WASHINGTON (MNI) – The following is the first of three parts of the
complete text of the semi-annual monetary policy by Federal Reserve
Chairman Ben Bernanke before the Senate Banking Committee Wednesday:

Chairman Dodd, Senator Shelby, and members of the Committee, I am
pleased to present the Federal Reserve’s semiannual Monetary Policy
Report to the Congress.

Economic and Financial Developments

The economic expansion that began in the middle of last year is
proceeding at a moderate pace, supported by stimulative monetary and
fiscal policies. Although fiscal policy and inventory restocking will
likely be providing less impetus to the recovery than they have in
recent quarters, rising demand from households and businesses should
help sustain growth. In particular, real consumer spending appears to
have expanded at about a 2-1/2 percent annual rate in the first half of
this year, with purchases of durable goods increasing especially
rapidly. However, the housing market remains weak, with the overhang of
vacant or foreclosed houses weighing on home prices and construction.

An important drag on household spending is the slow recovery in the
labor market and the attendant uncertainty about job prospects. After
two years of job losses, private payrolls expanded at an average of
about 100,000 per month during the first half of this year, a pace
insufficient to reduce the unemployment rate materially. In all
likelihood, a significant amount of time will be required to restore the
nearly 8-1/2 million jobs that were lost over 2008 and 2009. Moreover,
nearly half of the unemployed have been out of work for longer than six
months. Long-term unemployment not only imposes exceptional near-term
hardships on workers and their families, it also erodes skills and may
have long-lasting effects on workers’ employment and earnings prospects.

In the business sector, investment in equipment and software
appears to have increased rapidly in the first half of the year, in part
reflecting capital outlays that had been deferred during the downturn
and the need of many businesses to replace aging equipment. In contrast,
spending on nonresidential structures–weighed down by high vacancy
rates and tight credit–has continued to contract, though some
indicators suggest that the rate of decline may be slowing. Both U.S.
exports and U.S. imports have been expanding, reflecting growth in the
global economy and the recovery of world trade. Stronger exports have in
turn helped foster growth in the U.S. manufacturing sector.

Inflation has remained low. The price index for personal
consumption expenditures appears to have risen at an annual rate of less
than 1 percent in the first half of the year. Although overall inflation
has fluctuated, partly reflecting changes in energy prices, by a number
of measures underlying inflation has trended down over the past two
years. The slack in labor and product markets has damped wage and price
pressures, and rapid increases in productivity have further reduced
producers’ unit labor costs.

My colleagues on the Federal Open Market Committee (FOMC) and I
expect continued moderate growth, a gradual decline in the unemployment
rate, and subdued inflation over the next several years. In conjunction
with the June FOMC meeting, Board members and Reserve Bank presidents
prepared forecasts of economic growth, unemployment, and inflation for
the years 2010 through 2012 and over the longer run. The forecasts are
qualitatively similar to those we released in February and May, although
progress in reducing unemployment is now expected to be somewhat slower
than we previously projected, and near-term inflation now looks likely
to be a little lower. Most FOMC participants expect real GDP growth of 3
to 3-1/2 percent in 2010, and roughly 3-1/2 to 4-1/2 percent in 2011 and
2012. The unemployment rate is expected to decline to between 7 and
7-1/2 percent by the end of 2012. Most participants viewed uncertainty
about the outlook for growth and unemployment as greater than normal,
and the majority saw the risks to growth as weighted to the downside.
Most participants projected that inflation will average only about 1
percent in 2010 and that it will remain low during 2011 and 2012, with
the risks to the inflation outlook roughly balanced.

One factor underlying the Committee’s somewhat weaker outlook is
that financial conditions–though much improved since the depth of the
financial crisis–have become less supportive of economic growth in
recent months. Notably, concerns about the ability of Greece and a
number of other euro-area countries to manage their sizable budget
deficits and high levels of public debt spurred a broad-based withdrawal
from risk-taking in global financial markets in the spring, resulting in
lower stock prices and wider risk spreads in the United States. In
response to these fiscal pressures, European leaders put in place a
number of strong measures, including an assistance package for Greece
and 500 billion of funding to backstop the near-term financing needs of
euro-area countries. To help ease strains in U.S. dollar funding
markets, the Federal Reserve reestablished temporary dollar liquidity
swap lines with the ECB and several other major central banks. To date,
drawings under the swap lines have been limited, but we believe that the
existence of these lines has increased confidence in dollar funding
markets, helping to maintain credit availability in our own financial

Like financial conditions generally, the state of the U.S. banking
system has also improved significantly since the worst of the crisis.
Loss rates on most types of loans seem to be peaking, and, in the
aggregate, bank capital ratios have risen to new highs. However, many
banks continue to have a large volume of troubled loans on their books,
and bank lending standards remain tight. With credit demand weak and
with banks writing down problem credits, bank loans outstanding have
continued to contract. Small businesses, which depend importantly on
bank credit, have been particularly hard hit. At the Federal Reserve, we
have been working to facilitate the flow of funds to creditworthy small
businesses. Along with the other supervisory agencies, we issued
guidance to banks and examiners emphasizing that lenders should do all
they can to meet the needs of creditworthy borrowers, including small
businesses. We also have conducted extensive training programs for our
bank examiners, with the message that lending to viable small businesses
is good for the safety and soundness of our banking system as well as
for our economy. We continue to seek feedback from both banks and
potential borrowers about credit conditions. For example, over the past
six months we have convened more than 40 meetings around the country of
lenders, small business representatives, bank examiners, government
officials, and other stakeholders to exchange ideas about the challenges
faced by small businesses, particularly in obtaining credit. A capstone
conference on addressing the credit needs of small businesses was held
at the Board of Governors in Washington last week. This testimony
includes an addendum that summarizes the findings of this effort and
possible next steps.

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** Market News International Washington Bureau: 202-371-2121 **

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