of the market expectations for our easing, and I think that is a good thing. The “roughly balanced” language will raise the hurdle a bit for ourselves to ease again in December if we have some weak data, but it won’t raise it so high that, if the data are really weak, we can’t react in a constructive way to change it. So putting all of this together and admitting that it is a close call, I think that alternative A—roughly balanced risks—minimizes the deviations from where we want to be, helps us send the signal about what we think might be coming and what our concerns are, and comes closest to furthering economic performance toward our objectives. I certainly agree with President Lacker that alacrity will be required. I think I actually called it “nimbleness” in the speech I gave—I want to quote myself again—and that will be very much in the forefront as we go forward next year, I agree. Thank you, Mr. Chairman." FOMC20050630meeting--282 280,MR. WILCOX.," This chart is trying to get at exactly that sort of iterative process of a futures market that, meeting by meeting, ratcheted up its expectation of oil prices, as illustrated in the upper right-hand panel. And yet, meeting by meeting, the futures market—and we along with it—figured that oil prices would level out from that point forward. Sometimes, for our inflation outlook, the absence of a negative is a positive—in the sense that with oil prices not moving up further in our projection, we don’t have that upward impetus." FOMC20060629meeting--105 103,MR. POOLE.," We’ve been using the term as a way of understanding some of the underlying pricing power that firms have. Firms do absorb cost increases in the short run, but they can’t absorb them in the long run. So what has to happen is that the secondary effects will show up in the level of core unless we put downward pressure on the non-energy-related parts, so that this ends up being a relative price change and not a change in the aggregate price level. That’s the point I’m trying to make." CHRG-110hhrg44900--203 Secretary Paulson," You know, that's interesting. I have heard a number of people say that one of the reasons the price of oil has gone up so much is the dollar has depreciated. And yet when you look at the statistics, look at what has really happened, if you go back to February of 2002, the dollar has declined in value 24 percent, the price of oil gone up over 500 percent. And so again, I really think the price of oil is being driven by supply-and-demand factors, and the real solution here is to address both. There is not an easy, short-term solution, but there is a lot that has to be done. " CHRG-110hhrg46593--379 Mr. Feldstein," Housing prices have to fall further. So I don't think that government should be trying to stabilize house prices at the current level. They overshot on the way up. They have come partly down. They have to come down further. The danger is that they can way overshoot on the way down. And that would be a bad thing. That would destroy financial institutions that are holding mortgage-backed securities. It would destroy household wealth, which, in turn, would make people cut back on their spending. That, in turn, would drag the economy down. So the ideal thing would be to see house prices come down to a sustainable level but not overshoot on the way down. And that is why I talk about this firewall as a way of stopping house prices from falling beyond the amount that is necessary to get back to pre-bubble levels. " FOMC20080916meeting--149 147,MS. CUMMING.," Thank you, Mr. Chairman. In our forecast, we do show a downgrade in real activity in the near term since the August meeting. Downside risks to the economy we see as still very considerable, and I would probably say that they really have increased quite a bit. I'll say a few more words about that. I'll also talk about the inflation front. We have long thought that inflation in the medium term will moderate, and we've been taking some comfort from recent developments that have been cited already. On the weaker economic outlook, we see the intensification of adverse growth coming from many things mentioned already: the unemployment rate increase and the likelihood that consumer spending is going to be negative. I would put great stress also on indications that world demand is slowing abruptly, as Nathan mentioned. I think that all three of these things are occurring in an environment in which we have massive correction, adjustment, structural change in autos, housing, and financial intermediation. That adjustment is really interconnected--one has effects on the others. As part of this--particularly in the financial sector, I would say--in our senior loan officer survey we've seen indications that, even as rates in, say, the mortgage markets start to ease a bit, nonprice terms may still be tightening. President Pianalto talked about other areas in which borrowers are facing much tougher terms. As financial institutions feel their capital is constrained--and there's plenty of evidence that balance sheets are constrained across much of the financial sector--those kinds of nonprice rationing measures probably will become more evident. Second, as we discussed earlier, we've seen that credit losses, which thus far have been largely confined to the financial sector and increasingly their shareholders, run some risk of spilling over to other kinds of investors, who to date really have not felt that impact, such as money market fund investors, as mentioned earlier. In addition, the three big corrections that we have seen in autos, housing, and financial intermediation are not limited to the United States. In particular, as you know, several G-10 countries are facing very difficult situations in their housing markets, not much different from us; and the financial intermediation adjustment is truly a global correction. On the inflation side, as I mentioned, we have acknowledged that we've seen elevated rates of inflation. But the recent developments--as we've seen in inflation expectations discussed earlier, in energy and other commodity prices, the unit labor cost developments that President Yellen discussed, and the year-over-year changes in import prices--are all pointing in the direction of some moderation of inflation and moderation of inflation expectations. In particular, we have looked at inflation expectations as measured by financial markets and feel that the decline that we see in those expectations cannot be explained simply by the drop in energy prices and technical factors but look larger than that. We would attribute that to indications, again, that global demand is slowing. Coming into this meeting today, we favor alternative B. I would associate myself with the comments of President Stern and President Evans, that if we were, in fact, going to make a move today, it would be better to make a large move of 50 basis points. Thank you, Mr. Chairman. " FOMC20071211meeting--25 23,MR. DUDLEY.," The risk to the municipal market is really through the financial guarantors, not so much the mortgage insurers. The fact that MBIA was able to raise $1 billion of equity capital yesterday for, I think, about one-seventh of their book value—so it is a fairly large capital commitment relative to the size of the company—is an important development. You saw that MBIA stock yesterday rose more than 10 percent because it basically was a confirmation, at least in the minds of some people in the market, that MBIA was a viable business and that someone was willing to put $1 billion of new capital in. I think that was reassuring to the market. Generally, the people I have talked with suggest that the barriers to entry into those businesses are pretty high. The second thing that is happening is, obviously, as you see this distress, their pricing power on new business is actually improving. That would suggest that there is a reasonable chance that these firms will be recapitalized, but it depends on how far down the path they are toward serious problems." CHRG-111hhrg48875--201 Mr. Minnick," But to the extent that the taxpayer--the desire to ensure the taxpayer receives maximum price leads to the financial institutions receiving less than a fair price. It will increase the need for you to induce capital directly. " CHRG-111hhrg51698--462 Mr. Hale," Chairman Peterson, Ranking Member Lucas, Committee Members, thank you. My name is Bill Hale. I have been in the grain merchandising business with Cargill for 35 years. I am joined this morning by David Dines, who has managed our OTC business for the past 15 years. As a merchandiser and processor of commodities, the company relies heavily upon efficient and well-functioning futures markets. First, I would like to thank the Chairman for holding this hearing and for his willingness to listen and address some of our concerns. We appreciate the changes made in the draft to better accommodate highly customized risk management products. Cargill encourages policymakers to develop regulatory systems that foster efficient, well-functioning, exchange-traded and OTC markets for agriculture and energy products. This can best be achieved by establishing better reporting and transparency for market participants, establishing and ensuring enforceable position limits. The existing draft of the Derivatives Markets Transparency and Accountability Act takes several positive steps, especially in the area of reporting, which will enhance the ability of the regulator to properly monitor market activities. However, the draft bill has two areas of concern. Section 6, position limits which are not constructed in the same manner for exchange-traded and OTC markets. This can be addressed by modifying how position limits are structured. This is not a question of whether they should apply. To put this in perspective, think in terms of highway speed limits. They apply to individual drivers. You do not send a car-maker a ticket when someone speeds. The same structure currently applies in the Chicago futures markets, and the same structure should apply in the OTC market. The other area of concern is section 13, mandatory clearing, which will stifle activity in the OTC market and reduce hedging opportunities in the agricultural and energy markets. This can be addressed by increased reporting requirements for OTC providers. While Cargill supports better reporting, transparency, and enforceable position limits, we urge caution and restraint for policymakers. We believe there is real danger in treating all over-the-counter products across all asset classes the same. In addition, the changes needed to improve some commodity-specific exchange-traded markets, particularly wheat and cotton, are often contract issues that have to be resolved between the exchanges and the market participants. Legislative measures are poor instruments to resolve these specific issues. Products provided by the OTC markets help hedgers, such as food, feed, industrial companies, meet risk management needs with tailored alternatives. Too often it is thought that the OTC market is solely used by speculators. However, it is critical to note that the majority of our OTC activity is for commercial and producer hedgers seeking tailored management solutions. Most critically during this unprecedented volatility, systemic risk was avoided because of the availability of both OTC and exchange-based hedging tools. Given the stress on the markets, some weaknesses were exposed, and the bill seeks to address those areas. But much of the basic functionality of the agriculture and energy markets performed well. It is important to remember that the dramatic volatility and price rise in 2008 was influenced by many variables. With strong fundamentals, commodity markets attracted many participants, both hedgers and speculators. Regarding section 6, Cargill supports enforceable position limits for noncommercial participants. However, as it was designed in the draft bill, position limits are not applied in the same manner for the OTC market as they are in exchange-traded markets. They should be structured in a similar manner for both markets. The draft bill seeks to apply the same position limit to the OTC provider as it does to the noncommercial participant. This is too restrictive to the OTC provider, since its role is to serve as an intermediary to more than one customer. This restriction will limit the size of the OTC market beyond the intended noncommercial position limits. The Committee will be able to achieve its objective of ensuring position limits in OTC transactions by applying position limits to the noncommercial participants. For section 13, we do not believe that mandatory clearing is needed. The stated benefits of central clearing are better transparency, reporting, and mitigation of counterparty risk. This can be accomplished efficiently by having standardized reporting requirements to the CFTC. The CFTC would have the ability to investigate and curtail any OTC customer whose position they believe is to large for the underlying commodity market. Centralized clearing has a role and should be encouraged for financially weaker market participants. However, financially strong food companies, industrials, commercials, and producers should have the flexibility to negotiate credit terms. Removing this flexibility from both simple and tailored OTC products will greatly reduce hedging activity through the working capital requirements of margin. Changes to the current system would be occurring at a time when liquidity and credit are already constrained, and at a time when hedging should be encouraged. Agriculture and energy OTC providers for many years have effectively used collateralized margining agreements and other credit support mechanism to manage credit and market exposures. This system works very well. It was simple OTC swaps on the grains that helped enable Cargill and other grain buyers to reopen deferred grain purchases from the farmer during 2008. Had the bill been in place in its current form, Cargill and other grain buyers would have been unable to use simple swaps to mitigate the margin requirements imposed on futures hedges. As a consequence, farmers would have been further burdened by the lack of pricing and liquidity for their crops. While the bill currently has provisions that allow for exceptions to centralized clearing for highly customized transactions, it is a little unclear to us what will and will not qualify for this exception. It is critical that no changes be made that would inhibit customized hedges, as this would also significantly reduce prudent hedging among market participants. If you think of the futures contract as one type of product, Cargill has over 130 different types of OTC products. The hedging customer can choose to further tailor the protection time frame, price level, and transaction size. Given this, no two 0TC transactions are identical, which is why centralized clearing is problematic. Clearing organizations do not have the systems and processes necessary to value and clear a wide range of products with a high degree of customization. In conclusion, Cargill appreciates the work of the House Agriculture Committee, ensuring that both exchange-traded and OTC markets perform well. These markets provide critical functions. This past year was clearly a volatile and difficult time for the commodity markets. Steps can and should be taken to improve market transparency and reporting, as well as ensuring that position limits are effectively enforced. We have serious concerns about sections 6 and 13 in the draft legislation, but we are confident that we can work constructively with Members of the Committee to develop policy alternatives that will help ensure the integrity of the markets. Thank you. [The prepared statement of Mr. Hale follows:]Prepared Statement of William M. Hale, Senior Vice President, Grain and Oilseed Supply Chain North America, Cargill, Incorporated, Wayzata, MN My name is Bill Hale, Senior Vice President, Grain and Oilseed Supply Chain North America. I am testifying on behalf of Cargill, Incorporated and have been in the grain merchandising business for 35 years. I am also joined this morning by David Dines, President of Cargill Risk Management. Cargill is an international provider of food, agricultural, and risk management products and services. As a merchandiser and processor of commodities, the company relies heavily upon efficient and well-functioning futures markets. Cargill is also active in the energy markets, offering risk management products and services to commercial customers. Cargill encourages policymakers to develop regulatory systems that foster efficient, well-functioning exchange-traded and over-the-counter markets for agricultural and energy products. This can be best achieved by: Establishing better reporting and transparency for market participants. Establishing and ensuring enforceable position limits. This past year was a period of remarkable volatility driven by many factors and, by large measure, the agriculture and energy commodity markets responded appropriately. The existing draft of the Derivatives Markets Transparency and Accountability Act of 2009 takes several positive steps, especially in the area of reporting which will enhance the ability of the regulator to properly monitor market activities. However, the draft bill has two areas of concern: Section 6: Position limits, which are not constructed in the same manner for exchange-traded and OTC markets. This can be addressed by modifying how the position limits are structured. This is not a question of whether they should apply. Section 13: Mandatory clearing, which will stifle activity in the OTC market and reduce hedging opportunities in the agricultural and energy markets. This can be addressed by increased reporting requirements for OTC providers and segmenting credit default swaps from traditional agriculture and energy contracts. While Cargill supports better reporting, transparency and enforceable position limits, we urge caution and restraint for policymakers. The agricultural and energy over-the-counter markets are not the source of systemic risk and abuse that the credit default swap market has been. We believe there is real danger in treating all over-the-counter products across all asset classes the same. In addition, the changes needed to improve some commodity-specific exchange-traded markets, particularly wheat and cotton, are very often contract issues that have to be resolved between the exchanges and the market participants. A well-informed regulator can be helpful in making sure balanced decisions are made that ensure contract functionality and market integrity, but broad legislative measures are poor instruments to resolve these specific issues.Role of Commodity Futures Markets and Over-the-Counter Markets The objective of a commodity futures market is to provide a price discovery mechanism and allow for effective risk transfer. For a commodity futures market to meet this objective, there must be both convergence with the futures price relative to the underlying cash value of the commodity at the time of delivery and a balanced range of market participants to provide adequate liquidity and efficiency. In addition to buyers and sellers with a physical interest in the underlying commodity, speculators also play a vital role in enhancing liquidity and futures contract performance. In effect, they help bridge the gap between buyers and sellers and ensure that contracts are quickly filled with the least possible transaction costs. Beginning with farmers and other commodity producers, and extending all the way through the supply chain to end-users, it is critical to have well-performing futures markets. Futures products allow farmers to know what their product is worth and to better manage their risks by setting a price for the commodity that is close to their actual delivery time. For consumers or processors, the same is true in allowing them to hedge their risks and gain greater certainty over their costs. Products provided by the over-the-counter (OTC) markets help hedgers meet risk management needs with tailored alternatives that cannot realistically be provided by traditional commodity futures and options markets. Too often is it thought that the OTC market is solely used by speculators, however it is critical to note that a majority of our OTC activity is for commercial and producer hedgers seeking risk management solutions tailored for their business needs.Unprecedented Commodity Market Volatility During 2008 During 2008, we experienced an unprecedented increase in commodity prices, only to be immediately followed by a decline of the same historical magnitude. This in itself has been tough for market participants to bear, but we now know that this has been followed by one of the worst economic crises in 80 years. In the world of risk management, we often talk of stress events and this was one of epic proportions. No risk manager could have ever contemplated what the markets have just gone through. I mention this because if there was ever a test for the agricultural and energy futures and over-the-counter markets it was these past twelve months. Fortunately, in many ways, these markets performed well as demonstrated by limited credit issues and limited contract defaults. Most critically, during this unprecedented volatility, systemic risk was avoided because of the availability of both OTC and exchange-based hedging tools. Given the stress on the markets, some weaknesses were exposed and the bill seeks to address those areas, but much of the basic functionality of the agriculture and energy markets performed well.Fundamental Factors Influencing Market Behavior and Speculation It is important to remember that the dramatic volatility and price rise in 2008 was influenced by many variables. Ending stocks for many of the key commodities were tight. In wheat, for example global supplies had been reduced by 2 years of major drought in Australia, a major wheat exporter. Global stocks of grain and key oilseeds[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Source: USDA. Foreign Agricultural Service. The ethanol mandate increased demand for corn. In response, producers planted more corn acres during the 2007 crop year and fewer soybeans, resulting in a very tight carryout balance for soybeans prior to the 2008 harvest. Also on the demand side, projections for continued growth in China, India and much of the developing-world showed growing needs for many of the basic agricultural and energy commodities. These factors were widely known within the farming, trading, processing, and investing communities. USDA Ag Outlook 2008 Projected Demand Growth 1996 = 100[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Source: USDA. With strong fundamentals, commodity markets attracted many participants, both hedgers and speculators, who believed commodity prices would rise. These fundamentals did not only attract capital to futures markets, but also attracted resources toward physical commodity production. Land costs increased for good quality farmland and producers stepped up investments in production technology through equipment, seeds and fertilizer. It is also important to note that even exchange-traded markets with no index fund participation also experienced extreme volatility this year. The volatility and price movements of the Hard Red Spring Wheat contract traded at the Minneapolis Grain Exchange were especially dramatic. Prices rallied 500% from May 2007 through February 2008, reaching a high of $25 per bushel.Derivatives Markets Transparency and Accountability Act of 2008 Cargill supports many of the components of the draft bill before the Committee today and appreciates the work of the Chairman. The bill would improve reporting and transparency. However, we are concerned with two specific areas under consideration by the Committee: Section 6, regarding how position limits may be applied to OTC product providers. Section 13, regarding mandatory clearing of OTC transactions through a derivative clearing organization. Both provisions have negative unintended consequences.Section 6: Application of Position Limits Cargill supports enforceable position limits for noncommercial participants. However, as designed in the draft bill, position limits are not applied in the same manner for the OTC market as they are in the exchange-traded markets. They should be structured in a similar manner for both markets.