Hearing on Semiannual Monetary Policy Report

CQ Transcripts Wire
Wednesday, February 14, 2007; 1:30 PM



FEBRUARY 14, 2007



























DODD: The committee will come to order.

Let me thank all of our colleagues and others who have made it in this morning to participate in this hearing in our first true winter morning this year.

Mr. Chairman, we thank you for being with us as well, and appreciate your testimony before the committee.

Let me open the -- I will do is open up with a brief opening statement. I'll turn to my colleague, Senator Shelby, and then any of my other colleagues who would like to make some brief opening remarks.

Their full statements, I'll guarantee, will be included in the record, as will yours and any supporting documentation, Mr. Chairman, you'd like to be a part of the record this morning.

And we'll try and move along so we can get to the question-and- answer period with you as quickly as possible.

This morning, the committee is pleased to welcome Federal Reserve Chairman Bernanke to deliver the Feds semi-annual monetary policy report.

I want to congratulate you, Mr. Chairman, for completing your first year as chairman. Following in the footsteps of a very successful chairman can be difficult and is something that I can certainly relate to, sitting in this chair and sitting next to my friend from Alabama.

But I believe that you have done a very good job in gaining the respect and confidence of the markets and your colleagues on the Federal Reserve Board.

The Feds monetary policy, most notably its decision to stop rising interest rates in June, has played a very important role in some recent positive economic developments.

During 2006, the economy grew at a sustainable rate and unemployment was kept to under 5 percent. While this is not quite as strong as it was in the late 1990s, when growth was higher and unemployment fell below 4 percent with much higher labor force participation, this economic news is welcome.

Long-term interest rates have remained at modest levels despite a large federal budget deficit, historic current account deficit, and the cumulative effect of the Feds two-year cycle of raising interest rates that ended in June.

While these developments are, as I said, positive, there are other facts that in my view raise some very important questions about our nation's long-term ability to provide economic security, opportunity and prosperity to the people of this country.

As I travel around these days and talk to many people from a variety of walks of life, I'm confronted with people who are concerned about the future: whether or not we'll have the kind of stability and long-term growth necessary for our success.

DODD: What I'm hearing from people is that they are concerned about many of the same things. Health care costs are rising at a rate that is unsustainable for businesses and employees. Over the past six years, health care costs have increased by 30 percent.

More than 46 million Americans have no health insurance at all today, as we all know. That's an increase of 6 million people over the past six years.

The price of gasoline, home heating oil and other forms of energy has skyrocketed over the past years. This past summer, gasoline cost over $3 per gallon in many parts of the country. And while it's much lower today, it is still twice as high as it was five years ago.

Families are concerned as well. They cannot afford to send their kids to college. My colleague from New York Senator Schumer has spent a lot of time on this issue. College tuition has risen by more than twice the rate of inflation over the past 20 years. Room, board and tuition at many private universities now cost well over $50,000 a year.

As these costs rise, working Americans are experiencing more and more uncertainty about their future. People are wondering whether their home is losing value, as they see houses in their neighborhood sell for less today than they did a year ago.

And millions of Americans are in exotic and subprime mortgages, while the potential for sharp increases in monthly payments -- right around the corner, these increases in monthly payments. Several credible reports say that we are facing a tidal wave of defaults and foreclosures, which could strip these families of their major, if not their only, source of wealth and long-term economic security.

Despite some recent gains in household incomes, the real median family income -- what a family right in the middle of the middle class earns in a year -- is lower today than it was six years ago. People are working longer and harder, but many are not bringing home enough money to keep pace with what they need.

And for those who lose their jobs, the prospect of falling out of the middle class is greater today. Americans are more than twice as likely to experience a precipitous drop in income as Americans of a generation ago, according to a recent research study by Jacob Hacker (ph) at Yale University.

As we worry about some Americans falling out of the middle class, we must also be concerned about those working hard to climb into the middle class. Over 10 million Americans today do not have access to mainstream financial institutions, such as a bank or a credit union or a thrift. For these entrepreneurs and workers, affordable credit and capital services are scarce, if not impossible, to find.

And as a result, millions of our fellow citizens lack the financial tools that they need to build more secure and prosperous futures for themselves and their families.

Finally, Mr. Chairman, our nation finds itself with trade policies that are unsustainable as well, in my view.

We learned this week that last year we ran a record trade deficit of $763 billion. Our nation's current account deficit will approach 7 percent of our GDP. We are relying on over $2.4 billion a day from foreign investors, who are increasingly foreign governments, to finance our economic growth because of the lack of savings here at home.

The administration has an official trade policy that is, in key respects, out of touch, I think, with reality. For instance, it is widely believed that China manipulates its currency. We had a very good hearing, as you may know, with Hank Paulson before this committee a week or so ago on the exchange rate issue. Yet the administration refuses to officially recognize that fact.

When Chairman Bernanke was in China as part of the strategic economic dialogue, he gave a speech that pointed out, and I quote, "the effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting," end quote.

But this subsidy is not the sole cause of either our record international trade deficit or our loss of over $3 million manufacturing jobs, including about 1 million of those jobs in critical national defense-related industries. The distortion of Chinese currency manipulation is having, I think, a very significant negative impact on American manufacturing jobs.

As policymakers, I think we need to ask ourselves a very fundamental question: Are we satisfied with America's place in the world at the beginning of this new century? I don't think that any one of us can look at all the facts and reach any conclusion other than that we can do a lot better than I think we are. And for the sake of the people we serve and generations coming after them, I think all of us would agree we've got to do better.

There are steps we can and should take, in my view, to build a stronger foundation for a more secure and prosperous future. Today's hearing provides the committee with an opportunity to discuss some of these steps.

We can start by keeping interest rates at modest levels. And again, I congratulate the Fed on doing that since last June.

Certainly monetary policy is obviously an important component of our economic future. The Fed's dual mandate is to promote full employment and price stability. This is a vital and difficult mission. And we look forward to hearing from the chairman about the steps the Fed has taken since its last report to fulfill that statutory mandate.

In addition, we need our federal financial regulatory agencies to be vigilant in ensuring not only the safety and soundness of our financial institutions but, indeed, that those institutions are serving, not thwarting, the aspirations of Americans to build a more secure and prosperous life for themselves and those families.

DODD: So I look forward to discussing the aspect of the Fed's mission, as well as with you, today, Mr. Chairman.

And I would turn to my colleague from Alabama for any opening comments he may have, and then to my colleagues here as well for any brief statements they want to make as we start this hearing.

SHELBY: Thank you, Chairman Dodd.

Chairman Bernanke, we're pleased to have you before the committee again to deliver the Federal Reserve's semiannual monetary policy report.

This hearing, as you know, provides an important mechanism for sharing accountability over the Fed's policies and operations.

Chairman Bernanke, you have recently completed one year at the helm of the Federal Reserve System. When President Bush nominated you for this position, I noted at the hearing that you would have big shoes to fill following the footsteps of the distinguished Chairman Greenspan. I also noted my belief that the president made a superb choice in asking you to take on this responsibility.

The Federal Reserve's conduct of monetary policy thus far under your leadership has given me further reason to applaud your service.

Chairman Bernanke, as 2006 began, there was much debate as to whether the Federal Reserve would prove successful in engineering a soft landing after many successive increases in the Fed fund's target rate.

Certainly the economic data in recent weeks tells us that the debate is maybe all but over. Analysts and other Fed watchers are now giving you high praise for the manner in which you've handled your responsibilities, and I join them.

Real gross domestic product, GDP, increased at an annual rate of 3.5 percent in the fourth quarter of 2006. For all of 2006, GDP grew 3.4 percent, compared with 3.2 percent increase in '05. Both numbers topped the 20-year average of 3.1 percent.

Along with the strong growth, we've seen positive news on the job front. The Labor Department reported that the economy created, Mr. Chairman, more than 2.2 million jobs last year; 400,000 more than previously estimated. We continue to enjoy a low unemployment rate, both historically and relative to other industrialized nations.

At its most recent meeting on January 31, the Federal Open Markets Committee kept the federal funds target rate at 5.25 percent, the fifth consecutive meeting with no change.

Fed watchers noted that the latest FOMC statements seem more upbeat on growth prospects and keeping inflation in check.

