Part 1: Overview: Monetary Policy and the Economic OutlookMonetary Policy Report submitted to the Congress on February 24, 2010, pursuant to section 2B of the Federal Reserve Act
After declining for a year and a half, economic activity in the United States turned up in the second half of 2009, supported by an improvement in financial conditions, stimulus from monetary and fiscal policies, and a recovery in foreign economies. These factors, along with increased business and household confidence, appear likely to boost spending and sustain the economic expansion. However, the pace of the recovery probably will be tempered by households' desire to rebuild wealth, still-tight credit conditions facing some borrowers, and, despite some tentative signs of stabilization, continued weakness in labor markets. With substantial resource slack continuing to suppress cost pressures and with longer-term inflation expectations stable, inflation is likely to be subdued for some time.
U.S. real gross domestic product (GDP) rose at about a 4 percent pace, on average, over the second half of 2009. Consumer spending--which was boosted by supportive monetary and fiscal policies--posted solid increases, though it remained well below its pre-recession level. Meanwhile, activity in the housing market, which began to pick up last spring, flattened over the second half of 2009. In the business sector, investment in equipment and software posted a sizable gain in the second half of last year, likely reflecting improved conditions in capital markets and brighter sales prospects. In addition, firms reduced the pace of inventory liquidation markedly in the fourth quarter. In contrast, investment in nonresidential structures continued to contract. With the recovery in U.S. and foreign demand, U.S. trade flows rebounded in the second half of 2009 after precipitous declines late in 2008 and early in 2009. Nevertheless, both exports and imports stayed considerably below their earlier peaks.
Despite the pickup in output, employment continued to contract in the second half of 2009, albeit at a markedly slower pace than in the first half. The unemployment rate rose further during the second half, reaching 10 percent by the end of the year--its highest level since the early 1980s--before dropping back in January. Although job losses have slowed, hiring remains weak, and the median duration of unemployment has lengthened significantly.
Headline consumer price inflation picked up in 2009 as energy prices rose sharply: Over the 12 months ending in December, prices for personal consumption expenditures (PCE) increased about 2 percent, up from 1/2 percent in 2008. In contrast, price increases for consumer expenditures other than food and energy items--so-called core PCE--slowed noticeably last year. After rising at an annual rate of about 1-3/4 percent in 2008 and the first half of 2009, core PCE prices increased at an annual rate of just over 1 percent in the second half of the year.
The recovery in financial markets that began last spring continued through the second half of the year and into 2010. Broad equity price indexes increased further, on balance, and risk spreads on corporate bonds narrowed considerably. Conditions in short-term funding markets returned to near pre-crisis levels; liquidity and pricing in bank funding markets continued to normalize, while risk spreads in the commercial paper market were stable at the low end of the range observed since the fall of 2007. The functioning of financial markets more generally improved further.
Investors became more optimistic about the outlook for financial institutions during the first half of last year. That development was bolstered by the release of the results of the Supervisory Capital Assessment Program (SCAP), which were seen as helping clarify the financial conditions of the largest bank holding companies and provided investors with greater assurance about the health of the institutions. Sentiment rose further over the remainder of the year as investors became more optimistic about the economic outlook. Most of the 19 bank holding companies included in the SCAP issued equity, some to augment or improve the quality of their capital and some to repay investments made by the Treasury under the Troubled Asset Relief Program. Still, delinquency and charge-off rates at commercial banks increased further in the second half of the year, and loan losses remained very high.
Nonfinancial firms with access to capital markets took advantage of the improvement in financial conditions to issue corporate bonds and equity shares at a solid pace; a significant portion of issuance likely reflected an effort by businesses to substitute attractively priced longer-term financing for shorter-term debt. In contrast, many small businesses and other firms that depend largely on banks to meet their funding needs found their access to credit severely restricted; banks continued to tighten their lending standards and terms, though to a more limited extent, during the second half of 2009 amid higher loan losses on their commercial loans and reports of lingering uncertainty about business credit quality. According to survey data, demand for business loans was also weak throughout 2009.