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In exchanged traded markets, the clearing broker serves as an intermediary or aggregator of positions, just like the dealer does in the OTC market. Position limits are applied to noncommercial participants in exchange-traded markets and not to the clearing broker. Limits in the OTC market should be categorically applied in the same manner, only to the noncommercial participant and not the OTC provider. The draft bill seeks to apply the same position limit to the OTC provider as it does to the noncommercial participant. This is too restrictive to the OTC provider since its role is to serve as an intermediary to more than one customer. This restriction would limit the size of the OTC market beyond the intended noncommercial position limits. The Committee will be able to achieve its objective of ensuring position limits in OTC transactions by applying position limits to only the noncommercial participants. Addressing this issue in this manner will ensure enforceable position limits and continue the functionality of this segment of the market.Section 13: Clearing of Over-the-Counter Transactions Substantial benefits can be achieved through better reporting by OTC providers. Segment the OTC market to focus on areas with the greatest challenges. Tailored risk management OTC contracts for hedgers cannot be cleared. Standardized swaps convey substantial benefits to a wide range of market participants and these benefits will be lost if clearing is mandatory. A stated benefit of central clearing is better transparency and data reporting. However, this is a restrictive and expensive means for collecting data about OTC market positions and participants. Cargill believes that this can accomplished efficiently by having standardized reporting requirements to the CFTC by the OTC provider community. Other sections of the draft bill directly address the issue of better data and reporting, and will achieve the needs of the Commodity Futures Trading Commission and Congress. One solution would be to have the CFTC restrict OTC activity to approved OTC providers. These approved OTC providers would have a reporting requirement to the CFTC in a standardized format and on a regular basis of all OTC transactions by customer that exceed a certain size threshold. The CFTC would have the ability to investigate and curtail any OTC customer whose position they believe is too large for the underlying commodity markets. The CFTC has this existing authority for investigating customer positions at the clearing broker on listed futures and it works well. Another stated benefit of centralized clearing is the mitigation of counterparty credit risk, since it requires both initial margin and the daily settlement or margining of 100% of the mark-to-market differences between the two parties. While centralized clearing has a role and should be encouraged for financially weaker market participants, financially strong food companies, industrials, commercials and producers should have flexibility to negotiate their own credit terms. As they stand today, the agriculture and energy OTC markets allow for efficient and prudent extension of credit by the OTC provider to financially strong hedging customers. Removing this flexibility for both simple and tailored OTC products will greatly reduce hedging activity due to the working capital requirements of margining. Changes to the current system would be occurring at a time when liquidity and credit are already critically constrained, and at a time when hedging should be encouraged, given the volatility in today's commodity markets. Agricultural and energy OTC product providers for many years have effectively used margining agreements and other credit support mechanisms to manage credit exposures. OTC product providers, including Cargill, have developed processes and built systems that enable us to value our customers' OTC positions and send position statements daily with updated and transparent product valuations. Based upon these valuations and statements, the parties pay or receive margin collateral daily once a credit threshold is reached. This system works very well. Again, if there was ever a test for this it was during the past year. Changing this flexibility in setting credit terms will have the perverse effect of reducing the hedging activity across financially stronger customers since they are the ones currently receiving margining credit from the OTC provider community. Financially weaker customers are either not receiving the margining credit from the OTC provider or they are already using futures because it is their only option. It must be recognized that centralized clearing penalizes participants with strong financial positions.Mandatory Clearing Can Impact Producer Pricing Opportunities Within the agriculture and energy markets, simple OTC swaps convey many benefits through the flexibility in setting credit terms. In the physical grain business, cash flow mismatches exist for grain buyers since they are required to meet the daily margining requirements of futures hedges and are not able to collect an offsetting margin payment from the farmer since physical grain purchase contracts are typically not margined with the farmer. Last Spring, many U.S. grain buyers, including Cargill, curtailed their deferred purchases of grain from farmers because of the historic run-up in commodity prices and the significant amounts of working capital that were needed for operational inventories and to fund the margin requirements of the underlying futures hedges for deferred contracted grain. This was an extremely difficult time for farmers and for grain buyers. Critically, it was simple OTC swaps on the grains that helped enable Cargill and other grain buyers to reopen deferred purchases of grain from the farmer during 2008. Using simple OTC swaps, grain buyers were able to move their hedging for contracted bushels from futures to OTC swaps with OTC providers that put in place margin credit thresholds on the mark-to-market exposure. The bill in its current form only grants an exception to centralized clearing for highly customized swaps, but not for simple swaps. Had the bill been in place in its current form, Cargill and other grain buyers would not have been able to use simple swaps to help mitigate the margin requirements imposed on futures hedges. As a consequence, farmers would have been further burdened by a lack of pricing and liquidity for their crops.Mandatory Clearing Is Extremely Difficult for Customized Products While the bill currently has provisions that allow for exceptions to centralized clearing for highly customized transactions, it is unclear what will and will not qualify for this exception. It is critical that changes are not made that would in any way inhibit customized hedges, as this would also significantly reduce prudent hedging among market participants. A key attribute of the OTC markets in agricultural and energy is the broad menu of product choices, as well as specific tailoring of the hedging instrument to precisely meet the hedger's needs. The advantages of product choices and tailoring are that they deliver both a more efficient hedge and a more cost-effective hedge because the hedger is not paying for something that they do not need. It also allows for diversification of products, which is so critical in today's marketplace. OTC product choices include protection size, protection periods, protection levels, and types of protection. If you think of a futures contract as one type of product, Cargill has over 130 different types of OTC products that we are offering our hedging customers. From these 130 different product types, the hedging customer can choose to further tailor the protection timeframe, price level and transaction size. Given this, no two OTC transactions are identical, which is why centralized clearing is problematic. Clearing organizations do not have the systems and processes necessary to value and clear a wide range of products with a high degree of customization. If this were the case, tailored risk management services would have become available on exchanges years ago. OTC providers such as Cargill create new products by having strong customer relationships, listening to and understanding our customers' commodity risks, and developing products to address these risks. This requires a significant investment of time, human and technological resources, and financial capital. Centralized clearing will put intellectual property in the public domain immediately which will eliminate any economic incentive that OTC providers have for new product development. Now more than ever, customers need new and better products to help them hedge.Summary Cargill appreciates the work of the House Agriculture Committee in ensuring that both the exchange-traded and OTC market perform well. These markets provide critical functions in allowing open price discovery and enhance risk management opportunities. Well performing markets benefit all participants across the supply chain. This past year was clearly a volatile and difficult time for the commodity markets. Steps can and should be taken to improve market transparency and reporting, as well as ensuring that position limits are effectively enforced. We have serious concerns about sections 6 and 13 in the draft legislation, but we are confident that we can constructively work together with Members of this Committee to develop policy alternatives that will help ensure the integrity of the markets, while minimizing the unintended consequences. Thank you for the opportunity to testify before the Committee today and we look forward to working together as the legislation continues to develop. " CHRG-110hhrg41184--120 Mr. Bernanke," Congressman, the Federal Reserve Act tells me that I have to look to price stability, which I believe is defined as the domestic price--the consumer price index, for example--and that is what we aimed to do. We looked for low domestic inflation. Now you are correct that there are relationships obviously, between the dollar and domestic inflation and the relationships between the money supply and domestic inflation. But those are not perfect relationships, they are not exact relationships. And given a choice, we have to look at the inflation rate, the domestic inflation rate. Now I understand that you would like to see a gold standard for example, but that is really something for Congress, that is not my-- Dr. Paul. But your achievement, we have now PPI going up at a 12 percent rate. I would say that doesn't get a very good grade for price stability, wouldn't you agree? " CHRG-110hhrg44900--111 Mr. Bernanke," Let me start, Congressman. First of all, it does take a bit of time for the oil price increases to feed through to the consumer. So when oil prices go up, it takes a bit of time before it shows up at the pump. And so over the next couple of months, we would expect to see the headline inflation rate rising, reflecting that. Once that impulse has passed through, if oil prices stabilize, even at the current level, then you would expect to see inflation come back down. But of course, that is an uncertainty at this juncture. I don't think we have a strong comparative advantage. We have been--in energy--we do produce certain kinds of energy. But we are less energy efficient than some countries. We have less alternatives than some countries. So I think it's very important--one of the benefits of a high price of oil--the--cost of course, but there is at least one benefit, which is it generates incentives for development of alternative forms of energy for conservation, and even for exploration and development of oil. So we need to allow that process to work. I think it will help us develop the energy, not necessarily independence, but less vulnerability to energy prices than we currently have. " FOMC20080805meeting--155 153,MR. HOENIG.," Thank you, Mr. Chairman. I appreciate the fact that reasonable people may differ, and I do differ. In saying that, I am not advocating a tight monetary policy. I am advocating a less accommodative monetary policy. I recognize Governor Kohn's point that relative prices are adjusting, and others have made that point. I think around that context is the fact that we are seeing a systematic increase in the price indexes, both total and core, and I don't think we should ignore that. Now, the core is creeping up, but up nevertheless, and it is systematic in my view. I would feel more comfortable that it was transitory if policy were not so accommodative, which affirms the likelihood of further increases in inflation going forward. That is really where I am focused, I guess is the way to say it. We introduced the policy that we have, as I think others mentioned, as an insurance policy early on, when we were more in an immediate crisis. I don't negate or minimize the tension that we are under, but I do think we have become very accommodative in our policy with negative real rates. So here we are with this insurance. We have this subpar growth. The subpar growth is not going to go away soon, so we are delaying removing the insurance policy. I worry about that. I think in the long run that does increase the risk of an inflationary problem of a sizable magnitude later on. I know we have this immediate problem, but our role also is to take a long-run view, and I think we would be wise to raise the rate now modestly. It would still be an easy policy. The effects of that increase might be disturbing to the markets. On the other hand, it might actually give more confidence to the markets that inflation is going to come down because we are going to insist that it does. I think there would be some good effects from that. So that is where I am coming from on preferring that we move rates up slightly at this point. Thank you. " fcic_final_report_full--61 The derivatives markets are organized as exchanges or as over-the-counter (OTC) markets, although some recent electronic trading facilities blur the distinctions. The oldest U.S. exchange is the Chicago Board of Trade, where futures and options are traded. Such exchanges are regulated by federal law and play a useful role in price discovery—that is, in revealing the market’s view on prices of commodities or rates underlying futures and options. OTC derivatives are traded by large financial institu- tions—traditionally, bank holding companies and investment banks—which act as derivatives dealers, buying and selling contracts with customers. Unlike the futures and options exchanges, the OTC market is neither centralized nor regulated. Nor is it transparent, and thus price discovery is limited. No matter the measurement—trad- ing volume, dollar volume, risk exposure—derivatives represent a very significant sector of the U.S. financial system. The principal legislation governing these markets is the Commodity Exchange Act of , which originally applied only to derivatives on domestic agricultural products. In , Congress amended the act to require that futures and options con- tracts on virtually all commodities, including financial instruments, be traded on a regulated exchange, and created a new federal independent agency, the Commodity Futures Trading Commission (CFTC), to regulate and supervise the market.  Outside of this regulated market, an over-the-counter market began to develop and grow rapidly in the s. The large financial institutions acting as OTC deriva- tives dealers worried that the Commodity Exchange Act’s requirement that trading occur on a regulated exchange might be applied to the products they were buying and selling. In , the CFTC sought to address these concerns by exempting cer- tain nonstandardized OTC derivatives from that requirement and from certain other provisions of the Commodity Exchange Act, except for prohibitions against fraud and manipulation.  As the OTC market grew following the CFTC’s exemption, a wave of significant losses and scandals hit the market. Among many examples, in  Procter & Gamble, a leading consumer products company, reported a pretax loss of  million, the largest derivatives loss by a nonfinancial firm, stemming from OTC interest and foreign exchange rate derivatives sold to it by Bankers Trust. Procter & Gamble sued Bankers Trust for fraud—a suit settled when Bankers Trust forgave most of the money that Procter & Gamble owed it. That year, the CFTC and the Securities and Exchange Com- mission (SEC) fined Bankers Trust  million for misleading Gibson Greeting Cards on interest rate swaps resulting in a mark-to-market loss of  million, larger than Gibson’s prior-year profits. In late , Orange County, California, announced it had lost . billion speculating in OTC derivatives. The county filed for bankruptcy—the largest by a municipality in U.S. history. Its derivatives dealer, Merrill Lynch, paid  million to settle claims.  In response, the U.S. General Accounting Office issued a re- port on financial derivatives that found dangers in the concentration of OTC deriva- tives activity among  major dealers, concluding that “the sudden failure or abrupt withdrawal from trading of any one of these large dealers could cause liquidity prob- lems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole.”  While Congress then held hearings on the OTC derivatives market, the adoption of regulatory legislation failed amid intense lob- bying by the OTC derivatives dealers and opposition by Fed Chairman Greenspan. In , Japan’s Sumitomo Corporation lost . billion on copper derivatives traded on a London exchange. The CFTC charged the company with using deriva- tives to manipulate copper prices, including using OTC derivatives contracts to dis- guise the speculation and to finance the scheme. Sumitomo settled for  million in penalties and restitution. The CFTC also charged Merrill Lynch with knowingly and intentionally aiding, abetting, and assisting the manipulation of copper prices; it settled for a fine of  million.  CHRG-110shrg50369--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Chairman Dodd. Chairman Bernanke, we are pleased to have you again before the Committee to deliver the Federal Reserve's Semiannual Monetary Policy Report. I will keep my remarks brief this morning as we are all here to hear your views on the U.S. economy and other related issues. We also have the benefit of having read about your remarks before the House yesterday. Chairman Bernanke, the Federal Reserve has taken a number of steps over the past 6 months to address the tightening of credit markets and the slowdown in economic growth. In a bid to improve interbank liquidity, the Federal Reserve established the term auction facility in December of last year and has conducted, as I understand it, six auctions to date. Since last August, the Federal Open Market Committee has reduced the Federal funds target a total of 225 basis points, taking the target from 5.25 percent to 3 percent. Mr. Chairman, since monetary policy works with a lag, the full impact of this boost to the economy is not yet clear to you or to us. I know that we will spend time this morning discussing the length and the depth of the housing correction that Senator Dodd alluded to, and I think we should. I also want to make sure, however, that this Committee focuses on the risks associated with increasing inflation. The Labor Department, Mr. Chairman, reported this week, as you know, that wholesale price inflation hit a 26-year high in January. The January rise in the Consumer Price Index meant a 12-month change in the overall CPI of 4.3 percent, twice the pace of a year ago. In addition, gold and oil are at all-time highs. These numbers certainly raise questions, Mr. Chairman, as to how much more room the Federal Reserve will have to provide further monetary accommodation without threatening long-term price stability, which is very important to all of us. While it is difficult to see our Nation's economy experience minimal growth, the consequences of failing to restrain inflation will be far more painful and more difficult to unwind. Chairman Bernanke, we are pleased to have you with us this morning, and we look forward to your thoughts on this and other issues. " FOMC20060920meeting--181 179,MS. YELLEN.," Thank you, Mr. Chairman. It is still too early to know whether our current policy stance will succeed in lowering inflation to an acceptable level over time, but the data since our last meeting reassured me that our decision to step off the escalator was wise, and I think we should remain on the sidelines today. Recent inflation readings have contained no adverse surprises. Inflation expectations remain contained. I think the inflation outlook is slightly improved because of the reduction in energy and commodity prices, and growth during the second half of the year now appears quite likely to fall short of trend. I view the risks to the attainment of our objectives as more balanced than they were in August, and I certainly judge the downside risks to growth to have increased. Your discussion of nonlinearities, Mr. Chairman, was interesting, and it is important to be sensitive to that possibility. That said, I think that the upside risks to inflation still outweigh the downside risks to growth. With inflation projected to remain uncomfortably high over a sustained period and with the economy still likely operating beyond potential, I favor alternative B and think it’s important that we do at least hint at an upward bias for fed funds rate changes. With respect to the language, I prefer alternative B to alternative B+ because the latter points to a greater possibility of a near-term tightening. I am concerned, however, that markets appear to think that the fed funds rate has peaked and that cuts seem very likely by next spring. I do not think alternative B would shake that view in the market. In contrast, I find myself more in agreement with the Greenbook baseline for the fed funds rate, suggesting that we’re likely to want to hold it near its present level for some time to bring inflation down. Now, markets obviously may turn out to be right. But if, as the months go by, developments raise our confidence in the Greenbook baseline view, then I think it would be useful for us to think about ways to signal to markets— possibly through some forward-looking language—an extended policy path in somewhat clearer terms than any of the options in table 1 currently allow." FOMC20071211meeting--102 100,MR. PLOSSER.," Thank you, Mr. Chairman. There has been little change in the economic conditions in our District since the October meeting. Except for housing activity, manufacturing and other businesses are expanding at a modest pace, somewhat below trend. Our business contacts are a little less optimistic about growth in the near term than they were earlier in the fall