My colleagues and I, Mr. Chairman, will no doubt spend time this morning trying to figure out how long the FOMC intends to leave short- term rates unchanged. And I'm certain that today's hearing will also include some discussions of the potential risks in the economy, such as the housing market slowdown, among others.

Mr. Chairman, while it's our responsibility to continue to examine the horizons of such risk, we must also note the strong performance of this economy. I hope that we'll also take time today to discuss the various strengths and how to maintain and build upon them.

Chairman Bernanke, again, we welcome you back to the committee. And we like the job you're doing.

DODD: Senator Schumer was next on our list, but Senator Casey -- and this early-bird rule applies here, so Senator Casey...


CASEY: Mr. Chairman, thank you very much for gathering us here.

CASEY: Chairman Bernanke, thank you for your time here today and for your service.

I don't have a long statement, but I just wanted to highlight a couple of things I know that you've touched on before and I'm sure will speak to today.

Some of the long-term fiscal challenges that you outlined here in your previous testimony, I guess a week or so ago, with regard to Medicare and Social Security and other demands that are being placed on the federal budget into the future; and I appreciate the fact that you're thinking about it and focusing on that and building that into your -- the planning that you do.

And I think, also, the people that I represent in Pennsylvania are concerned about those costs. They're concerned about the deficit, which I guess last year was $248 billion; this year the projection is for something less than that.

But they're also concerned about the impact, as Chairman Dodd outlined, of the cost in their own lives. And they realize -- and you know this -- the cost of health care and college tuition and housing and so many other areas that I hope that one of the things we have a chance to discuss today is the impact that those costs have, the impact not just on that family, the horrific impact it can sometimes have on their budgets, but also the impact that that has on overall long-term economic growth and stability.

So I look forward to discussing that today with you. And we appreciate the time you're spending with us and appreciate the report.

DODD: Senator Bunning?

BUNNING: Thank you, Mr. Chairman.

Chairman Bernanke, thank you for being here today.

To repeat what I told you at the Budget Committee hearing a few weeks ago, the Federal Open Markets Committee did the right thing by stopping the increases in the Fed fund rates after the June '06 Fed meeting. By holding rates constant, you have done the right thing ever since. After the latest increases, stock markets took off and the cost of credit leveled off.

If the Fed had chosen to continue hiking rates, mortgages and other forms of credit would have become less and less affordable to the average American.

Over the last two years, the cost of credit, such as mortgage -- student loans and credit cards -- have all increased. I'm not sure how much more tightening consumers could have handled before serious harm was done to the economy.

Higher interest rates accelerated the housing decline. We will not know the full extent of the damage for months, if not longer. If the Fed had not stopped when it did, we would have been in even more danger.

You have been at the helm of the Fed for a year now. My initial fears were that you would be a carbon copy of your predecessor, yet you have done some things I have never seen your predecessor do: embrace open and full debate.

BUNNING: There is an old saying that there is a reason we have two ears and one mouth: It is often more important to listen than to talk.

During your brief tenure at the Fed, you have made a serious effort to improve on how the Fed listens.

But you know I'm not going to let you off that easy, even though today is Valentine's Day.


The people of my state and I have real concerns about the dangers that lie ahead for our economy. As this committee discussed with Secretary Paulson last month, our constituents are nervous when they see more and more manufacturing jobs going to the Chinese. They are concerned about the future of the housing market. They are particularly concerned about the effects the potential repeal of the Bush taxes will have on our economic recovery.

You inherited an economy that was approaching a tipping point, and so far you have managed not to push it over. I urge you to act with caution and deliberation in the coming year.

Finally, soon there will be two vacancies on the Board of Governors. I hope the president moves quickly to fill these positions with people who have real experience in the financial service and commercial banking, not just ivory tower academics.

I look forward to your remarks.

Thank you, Mr. Chairman.

DODD: Thank you, Senator Bunning.

Senator Bayh?

BAYH: Thank you, Mr. Chairman.

Chairman Bernanke, I suspect that most of the people here today are -- have gathered to listen to you, not me. And I will, therefore, reserve my comments for the question period.

DODD: Very good.

Senator Martinez?

MARTINEZ: I will almost resist the temptation, but I will...

DODD: OK, that was a standard he set there...



MARTINEZ: I'll be very brief, Mr. Chairman. Thank you very much.

Mr. Bernanke, Chairman, welcome. And I, again, join in the high praise that you've been receiving from your first year in the job.

I will simply look forward to hearing your comments as it relates to the housing market: great concern to me, housing affordability; also the issue that we dealt with last week in this committee, which is subprime lending and the rate of defaults in that area; and just in general the effect of the hurricanes in the Gulf Coast, which continue to be an impact on the economies of the Gulf states.

MARTINEZ: So I look forward to your comments. And thank you for being with us today.

DODD: Thank you very much.

Senator Menendez?

MENENDEZ: Thank you, Mr. Chairman.

Chairman Bernanke, welcome. It's great to welcome a fellow New Jerseyian back again to the committee.

Today some people say the economy is solid, due to some of the leading economic indicators appearing generally healthy, with unemployment below 5 percent, with moderate economic growth, with inflation stabilized.

And I certainly want to commend you for the stewardship you're showing at the Fed in working on this economy.

But at the same time, I also worry about who's benefiting from this economy and who is being left behind.

Indeed, there are serious limitations, I think, in judging a situation solely through looking at the big-picture numbers, as this view often hides the details of the situation. And specifically, I'm talking about the burden being placed on our middle class.

So while some in this country might believe that our economy is chugging along quite well because our gross domestic product continues to grow, there seems to be an increasing gap between the average citizen and those at the top of our economic ladder. And the disparity that continues to grow in my mind is widening at an alarming rate.

When I'm back in New Jersey, I hear more and more from New Jerseyians that our current economic policies are not working for them. The middle class continues to shrink. Poverty is increasing. The gap between the rich and the poor is growing wider. We have a record-breaking national debt and a record-breaking trade deficit.

Personal savings rate is now below zero, which hasn't happened since the Great Depression. Millions of Americans are seeing their wages stagnant and their pension and health care benefits slashed, while the wealthiest people in the country are doing better than ever.

So ultimately, my concern is that our economy is not working for the broadest scope of Americans that we would hope. The middle class is shrinking instead of growing, and we seem far more concerned about boosting the incomes of the wealthiest Americans, while denying our responsibility to those struggling to make ends meet.

I don't think we can sustain that position over the long term. We're borrowing to pay for tax cuts and the war effort. It's an unfair burden we're placing on our children and grandchildren.

So I look forward to your testimony today and hearing your thoughts on some of these things I've mentioned; some of the other things I hope you'll address, like the cooling off of the housing market, what that may mean, energy prices, the consequences of deficit and debt, from large budget deficits to record personal debt.

And I understand that in your capacity as chairman of the Federal Reserve, you're responsible for keeping inflation low and stable while maintaining economic growth, not economic equality. But I do hope, either in your opening statements or subsequently in the questions, that we'll have an opportunity to ask to hear your views about how we get this economy working in a direction that really helps middle-class families in this country.

Thank you, Mr. Chairman.

DODD: Thank you very much.

Senator Hagel?

HAGEL: Mr. Chairman, thank you.

Mr. Chairman, welcome. We're glad you're here.

I want to personally thank you for you taking time to address the Greater Omaha Chamber of Commerce at their annual meeting two weeks ago. It was a rather significant event, as it always is. And your speech matched the expectations that many had. And I appreciate you very much, taking a day of your time to come to my state and deliver that speech and spend some time with our leaders in Nebraska.

And I look forward to your testimony.

Thank you.

DODD: Thank you very much.

Senator Tester?

TESTER: Thank you, Chairman Dodd.

Chairman Bernanke, I want to also welcome you here. This is one of those odd occasions where I don't have another committee; thank God for snow. So I look forward to your comments. And I'll have questions when you're done.

Thank you.

DODD: Thank you very much.

Senator Bennett?

BENNETT: Thank you, Mr. Chairman.

I had planned to follow Senator Bayh's standard, but I've heard so many things being said here that I think at least one voice ought to rise in defense, if you will, of where certain things have been going.