Availability of credit for households remained constrained in the second half of 2009, even as interest rates declined for mortgages and many consumer loans. Restrictive bank lending policies to individuals likely were due importantly to banks' concerns about the ability of households to repay loans in an environment of high unemployment and continued softness in house prices. In addition, senior bank loan officers reported weakening loan demand from households throughout 2009. However, in part because of support from the Federal Reserve's Term Asset-Backed Securities Loan Facility, the consumer asset-backed securities market, which is an important funding source for consumer loans, improved. All told, in 2009 nominal household debt experienced its first annual decline since the beginning of the data series in 1951.
The Federal Reserve continued to support the functioning of financial markets and promote recovery in economic activity using a wide array of tools. The Federal Open Market Committee (FOMC) maintained a target range of 0 to 1/4 percent for the federal funds rate throughout the second half of 2009 and early 2010 and indicated that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for an extended period. Further, the Federal Reserve continued its purchases of Treasury securities, agency mortgage-backed securities (MBS), and agency debt in order to provide support to mortgage and housing markets and to improve overall conditions in private credit markets. To promote a smooth transition in financial markets as the acquisitions are completed, the Federal Reserve gradually slowed the pace of these purchases in late 2009 and early 2010. The planned acquisitions of $300 billion of Treasury securities were completed by October, while the purchases of $1.25 trillion of MBS and about $175 billion of agency debt are expected to be finished by the end of the first quarter of this year.
In light of the improved functioning of financial markets, the Federal Reserve removed some of the extraordinary support it had provided during the crisis and closed many of its special liquidity facilities and the temporary liquidity swap arrangements with other central banks in the fall of 2009 and early in 2010. The Federal Reserve also began to normalize its lending to commercial banks through the discount window by reducing the maximum maturity of loans extended through the primary credit facility from 90 days to 28 days, effective on January 14, and by announcing that the maturity of those loans will be reduced further to overnight, effective on March 18. The rate charged on primary credit loans was increased from 1/2 percent to 3/4 percent effective February 19. In addition, the Federal Reserve announced that the final auction under the Term Auction Facility will occur in March and later noted that the minimum bid rate for that auction had been increased by 1/4 percentage point to 1/2 percent. Overall, the size of the Federal Reserve's balance sheet increased from about $2 trillion in the summer of 2009 to about $2.3 trillion on February 17, 2010. The composition of the balance sheet continued to shift as a considerable decline in credit extended through various facilities was more than offset by the increase in securities held outright. The Federal Reserve continued to broaden its efforts to provide even more information to the public regarding its conduct of these programs and of monetary policy (see box in Part 3).
The Federal Reserve is taking steps to ensure that it will be able to smoothly withdraw extraordinary policy accommodation when appropriate. Because the Federal Reserve, under the statutory authority provided by the Congress in October 2008, pays interest on the balances depository institutions hold at Reserve Banks, it can put upward pressure on short-term interest rates even with an extraordinarily large volume of reserves in the banking system by raising the interest rate paid on such balances. In addition, the Federal Reserve has continued to develop several other tools that it could use to reinforce the effects of increases in the interest rate on balances at Reserve Banks. In particular, the Federal Reserve has tested its ability to execute reverse repurchase agreements (reverse repos) in the triparty repo market with primary dealers using both Treasury and agency debt as collateral, and it is developing the capability to conduct such transactions with other counterparties and against agency MBS. The Federal Reserve has also announced plans for implementing a term deposit facility. In addition, it has the option of redeeming or selling assets in order to reduce monetary policy accommodation.
In conjunction with the January 2010 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 agreed that economic recovery from the recent recession was under way, but that they expected it to proceed at a gradual pace, restrained in part by household and business uncertainty regarding the economic outlook, modest improvement in labor markets, and slow easing of credit conditions in the banking sector. Participants expected that real GDP would expand at a rate that was only moderately above its longer-run sustainable growth rate and that the unemployment rate would decline only slowly over the next few years. Most participants also anticipated that inflation would remain subdued over this period.
Nearly all participants judged the risks to their growth outlook as generally balanced, and most also saw roughly balanced risks surrounding their inflation projections. Participants continued to judge the uncertainty surrounding their projections for economic activity and inflation as unusually high relative to historical norms. 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. The central tendencies of these longer-run projections were 2.5 to 2.8 percent for real GDP growth, 5.0 to 5.2 percent for the unemployment rate, and 1.7 to 2.0 percent for the inflation rate.