primarily because of uncertainty surrounding the outlook rather than any immediate change in their business activity. I’ll begin by reporting on what our contacts say about credit conditions. Business contacts as well as our board of directors have told me that credit activity has changed very little. Creditworthy borrowers, as far as they were concerned, have had no problem accessing credit. Banks have reported some tightening of lending standards, but mostly that has occurred for real estate developers and in residential mortgages. Some loan demand has dropped because of businesses’ uncertainty about the future, as I suggested earlier. That is, businesses seem to be a bit more cautious. But banks do not appear to be conserving capital. In fact, they’re actively seeking good credits. To quote one of my directors, “The crunch on Wall Street has not hit Main Street.” A couple of bankers I spoke to, one representing a very large regional bank and another a very large community bank, expressed the view that they were actively seeking to regain market share from the larger banks because they did not engage in the same off-balance-sheet financing of riskier debt that the large banks did and so they were not facing either capital or funding constraints. Some bankers acknowledge that consumer credit quality seems to have deteriorated slightly, but they reminded me that this was from very good levels. So the defaults and delinquencies remain well within historical norms. Turning to the economy, payroll employment continues to expand at a somewhat slow pace in our three states, yet the unemployment rate is still 0.4 percentage point below that of the nation. Retail sales picked up in November. Moreover, retailers generally said they met their expectations for the Thanksgiving weekend. However, these sales seem to have been boosted by fairly heavy discounting, according to them; and despite the reasonable showing to date, retailers are wary and uncertain for the holiday season. Housing construction and sales continue to decline, but the pace of that decline is in line with the expectations at the time of our last meeting. Nonresidential real estate markets remain firm in our District. Office vacancy rates continue to decline, and commercial rents are rising. New contracts for commercial real estate have declined, however; but with the decline in vacancy rates and with rising rents, the outlook of many developers is not as negative as the current level of spending would suggest. According to our Business Outlook Survey, manufacturing activity in the District has been increasing at a modest pace for the past few months. The index of general activity moved up slightly, to 8.2 in November from 6.8 in October. This is actually about the same average level that the outlook survey has maintained over the past two years. Shipments and new orders moved up slightly. However, optimism regarding the outlook over the next six months declined. It’s a common theme of many of our business contacts that their businesses have not changed much, but they seem to be reacting to the steady stream of negative news, and it is affecting their outlook. Indeed, the CEOs of several very large industrial firms in our District report business to be very strong both domestically and overseas, and the CEOs have seen little effect of the turmoil on Wall Street on their ability to obtain credit. Now, last time I said that there had been little change in the District’s inflation picture. However, we have started to see evidence of increased price pressures. The Business Outlook Survey’s prices-paid index has risen considerably since the beginning of the year and has doubled since August. The index for prices received has also more than doubled since August, rising sharply in both October and November. Also retailers have noted spreading price increases for imported goods, and a wide range of industries are reporting increases in energy and transportation costs. Firms continue to report higher health care costs, and at the same time, wages continue to be moderate, they say. In summary, economic conditions have changed little since our last meeting. The business activity in the region is advancing at a moderate pace. Credit constraints experienced by the large money center banks have not appreciably affected the banks in our District or their lending practices. In general, firms in the District remain cautiously optimistic about their businesses six months from now but not so much as they were last month. Price pressures have increased on the input side related to energy and commodity costs; more generally, many firms are now prepared to raise their own prices and are looking to do so in the near future, and the financial conditions of our banks remain good. Turning to the nation, financial market conditions, especially those associated with the big money center banks, have clearly deteriorated in recent weeks. Until the end of October, spreads were gradually declining. It seems that the potential for a serious meltdown was monotonically declining. However, since early November, as we all pointed to, a number of financial institutions, subprime mortgages, jumbo mortgages, asset-backed commercial paper, below-investment-grade bonds, and LIBOR have experienced increased spreads. Volatility has risen as well. Clearly, risk premiums have risen for certain classes of assets, and investors have fresh concerns about the way credit market conditions are evolving. Overall, the recent financial developments suggest that it will take longer before conditions are “back to normal” in all segments of the market. As I’ve said before, I continue to believe that price discovery still plagues many of these markets. It now looks as though it will take a little longer before these markets can sort things out and return to normal. Financial institutions continue to write off some of the investments and take losses. I view these write-downs as a necessary and healthy part of the process toward stabilization. Infusions of capital in some financial institutions, I think, are encouraging and helpful to the process. This does not mean that the ultimate agreed-upon market prices for some of these assets will bear any resemblance to what they did before August. Indeed, they probably won’t. But that’s not necessarily a bad sign, nor is it a cause for concern. In general, it may be a very healthy development. The news on economic activity has softened somewhat since our last meeting. Among the negatives, of course, the housing market and residential investment continue to decline. Foreclosures have continued to grow at unprecedented rates. Firms have become a little more cautious in their investment plans. Consumer spending has softened slightly, and real disposable personal income declined in October. Oil prices have moved higher. On the brighter side so far, there is some evidence of spillovers from the financial and housing markets to the broader economy, but I believe it is limited. Net exports and business fixed investment have been surprises on the upside. Finally, and most important, the labor market still looks pretty solid. Foreclosures and consumer weaknesses appear to be heavily concentrated in those states where the housing boom and thus the housing price declines have been most pronounced—especially California, Nevada, and Florida—and in those states, such as Ohio and Michigan, that are feeling the effects of the decline in automobile manufacturing. As President Poole indicated, credit card delinquencies were up but highly concentrated in California, Nevada, and Florida. Thus, based on such observations and the news that I hear from my District, I sense that the stresses in the economy vary significantly by region, and we must be mindful that the weaknesses on Wall Street are in those states that have exaggerated housing volatility and may not be representative of the rest of the economy. To be sure, we must be wary of continued deterioration and spillovers, but at this point my assessment is that they remain concentrated in a few regions and are not as widespread as some of the aggregate data might suggest. It’s important to note that, for a good part of the forecast for the fourth-quarter GDP, it’s payback for strong inventories and net export numbers in the third quarter. I note that, absent payback and despite the worsening news, economic growth would be on the order of 2 percent higher. To put this differently, the news since the last meeting has not altered the overall GDP forecast for the second half of 2007. It’s about the same. The news has clearly altered the Greenbook’s forecast for 2008, especially for the first half of the year but also extending into the second half of 2008. The forecast calls for explicit spillovers from financial markets and the housing sector to the broader economy, to consumption, to fixed investment, and so forth. I should note, however, that most private sector forecasters are significantly less pessimistic than the Greenbook. The Blue Chip survey, our just-released Livingston Survey, our Survey of Professional Forecasters, and several of the major forecasting firms that have issued forecasts in the last couple of weeks see weakness extending into the first and maybe the second quarter of 2008 but a much more rapid bounceback in the second half of 2008 than is suggested in the Greenbook. These private sector forecasts are more in line with my own view. While the news on growth is somewhat on the downside, the news on inflation is on the upside. Readings on core inflation have been stable over the last few months, but headline inflation rates have risen sharply, with increases in energy and commodity prices. The broader scope of these commodity price increases and their breadth suggest that perhaps there are more-generalized inflationary pressures out there rather than these isolated relative price shocks. I will note that the core PCE inflation rate for March to June was 1½ percent; and in every three-month window subsequently, the inflation rate has risen monotonically, now reaching 2.26 percent for the latest three-month period from August to October. This comes after fairly steady declines in core rates during the first half of the year. In my comments on the Third District, I noted the greater prospects for price increases indicated by our manufacturing firms. I also am going to cite another statistic from the same survey that President Evans referred to—Duke University’s CFO Magazine survey. The survey to which he referred was a survey conducted in late November and early December of more than 600 CFOs. In the survey, the average price increase that these CFOs were estimating for their own products in the coming year was 2.8 percent, and that was up from just 2 percent in the previous quarter. Thus, it appears that firms are beginning to be more interested in increasing prices and are more able to do so than they were just a few months ago, even though the same CFOs were more pessimistic about the economy than they were in the last quarter. Another piece of news on inflation expectations comes from the Livingston Survey, which was just released yesterday. There the forecast of the average annual change for the CPI for 2007 to 2008 moved up from 2.3 percent to 3 percent. This, of course, partially reflects the behavior of oil prices during the past several months. The December-to-December forecast, on the other hand, also rose, but only slightly. Thus, overall, the economy is weak but only slightly more so than I anticipated. Volatility in the financial markets continues, and the repricing of risk has not progressed as smoothly as I would like to see. Nevertheless, the spillovers from the financial turmoil seem geographically concentrated, and broader spillovers appear limited to date. I view inflation expectations as fragile and see evidence that price pressures are growing and that more and more firms feel that price increases are coming and are supportable. I think we will have to be very careful not to presume that just because price expectations and prices have remained contained that they will continue to be so, independent of our actions. Thank you." FOMC20060808meeting--52 50,MR. FISHER.," Mr. Chairman, at our last FOMC meeting in my now over one-year-long attempt to stay away from any analogies referring to innings or baseball [laughter], I used the analogy of Phil Mickelson at the U.S. Open to suggest an opposite strategy. What I suggested was that we use the minutes we are about to release and especially your testimony, if you recall, to center the ball on the fairway so that we could approach the green from the point of this meeting. It appears now that we have done that, you have done that, and the minutes have done that, and we are basically at a point where we are confident of either a hawkish pause or one more tightening of the screw in terms of raising the federal funds rate. The Greenbook and the Bluebook do a good job of presenting us with an analytical framework for this meeting. I want to compliment them, with an “i,” but I also thought it might be helpful to complement them, with an “e,” with some of the data and inputs from our business contacts and the work of our own research staff on the issues we have been talking about. Let me start with housing. I regularly talk to CEOs of two of the five big builders. They like using analogies. In the words of the second largest builder in the country, “The pig is still in the python.” That is, he expects the decline from peak to trough in home sales to exceed that forecast in the Greenbook. I think we had 17½ percent; he is talking about a correction of 25 percent. To adhere to the convention of reporting on my District, which we are supposed to do, I’m happy to say that only Texas, where our economy is on the verge of employing ten million workers, is holding up in the books of these two homebuilders. Even the Carolinas are starting to fold over, and the weakest area is California. The Big Five builders and other homebuilders are reacting as you might expect. They are cutting staff. They are renegotiating their prices and getting concessions from their subcontractors. They are walking away from their planned land deals, and they are renegotiating existing contracts. This is what a macroeconomist would expect in reaction. In answer to Cathy’s and David’s questions, one CEO, who has been in the business since 1973, reports that this correction is the roughest and most sudden he has seen, with one exception. That exception is that the industry is significantly consolidated, with most of the big builders either supporting very strong balance sheets or having ready accessibility to capital from a flush banking system and eager private equity groups. So the reports I received from the Big Five are that, while they are wringing their hands, they’re also licking their chops; they are plotting acquisitions of smaller, weaker builders when they reach the depths of despair. This situation may signal the prospect of a shorter turnaround time for a correction, or it may not, but I just throw it out for your contemplation. Clearly, however, the housing downturn and the cumulative effect of energy and electricity price increases are having an effect. One of my contacts is the CEO of a large “casual dining” restaurant chain, which employs 110,000 out of the 4.8 million people employed in that segment of the restaurant business. He reports that his utility costs this year have risen 30 percent and his materials costs have risen 15 percent. Although customers are moving downscale in terms of the dining chain, guest counts for that segment of the market, which again employs 4.8 million people, are down 5 percent in the last week, and he sees that trend continuing. The CEO of a national middle price point retailer reported that furniture sales in July were down 21 percent. A low-end price point retailer—the low-end price point being Wal-Mart to 7-Eleven—reports slowing traffic. In the words of the head of Wal-Mart USA, John Menzer, “What we saw last month is getting worse.” So-called morning madness sales, which are common in September, have been moved up to July and August. The railroads report a significant slowdown over the past four weeks in the shipment of forest products. So we do have a slowdown, although it is important to point out that the rails, according to the companies themselves, expect to increase traffic 3 percent during the second half because of industrial demand. UPS reports through its CFO that it is shipping 13.2 million packages a day, which is down from about 13.5 in the first half but up from 12.7 in ’05. Incidentally, their report last quarter proved to be remarkably accurate in terms of their expected growth for the second quarter, if it, in turn, is revised upward toward 3 percent. So I want to stick with what I reported at the June FOMC meeting—that our “roadster” economy has downshifted in growth. I also reported a sense that inflation pressure gauge needles were moving forward, and my soundings this time indicate that they continue to do so. I thought that the briefing the staff gave to the Board and circulated to us was very helpful, and I appreciate very much the discussion we had earlier on inflation in answer to President Poole’s question. It is important to point out that the monthly trimmed mean PCE inflation rate in June was 3.1 percent. On a twelve-month basis, it picked up to 2.7 percent. But very importantly—if, as President Poole suggested, you break down the PCE components, whether you trim it or you use it “fully garbed” [laughter]—83 percent of the components are increasing in price. That is up from 73 percent in April. What that means is that only 17 percent of prices are falling compared with 27 percent two months ago. We know that inflationary pressures are building abroad. Karen, our work in Dallas is very much in its infancy; but to the extent that it helps, our measurement of industrial capacity utilization in all the large member states of the European Union is up. Recent revisions to the United Kingdom’s national accounts indicate that the Brits are operating closer to capacity; and if you look at the Tankan survey, for the first time in more than a decade, Japan is reporting capacity constraints. Like everybody else, we have no reliable data on China and India, but we know that their economies are steaming along. As they grow, they cut into existing global capacity available to U.S. businesses. Let me give you an example. Our shipping CEOs report that a portion of the international fleet of large bulk carriers, although they estimate that this portion is only about 2 percent, has now been rerouted and is being used for intracoastal, intra-Chinese trade. So at a time of the year when usually the rates cave for these Panamax ships, which are the largest bulk carriers, the daily rate has stiffened another $1,000. It is up to $23,000 from the $22,000 that I reported at our last meeting, even though this is usually the soft time of the year. Just for a reference point, last year at this time it was one-half that price. At home our bankers report, in the words of the CEO of the largest bank in Texas, “more talk about price increases and pass-throughs.” We are seeing the return in our District of the term “air ball financing,” which is financing based on prospects not on hard reality. One example that caught my interest, which is yet unreported in the public press, is that, according to the CEO of a large corporation with a $30 billion market capitalization, they have been approached by a single buyout group to take them private. So there is a lot of liquidity left in the system. The CEO of Wal-Mart USA reports that they are building in a price increase of 1 percent this year. It is the first increase in a long, long time. Typically they built in minus 1 percent to minus 2 percent. The increase was confirmed by the CEO of one of Wal-Mart’s largest suppliers of nongrocery goods, who quoted Lee Scott as telling him last week, “We are reaching the limits of productivity enhancement and may have to take it out in price increases.” Kimberly-Clark’s CEO reports that he started the year planning for an inflation factor in their cost of goods sold of $150 million. It has been ratcheted up in two intervals and is now at $350 million. He reports that they are covering increases in the cost of goods sold through price increases. This is in sharp contrast to what he has been telling me before every previous meeting. Food processors report the same. It might be noteworthy that corn prices—even though we don’t include them in the core PCE—are, because of ethanol production, up significantly. That’s very unusual at this time of the year. Frito-Lay’s CEO reports an overall inflation shift— in his own words, “the ability to pass through price increases and make them stick.” Finally, Mr. Chairman, at a recent meeting you asked about my reports from Hewitt, the consulting company, regarding the prospects for health care costs. According to one of my sources, several of the largest insurers are focusing on a settlement range of roughly 7 percent to 8½ percent growth for next year. It is a little more than they had expected; it is roughly what it was last year. I might point out that those companies cover a large number of people. To supplement this input, I touched base with three people I consider to be the best long-term practitioners in the fund-management business. Each one has been in the business for more than thirty years. Besides reporting continued high appetites for risk and continued elevated liquidity in the marketplace, these gnarly old-timers report a shift in the attitude of businesses that they cover in investing. To quote one, “Before, the operators we deal with were worried about getting their heads handed to them if they tried to pass through price increases; now they’re trying to see what they can get away with.” In summary, the CEO of Cadbury Schweppes—to kill the serpentine analogy—says that “we’re just not through the snake yet on inflation.” Mr. Chairman, this is a long and faithful report. For all the inherent risks, I pay close attention to what I hear from my CEO contacts. According to them, in addition to the data that we are seeing, the economy is slowing from its torrid pace of growth and downshifting to a more normal range. Global capacity and utilization are not slowing apace from what we can see, or if they are slowing, overall global capacity utilization is staying at an even level. It is also clear that the business community has its finger poised on the trigger of price increases. It may well be that the lagged effect of our de-accommodation has yet to temper the price equation. It may be that energy prices and other cost-push factors are at a point of tapering off. It may be that moderation in the domestic economy’s growth rate will remove demand-pull potential, and it may be that tightening measures of our counterparts abroad will tamp down input prices for our producers here, although it could have a counter-effect in terms of the exchange rate effect on the costs of imports. But I do want to ask us to remember that inflation is—as stated in a paper that was circulated previously—an inertial process. (The paper may have been from you, Bill.) We must be very careful in word and in deed that we do not encourage impulses that will spur that inertia and that will prove harder and more costly to rein in further down the road. Thank you." FOMC20050920meeting--76 74,MR. MOSKOW.," Thank you, Mr. Chairman. Overall, the fundamentals in the Seventh District continue to improve, although