Mr. Chairman, you know my personal affection for you, but it will not be a surprise that I disagree with your opening statement.

DODD: I'm shocked to hear that.


BENNETT: And by coincidence, I suppose the best rebuttal is in a piece that appeared in this morning's paper by Brian Wesbury, who is the chief economist at First Trust Advisers LP in Illinois, "A Portrait of the Economy."

BENNETT: And I would ask unanimous consent that the entire piece appear in the record.

DODD: Without objection.

BENNETT: But I would like to read a few appropriate words that I think are something of a response to what we've heard.

He starts out, "It's the best of times. It's the scariest of times. Last year U.S. exports, industrial production, real hourly compensation, corporate profits, federal tax revenues, retail sales, GDP, productivity, the number of people with jobs, the number of students in college, airline passenger traffic and the Dow Jones industrial average all hit record levels."

"For the third consecutive year, global growth was strong, continuing to lift and hold millions of people out of poverty.

"From 30,000 feet -- heck, from 1,000 feet, it sure looks like the best of times. In relative terms, the first five years of the current recovery have been much better than the first five years of the 1990s recovery.

"But this has not softened the pessimism of many pundits and politicians, who are either unimpressed or expect the whole thing to come crashing down any minute, unless the government firmly grabs the rein of a global economy and steers it clear of disaster."

And then he goes on to outline the history of how badly things have gone every time the government has tried to step in and steer it clear, starting with the '30s and then the '70s.

He makes this comment about the '70s, which I responded to. And it says, "Forgotten in the rush to pass judgment on capitalism is the fact that the last two times the government seriously tried to control the economy in the '30s and '70s, they made a terrible mess of it."

BENNETT: Well, I will leave the rest of it for people to read.

But the one thing I'd say to you, Mr. Chairman, if he's right -- and I think he is -- that in the year of your stewardship, the last year, exports, industrial production, real hourly compensation, profits, tax revenues, retail sales (inaudible) all are at record levels, you must have been doing a pretty good job.

And if you were running for office, you would take full credit for absolutely all of it.

Thank you, Mr. Chairman.

DODD: Thank you, Senator Bennett.

Senator Brown?

BROWN: Thank you, Mr. Chairman.

Chairman Bernanke, I appreciate your joining us today to share your thoughts on the direction of monetary policy in the months ahead. I also appreciate the comments you've made in Nebraska and other places before other groups on the steps you've taken toward greater transparency.

I'm sure that you can appreciate for most of the families in my state of Ohio and elsewhere many of the issues we discuss today are far-removed from their day-to-day lives. As Senator Menendez said, the uncertainties that middle-class families face are not uncertainties that columnists that Senator Bennett mentioned and others, economists, worry about as often, perhaps, as they should.

I know and appreciate your acknowledging the widening gap of income in our society. I commend you for adding your voice to that discussion.

I agree with you that we should look at ways to improve education and training of our citizens, but I don't think that's nearly enough.

Globalization has had a tremendous impact on workers in this country, on communities, on teachers, on firefighters, on cities' ability to deliver services to their constituents.

There's no question that good-paying manufacturing jobs have gone off shore. Fourteen years ago, the trade deficit in this country was $38 billion. Today, announced just this week, it exceeds $760 billion.

BROWN: George Bush the first said that a billion-dollar trade deficit translates into 13,000 lost jobs. You do the math.

Of course, we must trade with the world. The question is not if we will trade with other countries; rather it's how we will trade with them and who will benefit.

If the beneficiaries are limited to those with investment capital and the losers too often are workers and their communities across the country, we simply will not have a very sustainable trade policy.

We devote substantial time and effort to protecting intellectual property in our trade negotiations and enforcement. We need to do this. But we exert almost no effort in protecting the rights of our workers and their counterparts overseas. That simply has to change.

Many in the media and some in government label those of us who advocate for labor and environmental standards as protectionists, yet when our trade agreements protect the drug industry or Hollywood films, we call that simply "free trade."

If we can protect an Ohio inventor, if we can protect pharmaceuticals, if we can protect copyrights, as we should, we can do a much better job protecting workers and the environment.

I thank you for your time.

DODD: Thank you very much, Senator.

Senator Allard?

ALLARD: Thank you, Mr. Chairman. I'd like to thank you and Senator Shelby for holding this hearing. This is important. I always look forward to hearing from Chairman Bernanke.

I think that you have started off very well in your tenure as chairman of the Fed Reserve. And I want to congratulate you on that initial effort.

I think you've gained the confidence of the markets and I think you've gained the confidence of many members of the Congress, although there's a few skeptics still among us.

But I would like to emphasize that the economy is doing well. We look at economic growth: This last year, it's 3.4 percent. Previous year it's it's 3.2 percent. The average, over 20 years, is somewhere around 3.1 percent.

ALLARD: So we are above the average in economic growth. I think a lot of that is attributable to the economic growth package that we put in place in 2003 and the tax cuts that we had in 2001.

And we've heard a lot of comments here on this committee about how it's going to impact the family. In my view, the hardest-working American is the small-business man. And those economic growth packages were targeted to the small-business man. That's where our economic growth occurs.

And there are members in the Congress that are pushing hard to do away with those temporary tax reductions that we put in place to stimulate this economy.

My question to you is how would you -- and I hope you'll address this -- that, you know, if we let those become -- those temporary tax cuts go away, what kind of impact's that's going to have on the average family. I think it's going to be -- have a dramatic impact, particularly on the hard working men and women of this country who are in business for themselves.

And I hope that you can address that in your comments.

Thank you very much.

DODD: Thank you, Senator Allard.

Senator Reed?

REED: Well, thank you, Mr. Chairman.

And thank you, Chairman Bernanke, for joining us today.

And your task in setting the right course for monetary policy is complicated by fiscal policy and international imbalances. We no longer have the fiscal discipline that we had in the '90s, which allowed for a monetary policy that was more encouraging, I think, of robust investment and long-term growth.

The president's large and persistent budget deficits have led to an ever-widening trade deficit that forces us to borrow vast amounts from abroad and puts us at risk of a major financial collapse if foreign lenders suddenly stop accepting our IOUs.

Continued budget and trade deficits will be a drag on the growth of our standard of living and leave us ill-prepared to deal with the effects of retirement of the baby boom generation.

Strong investment, financed by our own national saving, not foreign borrowing, is the foundation of a strong and sustained economic growth and rising standards of living.

REED: One final issue that I'd like to raise is the growing inequality of income, earnings and wealth in the U.S. economy.

Between 2003 and 2005, GDP grew at a rate of 3.5 percent per year. However, after adjusting for inflation, the typical weekly earnings of full-time wage and salary workers at the median of the earnings distribution went up only 0.6 percent between the end of 2000 and the end of 2006. Obviously, these median workers are not sharing in that robust GDP.

Data from the Federal Reserve Board Survey of Consumer Finances show that household wealth is very unevenly distributed. The wealthiest 1 percent of families held more of the country's wealth than the bottom 90 percent of families combined.

Even more disturbing is the large number of families, particularly African-American and Hispanic communities, that have little or no net wealth.

Chairman Bernanke, I was heartened to read your comments in Omaha last week, emphasizing the importance of education and training in reducing this economic inequality, and I know you share the concern that widening inequality is not good for our democracy and the fabric of the country.

So I hope you'll agree that there is any consistency, at best, in the administration's pursuit of tax breaks for those who are already well off, including the permanent elimination of the estate tax, while continuing to propose cuts to elementary and secondary education, student aid and loan assistance for higher education, and job training for displaced workers.

The challenges facing our economy are compounded by the disarray that characterizes our fiscal policy. We've been running unsustainable fiscal deficits, and in order to make the necessary investments in training and education, we must reverse the course.

And I would be remiss if I did not note that the lead story today in most of the wire services is Chrysler is cutting 13,000 jobs. I suspect that that will probably raise the stock of Chrysler, make the investors happy and the investment bankers who are structuring this transformation of the company. It's necessary perhaps to do.

But the 13,000 who used to have good jobs with good health benefits, they're in a quandary. And our obligation is to them as well as it is to the shareholders of that company.

So I think we've got to do a lot more, and I think you do sense that. And I think, together, hopefully, we can make some progress.

DODD: Thank you, Senator Reed.

