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Board of Governors of the Federal Reserve System
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Board of Governors of the Federal Reserve System

Part 1: Overview: Monetary Policy and the Economic Outlook

Monetary Policy Report submitted to the Congress on July 21, 2009, pursuant to section 2B of the Federal Reserve Act

Amid a severe global economic downturn, the U.S. economy contracted further and labor market conditions worsened over the first half of 2009. In the early part of the year, economic activity deteriorated sharply, and strains in financial markets and pressures on financial institutions generally intensified. More recently, however, the downturn in economic activity appears to be abating and financial conditions have eased somewhat, developments that partly reflect the broad range of policy actions that have been taken to address the crisis. Nonetheless, credit conditions for many households and businesses remain tight, and financial markets are still stressed. In the labor market, employment declines have remained sizable--although the pace of job loss has diminished somewhat from earlier in the year--and the unemployment rate has continued to climb. Meanwhile, consumer price inflation has remained subdued.1

U.S. real gross domestic product (GDP) fell sharply again in the first quarter of 2009, but the contraction in overall output looks to have moderated somewhat of late. Consumer spending--which has been supported recently by the boost to disposable income from the tax cuts and increases in various benefit payments that were implemented as part of the 2009 fiscal stimulus package--appears to be holding reasonably steady so far this year. And consumer sentiment is up from the historical lows recorded around the turn of the year. In the housing market, a leveling out of home sales and construction activity in the first half of 2009 suggests that the demand for new houses may be stabilizing following three years of steep declines. Businesses, however, have continued to cut capital spending and liquidate inventories in response to soft demand and excessive stocks. Economic activity abroad plummeted in the first quarter and has continued to fall, albeit more slowly, in recent months. Slumping foreign demand led to a sharp drop in U.S. exports during the first half of the year. However, the ongoing contraction in U.S. domestic demand triggered an even sharper drop in imports.

The further contraction in domestic economic activity during the first half of 2009 was accompanied by a significant deterioration in labor market conditions. Private-sector payroll employment fell at an average monthly rate of 670,000 jobs in the first four months of this year before declining by 312,000 jobs in May and 415,000 jobs in June. Meanwhile, the unemployment rate moved up steadily from 7-1/4 percent at the turn of the year to 9-1/2 percent in June. With the sharp reductions in employment, the wage and salary incomes of households, adjusted for price changes, fell during this period.

Overall consumer price inflation, which slowed sharply late last year, remained subdued in the first half of this year as the margin of slack in labor and product markets widened considerably further and as prices of oil and other commodities retraced only a part of their earlier steep declines. All told, the 12-month change in the personal consumption expenditures (PCE) price index was close to zero in May, while the 12-month change in PCE prices excluding food and energy was 1-3/4 percent. Survey measures of longer-term inflation expectations have remained relatively stable this year and currently stand at about their average values in 2008.

During the first few months of 2009, pressures on financial firms, which had eased late last year, intensified again. Equity prices of banks and insurance companies fell amid reports of large losses in the fourth quarter of 2008, and market-based measures of the likelihood of default by those institutions rose. Broad equity price indexes also fell in the United States and abroad, and measures of volatility in such markets stayed at near-record levels. In addition, bank funding markets were strained, flows of credit to businesses and households were impaired, and many securitization markets remained shut.

The Federal Reserve and other government entities continued to respond forcefully to these adverse financial market developments. The Federal Reserve kept its target for the federal funds rate at a range between 0 and 1/4 percent and purchased additional agency mortgage-backed securities (MBS) and agency debt. Throughout the first half of the year, the Federal Reserve also continued to provide funding to financial institutions and markets through a variety of credit and liquidity facilities. In February, the Treasury, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision announced the Financial Stability Plan. The plan included, among other elements, a Capital Assistance Program designed to assess the capital needs of banking institutions under a range of economic scenarios (through the Supervisory Capital Assessment Program (SCAP), or stress test) and, if necessary, to assist banking institutions in strengthening the amount and quality of their capital. In early March, the Federal Reserve and the Treasury launched the Term Asset-Backed Securities Loan Facility (TALF), an initiative designed to catalyze the securitization markets by providing financing to investors to support their purchases of certain AAA-rated asset-backed securities. At the March meeting of the Federal Open Market Committee (FOMC), the Committee decided to expand its purchases of agency MBS and agency debt and to begin buying longer-term Treasury securities to help improve conditions in private credit markets. In May, the Federal Reserve announced an expansion of eligible collateral under the TALF program. In the same month, the results of the SCAP were announced and were positively received in financial markets.

These policy actions, and ones previously taken, have helped stabilize a number of financial markets and, in some cases, have led to significant improvements. In recent months, strains in short-term funding markets have eased, with some credit spreads in those markets returning close to pre-crisis levels. The narrowing in spreads likely reflects, in part, a decrease in the probability that market participants assign to extremely adverse outcomes for the economy in light of the apparent moderation in the rate of economic contraction. Global equity prices have recouped some of their earlier declines, and measures of volatility in equity and other financial markets have retreated somewhat, though they remain at elevated levels. Issuance in some securitization markets that were essentially shut down earlier has begun to increase. Although yields on longer-term Treasury securities have risen, some of these increases are likely attributable to improvement in the economic outlook and a reversal in flight-to-quality flows. Mortgage rates have risen about in line with Treasury yields, but corporate bond yields have continued to decline. By early June, the 10 banking organizations required by the SCAP to bolster their capital buffers had issued new common equity in amounts that either met or came close to meeting the SCAP requirements. Nonetheless, despite these notable improvements, strains remain in most financial markets, many financial institutions face the possibility of significant additional losses, and the flow of credit to some businesses and households remains constrained.

In conjunction with the June 2009 FOMC meeting, the members of the Board of Governors of the Federal Reserve System and presidents of the Federal Reserve Banks, all of whom participate in FOMC meetings, provided projections for economic growth, unemployment, and inflation; these projections are presented in Part 4 of this report. FOMC participants generally viewed the outlook for the economy as having improved modestly in recent months. Participants expected real GDP to bottom out in the second half of this year and then to move onto a path of gradual recovery, bolstered by an accommodative monetary policy, government efforts to stabilize financial markets, and fiscal stimulus. However, all participants expected that labor market conditions would continue to deteriorate during the remainder of this year and improve only slowly over the subsequent two years, with the unemployment rate still elevated at the end of 2011. FOMC participants expected total and core inflation to be lower in 2009 than during 2008 as a whole, in part because of the sizable amount of slack in resource utilization; inflation was forecast to remain subdued in 2010 and 2011.

Participants generally judged that the degree of uncertainty surrounding the medium-term outlook for both economic activity and inflation exceeded historical norms. Participants viewed the risks to their projections of economic growth over the medium run as either balanced or tilted to the downside, and most saw the risk to their projections of medium-run inflation as balanced. Participants also reported their assessments of the rates to which key macroeconomic variables would be expected to converge in the longer run under appropriate monetary policy and in the absence of further shocks to the economy. Most participants expected real GDP to grow in the longer run at an annual rate of about 2-1/2 percent, the unemployment rate to be about 5 percent, and the rate of consumer price inflation to be about 2 percent.


1. Note: A list of abbreviations is available at the end of this report. Return to text

Last update: July 21, 2009