we are still underperforming the national economy. Prior to Katrina, most of our contacts thought that their businesses were expanding at rates consistent with the long-run trends in their industries. One exception was the motor vehicle sector. The size of the drop in sales in August was a disappointment to automakers, but not a surprise. They also complained about the effect of gasoline prices on demand, particularly the shift in sales away from big SUVs toward more fuel-efficient but less profitable models. When we asked our contacts about the impact of Hurricane Katrina, they reported several different kinds of effects. Some noted increased activity in response to the storm. A number of firms in our District received orders for items such as RVs, construction materials, heavy equipment, and appliances. And Ford said that they were looking at increasing their fourth- quarter production schedules to replace vehicles destroyed by the hurricane. But we also heard September 20, 2005 35 of 117 contacts noted some decline in activity, which they attributed to higher energy prices, uncertainty, and a CNN effect. High- and low-end stores were reported to be doing okay, but specialty retailers were taking a hit. Katrina also has led to some cost increases in our District. Grain elevators are paying more to work through transportation disruptions and to dry crops in storage. We also heard concerns that the diversion of resources to the Gulf Coast will drive up the cost of construction materials and skilled tradesmen throughout the country. And several contacts noted increases in costs for fuels, fertilizer, and shipping. Of course, not all of the cost increases we have been hearing about are related to Katrina. Indeed, a major retailer and one of our temporary help contacts commented that wage pressures had increased notably at the national level. Turning to the national outlook, the data we had in hand prior to Hurricane Katrina pointed to a solid expansion in activity. We all know how devastating Katrina was in terms of the misery it caused the people of the Gulf Coast. Nonetheless, although the uncertainty is great, the hurricane’s effects on the national economy likely will be short-lived. Even in the near term, the Greenbook baseline projection doesn’t have Katrina reducing GDP growth below trend; and certainly by early next year the hurricane should have a net positive effect for growth, given the large federal spending coming on line. With regard to inflation, the July and August readings on core prices were good, but even so the Greenbook forecast for core PCE inflation next year has been raised to 2¼ percent. Last time many of us were concerned that core inflation was running at the upper end of the range September 20, 2005 36 of 117 Greenbook, and as we were talking about earlier, one major reason for this increase in the inflation forecast is the expected pass-through of higher energy and distribution costs. Another important risk is faster compensation growth. Both compensation per hour and the ECI are projected to increase significantly next year, and this seems consistent with the anecdotes I noted earlier about wage pressures. These pressures are of particular concern at this stage of the cycle because we can’t expect continued outsized gains in productivity to hold down unit labor costs. Some cost increases may be absorbed by lower profit margins, but there is a risk that they may show up in higher prices as well. With the outlook for inflation already higher, and with so much liquidity in the financial system, the cost of excessive policy accommodation could be significant. So at this point, we should continue to increase rates until they are safely in the neutral zone." FinancialCrisisInquiry--88 CHAIRMAN ANGELIDES: Time—time, Mr. Hennessey. HENNESSEY: Just—just 15 seconds. There is a significant difference between an increase in the perception that your firm will fail and whether or not a put option exists. They may both be the case. It may be the case that your spreads increased significantly after Lehman failed, but there might still be— investors still might be pricing in the risk the possibility that the government would step in and rescue your firm. Thank you. CHAIRMAN ANGELIDES: Thank you, Mr. Hennessey. Mr. Wallison? WALLISON: Thank you, Mr. Chairman. I’d like to focus on a couple of things—a few things for all of you that relate specifically to what caused the financial crisis. The newspapers have covered this somewhat, but I’d like to get it in the record. VICE CHAIRMAN THOMAS: Excuse me, Mr. Wallison. Would you pull that mike down and make it more toward you, and then pull it up. I know it’s hard, but it allows... WALLISON: Got it. I got it. Mr. Blankfein, I’d like to start with you. And incidentally, I’d like to say that we “W’s” always envied you “B’s” because you always went first. (LAUGHTER) CHRG-111hhrg52397--134 Mr. Price," How about any over-the-counter products? " CHRG-111hhrg58044--75 Mr. Price," Do you dispute that number? " CHRG-110hhrg46591--167 Mr. Price," Mr. Johnson. " CHRG-110hhrg46591--154 Mr. Price," Mr. Seligman? " CHRG-111hhrg55809--144 Mr. Price," And so how long does that list get? " CHRG-111hhrg54868--133 Mr. Price," We can do the wrong thing. " CHRG-111hhrg52400--124 Mr. Price," Mr. Hill? " CHRG-111hhrg52400--118 Mr. Price," Mr. Nutter? " CHRG-111hhrg48868--155 Mr. Price," I thank the Chair. " CHRG-111hhrg48868--145 Mr. Price," With the board of AIG? " CHRG-111hhrg48868--143 Mr. Price," And in 2006 or 2005? " FOMC20080121confcall--41 39,MR. KOHN.," Thank you, Mr. Chairman. I strongly support your proposal. As I noted in our conference call a couple of weeks ago, I think our reaction to the incoming data and to the change in financial conditions, even as of a couple of weeks ago, was much smaller than it needed to be to stabilize the economy. We had a long way to go, and the situation has deteriorated since then, a little bit on the data side--the consumption data were a little weaker than we expected--but much more in the financial markets. We have a vicious cycle in housing between the financial markets and the housing markets, where the decline in the housing markets is feeding into the credit markets, which is feeding back on the housing market. I think there is evidence, as others have cited, that it is spreading geographically a bit to other countries, which means that the export support that we were counting on may not be as strong as it was, and spreading to other markets like the consumer credit markets. I agree that the equity markets per se aren't our goal, but declines in equity prices destroy wealth. I think they are symptomatic, as you indicated, Mr. Chairman, of a fear and a declining confidence in where this economy is going. That dynamic of declining confidence and growing fear argues for early action despite a number of reasons to wait for the next meeting. I agree with President Poole that no one can be certain what the market reaction will be and what kind of responses we will get now and in the future. We could look panicky. We could set up expectations in the future that we would regret. But I think the greater risk would be in not acting. Given the dynamic out there, living through another nine days before the next meeting has a very high degree of risk that we could come into that meeting in a very, very adverse spot in terms of where the markets are and what is expected of us. So there is no guarantee of success here. That is for sure. But if I were going to place my bets--and I guess I am as a voting member of the Committee--I would place it on acting now rather than later. President Lockhart talked about the potential positive effects on psychology. I think that is part of it. There are also just the normal channels through which monetary policy works on the economy. Lowering interest rates will help in terms of asset prices, and it will help financing costs; and given the risk of waiting, I think we should get to that right away. I agree that it is not going to do anything directly for the monolines or for the other institutions that need capital. But part of what is driving this fear and eroding confidence is the concern about recession. I think lowering interest rates, doing it promptly, and doing it emphatically with 75 basis points, as well as acting through the usual channels, will help ameliorate that fear. In terms of taking it back, the point that President Hoenig made, I think the history of what we have done is pretty complicated and more complex maybe than that we are always too late taking it back. If we were always too late, we would have seen an upward trend in inflation. But we haven't. We have seen a downward trend in inflation for the past 25 years. So it seems to me that the proof of the pudding is in the inflation eating, and I don't think we have been reluctant to--I mean, yes, you can argue that we should have done it one meeting sooner or that sort of thing. That is all 20/20 hindsight. You know, you can always make that argument. But I think basically monetary policy has accomplished its objectives pretty darn well over this period, reacting to financial market distress and then taking it back when we see the distress being alleviated. I think, President Hoenig, if we keep our eye on the inflation forecast, if we make sure that we are forward-looking in that regard, that we will take it back in a timely way. Even if we get started a meeting or two too late, we can move up faster after we start. So I don't think our history is so unambiguous that we are always late taking things back. I don't think the results support that kind of assertion. I agree with you, Mr. Chairman, that we cannot take our eyes off inflation, particularly inflation expectations. If we had a build in inflation expectations, that would set into motion a very serious and destructive dynamic, especially with the dollar. But I do think that declining resource utilization, a soft economy, even if it's not in recession, will exert competitive pressures on both workers and businesses as they consider raising prices. Our focus right now, as several of you have remarked, given the risk to the economy, must be on financial stability and its implications for the economy. That is where we need to focus our attention at the moment. Thank you, Mr. Chairman. " CHRG-111hhrg63105--203 Mr. Marshall," Thank you, Mr. Chairman. I guess it is the influx of the index fund money that some say would push prices higher, and then that you would reach some sort of stable state where they are getting out and they are not affecting price the way you describe. Mr. Duffy? " FOMC20080625meeting--94 92,MR. WARSH.," Thank you, Mr. Chairman. At this point everything has been said, but everybody hasn't said it. So let me try. [Laughter] Let me make three summary points, and then I will talk about three issues that I think are harder. First, on the economy, through late May, as the Greenbook suggests, the real economy proved more resilient and more dynamic than the consensus had anticipated. Consumer spending was moderate but positive, and the labor markets were soft, but neither was necessarily indicative of a recession through late May. Business fixed investment and corporate profits ex financials look all right. Productivity growth looks, frankly, impressive, and corporations, unlike consumers, still appear okay through the month of June--but I'm going to return to June in just a short while. In sum, my assessment of the economy reasonably approximates the average GDP from the Greenbook for 2008, but I remain considerably more cautious on the catalyst for return-to-trend growth in the forecast period of 2009 and beyond. I suspect that this is a long, slow climb with the credit channels needing to be rebuilt and that the process is still in its very early stages. Second, let me talk about the financial markets. Financial markets continue to show tenuous but real improvements in market functioning--which, as Bill Dudley suggested, is remarkable given the weakness among financial institutions themselves. Leveraged loans and high-yield markets continue to trend toward improved market functioning. Credit spreads are well off their March highs. Credit markets, in particular, are holding up well, despite the broad weakness across equities. Third, let me turn to inflation risks. Inflation risks, in my view, continue to predominate as the greater risk to the economy. There is more evidence of a global secular reversal of inflation trends, making the jobs of central bankers worldwide considerably more difficult. I remain worried about energy and food pass-through and the effect of a weakening dollar if our policy rates and those of our major trading partners are perceived to diverge. I would expect import prices, core inflation, and expectations to move up in the coming months even more than in the Greenbook, likely causing a policy response by our foreign peers. Commodity prices, again, with the exception of metals, have been moving up while global demand is falling, and markets have come to see this rise of some, if not most, commodities as essentially permanent. So at the end of the day, we have to be concerned about this period of above-acceptable inflation. It's crucial that broader prices do not start to rise at still-faster rates, and that could well happen if those making decisions about prices and pay expect higher inflation in the future. Anecdotes are not comforting, particularly on the price front. As a result, I think the trajectory of inflation is less favorable than in the Greenbook, thereby necessitating a policy response more significant than the Greenbook would suggest. Let me turn to three even harder issues. One is consumer spending. We're not done with the second quarter, and my sense of what's happened in the first three weeks of June is pretty miserable. I hate to extrapolate based on three weeks of data to the trajectory of the economy. But from a discussion with contacts from three credit card companies that constitute a little more than half of the credit card spend, I would say that the views from these guys were shocking in how bad things looked in the past three to four weeks, particularly in comparison to reasonably positive news from the previous two months. It is suggestive that June will be much weaker than May, and if I add that to the figures on autos that are coming out of the Detroit Three, those are a couple of anecdotes that make me a little hesitant to declare with an exclamation mark what an enviable second quarter we've had. I also look at equity market prices sometimes as maybe telling us something. I would say that consumer companies and retailers over the last three weeks have gotten killed. So I'm a little hesitant to suggest that the second quarter is going to be strong. Delinquencies and charge-offs have also moved meaningfully to the downside in the last three or four weeks among these credit card companies, and this weakness appears to be much more focused on the coasts than it is in the center of the country. I heard that from three of three. My own view may be influenced by my take on the fiscal stimulus--it sure doesn't appear to be helping very much. The second issue that I continue to struggle with is financial institutions. Financial institution equity prices showed significant underperformance, and some people say that is the Federal Reserve's fault. We're talking up our concerns about inflation. We're changing the Treasury curve going forward. I think that is a total red herring. The reason that financials are getting killed is an equity story. They have business models that are having a hard time delivering profits in this environment. They have had to show a very tough quarterly set of losses. I think the problems on financials have to do with financials and not with the Fed, though there is a disturbing amount of chatter in the markets that somehow we're the cause of that. I am comforted, again as Bill Dudley reminded us, that the broader market functioning has been able to withstand this dramatic financial institution weakness. Whether at some point that will give out I don't know, but I'd say that's extremely encouraging. In addition, we have to recognize that massive amounts of new capital are going to be needed for financial institutions of all sizes. Given the weak performance of virtually every financial investment from November till now, I think it is very easy to see a supply�demand problem. It is very easy to see that, with the number of banks that come to these markets, some of them at some point might not be able to find capital even at dramatically lower prices than their expectations. It is prudent for us at the Fed to think about alternative sources of more-patient institutional funding during this period. The third issue for discussion is credit availability, especially for small businesses. This strikes me as being key to the labor market situation. Credit availability for small businesses has held up better than I would have expected four or five months ago, but pockets of weakness remain, particularly among the regional banks, which are a source of concern. I guess I've become convinced that credit lines have not been tapped out. There was a theory, one that I even had some sympathy toward, that increases in C&I lending in the last few quarters were involuntary, reflecting existing credit lines that were called upon. That strikes me as being somewhat overstated. According to anecdotes and our own survey of the terms of business lending, it does suggest that capital is still available for these small businesses to provide some strength to the economy; but again, continued weakness among the regionals could call that into question. Let me turn finally, Mr. Chairman, to the projections. I have some sympathy for the view that Vice Chairman Geithner put forth. It strikes me that at this time the markets will see the benefits of changing our communication strategy as, yet again, pretty small. The costs are harder for me to be certain about. So if anyone is proposing to do this during the next six months, I would have real hesitancy about introducing this variable into our communication strategy amid our assessment of all the other challenges that we have. So I favor having a trial run come October, but I think we should revisit where we stand on the inflation front, the financial institution front, and the growth front before adding this to the mix. To the extent that we find the appropriate time to go down this path, I would favor option 3. Thank you, Mr. Chairman. " CHRG-111hhrg51698--471 Mr. Brickell," Thank you, Mr. Chairman. Thank you, Members of the Committee, for inviting Blackbird Holdings to testify at this hearing about the ``Derivatives Markets Transparency and Accountability Act of 2009.'' We are grateful that the Committee and the Congress want to address the causes of the financial crisis. Americans are concerned. Banks have been shaken. The stock market has tumbled. Pension investments and home values have shriveled. The wolf is at the door. What can Congress do to help? The first step would be to identify the true causes of the financial crisis. Our global financial crunch is a housing finance crisis. Trillions of dollars of mortgage loans have been made that are not being repaid on time. Those loans are worth less than face value, and so are the mortgage-backed securities that contain them. Stockholders, bond holders, taxpayers will absorb as much as $1 trillion of losses from loans that should not have been made. But this bill doesn't target foolish mortgage loans. It targets derivatives. If our country has a wolf problem, it probably won't help to go into the field to shoot birds. Mr. Chairman, these privately negotiated derivatives, these swap contracts, have helped the financial system and the economy. Every company faces risks when it opens its doors to do business, and swaps help those companies shed the risks they don't want and assume the risks that they do. Each company's portfolio of risks is unique. Each firm's appetite and ability to manage risk is unique. And swaps meet those individual needs because they can be custom-tailored. Banks structure them to meet a client's market risks, right down to the dollar and to the day, if necessary. And we don't just structure them to meet market risks. Swappers custom-tailor the credit risk of the contracts, too. Each counterparty in a swap contract is on the hook to the other. So each one has a good reason to assess the other's credit quality, and do it with care. If one doesn't like what he sees, he asks the other to shrink the deal, or shorten the maturity, or post collateral, or raise more capital. We use innovative technology to promote transparency, integrity, and control of credit risk, the goals of your bill. And our company has built an electronic trading platform for swaps. Not only does it allow users to find counterparties for their swaps online, our patented credit filter prevents one firm from trading with another when credit lines are full. Credit risk is managed more precisely than it is with a central clearinghouse to the individual specifications of each user of the system. Companies need custom-tailoring, and that is why swaps were invented. It is also why there are nearly $700 trillion, a notional amount, that are managing risks today for companies and governments around the globe. And Congress knows this. You all have passed the laws that make the framework in which standardized futures contracts are traded on futures exchanges, regulated by the CFTC, and cleared through CFTC-regulated clearinghouses. While swaps that have many of the same risks as bank loans are defined in Federal law as banking products, banking supervisors have access to the details of every swap on a bank's books. How good is this framework? Not only has it been good for the economy, it has also been good for the futures exchanges. The custom-tailored risks that banks collect from their clients they often manage with futures contracts. So futures trading has grown along with swap activity. No country has built a more diverse, robust risk management industry. Now, it is not perfect. No financial transaction or system of risk management can prevent all investment losses. Good judgment remains the essential element in sound financial management. But it is good. Swaps make it easier and less expensive to create the risk management profile that a company prefers. I am concerned about the proposed legislation because it will do damage to all of this. It is not just that derivatives are the wrong target. This legislation is like shooting doves with an 8-gauge: If you connect, there won't be anything left. And American firms, in the middle of a credit crunch, would face new obstacles as they try to manage credit risk. Important tools for managing not just credit risk but interest rate risk, as well, would be more costly and less available. So American firms would have to watch from the sidelines as their competitors in other countries manage their risks with greater precision, and more freely than American companies would be able to do. So if this bill passes, we will not have much of a swaps activity left in the United States, and we would not be better off. Suppose that Congress passed a law that outlawed swaps completely? Would the financial crisis be gone? No. Those trillions of dollars of troubled mortgage loans would still be there. They would just be harder to manage. Privately negotiated derivatives with bilateral infrastructure, sound documentation, netting provisions to support them, have been called no less