Senator Sununu?

SUNUNU: Thank you very much, Mr. Chairman.

Senator Bennett I thought was somewhat eloquent in talking about the very positive trends we've seen in the economy: record job creation and above-average recovery period, record homeownership, rising income levels.

It's fair to say, though, for any member that's spent a little time back home, there is a sense of insecurity that can be felt even in what are relatively strong economic times.

SUNUNU: And I think that's an issue or set of issues dealing with their insecurity or uncertainty that we ought to deal with as policymakers, and, perhaps, that at some level can even be addressed by the Fed.

But I think it's important to understand that the role of the Fed is not to redistribute wealth, not to raise taxes not to establish protectionist trade measures. And I think that's a good thing.

I suspect maybe Chairman Bernanke thinks that's a good thing, because he has a tall enough order as it is.

The areas where the Fed can have a very positive impact within their mission are to deal with the uncertainties of inflation, the uncertainties of establishing a sustainable and steady record of economic growth, the security that comes from the establishment of safe and sound financial markets.

And those are all responsibilities of the Fed, I think responsibilities that Chairman Bernanke takes very seriously. You've spoken very well to those issues in the past. And I look forward to hearing your comments on those and other issues this morning.

Thank you, Mr. Chairman.

DODD: Thank you very much, Senator Sununu.

Mr. Chairman, we welcome you, again, to the committee. We're anxious to hear your comments. And a full statement and supporting documents will, of course, be a part of the record.

Welcome to the committee.

BERNANKE: Thank you.

Chairman Dodd, Senator Shelby and other members of the committee, I'm 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 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 six months, and the unemployment rate, at 4.6 percent in January, remains low.

BERNANKE: 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 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 about 3.5 percent in real terms during the second half of last year, broadly matching the brisk pace of the previous three years.

Consumer outlays were supported by strong gains in personal income, reflecting both the ongoing increases in payroll 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 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 four and a half months' supply in 2005 to nearly seven 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 homebuyer 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 income should continue to rise, although the pace of employment gains may be slower than that to which we've 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 in the work force, 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.

BERNANKE: 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 non-residential 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 at 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 of 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.

BERNANKE: 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.

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.

BERNANKE: But as we've been reminded only too well in recent years, the price 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 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 markup of prices over unit labor costs is high by historical standards, so such an outcome is certainly possible.

BERNANKE: 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 2.25 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 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.

BERNANKE: 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 the 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.

DODD: Thank you very, very much, Mr. Chairman, for a very comprehensive statement.

What I'm going to do is I'll allocate seven minutes per member. Not to hold that so tightly, I'll just ask members to be conscious of the time, and we have the clocks in front of you here, so we can make sure everyone has an adequate time to ask questions and give you an adequate time to respond to them as well.

Let me pick up, if I can -- and a number of my colleagues referred to your speech in Omaha. Senator Hagel talked about your reception there, and the comments you made about income and equality. And I want to pick up on those comments, if I can, as well.

I think all of us recognize here -- I say to my friend from Utah and colleague, we're all very conscious of the tremendous wealth that's been created in certain sectors of our economy, that there are good things that are happening. None of us are suggesting all is bad.

There is a sense, as Senator Sununu has said and others, of uncertainty that people are feeling across the country about the long- term economic growth and stability of the nation.

And I think those of us who trust in those views too, here, Mr. Chairman, probably reflect your comments as well, as I read them. Your quote in Omaha -- I'm quoting here -- "By many measures, inequality in economic outcomes has increased over time."

Your predecessor, Chairman Greenspan, was very concerned about the growth in income inequality as well. He testified, and I quote him. He said, "I think the income distribution issue is very critical, because we cannot have a significant inequality of income and expect to have support for the type of institutions that have made this country great," end of quote.

Do you share Chairman Greenspan's concern, Mr. Chairman, that continued economic growth of inequality is a significant threat to our nation's fundamental promise of economic opportunity? Do you suggest by your comments here that we ought to have a balanced view?

I just left a markup a few minutes ago, before coming here, marking up a new Head Start bill that will hopefully deal with greater accountability, but serving about 900,000 to a million young people in this country in the past 41 or 42 years that has tried to give those children an opportunity to become active and successful members of our economy in the future.

I'm concerned, as we look at this, that the decisions we make here will lack that kind of balance. And your comments seem to suggest a similar train of thought.

And I wonder if you might just take a few more minutes this morning to expound on those comments in Omaha. And just a general observation -- I'm not asking you to endorse a specific spending program here and there, but just your general observation about this inequality issue and your concerns that you obviously expressed in Omaha.

BERNANKE: Thank you, Mr. Chairman.

The very important drivers of economic growth and prosperity in this country include free and open trade and technological progress. It's very important to allow those forces to continue to operate in our economy.

However, we do have to recognize, as I discussed in Omaha, that the effects of these forces can be differential across the population. They may create greater income possibilities for some than others. They may create painful dislocations, for example, if the composition of industries changes or job skill requirements change.

I agree with Chairman Greenspan's general point that in order to support and retain support for policies of free trade, open borders, technological change, flexible labor markets, we need to make sure that the gains and benefits from these powerful, growth-producing forces are broadly shared and that people understand that these things are good for the American economy and good for people, generally, in the economy.

How to do that is very difficult. It's easy enough to say, "Let's promote economic opportunity." I certainly support that idea. Doing it is not necessarily easy.

I discussed in my speech some general issues, some general approaches, including education: not only K-12 education, but training throughout the lifespan, from early childhood through adult retraining. I think that's very important.

I think we need to help people who are dislocated by these powerful dynamic forces to find new jobs, to find new opportunities. And I think that's very important.

I would just say, though, I'm glad you didn't ask me to endorse specific policies, because making that work in practice is difficult. And we have to find ways to achieve these objectives -- you know, for example, retraining workers -- in ways that work well, that are effective and are effective in terms of the spending that we put into it.

And so, it's a great challenge for us, going forward, to look among all the possible approaches and decide, you know, which types of programs, which types of initiatives will be most effective at achieving this objective.

That being said, again, I do agree that we need to spread the benefits widely and make people understand that open trade and technological change are beneficial for not only the economy in the aggregate, but for the great majority of people in the economy.

DODD: I don't know if you had the chance to read a report called "The Gathering Storm" that was prepared by a number of senior retired corporate executives, along with some of our leading academicians in the country, about a year and a half ago; took a month off and examined where we were in K-12 in science and math -- again, without getting to the specifics of individual programs.

But they were very cautious -- in fact, they warned us, all of us, those of us who sit on this side of the dais as well as others across the country, that if we do not make some investments in the quality of education, particularly in the math and science, we could find abrupt changes occurring in our country very quickly in this century.

I don't know if you had an opportunity to look at that report or not, but if you had any -- whether or not you agreed with their conclusions about your concerns over whether or not this inequality could be exacerbated by the failure of us to have a level of education -- investments in education from that earliest -- early childhood area through the higher education opportunity.

BERNANKE: Mr. Chairman, I did read that report. I had a lot of interesting things to say.

I think if you look at it carefully it suggests that the issues are different in different parts of the educational system.

For example, our universities remain very strong. Our research universities lead the world. And so, in terms of research development, innovation and so on, the United States, I think, retains a substantial leadership in the world.

But at other parts of the educational system, perhaps in elementary school, for example, we're probably not doing what we should be doing in terms of ensuring that all children have opportunities to learn math and science and the applications of those areas.

Again, my wife is a teacher. I've been in education for a long time. I was on the school board for many years. I'm very sensitive to these issues.

But I also appreciate, from those particular positions that I've held -- you know, we've been worrying about educational quality for a long time, and it's a difficult thing to achieve. And I encourage continued thought and continued efforts to improve these vital components of our economy without having any delusions about how difficult that really is to accomplish effectively.

DODD: I thank you for that.

I'm going to turn to my colleague from Alabama.

But I want to -- I'll probably send this as a written question unless one of my colleagues raises it with you here.

Back in December, Senator Sarbanes, Senator Allard, Senator Reed, Senator Bunning, Senator Schumer and myself sent you and other regulators a letter regarding these exotic mortgages. We had a hearing here the other day -- and I've talked about this -- I'm a strong advocate of subprime lending. It's made a huge difference in assessability to homeownership. I'm also simultaneously very concerned about the predatory lending practices that go on. That concern about providing those subprime borrowers with the same kind of protections we do to the prime borrowers is a matter of concern to many here on this committee.

DODD: The letter we got back, frankly, Mr. Chairman, was a little inadequate. The notion "We're thinking about it" was nice to know, but I think many of us would like to know they're taking some additional steps.

And, again, I'll make this a written question to you. But I'm very concerned about this issue and some of the data we're receiving where as many as two million of our fellow citizens may be foreclosed out of their home because of predatory practices.

And so, again, I'll wait. I won't ask you. I want to turn to Senator Shelby, but I want to raise that issue with you and ask you to be thinking about it because it's an important concern for many of us.

Senator Shelby?

SHELBY: Thank you, Chairman Dodd.

Chairman Bernanke, the Federal Open Market Committee has held the federal funds rate target at 5.25 percent since June of '06. In the FOMC statement following your most recent meeting in January, the FOMC noted, and I quote, "The high level of resource utilization has the potential to sustain inflation pressures. The committee judges that some inflation risks remain," end quote.

Mr. Chairman, what data related to resource utilization will you be paying the closest attention to between now and the next FOMC meeting in March?

BERNANKE: Senator, the, sort of, a flip answer is "everything."

I should be clear: Our concern is not about the labor market, per se. Our concern is about the overall balance of spending and productive capacity.

SHELBY: The whole picture.

BERNANKE: The whole picture.

The Federal Reserve contributes to setting overall financial conditions which, in turn, stimulate spending by consumers and businesses on the product of our companies.

If we have a situation where 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 many indicators on labor markets and capital markets.

BERNANKE: We also look very much at prices, because prices are the canary in the coal mine. If prices begin to rise, that's indicative that there's 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.

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

SHELBY: Is your economic goal here basically price stability?

BERNANKE: Price stability consistent with strong employment, as well.

SHELBY: Productivity: The president economic report noted that between 2000 and 2005, productivity growth in the U.S. accelerated to about 3 percent, Mr. Chairman, the fastest growth of any G-7 country, which includes Canada, France, Germany, Italy, Japan and the United Kingdom. Most other major industrialized countries suffered a slowdown in productivity growth.

What factors do you believe explain the difference in productivity growth, given that the other G-7 countries also have access to the same technological improvements and broad capital markets that the U.S. has? And could you explain -- expand on these differences in productivity, what productivity implies for our standard of living and our long-term growth?

BERNANKE: Senator, you're quite correct that productivity began to grow more quickly in the United States about a decade ago, and that's been a very important factor in the strength of our economy.

About 1995, we saw a step up in productivity growth from 1.5 to 2.5 percent, which seems to have been driven primarily by improved and more efficient methods of producing high-tech equipment: faster computers, stronger, better communications equipment and the like.

Over the succeeding few years -- and, in fact, we saw productivity growth step up further around 2000 -- those technological innovations have been diffused through the economy in helping industries across the economy manage their production more efficiently, distribute their output more efficiently, and reduce costs, increase productivity.

So in some sense, the underlying factor is the technological change, the investment in information and communications technologies, and the diffusion of those technologies throughout the economy.

Now, you ask quite properly why do we -- have seen better results here in the U.S. than in some other countries. And I've given some speeches on that subject.

I do believe that it's the interaction of the new technologies and our flexible, dynamic economic system, that includes flexible labor markets that can adjust to changes in the market associated with technological change, that includes deep and liquid capital markets that can allocate capital toward new ventures, toward new technologies.

BERNANKE: And I believe that flexibility has been essential in helping us take technological advances and create from them economic benefits.

And this relates to my answer to Chairman Dodd, that we need to maintain that flexibility in our economy and that providing broad opportunity and education is one way to support that going forward.

SHELBY: Mr. Chairman, I want to get to another part of your responsibilities. That's bank regulation.

Regulation Z -- Senator Dodd has already referred to this. The Banking Committee held a hearing on the credit card industry that was widely followed.

Witnesses at the hearing highlighted a number of troubling industry practices, many of which are subject to Federal Reserve oversight. I understand that the Federal Reserve Board is currently reviewing this Regulation Z, which implements the Truth in Lending Act.

What is the status of the board's Regulation Z review? And does the board intend to use its review to address any of the questionable industry practices raised in the committee's hearing?

BERNANKE: Senator, we've been putting a great deal of effort into our review of Regulation Z, with particular focus on short-term and revolving credit, like credit cards.

One of the real challenges in improving disclosures for credit cards and other times of lending is to make the disclosures both compliant with legal requirements, but also sufficiently clear and understandable that people can understand what it is that they're getting into.

In order to try to improve the understandability and the clarity of disclosures, the Federal Reserve has conducted extensive consumer testing.

We haven't just done it in the ivory tower, as somebody mentioned. We've gone out into the public and we've conducted focus groups, we've done psychological testing to try to figure out how to structure disclosures in a way that people will notice them, pay attention to them and understand them. And so that has been a big part of our effort.

We are very close to the end of that effort. We expect to have a proposed rule out within a few months, by the middle of this year.

BERNANKE: And I believe and hope that it will address many of the appropriate concerns that people have had about disclosures and practices in the credit card industry and other short-term debt.

SHELBY: Chairman Dodd, I know my time is up, but can I just ask the chairman a question for the record? I think it takes time.

We've been concerned for some time about the implementation of the Basel II capital accord and the impact that Basel II may have on safety and soundness of the U.S. banking system.

I'm worried that Basel II may lead to a sharp reduction in the amount of capital banks are required to hold, which would put U.S. taxpayers ultimately at risk of having to pay for expensive bank failures, if there are some.

I believe it's critical that Basel II be implemented with the utmost care and diligence.

Mr. Chairman, would you, for the record, update the committee on the status of Basel II capital accords, the current time frame for implementing Basel II, and also comment on whether there's enough time for banking regulators, including yourself, to finalize the rules in implementing Basel II so that banks adopting Basel II can start the test run for Basel II presently scheduled to begin next year?

If you care, you can do it for the record.

BERNANKE: Should I answer, Mr. Chairman?

DODD: We'll make that for the record.

Let me add to that quickly, before I turn to Senator Schumer.

Some of my bankers have raised the issue, too, about foreign acquisition of domestic banks and whether or not they're really meeting the capital requirements today. I've got some real concerns raised by my bankers in Connecticut about this issue, that follow it very closely.

And I'd add that to the question Senator Shelby has raised with you; whether or not that's something we ought to be looking more closely at -- are they actually meeting those criteria before these acquisitions occur?

Senator Schumer?

SCHUMER: Well, thank you, Mr. Chairman.

And it's your first year. You've completed a year. You're getting good grades everywhere. And I'd concur. I think you're doing a fine job and have vindicated the support I think that you received almost unanimously from this committee.

My first question deals with the issues of income inequality and the speech you gave yesterday, where you pointed out that this is just in an ideas, almost instantaneous economy, wealth agglomerates to the top. You talked about Manny Ramirez.

I like to talk about Henry Ford, his great idea. He deserved to become rich from it, but he needed a million people to carry it out, and each of them made $10,000 a year to make the cars, distribute the cars.

Bill Gates, maybe the Henry Ford of our generation, had another.

SCHUMER: He mass-produced, in a certain sense, computer platforms. But he needed 10,000 people to carry it out. And they each made a couple of million dollars.

Given that this is happening -- and it is not the government's doing. This is just the nature of our economy, as you pointed out in our (ph) speech.

Doesn't it make sense, if this goes too far, to have a more progressive tax code, even though government didn't cause it, to keep a middle-class base, to keep too much wealth from agglomerating at the top?

I'm not asking you any specific policy, but just the general view that wouldn't progressivity -- further progressivity in the tax code help be an antidote to the natural flow of money to the very top, to the few who create those new ideas and deserve to make money from that and not get in the way of doing that?

BERNANKE: Senator, your comparison of Henry Ford and Bill Gates was very telling. Henry Ford developed the assembly line.


BERNANKE: And it allowed relatively low-skilled workers to be very productive in that context, and generated high wages for those workers.