than the creation of global law by contractual consensus. It is a system that has benefited thousands of companies, financial institutions, and sovereigns. It is a system that has an important part to play as we work to solve the problems of economic weakness and financial market uncertainty. Great care should be taken to optimize and not to weaken this innovative and important business. Thank you. [The prepared statement of Mr. Brickell follows:]Prepared Statement of Mark C. Brickell, CEO, Blackbird Holdings, Inc., New York, NY Mr. Chairman and Members of the Committee: Thank you very much for inviting Blackbird Holdings, Inc. to testify at this hearing about the ``Derivatives Markets Transparency and Accountability Act of 2009''. We are grateful to the Committee for asking for our views as it seeks a wide perspective on the benefit and drawbacks of legislation affecting privately negotiated derivatives. For more than 2 decades, swaps and related derivatives contracts have made an important contribution to improvements in risk management at banks, in the financial sector, and in the economy. The benefits of these transactions are sufficiently important that any measures adopted by the Committee or the Congress should not reduce the availability or increase the cost of these valuable tools.About Blackbird Blackbird Holdings, Inc. is a privately held corporation headquartered in Charlotte, North Carolina. It was founded by swap traders from J.P.Morgan & Co. who developed an electronic trading platform for the negotiation of interest rate and currency swaps. Our innovative technology has been patented three times by the U.S. Government. The benefits of electronic trading have already been achieved in the execution of most types of financial transactions, including foreign currency, equities, U.S. Treasury bonds and corporate bonds, and futures contracts. When swap contracts are executed electronically in greater numbers, swaps will have greater transparency, and accurate electronic records will be created at the moment the trade is executed so that error-free straight through processing, including accurate record-keeping, will be a hallmark of the business. Blackbird is still a small company, but we are global, and we help swap counterparties find each other and execute swaps either across our electronic platform, or through our people in Singapore, Tokyo, London, and New York. I have served as Chief Executive Officer of Blackbird since 2001. Before that, I served for 25 years at JP Morgan & Co., Inc., where I was a Managing Director and worked in the derivatives business for 15 years. During that time, I served for 4 years as Chairman of the International Swaps and Derivatives Association, and for 2 years as Vice Chairman, during more than a decade that I served on its board of directors. ISDA represents participants in the privately negotiated derivatives business, and is now the largest global financial trade association, by number of member firms. ISDA was chartered in 1985, and today has over 850 member institutions from 56 countries on six continents. These members include most of the world's major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on swaps and related contracts to manage efficiently the financial market risks inherent in their core economic activities. As a result, I was involved in discussions about all Federal swaps legislation between 1988 and 2000.Why Swaps? The moment that companies open their doors to do business, they become exposed to financial and other risks that they must manage. Changes in foreign currency rates can affect the volume of their exports; interest rate volatility the level of investment returns, and commodity price fluctuations the cost of raw materials--or sales revenue. Managing these risks was an essential part of decision-making in business and finance before swaps were developed, and would remain so if swaps did not exist. Custom-tailored swap transactions were developed to make it easier to manage these risks. They allow a party to shed a risk that he does not want to take, in return for assuming another risk to which he would rather be exposed, or for making a cash payment. By tearing apart and isolating the strands of risk that are entwined in traditional business and financial transactions, they make it possible to manage risks with greater precision, and allow businesses to focus on the things they do best. A company that sells hamburgers around the globe can use swaps to shift its exposures to interest rates and foreign currencies to other parties, and concentrate on managing its operations, raw materials costs, and real estate holdings, if it believes that these are the source of its comparative advantage. Similarly, the counterparties to its swap trades believe that they are better able to manage the interest rate and currency risks being shed by the other enterprise.Benefits of Swap Activity As thousands of swap counterparties make individual decisions about which risks to take and which to transfer to others, several useful things happen. First, the risk profiles of the firms improve every time they make a correct decision. This strengthens them, and makes it possible for them to serve their customers better and grow more rapidly. A bank that has a strong relationship with a borrower might find that the size of its loans to that customer was becoming so great that its loan portfolio was becoming poorly diversified. By entering into credit default swaps, the banker can transfer enough of the loan risk to make room for more loans to its customer, strengthening its business relationship and helping credit to flow. That's good for business, jobs, and the economy. Second, as thousands of swap transactions have been executed in the past 3 decades, bankers and finance professionals have gained access to new information about financial risks. This allowed better measurement and management of risks, first in swap portfolios and, as time passed, in the other financial portfolios. I watched that process take place in the 1980s as the risk management techniques developed on the swap desks of ISDA member banks, including my own, were adopted by the managers of the same risks that had long been embedded in other financial portfolios at their institutions, including the portfolios of loans and deposits. This process was so constructive that swap professionals were asked in 1993 by the Group of Thirty, to write down their best principles and practices for managing financial risks. The report that we produced was disseminated through the global banking system and other parts of the financial world, and was also used by banking supervisors and financial system regulators to improve their supervisory practices. As Paul Volcker, the Chairman of the Group of Thirty wrote in the introduction to our report, ``. . . there can be no doubt that each organization's conscious and disciplined attention to understanding, measuring, and controlling risk along the lines suggested should help ensure that the risks to individual institutions and to markets as a whole are limited and manageable.'' As swap transactions are executed, the prices of these deals reveal the beliefs of thousands of individuals about the future course of interest rates, or the creditworthiness of borrowers, which are collected and distilled in the price of the deals. This information can be used even by parties who do not enter into the transactions. Central bankers now use swaps prices to understand interest rate expectations and help them make decisions about monetary policies. Rating agencies have begun to track the information about the credit quality of borrowers that is contained in the price of credit default swaps to identify changes in market opinion, and alert their analysts to changes in the condition of companies that they rate, so that they can drill down on potential problems and strengthen the quality of their ratings. If credit default swaps had existed a decade earlier, to sound a tocsin of warning, current problems in the financial system might not be so grave. Of course, no type of financial transaction or system of risk management can prevent all investment losses. The good judgment of financial professionals remains the essential element in sound financial management. Swaps simply make it easier and less expensive to create the risk management profile that a company prefers. You might expect a business that does so much good for so many people to grow quickly, and the swaps business has. While I have been a participant in the swaps business, I have seen it grow by roughly 25% per annum for more than 20 years. As a result, there are now according to the BIS almost $684 trillion of swaps outstanding, mainly on interest rates and currencies As of January 27, there were some $28 trillion of credit default swaps outstanding. It is worth noting that, even when other financial activities become illiquid, the swap business tends to be resilient. Credit default swaps dealers, for example, indicate that there has been liquidity in swaps even when traditional cash markets have become illiquid at times in the past year.Public Policy for Swaps in the United States These are important benefits. They exist in part because Congress has legislated carefully and wisely with respect to swaps on at least five earlier occasions since 1988. We all want to preserve benefits like these, and I am grateful to you for identifying in legislation now before the Committee several policy ideas that have been floated in recent months, and for your careful consideration of those ideas at this hearing. With careful action, this Committee can continue to play an essential role in building a sound framework for swap activity. The policy consensus about swaps that is embodied in the statutory and regulatory framework reflects the fact that swap activity arose not in the exchange traded, centrally cleared business of standardized futures contracts regulated by the Commodity Futures Trading Commission, but in the banking sector. Swap contracts are custom-tailored transactions that are often designed to match the exact cash flows that a corporation wants to hedge; this makes them harder to construct, to value, and to transfer, than the futures contracts regulated by the CFTC, in much the same way that a bank loan is different from a corporate bond. This is why the first policy adopted by the CFTC with respect to swaps, in its May 1989 Swaps Policy Statement, after more than 18 months of study, was that swaps are not appropriately regulated as futures. That original CFTC Policy reflects a policy consensus that has lasted 2 decades, reaffirmed and strengthened by the 1991 CFTC Statutory Interpretation, the 1992 Futures Trading Practices Act, and the Commodity Futures Modernization Act enacted in 2000 and signed into law by President Clinton, as well as other legislation. That is why swaps are defined in Federal law as banking products. A robust, innovative American financial services business has been built on the foundation of this policy consensus. I am concerned that provisions in the legislation before the Committee would undermine that foundation and weaken a business that helps the American economy, and the world.Management of Credit Risk in Swaps Transactions One area of the legislation that would have that effect is the section requiring clearing of privately negotiated derivatives. Like every commercial and financial contract, swaps contain credit risk. One party must be confident that his counterparty will perform according to the terms of the contract. Financial institutions are able to manage this credit risk in different ways. In the banking system, where swaps originated, credit risk is managed by experts who analyze the quality of each counterparty, including its financial strength, the quality and character of management, even the legal and political risk of the country where it is based. In doing this, bankers and their counterparties often rely on private information available to them in their special role as creditors. The techniques used to manage the credit risk of swaps are usually the same ones used to manage the risk of other privately negotiated credit contracts such as bank loans or bank deposits, and they can include the posting of collateral so that if a counterparty defaults on a trade, the non-defaulting party will be able to enter into a new, replacement transaction at no additional cost. Of course, if a counterparty is not satisfied with the amount or quality of the information he receives, or the credit enhancement techniques available, he is not required to enter into any swap deal. Financial institutions have developed a number of ways to manage credit risk in privately negotiated derivatives, appropriate to their capital levels and those of their clients. First, there are different ways to document transactions. The simplest method is to use an exchange of confirmations, one for each transaction. This approach makes no attempt to reduce risks by netting, it simply relies on well drafted confirmations and good credit judgment in the choice of counterparties. Risks are reduced by netting under bilateral master agreements, either for single products--interest rate swaps against interest rate swaps--or reduced further by including other derivatives under the master. Netting across products--foreign exchange options against credit default swaps, for example--reduces potential exposures even more than single product netting. The ISDA Master Agreement is used around the globe to achieve this purpose. As you can see, we are starting to build a sort of continuum of approaches, in which increasing the numbers of transactions netted against each other results in greater netting benefits. Multilateral netting of credit risks is another step along the continuum, in which a multilateral clearinghouse substitutes its own credit for that or others, and has a bilateral relationship with each of them. In each bilateral relationship, the credit exposure at any moment in time is the net value of the transactions. At first, this might sound different from the banking model, because futures exchanges operate multilateral clearinghouses. But the difference is mainly one of scale. Every bank serves as a central counterparty for its inter-bank trading partners and its clients. So, in this sense, every swap dealer bank using netting provisions under the ISDA Master Agreement is a clearinghouse. Each swap dealer assesses the likelihood that his counterparty will default, and his own ability to withstand such a default. In doing so, he is mindful of his own capital base, and the capital strength of his counterparty. Where capital is not high relative to risk, it is more likely that one or both swap counterparties will demand collateral from the other. Now we have a more complete picture of credit risk mitigation schemes for derivatives. Each scheme has characteristics appropriate to its participants. On one end of the continuum are banks and insurance companies, with traditionally strong capital cushions. At the other end are margin-reliant entities including futures exchange clearinghouses.A Clearinghouse for Swaps? It should be clear at this point that creating a new clearinghouse for swaps, or for one type of swaps like credit default swaps, or forcing swaps into some other clearinghouse, would not exactly make order out of chaos. A good deal of order already exists. It is the order that markets bring to human affairs, giving participants the opportunity to choose, and to change their choices. Today swap participants can choose among several different methods to handle credit risk. We can keep the contracts on our own books, netting them against other contracts, taking collateral to support the risk as appropriate, or we can submit them to a third party clearinghouse. A system like this allows us to make the right judgments for ourselves and our counterparties, as capital positions change and the mix of clients changes. Every bank changes its mix of business along the continuum, every day. For this reason, section 13 of the bill is troubling. This section requires that all currently exempted and excluded OTC transactions must be cleared through a CFTC regulated clearing entity, or an otherwise regulated clearinghouse which meets the requirements of a CFTC regulated derivatives clearing organization. While the provision authorizes the CFTC to provide exemptions from the clearing requirement, it can only grant the relief under limited circumstances, provided that the transaction is highly customized, infrequently traded, does not serve a significant price discovery function and is entered into by financially sound counterparties. Driving swap activity into a central clearinghouse would be undesirable for several reasons. First, it would create a central choke point for activity that is, today, distributed across multiple locations. If a single swap dealer has processing problems or other difficulties, they affect only the dealer's clients. If a central clearinghouse were to have problems, they would affect the entire system's derivatives flows. Second, the same is true of the credit risk of such a central entity. Pulling the credit risk of swaps out of the institutions where they reside today, and forcing them into a central counterparty, risks creating a new, ``too-big-to-fail'' enterprise that represents a new risk to taxpayers. Third, a centralized, collateral-reliant scheme would tend to reduce market discipline. Because parties to bilateral netting agreements retain some individual credit exposure, they must assess their counterparties' credit standing, giving them an incentive to control their positions carefully. The resulting widespread awareness of credit risk makes the financial system safer. In contrast, clearinghouse arrangements tend to socialize credit risk. Our financial system today shows the ill effects of a reduction in market discipline, and Federal policies should increase it, not reduce it. Fourth, one reason for this is that credit discipline encourages financial institutions to strengthen their capital bases. Finally, building a central clearinghouse may be an expensive proposition, requiring new capital of its own. In contrast, increased use of bilateral cross product netting under ISDA Master Agreements can be accomplished at low cost. The marginal cost of adding another transaction to an ISDA bilateral master agreement is zero. No other technique offers such substantial risk reduction at such a low cost. Since, as I indicated above, every swap dealer bank serves as a clearinghouse for its swap trading partners and clients, the provision would have the effect of limiting the ability of banks to engage in this segment of the banking business without the approval of the CFTC. I do not know of any reason to unwind the policy consensus for swaps to adopt such a policy. The netting and close out arrangements that are in use among swap counterparties are the result, in part, of careful work by Congress to establish the enforceability of netting agreements under bankruptcy law. These arrangements have been used in the marketplace and tested in the courts and have managed the credit risk of hundreds of thousands of swap transactions. In the last 12 months alone, the failure or default of a major swap dealer, Lehman Brothers, two of the world's largest debt issuers, Fannie Mae and Freddie Mac, and a sovereign country Ecuador, in addition to the more routine failures of other counterparties have been successfully resolved using these arrangements. In every case the well drafted netting and close out provisions of the ISDA Master Agreements have done what they were supposed to do. Simply put, these arrangements work well, and there is no evidence to support a statutory requirement for clearing of all swap agreements through CFTC-approved central counterparties.Conclusion The privately negotiated derivatives business--and the bilateral infrastructure, documentation, and netting that support it--have been called ``no less than the creation of global law by contractual consensus.'' It is a system that works. It is a system that has well served the economy and the financial markets in the U.S. and around the world. It is a system that has benefitted thousands of companies, financial institutions and sovereigns. And it is a system that has an important part to play as we work toward a solution to today's economic weakness and financial markets uncertainty. Great care should be taken to optimize--and not weaken--this innovative and important system. " FOMC20060808meeting--68 66,MR. POOLE.," Thank you, Mr. Chairman. I want to offer just a few anecdotes, starting with Wal-Mart. At the beginning of the year, Wal-Mart’s plan for same-store sales was for growth of 3 percent to 5 percent, but growth has run persistently below that since Easter. July came in at 2.6 percent. They had expected a range of 1 to 3 percent. However, I think we have to be a little careful in interpreting July data in general because it was unusually hot over much of the country, and Wal-Mart says that they particularly sold a lot of what they call “hot weather goods,” like air conditioners and fans. My contact says that higher-priced items with higher margins are generally doing better than the lower-priced goods. He is still seeing pressures on the lower-income shoppers at Wal-Mart. Food inflation is actually coming down a bit: It is now below 1 percent. My contact observed that suppliers seem to have paused in taking price increases, but he’s not sure whether that’s just part of a cycle during the year. He also noted that the rate of price deflation is also less than it was for a number of items—particularly apparel and standard electronics items—that have been deflating for quite a number of years. Those prices are still declining but not as rapidly as before. I had two readings from the transportation industry suggesting that July was surprisingly weak. UPS Express volume in July came in 3 percent to 4 percent below plan, and a large trucking company said that the July truck volume was flat year over year and the weakness was pretty much spread over all parts of the country, although more pronounced in the upper Midwest. It seems to be broadly based in terms of product category. He said that in the trucking industry, or at least in his firm, they are increasingly nervous about recession. UPS noted that there is potential for disruption. Their pilots’ union is currently in a ratification vote, which is supposed to be complete by September 1. There’s a great deal of opposition within the union and some genuine possibility that the contract will be voted down, with associated job actions and disruption of various sorts. My FedEx contact said he really had nothing new, and he didn’t even want to talk about that. [Laughter] Let me make a comment about the national economy. I want to talk about it in terms of the risks we face and to use a Phillips curve diagram as a device. We’ll center the axes on the Greenbook forecast. One of the quadrants here has higher growth and lower inflation than forecast. I think we’re not very likely to be in that quadrant—it’s not impossible, but I don’t think it’s probable. So let’s talk about the other three quadrants. One of them has good growth and higher inflation. We could end up in that quadrant, and that would just mean that we’re going to have the problem of dealing with the inflation over the longer haul even though our immediate future might not have a growth complication. Quite frankly, I think we’re most likely going to be dealing with one of the other two quadrants. One of them has lower growth with declining inflation. I think the inflation pressures are pretty persistent and sustained, so I think we’re actually most likely going to end up in the very unfortunate quadrant where we have sustained inflation pressures running at the Greenbook forecast rate or above and growth running at that rate or lower. That situation is going to be very uncomfortable for us, but we’re going to have to be ready to deal with it. Thank you." FOMC20070628meeting--124 122,MR. POOLE.," Thank you, Mr. Chairman. Let me talk first about some of the anecdotal reports. A contact with a large software company suggested that the IT industry is doing fine. Labor is very tight because technical people are in such scarce supply. This company is expanding development facilities in China and India. They are not allowed to import the labor they need, and so they will send the operations abroad. My contacts with transportation industry people get the same information that Richard Fisher is emphasizing. Movement of goods is just really, really flat. The over-the-road trucking industry is actually taking down capacity, selling off the older, less efficient trucks. In the express business, UPS is taking down capacity. FedEx is more optimistic, probably taking market share. A contact with the fast food industry says that their business volume is down. The whole industry is down. Sales revenues are up a bit, but it is because of price increases. The casual dining industry is down even more. There is sort of a disconnect here between the overall view of the economy, I think, and the anecdotal reports that come from the movement of goods. Of course, the most cyclical part of the economy is always the goods part. The services part is much more stable. Perhaps what is going on here is simply what is also in the Greenbook’s second-quarter numbers, because the goods part of the economy—consumption—is pretty flat. I think consumption is only—I forget the exact number—1.6 or something. That is an annual rate. You have to divide that by 4 to tell you what is actually going on in the quarter itself. Of course, the housing industry continues to decline. So maybe these anecdotal reports really are consistent with what is going on and what is in the Greenbook picture. The Greenbook picture makes a lot of sense to me. Let me talk a little more about housing. The staff presentation had a point that I want to underscore—that the housing downturn is unlike any other that we have had. I think the chart went back to 1972, but you could go back before that. If you look at the housing downturns and the recessions of the 1950s, they were all related to a very standard cyclical pattern. Interest rates would rise, housing—starts, permits, construction—would start to turn down well before the cycle peak, and then housing would start to recover after the cycle peak as interest rates came down. The current situation is completely different from that standard pattern. Here we had a housing boom driven by a period of very low interest rates. The period really got started when we were holding the fed funds rate at 1 percent. Then you had a lot of these financial innovations and subprime mortgages that added a sector to the market that hadn’t traditionally been there. Interest rates came up, housing prices are flattening out, and my concern is that there is a lot more to go. This is an asset market that does not work anything like securities markets. It is completely different from the stock market and the bond market. Housing starts and permits peaked in the early part of last year, and the adjustment really got under way. But if you think about how much of the adjustment is complete—well, there is not much sign that much is complete because the inventory of unsold new houses is close to its peak. There is no convincing evidence that it is really starting to come down. We have seen some bankruptcies of builders, but not very many. A lot of banks—I know from our contacts—are putting pressure on their builders to sell out their houses and pay off the loans. The same thing is true of “the ground,” as the real estate people like to put it. Builders are stopping their development of new land for housing developments because they don’t have the financing to support it anymore. The banks are starting to turn off the credit spigot because these companies are getting pretty close to the edge. They have laid off a large number of workers, but they have to sell out their inventory. Still, the number of months’ supply that they are sitting on is abnormally high; it really hasn’t come down. We also know that prices in this market respond with a very substantial lag to the underlying determinants of prices. So prices of existing homes are only gradually adjusting, and I think there is probably more of that to go. We know that there will be a lot more resets of these adjustable-rate mortgages. The projections are that a lot more defaults than we have yet seen will occur in that area. So I think that we have a long adjustment to go here. Whether that will spread into the rest of the economy, I don’t know. I share the Greenbook estimate that probably there won’t be major fallout, but it seems to me that the risk there is significant. I just wanted to underscore that point because I think this risk is by far the biggest that we face at this time. Thank you." FinancialCrisisInquiry--9 One of the largest stresses placed on Goldman Sachs and other firms during the height of the crisis was the possibility that we were managing risk in the same way other institutions, which were severely hampered or later failed, had managed their risks. Getting the market to recognize that our balance sheet was well marked and that our reported capital levels were accurate was one of our most significant challenges. Without question, direct government support was critical in stabilizing the financial system. And we benefitted from it. The system clearly needs to be structured so that in the future private capital rather than government capital is used to stabilize troubled firms promptly before a crisis takes hold. The two mechanisms that seem to hold the most promise for addressing this goal and addressing too-big-to-fail are ongoing stress tests, which are made public, and contingent capital possibly triggered by failing a stress test. These two elements could also be the core of a strong but flexible resolution authority. Certainly, enhanced capital requirements in general will reduce systemic risk. But we should not overlook liquidity. If a significant portion of an institution’s assets are impaired and illiquid and its funding is relying on short-term borrowing, low leverage will not be much comfort. Regulators should lay out standards that emphasize prudence and the need for longer-term maturities depending on the assets being funded. Institutions should also be required to carry a significant amount of cash at all times ensuring against extreme events. Lastly, I wanted to briefly discuss our firm’s experience during 2008 and 2009. While we certainly had to deal with our share of challenges during the financial crisis, Goldman Sachs was profitable in 2008. As I look back to the beginning and throughout the course of the crisis, we couldn’t anticipate its extent. We didn’t know at any moment if asset prices would deteriorate further or had declined too much and would snap back. FOMC20080805meeting--143 141,CHAIRMAN BERNANKE.," You want it before 2:15, though. All right. Well, I spent a lot of time through the meeting and during the break working up a crystalline summary of the discussion. [Laughter] But I am a bit concerned about getting to lunch and avoiding the 2:15 hard deadline; so if you would excuse me, this time I will just go directly to a few comments of my own, and then we can go to the policy round. We saw growth of about 2 percent in the second quarter, which suggests a campaign slogan for the Republicans, ""The Economy: It Could Be Worse."" [Laughter] The question, though, is whether this higher-than-expected growth rate in the second quarter implies that we are actually looking forward to a better-than-expected remainder of the year or whether this was in some sense a last hurrah of borrowing from the future. I feel that I am very strongly in the latter camp, unfortunately. I do think that, for reasons people have talked about, the remainder of the year and into next year are likely to be quite weak. I don't know how weak, but if you look at each component of spending or component of production, you see mostly very negative indicators. We have talked about consumption. We know about all the fundamental issues that are affecting consumers, and we have seen recently, I think both anecdotally and in terms of the data, some softness, particularly in the auto area. In the labor market, several people have noted that the loss of payroll jobs has not been as rapid as, for example, in 2001. The unemployment rate, though, has risen as quickly as in previous episodes, and any look at the unemployment rate would suggest that this is something close to a normal recession dynamic. Housing, of course, remains very uncertain. We don't really know when the bottom will be, although I would add, a point that I think Bill Dudley made, that there seems to be a growing confidence that when we have reached the bottom in housing, whenever that may be, we will see a very quick improvement, both in the financial markets and then, presumably, in the economy as well. In other areas, such as nonresidential construction, architectural billings and other factors suggest slowing there. We see slowing in the other industrial countries, although some strength is still in the emerging markets. So just looking at the traditional indicators of growth and production, I think the best guess is for a slow second half, a slow beginning of 2009, and an unemployment rate that continues to rise from here. I do believe that the financial stress and its implications for credit availability are important in this whole dynamic. I guess President Lacker and I keep talking past each other, but I don't think that the federal funds rate is an adequate description of the stance of monetary policy. To give another example, in the past we have used money growth as an indicator of monetary policy. If we used that indicator, it would look quite different. I think the appropriate indicators are the rates and terms that are being faced by the people making decisions to spend in the economy. You can go through the entire list, and in every case, as Governor Kohn suggested, the actual rates being faced in the data by borrowers are as high as or higher than they were last summer. Mortgages, which are a particularly sensitive area, are of course critical here. Despite the decline in the federal funds rate, the spread between mortgage-backed securities and duration-matched Treasuries is now about 260 basis points compared with 120 basis points last summer. In addition, for the spread between jumbo loans and conforming loans, which in the past has normally been between 25 and 50 basis points, the offer rate is about 120 basis points. So there seems little doubt--and we can check with Governor Duke about this--that, despite the lower rate on overnight bank lending, the rates that matter for economic activity are largely higher than they were a year ago. Therefore, I don't think it is evident at all that we are in a financial situation that is conducive to rapid, excessive growth and inflationary increases a priori. Now, going forward, of course, a lot of what happens in the economy is going to depend on bank balance sheets. I won't spend much time. In April, I talked about the staff's estimates of losses going forward. That has been updated. Nellie Liang is working with people in New York. The numbers are not too encouraging under the baseline scenario, forgetting about the more severe scenarios. The staff now projects about $228 billion in losses for U.S. banks and thrifts in '08 and '09. That excludes investment banks. That excludes write-downs. If that occurs, it would be about a 2 percent loss rate over the next two years, which would be above the peak of 1991 and 1992. Of course, if the economy does worse, it would be even higher. Relative to that $228 billion in losses, there are so far loan-loss provisions of about $68 billion. So it looks as though we still have a long way to go in terms of bank losses and write-downs. In addition, some of the biggest banks will take very significant hits. This is very preliminary, and I don't want to make too much of it, but the preliminary analysis shows that for five of the very biggest banks, under a baseline scenario and looking at the composition of their asset holdings, their current tier 1 capital ratios will be reduced between 30 percent and 50 percent over the next two years. So there is a real concern about the availability of credit and about the cost of credit. I could go on and talk about a variety of other areas, including the Senior Loan Officer Opinion Survey, which suggests that credit will be a concern going forward. President Lacker and I have, I hope, respect--I respect him, and I hope he respects me. But we disagree also about President Bullard on systemic risk. I take his criticism to be that it works in practice, but can it work in theory? Systemic risk is an old phenomenon. There are literally dozens and dozens of historical episodes that are suggestive of that phenomenon. There is also an enormous theoretical literature. Maybe it is not entirely satisfactory, but certainly many people have thought about that issue. I, myself, have obviously worked in this area. Clearly, it is not something that we can tightly explain in all aspects, but I do think it is a concern. We need to remain concerned about it. Although it is true, as President Bullard points out, that there is an accommodation and a basis for anticipating crises as we go forward, it is also the case, as I think Governor Mishkin noted, that after a year we are also facing a situation of greater fragility, of much lower capital, and fewer shock absorbers. Those things will make any crisis that much more severe, should it occur. So overall I think there is still significant downside risk to growth. I think the baseline of slow growth is right. I am hopeful that we will see growth restored early next year, but I think it is very uncertain at this point. On inflation, I do have concerns, as everyone else does. I think that the commodity price movements we have seen are good news. They have been quite significant. Besides oil prices down about 10 percent and natural gas prices down about 32 percent, since the last meeting corn is off 27 percent; soybeans, 17 percent; and wheat, 16 percent. Those are not small changes. Now, obviously, the level of prices is still very high. It has risen considerably over the past year. We will continue to see that high level of prices being passed through into the core, as Governor Kohn noted, but I would argue that if--and this is a very big ""if""--commodity prices do begin to stabilize within the general range of what we see now, I think that the inflation concerns will moderate over time because they will have lost essentially their driving force. We don't really have the conditions to turn the commodity price increases into persistent inflation, absent continued pressure on that front and absent changes in inflation expectations, of which there is only limited evidence at this point. So I want to be very clear: I think that containing inflation is enormously important, and I think it is our first responsibility. We need to watch this very carefully. I think there will be continued pressures even if commodity prices don't rise, but I do think there is also a chance that we will see a moderation of this problem going forward. What else? I guess there has been a lot of discussion about the appropriate withdrawal of stimulus. Again, I don't think I accept the idea that we are currently in an extremely stimulative situation. However, if financial markets were to normalize, for example, that would lead to a more stimulative situation. I would like to say just a word about that. That is to say that the speed at which we remove the accommodation--and I think it is clear we do have to do that relatively soon--should depend to some extent on how inflation evolves. Under the more benign scenario that I have just described--if inflation does decline significantly because of commodity prices--I think that we obviously have more time. I would just note for comparison past episodes. In 1994, for example, the pause lasted 17 months, and the first increase in rates came two years after payrolls began growing again. In 2001, again, it was more than a year after unemployment rates started coming down, and payrolls began growing before the rates started going up. Now, I think there is a view, which is a reasonable one, that maybe in at least the second of those two episodes we waited too long to begin to normalize. That is entirely possible. But, again, it would be extraordinary if we were to begin raising rates without an immediate inflation problem with the economy still in a declining or extremely weakened situation. If inflation does in fact become the problem that many around the table think it is, particularly if commodity prices begin to go up again or if the dollar begins to weaken, then I will be the first here to support responding to that. I do think it is incredibly important to keep inflation expectations well anchored, particularly to the extent that movements of commodity prices and the dollar seem to be derived from monetary policy as opposed to things like geopolitical risk. Then, I think we can't treat them as truly exogenous. We would have to respond to those things. So I welcome the ongoing discussion we should have about the pace of withdrawal of accommodation. I do think it depends very much on how things evolve, and I do think that our strategy should be to watch carefully and to make the right decisions as we see the data come in. Let me stop there and turn to the last round and ask Brian, please, to introduce the policy discussion. " FOMC20080130meeting--208 206,CHAIRMAN BERNANKE.," Thank you, and thank you all for succinct and very insightful comments. [Laughter] I'm going to try as usual to summarize what I've heard; but even more so than usual, no warranty is expressed or implied. Again, trying to bring together some of the comments, we noted that incoming data since the last meeting have been broadly weaker than expected, and anecdotes generally suggest slower growth, in some cases significantly slower growth. Housing demand, construction, and prices have continued to weaken, and inventories of unsold homes are little changed. Housing weakness has implications for employment, consumer spending, and credit conditions. With respect to households, consumption growth has slowed, reflecting falling house and equity prices and other factors, including generally greater pessimism about the labor market and economic prospects. The labor market has softened by a range of measures, with unemployment jumping in December. However, workers in some occupations remain in short supply. Together with financial indicators, weaker labor and consumption data suggest that the economy is at a risk of recession; in any case, it is likely to grow slowly for the first half of the year. The second half of the year may be better, the result of easier monetary policy, fiscal stimulus, and possible improvement in housing and credit markets. However, there are significant downside risks to growth, including the possibility of an adverse feedback loop between the economy and credit markets. Reports by firms are mixed. Investment may have slowed, reflecting uncertainty and slower growth in demand. Commercial real estate activity may be constrained by tighter credit conditions. Manufacturing is slow to mixed, though IT, energy, and some other sectors continue to be strong. Financial markets remain stressed. Credit conditions more generally appear to be worsening, and the problems may be spreading beyond housing. Additional risks are posed by the problems of the monoline insurers. Credit losses have induced tighter lending standards, and a key question is how severe those may become and how persistent they may be. One offset is the ability of banks to raise capital. Core inflation and headline inflation have remained stubbornly high and are a concern. One risk is the ability of some firms to pass through higher input costs. Inflation compensation has risen at long horizons, reflecting some combination of higher inflation expectations and inflation risk premiums. Going forward, a slowing economy, anchored inflation expectations, and possibly stabilizing food and energy prices should lead to more moderate core and total inflation. However, some see upside risks, especially the possibility that higher headline inflation might affect inflation expectations. So that's my attempt to summarize. There's a great deal more detail and a great deal more color in the conversations around the table. Let me try to add a few points. Again, much of what I'll say has been said. I do think that there has been a significant deterioration in the outlook for economic growth and an increase in the downside risks to growth. It was sufficiently severe as to prompt me to call the January 9 videoconference that we had, and I think that since then we have had further deterioration. A number of things have happened and are going on. Very important, perhaps most important, is the continued further deterioration in the prospects for the housing market. Housing, of course, feeds directly into the real economy through employment, income, and wealth, and I think there are some indications that spillover from the housing sector to the rest of the economy is increasing. However, the critical aspect of the housing outlook is the relationship to the financial system, which I'll come back to. Consumer spending has slowed. I think there's little doubt about that at this point. There are a lot of factors now that are acting as headwinds in the consumer sector. Let me just point out the basic fact that most households in the United States have very little in the way of liquid financial assets. Therefore, when they, on the one hand, are denied access to home equity if they see tighter credit conditions on cards, autos, and so on, and if at the same time they see greater uncertainty in the economy and the labor market, then their natural tendency would be to be much more conservative in their spending. I do note that fiscal action may be of some help, particularly for people in that kind of situation. Like President Yellen, I think the indicators of a weakening labor market are broader than just the payroll report. There are a number of other things as well. We may get a better report this week. The UI claims are a little encouraging, but I do think that the weakening economy is going to drag down the labor market to some extent. Certainly the financial markets have deteriorated, reflecting greater concern about recession. We see it in the equity markets but also in short-term interest rates and a variety of credit measures as well. Finally, just going through this list of items, we continue to see problems--credit issues, banks concerned about additional losses not just in mortgages but perhaps in other areas as well--with the potential implication of a further tightening of credit conditions. Those are some of the developments that we've seen since the last meeting. On