BERNANKE: Bill Gates created a new model of operating systems in the high-tech industry. The kinds of workers he needed to execute...

SCHUMER: Exactly.

BERNANKE: ... were much more skilled workers.

SCHUMER: Exactly, but many fewer of them as well.

BERNANKE: Fewer of them, certainly.

And so I think that one very important lesson from that comparison is that those who are going to benefit the most from globalization and technology are those who have the skills, who have the capabilities to benefit and to be productive in that context.

And so I would say, whatever we do with tax policy and transfer policy, I hope that we'll, you know, try to address the issues of skills and...

SCHUMER: I agree with you completely.

BERNANKE: ... individual productivity.

SCHUMER: But that's going to take a while.

BERNANKE: Senator, on the issue of progressivity, you'll be unsatisfied.

I'm the head of the nonpartisan central bank. I think it's very important for me not to take sides on issues where values are very important.

I mean, evidently, this is a decision, trading off issues of equity...

SCHUMER: Well, sir, talking about more money or more help for education is as much a policy decision as talking about the progressivity of the code.

I'm not asking you about a specific policy. And I think you should address it.

BERNANKE: Senator, I'm sorry. I decline because there really is a value judgment involved in trading off -- I talked about this in my inequality speech.

I said, on one hand, you have the importance of promoting incentives, you know. Senator Bennett, I think, mentioned entrepreneurs, the people who take risks. We have to give them incentives to take risks. On the other hand, as you point out, correctly, you know, the tax code has an important role to play in generation more equality.

I can't -- I don't -- I'm not an elected official, I can't...

SCHUMER: OK, I think you're ducking it, in all due respect, because you do talk about other policy issues. But let me move on.

Trade deficit: Are you happy with the size of the trade deficit, at the rate of its growth? And do think stronger policies, particularly against those who we have huge balance of trade deficits with, to open their markets, not particularly to close ours, would be helpful in reducing the trade deficit? Obviously, my focus is on China, but I'd ask a more general question.

So the first question, are you happy with the size of the deficit and its rate of growth?

BERNANKE: No, I'm not happy with it.

SCHUMER: OK. Do you think policies that would importune other countries whose markets are not as open as ours to open theirs would be a salutary change and that we ought to emphasize that as a, if you will, pro-free-trade way to deal with the trade deficit?

BERNANKE: Senator, I'm entirely in favor of trying to open markets. We have the World Trade Organization. China is a signatory to the World Trade Organization. We should aggressively pursue attempts to open markets to foreign investments and...

SCHUMER: Do you think the Chinese have done enough on their currency?

BERNANKE: They've moved in the right direction but, no, I don't think they've done enough.

With respect to trade though, I would like to add that trade policies alone are not going to resolve the trade deficit.

SCHUMER: Understood.

BERNANKE: There's also the issue of saving and investment, which we do need to address as well.

SCHUMER: I think I agree with you on that.

Senators Graham and myself and Baucus and Grassley are going to try to do a WTO-friendly way or compliant way of getting the Chinese to do more on currency. And I hope you will look at the carefully and be supportive.

Final question is on competitiveness of our financial institutions and industries. Coming from New York, I'm obviously concerned, but so should my colleagues from many other states: the Carolinas, South Dakota, so many in New Jersey. So many other states have a stake here.

And the problem we seem to be facing is this: that other regulatory and legal regimen in other countries are looser than ours. And now that capital can flow quite freely, companies who are international -- and their loyalty to their stockholders means they're not going to be loyal to the United States or may precede their loyalty to the United States -- may seek the lowest common denominator or a lower common denominator.

And the pretty exquisite balance between regulation and entrepreneurialness that we've had over the last quarter of the last century seems to be in some trouble; that people are fleeing to go to less regulated places for their short-term gain, even if it creates problems in the system as a whole.

SCHUMER: Could you comment on that problem? Do you think it's a real one? Do you think it is only caused by simply knowledge spreading and the Internet, or is caused by some of these regulatory differences? And do you think we ought to look at that in a policy way to do something about it?

BERNANKE: Senator, to some extent, it's caused by the diffusion of knowledge and the growth of other markets. And to the extent that we're having a more competitive, deeper, broader capital market around the world, that's probably good for world growth, it's probably good for even our companies because they have more options for raising funds.

There is, though, I think, an issue of regulation, as has been pointed out in the two reports that you're quite familiar with. And there's a subtle distinction to make.

If you take Sarbanes-Oxley as an example, to the extent that Sarbanes-Oxley appropriately balances disclosures and governance against the costs of achieving those disclosures and governance, I think it's worthwhile to keep even if there's some short-run tendency for firms to run away from that. Because the investor wants that protection, and ultimately the investor will reward firms that list on exchanges that have appropriate, adequate protections, such as a well- designed Sarbanes-Oxley.

That being said, there are always concerns about Sarbanes-Oxley, about Basel II, about the regulatory structure, about the securities litigation, about CFIUS, many other things that we could point to, where legitimate questions can be raised about whether the costs of those regulatory schemes exceed the actual benefits to investors and to others of implementing them.

And I think, as a general matter, not just in the context of competitiveness of our exchanges, we should always be looking to try to restore that balance and make sure that the costs that we're imposing from a regulatory side are justified in terms of the social benefits.

So I think, for example, it is a good step that the Public Company Accounting Oversight Board and the SEC have taken some steps in revising the audit standard to reduce the burden of SOX 404 while maintaining, I believe, so far many of the benefits in terms of disclosure and controls that that law was intended to achieve.

DODD: Thank you, Senator Schumer.

Senator Bunning?

BUNNING: Thank you, Mr. Chairman.

Two of your predecessors, Paul Volcker and Alan Greenspan, always expressed great concern. I happened to serve on the House Banking Committee when Mr. Volcker was the head of the Federal Reserve and then Chairman Greenspan, both the House Banking and now the Senate Banking.

And yesterday in The Washington Post, there was an article about the inverted inversion of the yield curve for eight straight months, and how local banks and banking in general -- and since that's the Fed's charge, to make sure that our banks are sound and secure -- were having difficulty with the inverted yield curve.

I've questioned you about this before and you have always said it's not very important in this day and time.

I'm going to ask you again: How long can we stand to have -- and we've had it eight straight months now -- an inverted yield curve where short-term rates are higher than our 30-year bond rate?

BERNANKE: Senator, the usual context of this question is, does an inverted yield curve presage a recession or a slow-down in the economy?

BUNNING: Well, it also hurts our banks very badly.

BERNANKE: I'll address that, sir.

Just very quickly, though, on the forecasting power of the yield curve, there's been a good bit of evidence that declines in the term premium and perhaps a great deal of saving, chasing a relatively limited number of investment opportunities around the world, have led to a somewhat permanent flattening, or even inversion, of the yield curve, and that that pattern does not necessarily predict slowing in the economy or a recession.

Indeed, if you look at other measures of financial markets, such as corporate bond spreads, you don't see anything that suggests anticipations of future stress.

The question you raised is a different one, of course, which is the effects on the banking system, specifically. Banks that do their traditional business of taking deposits and making loans are going to be put under pressure because the short-term deposit rates tend to be higher than the loan rates they can get.

BERNANKE: I recognize that's a problem for some banks. Other banks have been able to deal with it by hedging interest rate risk, by getting fees and doing other ways of doing their business.

So, overall, I don't see the banking sector as being under tremendous pressure in terms of its profits and asset quality at the moment. But I recognize that particularly for smaller banks, which have fewer options in terms of funds, raising funds, and in terms of earning fees and income, that the inverted yield curve does produce some pressure.

From the Federal Reserve's points of view, we're entirely cognizant of that. We hear about it from bankers. We have to set monetary policy, of course, to try to achieve overall price stability and maximum sustainable employment growth. And we sometimes find that in the context of various industries that that policy could create some pressure on individual industries.

But we only have this one tool and we try to use it to achieve overall macroeconomic stability while fully recognizing that it does create some problems for some sectors.

BUNNING: You're telling us today that an inverted yield curve down the road will not affect the economy. Did I misunderstand that, or is that accurate?

BERNANKE: I think the yield curve can be inverted for a considerable period without significant implications for the economy as a whole, yes. Possible for some banks, but not for the economy as a whole.