our January 9 call, I talked about the regime-switch model and those ways of thinking about the business cycle. Others have talked about that today. I think many of those models would suggest that the probability of recession at this point is quite high, at least 50 percent or more. I don't think any of us would be happy to see a garden variety NBER recession; but if we had that, there would probably be a few benefits, including correction of some imbalances that we're seeing in the economy and perhaps some reduction at the edge in the inflation picture. But, like others, I am most concerned about what has been called the adverse feedback loop--the interaction between a slowing economy and the credit markets. A phrase you might have heard, which is getting great currency among bankers, is ""jingle mail."" Jingle mail is what happens when otherwise prime borrowers decide that the value of their house is worth so much less than the principal of their mortgage that they just mail their keys to the bank. (I wonder if that 140 percent is the right loan-tovalue number. Maybe it's less than that.) Even if prime mortgages hold up--and I think in some regions of the country there will be significant problems with prime mortgages--there is a lot of other potential trouble. We're just beginning to enter the period of maximum subprime ARM resets. Second lien piggybacks and home equity loans are all questionable at this point. We haven't begun to address the option ARM issue, which is about the same size as the subprime ARM category, and of course, we have the issues with the monolines and private mortgage insurers. Outside of mortgages, expectations for credit performance are worsening in a range of areas, including commercial real estate and corporate credit. So I think that even under the relatively benign scenario that the Greenbook foresees, we're going to see a lot of pressure in the credit markets and perhaps a long period of balance sheet repair, tight credit, and a drag on the economy. Again, our experience with financial drag or headwinds has been that it can be quite powerful and deceptively so, and I think that's a significant concern. Now, the central issue here, though, ultimately comes back to the housing market. Certainly by this point there must be some pent-up demand for housing. We've had obviously very low sales for a period. House prices are soft. Mortgage rates are low. Affordability is better. What's keeping people from buying houses is the fact that other people aren't buying houses. If there were some sense that a bottom was forming in the market or in house prices, we probably could actually see a pretty quick snap-back, an increase in housing demand, and that in turn would feed back into the credit markets, I think, in a very beneficial way. So there's the possibility that, if the housing market can get restarted, we could get a relatively benign outcome. " FOMC20060629meeting--31 29,MS. MINEHAN.," Whatever. [Laughter] I forget the code here, but just a little intervention there? It may be that the effect of oil-price increases on inflation is lower than it was two or three decades ago. But, say, over the past two years, 2004 to 2006, given that we’ve had a number of oil shocks, if you want to call the oil-price increases that—I don’t know if they all achieve the meaning of “shock”—would you say that one of the key reasons, if not the key reason, for the increase in core inflation over that period is energy prices? It seems to me that makes a difference because, if we think energy prices are going to subside, we can have a little more confidence about the falloff of inflation going forward. If the increase isn’t mostly related to energy, then I think we can have less confidence of a falloff of inflation going forward." CHRG-110shrg50414--191 Chairman Dodd," Thank you, Senator. Senator Casey. Senator Casey. Mr. Chairman, thank you very much for this hearing and for the way you have conducted it. I guess my first question will be directed mostly at Secretary Paulson and also Chairman Bernanke. Both of you have said today and on numerous occasions that the root cause of this, of course, is housing, and you have taken steps, both of you and others here today have taken steps to deal with that over time, and I think a lot of the strategies that have been employed have helped. I think we should enlarge them, especially at this time when we have an opportunity to do so. You know the numbers about foreclosures per day. It is approaching now, by one estimate, 10,000 per day. The Center for Responsible Lending is predicting that 6.5 million foreclosures over the next couple of years. And I know that both Chairman Bernanke and Secretary Paulson today, especially Chairman Bernanke, have spoken about both fire sale prices and hold-to-maturity prices. But I believe, and I think the evidence is compelling, that foreclosure itself forces fire sale prices of homes. And isn't it true that if these foreclosures occur, then all home values are going to drop and drop to the fire sale price and that that forces the hold-to-maturity price to fall to the fire sale price. So in essence, what I am asking in a long way is why does this proposal have this, what I would argue is a gaping hole in it, with no specific provisions that deal with foreclosure prevention? " CHRG-111hhrg51698--167 Mr. Boccieri," Mr. Damgard, I want to ask a question. I remember reading an article last year where it was suggested that big oil companies were betting on the price of fuel going up. To me, with a simple mind and simple notion, that sounds like insider trading, with respect to the fact that they knew that prices were going to go up because everybody was speculating and betting on the price of it going up, even though there was more supply of oil in the market than there was a year ago. Would you hold those unconscious participants, those speculators to the same criminal standard as manipulators? " CHRG-111hhrg51698--75 Mr. Buis," Well, thank you, Congressman. I was enthralled by the debate that was going on here, and certainly trying to follow along on those credit default swaps. Things on the farm are not good, and this deregulatory approach, or the lack of oversight by CFTC, has led to it. Farmers thought they were going to get good prices. They were precluded from the market, and Mr. Damgard is right, they ran up against their credit limits. But what they don't tell you is that those markets were going up, not because of market fundamentals, but because of the tremendous amount of Wall Street money that came into those markets. And everyone saw this as a great opportunity to make money. As a result, you gave false hopes to the grain farmers that they were going to get these prices. They were precluded. You gave false hopes or big scares to the livestock industry because they thought the prices were going to continue to go higher and higher, so they locked in feed costs. You gave false hope to the ethanol industry, the biodiesel industry, all the processors that, to hedge themselves, they paid higher prices because the big fear was that it was going to continue. And when the bubble burst, and when commodity prices collapsed, it has virtually impacted every aspect of agriculture. " CHRG-111shrg50814--207 RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON FROM BEN S. BERNANKEQ.1. I am very concerned that the Fed's tools could become limited and less flexible, and that the Fed's ability to stimulate the economy given an effective zero interest rate is hindered. What role will the Fed play going forward in our economic recovery?A.1. The Federal Reserve does not lose its ability to provide macroeconomic stimulus when short-term interest rates are at zero. However, when rates are this low, monetary stimulus takes nontraditional forms. The Federal Reserve has announced many new programs over the past year-and-a-half to support the availability of credit and thus help buoy economic activity. These programs are helping to restore the flow of credit to banks, businesses, and consumers. They are also helping to keep long-term interest rates and mortgage rates at very low levels. The Federal Reserve will continue to use these tools as needed to help the economy recover and prevent inflation from falling to undesirably low levels.Q.2. As part of the White House's new housing plan, the administration suggests changes to the bankruptcy law to allow judicial modification of home mortgages. Do you believe ``cramdown'' could affect the value of mortgage backed securities and how they are rated? Will bank capital be impacted if ratings on securities change? Is it better for consumers to get a modification from their servicer or through bankruptcy?A.2. The Federal Reserve Board and other banking agencies have encouraged federally regulated institutions to work constructively with residential borrowers at risk of default and to consider loan modifications and other prudent workout arrangements that avoid unnecessary foreclosures. Loss mitigation techniques, including loan modifications, that preserve homeownership are generally less costly than foreclosure, particularly when applied before default. Such arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower. (See Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages, released by banking agencies on September 5, 2007.) Modifications in these contexts would be voluntary on the part of the servicer or holder of the loan. Although various proposals have circulated regarding so-called ``cramdown,'' the common theme of the proposals would permit judicial modification of the mortgage contract in circumstances where the borrower has filed for bankruptcy. These proposals present a number of challenging and potentially competing issues that should be carefully weighed. These issues include whether borrower negotiation with the servicer or loan holder is a precondition to judicial modification, the impact on risk assessment of the underlying obligation by holders of mortgage loans, and the appropriateness of permitting modification decisions by parties other than the holders of the loan or their servicers. Whether a borrower would be better off with a modification from a servicer or through bankruptcy would depend on many factors including the circumstances of the individual borrower, the terms of the modification, and the conditions governing any judicial modification in a bankruptcy proceeding. In general, when a depository institution is a holder of a security, the capital of the institution would likely be affected if the security is downgraded. How bankruptcy would impact the servicer would depend in part on the securitization documents treatment of the mortgage loans affected by bankruptcies under the relevant pooling and servicing agreements and the obligations of the servicer with respect to those loans. In addition, because the terms that might govern judicial modification in a bankruptcy proceeding have not been established, it is not clear how the value of mortgage-backed securities in general would be affected by changes to the bankruptcy laws that would permit judicial modification of mortgages.Q.3. There is pressure to move quickly and reform our financial regulatory structure. What areas should we address in the near future and which areas should we set aside until we realize the full cost of the economic fallout we are currently experiencing?A.3. The experience over the past 2 years highlights the dangers that systemic risks may pose not only to financial institutions and markets, but also for workers, households, and non-financial Businesses. Accordingly, addressing systemic risk and the related problem of financial institutions that are too big to fail should receive priority attention from policymakers. In doing so, policymakers must pursue a multifaceted strategy that involves oversight of the financial system as a whole, and not just its individual components, in order to improve the resiliency of the system to potential systemic shocks. This strategy should, among other things, ensure a robust framework for consolidated supervision of all systemically important financial firms organized as holding companies. The current financial crisis has highlighted that risks to the financial system can arise not only in the banking sector, but also from the activities of financial firms, such as insurance firms and investment banks, that traditionally have not been subject to the type of consolidated supervision applied to bank holding companies. Broad-based application of the principle of consolidated supervision would also serve to eliminate gaps in oversight that would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors. In addition, a critical component of an agenda to address systemic risk and the too-big-to-fail problem is the development of a framework that allows the orderly resolution of a systemically important nonbank financial firm and includes a mechanism to cover the costs of such a resolution. In most cases, the Federal bankruptcy laws provide an appropriate framework for the resolution of nonbank financial institutions. However, the bankruptcy laws do not sufficiently protect the public's strong interest in ensuring the orderly resolution of nondepository financial institutions when a failure would pose substantial systemic risks. Besides reducing the potential for systemic spillover effects in case of a failure, improved resolution procedures for systemically important firms would help reduce the too-big-to-fail problem by narrowing the range of circumstances that might be expected to prompt government intervention to keep a firm operating. Policymakers and experts also should carefully review whether improvements can be made to the existing bankruptcy framework that would allow for a faster and more orderly resolution of financial firms generally. Such improvements could reduce the likelihood that the new alternative regime would need to be invoked or government assistance provided in a particular instance to protect financial stability and, thereby, could promote market discipline. Another component of an agenda to address systemic risks involves improvements in the financial infrastructure that supports key financial markets. The Federal Reserve, working in conjunction with the President's Working Group on Financial Markets, has been pursuing several initiatives designed to improve the functioning of the infrastructure supporting credit default swaps, other OTC derivatives, and tri-party repurchase agreements. Even with these initiatives, the Board believes additional statutory authority is needed to address the potential for systemic risk in payment and settlement systems. 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 critical payment and settlement systems have the necessary procedures and controls in place to manage their risks. By contrast, many major central banks around the world have an explicit statutory basis for their oversight of these systems. Given how important robust payment and settlement systems are to financial stability, and the functional similarities between many such systems, a good case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems. The Federal Reserve has significant expertise regarding the risks and appropriate risk-management practices at payment and settlement systems, substantial direct experience with the measures necessary for the safe and sound operation of such systems, and established working relationships with other central banks and regulators that we have used to promote the development of strong and internationally accepted risk management standards for the full range of these systems. Providing such authority would help ensure that these critical systems are held to consistent and high prudential standards aimed at mitigating systemic risk. Financial stability could be further enhanced by a more explicitly macroprudential approach to financial regulation and supervision in the United States. Macroprudential policies focus on risks to the financial system as a whole. Such risks may be crosscutting, affecting a number of firms and markets, or they may be concentrated in a few key areas. A macroprudential approach would complement and build on the current regulatory and supervisory structure, in which the primary focus is the safety and soundness of individual institutions and markets. One way to integrate a more macroprudential element into the U.S. supervisory and regulatory structure would be for the Congress to direct and empower a governmental authority to monitor, assess, and, if necessary, address potential systemic risks within the financial system. Such a systemic risk authority could, for example, be charged with (1) monitoring large or rapidly increasing exposures--such as to subprime mortgages--across firms and markets; (2) assessing the potential for deficiencies in evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products to increase systemic risks; (3) analyzing possible spillovers between financial firms or between firms and markets, for example through the mutual exposures of highly interconnected firms; (4) identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole; and (5) issuing periodic reports on the stability of the U.S. financial system, in order both to disseminate its own views and to elicit the considered views of others. A systemic risk authority likely would also need an appropriately calibrated ability to take measures to address identified systemic risks--in coordination with other supervisors, when possible, or independently, if necessary. The role of a systemic risk authority in the setting of standards for capital, liquidity, and risk-management practices for the financial sector also would need to be explored, given that these standards have both microprudential and macroprudential implications.Q.4. How should the government and regulators look to mitigate the systemic risks posed by large interconnected financial companies? Do we risk distorting the market by identifying certain institutions as systemically important? Should the Federal Reserve step into the role as a systemic regulator or should this task be given to a different entity.A.4. As discussed in response to Question 3, I believe there are several important steps that should be part of any agenda to mitigate systemic risks and address the problem caused by institutions that are viewed as being too big to fail. Some of these actions--such as an improved resolution framework--would be focused on systemically important financial institutions, that is, institutions the failure of which would pose substantial risks to financial stability and economic conditions. A primary--though not the sole focus--of a systemic risk authority also likely would include such financial institutions. Publicly identifying a small set of financial institutions as ``systemically important'' would pose certain risks and challenges. Explicitly and publicly identifying certain institutions as systemically important likely would weaken market discipline for these firms and could encourage them to take excessive risks--tendencies that would have to be counter-acted by strong supervisory and regulatory policies. Similarly, absent countervailing policies, public designation of a small set of firms as systemically important could give the designated firms a competitive advantage relative to other firms because some potential customers might prefer to deal with firms that seem more likely to benefit from government support in times of stress. Of course, there also would be technical and policy issues associated with establishing the relevant criteria for identifying systemically important financial institutions especially given the broad range of activities, business models and structures of banking organizations, securities firms, insurance companies, and other financial institutions. Some commentators have proposed that the Federal Reserve take on the role of systemic risk authority; others have expressed concern that adding this responsibility might overburden the central bank. The extent to which this new responsibility might be a good match for the Federal Reserve depends a great deal on precisely how the Congress defines the role and responsibilities of the authority, as well as on how the necessary resources and expertise complement those employed by the Federal Reserve in the pursuit of its long-established core missions. As a practical matter, effectively identifying and addressing systemic risks would seem to require the involvement of the Federal Reserve in some capacity, even if not in the lead role. The Federal Reserve traditionally has played a key role in the government's response to financial crises because it serves as liquidity provider of last resort and has the broad expertise derived from its wide range of activities, including its role as umbrella supervisor for bank and financial holding companies and its active monitoring of capital markets in support of its monetary policy and financial stability objectives.Q.5. The largest individual corporate bailout to date has not been a commercial bank, but an insurance company. What steps has the Federal Reserve taken to make sure AIG is not perceived as being guaranteed by the Federal government?A.5. In light of the importance of the American International Group, Inc (AIG) to the stability of financial markets in the recent deterioration of financial markets and continued market turbulence generally, the Treasury and the Federal Reserve have stated their commitment to the orderly restructuring of the company and to work with AIG to maintain its ability to meet its obligations as they come due. In periodic reports to Congress submitted under section 129 of the Emergency Economic Stabilization Act of 2008, in public reports providing details on the Federal Reserve financial statements, and in testimony before Congress and other public statements, we have described in detail our relationship to AIG, which is that of a secured lender to the company and to certain special purpose vehicles related to the company. These disclosures include the essential terms of the credit extension, the amount of AIG's repayment obligation, and the fact that the Federal Reserve's exposure to AIG will be repaid through the proceeds of the company's disposition of many of its subsidiaries. Neither the Federal Reserve, nor the Treasury, which has purchased and committed to purchase preferred stock issued by AIG, has guaranteed AIG's obligations to its customers and counterparties. Moreover, the Government Accountability Office has inquired into whether Federal financial assistance has allowed AIG to charge prices for property and casualty insurance products that are inadequate to cover the risk assumed. Although the GAO has not drawn any final conclusions about how financial assistance to AIG has impacted the overall competitiveness of the property and casualty insurance market, the GAO reported that the state insurance regulators the GAO spoke with said they had seen no indications of inadequate pricing by AIG's commercial property and casualty insurers. The Pennsylvania Insurance Department separately reported that it had not seen any clear evidence of under-pricing of insurance products by AIG to date.Q.6. Given the critical role of insurers in enabling credit transactions and insuring against every kind of potential loss, and the size and complexity of many insurance companies, do you believe that we can undertake serious market reform without establishing federal regulation of the insurance industry?A.6. As noted above, ensuring that all systemically important financial institutions are subject to a robust framework--both in law and practice--for consolidated supervision is an important component of an agenda to address systemic risks and the too-big-to-fail problem. While the issue of a Federal charter for insurance is a complex one, it could be useful to create a Federal option for insurance companies, particularly for large, systemically important insurance companies.Q.7. What effect do you believe the new Fed rules for credit cards will have on the consumer and on the credit card industry?A.7. The final credit card rules are intended to allow consumers to access credit on terms that are fair and more easily understood. The rules seek to promote responsible use of credit cards through greater transparency in credit card pricing, including the elimination of pricing practices that are deceptive or unfair. Greater transparency will enhance competition in the marketplace and improve consumers' ability to find products that meet their needs From the perspective of credit card issuers, reduced reliance on penalty rate increases should spur efforts to improve upfront underwriting. While the Board cannot predict how issuers will respond, it is possible that some consumers will receive less credit than they do today. However, these rules will benefit consumers overall because they will be able to rely on the rates stated by the issuer and can therefore make informed decisions regarding the use of credit.Q.8. The Fed's new credit card rules are not effective until July 2010. We have heard from some that this is too long and that legislation needs to be passed now to shorten this to a few months. Why did the Fed give the industry 18 months put the rules in place?A.8. The final rules represent the most comprehensive and sweeping reforms ever adopted by the Board for credit card accounts and will apply to more than 1 billion accounts. Given the breadth of the changes, which affect most aspects of credit card lending, card issuers must be afforded ample time for implementation to allow for an orderly transition that avoids unintended consequences, compliance difficulties, and potential liabilities. To comply with the final rules, card issuers must adopt different business models and pricing strategies and then develop new credit products. Depending on how business models evolve, card issuers may need to restructure their funding mechanisms. In addition to these operational changes, issuers must revise their marketing materials, application and solicitation disclosures, credit agreements, and periodic statements so that the documents reflect the new products and conform to the rules. Changes to the issuers' business practices and disclosures will involve extensive reprogramming of automated systems which subsequently must be tested for compliance, and personnel must receive appropriate training. Although the Board has encouraged card issuers to make the necessary changes as soon as practicable, an 18-month compliance period is consistent with the nature and scope of the required changes. ------ FOMC20070321meeting--203 201,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. I’m very comfortable with the center of gravity in this discussion. The boundaries have shifted just a bit, and we face a little more uncertainty on the growth front. But I think there’s still asymmetry in the balance of risks that we face, and we need to continue to highlight the risk that inflation may not moderate enough. The probability that we will tighten further has significantly diminished, but I think our expectations about what makes sense for policy are still above the market’s expectations. I don’t think that situation means that we need to try to push the market’s expectations up to ours. By adjusting the statement slightly in the direction of neutral, we face the risk that we all acknowledge that the market will price in more easing than they already have. But it is better to live with that risk than to preserve a formulation that implies a probability of further tightening that I don’t think is justified. We need to give ourselves the flexibility now to move to neutral sooner than might have seemed likely. Therefore, the broad outlines of alternative B make sense to me. On section 2, as Don said, the reason for putting more texture about the basis for our forecast going forward was, in part, to counteract the fact that we’re suddenly darker about the near- term outlook. The absence of any texture on our forecast makes the statement darker and conveys more concern. So although I like minimalism and although a lot of sensible things have been said about the specific references to financial conditions and housing, I think there’s some value in having more texture about the basis for our view. I’m not as troubled about the reference to financial conditions as many of you are. We could modify the rationale to say “supported by income gains, overall financial conditions, and the gradual waning” so that the characterization of financial conditions is implicit rather than explicitly favorable. But I don’t think that doing so would go far in meeting the concerns expressed around the table. So I would be fine with the Moskow formulation, stopping after “quarters.” I think the rest of the wording has it right. On “predominant” versus “principal,” let me give just the following argument. I don’t believe that a plain language reading of the two words justifies the conclusion that “principal” will be read as softer than “predominant.” People disagree, and in answering the question about what we expect to achieve by changing “predominant” to “principal,” I’m not sure we’d win the basic argument that people would say, “Yeah, it’s softer.” So, on the argument of consistency, I would stay with “predominant.” I don’t think our views of the risks on the inflation front have shifted significantly since the testimony, and so I don’t have any problem with maintaining that. Thank you, Mr. Chairman." CHRG-111shrg57320--5 Mr. Thorson," Chairman Levin, Senator Coburn, and Members of the Subcommittee, we thank you for the opportunity to be here today with my colleague, Mr. Rymer, to testify about our joint evaluation of the failure of Washington Mutual Savings Bank.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Thorson appears in the Appendix on page 101.--------------------------------------------------------------------------- Over the past 2 years, our country has found itself immersed in a financial crisis that started when housing prices stopped rising and borrowers could no longer refinance their way out of financial difficulty. Since then, we have seen record levels of delinquency, defaults, foreclosures, and declining real estate values. As a result, securities tied to real estate prices have plummeted. Financial institutions have collapsed. In many cases, these financial institutions seemed financially sound, but the warning signs were there as they were in the case of WaMu. At the time of its failure in September 2008, WaMu was one of the largest federally insured financial institutions, operating 2,300 branches in 15 States with assets of $307 billion. A very brief background. My office performs audits and investigations of most Treasury bureaus and offices and that includes OTS. We are required to conduct what is known as a material loss review (MLR), whenever a failed Treasury regulated bank or thrift results in a loss of $25 million or more to the FDIC's Deposit Insurance Fund. These MLRs determine the causes of an institution's failure and assess the supervision exercised over that failed institution. Since the WaMu failure did not result in a loss, it did not trigger a MLR by my office. Nonetheless, given the size of WaMu, Mr. Rymer and I decided that a MLR-like review was warranted. We completed that review on April 9, 2010. I will discuss the principal findings regarding the causes of WaMu's failure and OTS' supervision of WaMu. Mr. Rymer will then follow with a discussion of FDIC's role. WaMu failed because its management pursued a high-risk business strategy without adequately underwriting its loans or controlling its risks. WaMu's high-risk strategy, combined with the housing and mortgage market collapse in mid-2007, left WaMu with loan losses, borrowing capacity limitations, and a falling stock price. In September 2008, WaMu was unable to raise capital to counter significant depositor withdrawals sparked by rumors of WaMu's problems and other high-profile failures at the time. Mr. Chairman, as you pointed out in your opening statement, during the 8 days following the collapse of Lehman Brothers in 2007, they experienced net deposit outflows of $16.7 billion. With the severity and swiftness of the financial crisis, while that contributed to WaMu's failure, it is also true that WaMu was undone by a flawed business strategy. In 2005, it shifted away from originating traditional single-family homes towards the riskier subprime loans and Option Adjustable Rate Mortgages, also known as Option ARMs. They pursued this new strategy in anticipation of higher earnings and to compete with Countrywide Financial Corporation, who it viewed as its strongest competitor. To give the Subcommittee a sense of the profits that could be made, at least in the short term, with the type of non-traditional loan products that WaMu pursued, in 2006, WaMu estimated that its internal profit margin on Option ARMs was more than eight times that of government-backed loans, FHA or VA, and nearly six times that of normal fixed-rate 30-year loans. WaMu saw these riskier loan vehicles as an easy way to substantially increase its profitability. Unfortunately, they expanded into these riskier products without the appropriate level of risk management controls needed to effectively manage that risk. With respect to OTS' supervision, WaMu was the largest institution under OTS' regulation. At the time, it represented as much as 15 percent of OTS' fee revenue, and I should point out that like the other bank regulators, OTS is not taxpayer funded. It is funded with fees collected from those that it regulates. So that meant that OTS was collecting more than $30 million from WaMu annually. OTS conducted regular risk assessments and examinations that rated their overall performance satisfactory through the early part of 2008, though supervisory efforts, however, did identify the core weaknesses that eventually led to WaMu's demise--high-risk products, poor underwriting, and weak risk controls. Issues related to poor underwriting and weak risk controls were noted as far back as 2003, but the problem was OTS did not ensure that WaMu ever corrected those weaknesses. We had a hard time understanding why OTS would allow these satisfactory ratings to continue given that, over the years, they found the same things over and over. Even in WaMu's asset quality in their reports of examination, they wrote, ``We believe the level of deficiencies, if left unchecked, could erode the credit quality of the portfolio. We are concerned further that the current market environment is masking potentially higher credit risk.'' And despite what I just read to you, which was out of their own reports, it was not until WaMu began experiencing losses in 2007 and into 2008 that they began to downgrade their rating. When we asked OTS examiners why they did this, why they didn't lower it earlier, they told us that even though underwriting risk management practices were less than satisfactory, they were making money and loans were performing. As a result, they thought it would be difficult to lower the asset quality rating, and this position surprised us because their own guidance states, ``If an association has high exposure to credit risk, it is not sufficient to demonstrate that the loans are profitable or that the association has not experienced significant losses in the near term.'' Given this guidance, those things should have been done much sooner. In fact, OTS did not take a single safety and soundness enforcement action until 2008, and even then, what they took was quite weak. As troubling as that was, we became even more concerned when we discovered that OTS West Region Director overruled issues raised by his own staff with regard to one of those enforcement actions, which you mentioned, Mr. Chairman, the March 2008 Board Resolution. The Board Resolution only addressed WaMu's short-term liquidity issues and did not require it to address systemic problems repeatedly noted by OTS. Despite the concerns of his own staff, the OTS West Region Director approved the version of the Board Resolution written by WaMu. And as previously reported by my office, this was the same OTS official who also gave approval for IndyMac to improperly backdate a capital contribution to maintain its well-capitalized position just 2 months before IndyMac collapsed. As a final note, I just want to make one comment quickly about the contributions of our outstanding staff, which I always do in these things. I want to mention Marla Freedman, Bob Taylor, Don Benson, Jason Madden, and Maryann Costello, because it is their work that allows me to come here and read these statements. I thank you for the opportunity to be here and will answer whatever questions you have. Senator Levin. Thank you. Your appreciation of staff, I know, comes from long experience on Capitol Hill some years ago. We remember you well. " Mr. Rymer," TESTIMONY OF HON. JON T. RYMER,\1\ INSPECTOR GENERAL, FEDERAL fcic_final_report_full--213 Geithner told the Commission that he and others in leadership positions could have done more to prevent the crisis, testifying, “I do not believe we were powerless.”  AIG: “I ’M NOT GETTING PAID ENOUGH TO STAND ON THESE TRACKS” Unlike their peers at Citigroup, some senior executives at AIG’s Financial Products subsidiary had figured out that the company was taking on too much risk. Nonethe- less, they did not do enough about it. Doubts about all the credit default swaps that they were originating emerged in  among AIG Financial Products executives, including Andrew Forster and Gene Park. Park told the FCIC that he witnessed Financial Products CEO Joseph Cassano berating a salesman over the large volume of credit default swaps being written by AIG Financial Products, suggesting there was already some high-level uneasiness with these deals. Told by a consultant, Gary Gor- ton, that the “multisector” CDOs on which AIG was selling credit default swaps con- sisted mainly of mortgage-backed securities with less than  subprime and Alt-A mortgages, Park asked Adam Budnick, another AIG employee, for verification. Bud- nick double checked and returned to say, according to Park, “‘I can’t believe it. You know, it’s like  or .’” Reviewing the portfolio—and thinking about a friend who had received  financing for his new home after losing his job—Park said, “This is horrendous business. We should get out of it.”  In July , Park’s colleague Andrew Forster sent an email both to Alan Frost, the AIG salesman primarily responsible for the company’s booming credit default swap business, and to Gorton, who had engineered the formula to determine how much risk AIG was taking on each CDS it wrote. “We are taking on a huge amount of sub prime mortgage exposure here,” Forster wrote. “Everyone we have talked to says they are worried about deals with huge amounts [of high-risk mortgage] exposure yet I regularly see deals with  [high-risk mortgage] concentrations currently. Are these really the same risk as other deals?”  Park and others studied the issue for weeks, talked to bank analysts and other ex- perts, and considered whether it made sense for AIG to continue to write protection on the subprime and Alt-A mortgage markets. The general view of others was that some of the underlying mortgages “were structured to fail, [but] that all the borrow- ers would basically be bailed out as long as real estate prices went up.”  The AIG consultant Gorton recalled a meeting that he and others from AIG had with one Bear Stearns analyst. The analyst was so optimistic about the housing mar- ket that they thought he was “out of his mind” and “must be on drugs or some- thing.”  Speaking of a potential decline in the housing market, Park related to the FCIC the risks as he and some of his colleagues saw them, saying, “We weren’t getting paid enough money to take that risk. . . . I’m not going to opine on whether there’s a train on its way. I just know that I’m not getting paid enough to stand on these tracks.”  By February , Park and others persuaded Cassano and Frost to stop writing FOMC20050630meeting--377 375,MR. KOHN.," Thank you, Mr. Chairman. I made only small revisions to my forecast from last January. We’ve seen some notable fluctuations in data and sentiment over the last five months, but basically I think we’ve ended up pretty close to where we started, with prospects for growth that are close to the growth rate of potential, perhaps a bit above, and core PCE inflation stable at a little over its rate of last year. The data we received over the intermeeting period reinforced this favorable outlook, assuaging some of the concerns on both the demand and inflation fronts that I had at our meeting in early May. Growth in private final purchases has been good, with the second-quarter forecast to be around 4 percent. Slack in labor markets has continued to erode gradually. Core CPI inflation slowed, supporting the notion that some of the earlier pickup was a product of the pass-through of previous increases in energy and other import prices, and core PCE inflation has been stable. Commodity and intermediate goods price pressures have abated, consistent with the moderate pace of increase in production and a judgment that the global economy was not facing significant bottlenecks, except possibly in energy markets. And importantly, inflation expectations fell on balance despite the further increase in oil prices. The recent further rise in oil prices will indeed put some upward pressure on core inflation, but that should be limited in time, and increases in the prices of other imports should abate considerably, owing to the strength of the dollar. Moreover, the behavior of most measures of labor compensation suggests to me that labor markets are not in the process of overheating and may even have some degree of slack remaining. And declines in inflation expectations provide some assurance that past increases in energy and June 29-30, 2005 146 of 234 Over time, of course, it is appropriate monetary policy that will keep the balance between demand and potential supply and inflation in check, and I actually found that thinking about the appropriate path for policy was harder than thinking about the outlook. In a fundamental sense, the favorable outlook rests on a judgment that over the last year or so monetary policy has been well calibrated to the evolving situation. Market participants seem comfortable with policy to date and with their expectations for the future. The simultaneous decline in expected funds rates and inflation expectations over the intermeeting period indicates confidence that inflation will be contained. And the rise in equity prices and still fairly narrow risk premiums in credit markets must rest on expectations of continued solid growth. I think we can be fairly confident that appropriate policy is likely to require additional tightening even beyond this meeting. That’s what is built into the yield curve, and that structure of rates seems to be consistent with growth continuing around or perhaps a little above the rate of potential and with the output gap about disappearing. And with output probably close to its sustainable potential and inflation already having picked up a little, I agree with the rest of you that we’re at a point in the cycle at which we need to be especially careful about keeping inflation pressures contained. But how much further we need to tighten in order to accomplish that, and at what pace, are the interesting questions. The staff and markets have built in a leveling out of the funds rate at about 3¾ to 4 percent. That’s quite low by historical standards. The Greenbook has an implied short-run r* of only 1½ percent. Still, that’s not implausible, judging from the experience of the last few years when very accommodative policy has been associated with growth only moderately in excess of potential. And the recent downward revisions to market expectations for growth abroad—and expected policy June 29-30, 2005 147 of 234 demand. Nonetheless, the underlying truth is that we really don’t know how much we need to tighten, and, fortunately, we don’t need to figure that out today. I recognize that the 25-basis-points-per-meeting path is not an optimum policy. As we can see from the Bluebook simulations, an optimum policy would tend to flatten out the trajectory as we get close to what we think is a stopping point. The risk is that the 25-basis-points-per-meeting pace will tend to ratify your prediction, Mr. Chairman, that our last tightening will be one too many. Given the lags in the effects of policy, if we wait to see confirming signs that past increases have slowed growth on a sustainable basis—and we aren’t seeing just another soft patch—we probably will indeed have overshot the mark. The path could be especially problematic if it extends into the fall when our meetings get closer together. Surely, the pace of tightening shouldn’t be dictated by the meeting schedule rather than economic needs. But I do take some comfort in the expectation that policy doesn’t have to be that precise. The market will tend to compensate for any overshooting by building in a reversal, provided we let it know that we are open to that possibility when the time comes. For now, sticking to our path of gradual rate increases would seem to be the most prudent course, but such a path is conditional on the economy following its expected path. We should be willing to deviate either way, even as early as August, should the data indicate a very substantial deviation in the path of spending or prices. And our statement today should not be read as implying anything about our expectations beyond August. That will depend on data. The higher we go with rates, the more we need to keep an open mind about stopping places and possibly even the pace of tightening. Thank you, Mr. Chairman. June 29-30, 2005 148 of 234" FOMC20050630meeting--323 321,MR. FERGUSON.," You’ve told me in the past that the supply response in copper tends to take a year or two. The price has not been high enough necessarily, but one would have thought we’d start to see some supply response, getting these prices to come down even more quickly." CHRG-111hhrg51698--169 Mr. Boccieri," But if they are betting billions and billions of dollars that the price is going to go up, and to me part of this artificial control of the market, rather than letting supply and demand control the market, seems to me that that is a bit of--they unconsciously or consciously know that the price is going to go up at some point. " FOMC20050630meeting--59 57,MR. WILLIAMS.," In the optimal policy simulations, from the beginning of the simulations, which is the third quarter of this year, you know the entire future path of house prices and any other shocks that I add. So you are acting in anticipation of those future price changes." CHRG-110hhrg41184--75 Mr. Bernanke," Increasing supply generally lowers the price, so I think that's correct. But in these circumstances, Congress has to weigh the benefits of more oil supply against other considerations, including environmental issues and the like. Mr. Price of Georgia. Thank you. "