BUNNING: How does this economic cycle that we're in, in recovery and expansion, compare to previous recoveries and expansions, in other words, when we hit the wall in '92 and also in 2002? And how does this recovery that we're involved in now compare to those recoveries?

BERNANKE: I would say that qualitatively, it's fairly similar to the recovery that followed the '90, '91 recession, many of the same features. There was weakness for sometime after the recession ended. There was a period of jobless growth, so-called.

BUNNING: But we didn't have a housing market that...

BERNANKE: Well, the housing market was actually quite weak during the recession itself. The decline in residential starts during '90 and '91 was not quite as large, but in the same neighborhood as what we've recently.

BERNANKE: But during the recovery period, we didn't have that particular pattern.

But in many ways, it was a fairly similar expansion.

BUNNING: Could you estimate how close we are to a full employment in the United States?

BERNANKE: It's very hard to say specifically, and I don't pretend to know an exact number or an exact estimate.

But the economy has certainly been growing faster than potential for a number of years. And that can be seen in the tightening of labor markets and capacity utilization.

So, clearly, we are much closer today, I think it's safe to say, to full employment to the sustainable level of growth than we were a few years ago. And we've moved, clearly, in that direction.

BUNNING: And in your opening statement, you made the remarks to the effect that you have not seen any new evidence of inflation since your last Fed meeting in January or February.

BERNANKE: We haven't had much information on inflation since just two weeks ago. But the recent readings on inflation have been encouraging.

BUNNING: Encouraging?



BERNANKE: But as I've indicated in my remarks, they are somewhat noisy, the data, and we don't want to draw an entirely, you know, complete conclusion...

BUNNING: Well, that's why we have Fed meetings every month or two.

BERNANKE: That's correct, Senator.

BUNNING: Thank you very much, Mr. Chairman.

DODD: Thank you very much, Senator Bunning.

Senator Casey?

CASEY: Thank you, Mr. Chairman.

And the other chairman in the room, thank you for your time and for your service.

I have two general questions: one on debt and one on children.

With regard to debt, I was looking at the report that the Federal Reserve Board is submitting in connection with your appearance here today and your testimony. And in particular, on pages 12 and 13, I wanted to direct your attention and the attention of others to the report.

I note here that on page 12, which deals with the federal government and expenditures and outlays by the federal government, it says that -- and I'm reading in part on the second column on page 12 -- net interest payments increased 23 percent in fiscal 2006 as interest rates rose and federal debt continued to grow.

Then it goes on from there; talks about the outlays for Medicare Part D -- Medicare itself up 10.5 percent. It talks about disaster relief, Medicaid spending. And then it gets to the next part of the paragraph: "Outlays for defense" -- defense -- "in fiscal 2006 slowed to their lowest rate of increase since fiscal 2001, although the rise was still about 6 percent." That's the first predicate of my question.

Then I go to page 13 and it talks about debt: The federal debt subject to the statutory limit has increased. Now we're at the $8.6 trillion level.

And I guess, with that as a predicate, let me tell you what I think about think about this. I think that that's unsustainable. and as much as we've talked -- as important as it is to talk about the good, sound bite, "reducing our dependence on foreign oil," I think we need a lot more effort in this Congress and in this town on reducing our dependence on foreign debt.

I think it's making us less safe in the fight against terrorism. I think it's making us less safe in terms of our ability to spend money on defense, not to mention our ability to spend money on good investments in the economy, as you talked about: education, training and the rest.

So I guess my basic question is, in light of that data -- and any other data you want to factor into this question -- are these numbers sustainable: an $8.6 trillion debt and a 23 percent increase in net interest payments? Is that sustainable over time?

BERNANKE: I recently testified before the Senate Budget Committee, and I pointed out that it's not exactly a secret, but that the long-term prospects for the U.S. fiscal situation are quite serious.

In particular, as the population ages, we're going to start seeing expanded costs of entitlements, Social Security and Medicare. Those grow very quickly and, if no action is taken, will generate an increasing spiral of higher interest payments and debt.

I quoted in that testimony several interesting, useful simulations by the Congressional Budget Office. The intermediate simulation suggests that by the year 2030, the deficit will be 9 percent of GDP, and the debt-to-GDP ratio, which is currently about 37 percent, would be closer to 100 percent of GDP, a number which we've not seen since World War II.

So, obviously, there are a lot of issues that Congress will debate about the short-term spending and tax proposals. I'm certainly aware of that.

But I think if you think about the fiscal sustainability in a longer timeframe, dealing with the fiscal implications of the aging population and rising health care costs are going to be dominant, and essentially there won't be any way to address fiscal sustainability without addressing that issue in some way.

CASEY: I wanted to pick up, in the remaining time I have, on the issue of how we invest in children -- pick up on what Chairman Dodd spoke of earlier.

There's a great organization out there that has, as its moniker or as its message, "Fight crime, invest in kids." It's a great, great sound bite. Sometimes we need sound bites to make the point.

I would also assert -- and I'd ask for your sense of this and your reflections on this -- and you could use the same construct for the impact on how we invest in children and how we grow our economy. You could -- instead of saying, "Fight crime, invest in kids," you could say "Grow the gross national product," or, "Grow GDP," or, "Grow the economy, invest in kids."

And I ask you that, because we're going to be making some critically important decisions in the next couple of months and certainly in this 110th Congress.

Chairman Dodd talked about the issue of the Head Start program. There have been votes cast in the United States Senate in the last couple of years where the choice was clearly and unambiguously a choice between investing in Head Start or investing in education or investing in any other support for children and their economic future -- not to mention their future -- and tax cuts.

CASEY: Sometimes the votes have been that stark. And there are people here who voted for the tax cuts over Head Start and over some other priorities.

So I ask you about your opinion -- and this is a policy question, but I think you can answer this -- your opinion on the level of investment in children, whether it's with regard to education or Head Start, early learning -- all of these initiatives to give kids a healthy and smart start in life -- how you see that in the context of economic growth and GDP growth and whether or not you think the investment currently is adequate.

BERNANKE: I think that investing in children is extremely important. I think it has economic benefits. It also has social benefits. And I hope that Congress will continue to look very carefully at that.

What I don't know is precisely how best to do that. And I think you're going to have to bring real experts here to talk about different approaches and what works and what doesn't work. But I urge you to continue to do that.

In terms of priorities, you can -- to go back to Senator Schumer's question, I mean, clearly, there's always priorities. But you can weigh these things against tax cuts. You can weigh them against other kinds of spending. Clearly, you have to have an overall picture of what's important.

Again, I can't speak to the overall combination of taxes and spending, other than to say that they should be in balance. But I will go so far as to say that I think that there's a significant return to investing in young kids.

In my remarks in Omaha, I even cited some Federal Reserve research from the Federal Reserve Bank of Minneapolis which showed the very substantial economic returns associated with early childhood education. And I do think that's certainly worth investigating.

CASEY: Thank you.

DODD: Thank you, Senator Casey. Very good questions; I appreciate your focusing attention on that.

DODD: I want to just mention, before turning to Senator Martinez, your response, Mr. Chairman, to Senator Schumer's questions about Sarbanes-Oxley and competitiveness.

I appreciated your answer very much to that question. There are some things clearly can be done to try and show some balance and making sure we're not overburdening smaller public companies. But your thrust was that this is working pretty well.

And, frankly, anecdotally, I suspect most of here ask the question of every business we talk to, "How is this working?" And I must tell you, overall, the response I get is a good one.

I had one company the other day say to me that, "Even if Congress decided tomorrow to repeal Sarbanes-Oxley, we would decide to stay with all the things that's been required of us. We've found it's been very worthwhile for our company."

So I appreciate your comments about that.

Senator Martinez?

MARTINEZ: Mr. Chairman, thank you very much.

I hate to differ with the chairman, but I must say that the experience that I hear on the competitiveness and Sarbanes-Oxley issue is far different from that. I hear a great deal of concern about the incredible cost and the burden on competitiveness that it has created.

And, in fact, I'll begin with this area, because I intended to get into it.

But our colleague from New York Senator Schumer and Mayor Bloomberg recently released a report that I found quite interesting, detailing an analysis of market conditions in the U.S. and abroad and about the concern that there is about whether New York will continue to be the financial capital of the world or whether, in fact, there seems to be others competing for that title, which might include London. And there were some rather dramatic statistics of declines and increases in New York vis-a-vis London.

And one of the things that was mentioned in the report was that U.S. regulatory framework being too complicated and the implementation of Sarbanes-Oxley having produced heavier costs than were expected at the beginning or when we initiated that effort.

MARTINEZ: Also, it was mentioned, immigration policies which create problems for those from abroad who might wish to come here to do business, to invest in America, and the difficulties that occur in immigration -- problems (inaudible) that, and some of them coming to be educated, others coming just as business people and investors.

In any event, I wondered if you had an opportunity to see that report and whether its findings caused the same concerns to you that they raised to me.

BERNANKE: Senator, as I indicated, I do think that we should be looking to try to reduce regulatory burden, and in particular to ensure that the costs of the burden are commensurate with the benefits arising from the particular rule.

With respect to Sarbanes-Oxley, my intent was to say that I do believe that there are benefits from that legislation, including improved controls, improved disclosures, improved governance of corporations. So there are certainly some benefits.

It's important to decide whether the costs -- you know, if we can reduce the costs and retain the benefits.

And in that respect, I think that the recent change in audit standard, or the recent proposed change in audit standard being put forth by the SEC and the PCAOB is a step in the right direction because it attempts to focus on the most materially important issues. And it also makes allowance for the size and complexity of a firm, in setting up the audit standard.

So, to try to -- you know, to summarize, I think that Sarbanes- Oxley accomplishes some important objectives, but I do believe it can be -- those objectives can be accomplished at lower costs. And I think the new audit standard moves in that direction.

And we should, on all other regulatory areas, including those the Federal Reserve is involved in, we should continually be looking to find ways to accomplish the social or economic objectives of the regulation at a lower cost.

MARTINEZ: Well, I agree that there are many good features to Sarbanes-Oxley.

MARTINEZ: What I was speaking out is some of the excesses, particularly in the auditing arena and some of the areas that have caused such an overburden of costs. So I appreciate your comment on that.

Shifting to the issue of home sales, I used to sit in that very chair when I was housing secretary before this committee. And at times, I would be asked a question about a housing bubble, and in the overinflated and -- overheating, rather, housing market, whether, in fact, we were headed for a collapse and a bubble that would burst.

In fact, we've seen a significant decrease in housing starts. We've seen the market cool down significantly, but we have not seen a bursting bubble. I always said, at the time, that the fears of a bubble were misplaced, and that the housing market is more regional than it is national and there were many different features between that and a localized market.

But do you feel that the fear of a bubble has receded, given the fact that the market cooled off, that it has done so in a fairly modest way without any cataclysmic consequences?

BERNANKE: Senator, as I indicated in my opening testimony, we think we see some tentative signs of stabilization in demand in the housing market. That would, nevertheless, take some time yet to work its way out because of the inventories of unsold homes that still exist on the market.

And I would emphasize that the signs of stabilization are tentative and we don't want to jump to conclusions. It will be helpful to see what happens when the spring selling season begins and see how strong demand is at that time.

But it is interesting that so far the economy has done a good job of withstanding the slowdown in construction which, although substantial relative to the last couple of years, the level of construction is still similar to late '90s, for example. It isn't that we've had a complete collapse in construction, by any means.

So the decline in construction, while it slowed the economy, it has, obviously, not thrown us into a much slower growth situation, and we've not seen substantial spillovers from the housing slowdown to consumer spending or to other parts of the economy.

So it's early to say that this problem is over. I think we're going to have to watch it very careful. And as I indicated, I think it's a downside risk to the economy going forward. But so far the economy has reasonably adapted to this adjustment in the housing market.

MARTINEZ: You mentioned in your remarks also that household finance appears solid and that delinquency rates on most consumer loans, including residential mortgages, were low.

But you did note that the subprime mortgages with variable interest rates, where delinquency rates have increased appreciably.

MARTINEZ: And it's an issue that is of great concern to several of us on this committee, the issue of predatory lending, the abuse of some of our most vulnerable consumers. Any comments on that, or any issues that you see there which could impact the overall economy?

BERNANKE: I think, first of all, that this distress in the subprime area is a significant concern. I'm, obviously, following it very carefully, both in terms of the impact it has on the borrowers and also, you know, to see what effects it has on lenders, as well.

I don't think that it has, at this point, implications for the aggregate economy in terms of the ongoing expansion. But, as I said, it is an important issue for those sectors.

We at the Fed -- I won't take a long time. I could certainly list a wide variety of things that we do to try to address predatory lending, which I do think is an important issue and I think the subprime market, which is distinct from predatory lending, it's a legitimate market...

MARTINEZ: Right, It's a good distinction to make.

BERNANKE: ... also has some issues.

Just to note one action we've taken recently, along with the other federal banking agencies, we've issued guidance on nontraditional mortgages, mortgages that involve interest-only or option ARMs that may not be amortizing mortgages.

And we've emphasized to the lenders that they should be, first, very careful in their underwriting. That is, they should ensure that the borrower is equipped to deal with payment shock, if interest rates go up; that they have sufficient income to meet higher payments.

And secondly, that disclosures are adequate, so that the borrowers are fully informed about the nature of the contract that they're getting involved in.

So evidently there are some loans that have been made that are not turning out well, and to the detriment of both the lenders and the borrowers. We will certainly be watching that carefully and trying to provide guidance and oversight to minimize that risk going forward.

Thank you, Mr. Chairman.

DODD: Thank you very much, Senator Martinez.

Senator Bayh?

BAYH: Mr. Chairman, I'd like to ask you some questions about our national security interests and the role of the Fed and our financial system in protecting those interests.

BAYH: As you probably have read, there are the tentative outlines of an agreement with North Korea to begin to get them to change their behavior with regard to their nuclear program.

One of the reasons that we were able to at least achieve a tentative understanding was because of pressure that we brought to bear on a bank in Macau that the North Koreans use to interact with the global banking system.

Iran, as you know, is pursuing nuclear ambitions, as well. Several Iranian banks do business in Western Europe. We are currently attempting to do something similar with regard to a couple of Iranian banks.

My question to you is, what can the Fed do, what can the U.S. banking system do to cut off Iranian access to the global banking system to exert some pressure on them to behave in a more responsible way with regard to their nuclear ambitions?

BERNANKE: Senator, the primary responsibility for initiating such measures and enforcing them is with the Treasury, the Financial Crimes Enforcement Network, for example, and OFAC. And they have taken the leadership in trying to ensure that American banks and, through negotiation, banks from other countries do not deal with the banks you're referring to in Iran and North Korea.

So we are not the leaders in that effort. However, we, as bank regulators and overseers, have an important responsibility to try to ensure that it's carried out as the rules dictate.

And we have -- as a very extensive part of our oversight responsibility, we evaluate banks' compliance with Bank Secrecy Act and other such rules.

BAYH: I hope you'll make this a priority and bring some sense of urgency to it.

Iran is a tremendous problem. The military option is, obviously, something that no one wants to have to resort to. And so we're looking for other levers that we can utilize to try and get them to do the right thing here. And this seems to have been effective in the North Korean context.

My investigations in this area tell me that it has increased the cost of doing business to the Iranians. It's made things more inconvenient for them. And perhaps if we continue to pursue this, we might encourage a change in behavior on their part, as well.

So I would encourage you to be vigorous in this effort because it does affect our national security interests in a very important area.

Staying on the subject of Iran for a moment -- you're busy with many other things; you may not have noticed -- but they have indicated publicly that their response, if we did get to the point of having to take some action against them because of their nuclear program, would be to try and cut off the flow of oil from the Persian Gulf by closing the Straits of Hormuz so that not only they would suffer, but the Saudis and others -- trying to maximize the pain on the global economy.

I hope that there's some contingency planning being undertaken. So my question to you is, if such an event were to occur, what would the impact be on the global economy, on the U.S. economy.

Obviously, the price of oil. You mentioned the role that the cost of energy plays on our inflation expectations and that sort of thing.

So what would the effect of such an act to be on the economy?

Editor's Note: More to come Thursday

Feb 14, 2007 14:58 ET .EOF

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