Part 3: Monetary Policy: Recent Developments and OutlookMonetary Policy Report submitted to the Congress on March 1, 2011, pursuant to section 2B of the Federal Reserve Act
Monetary Policy over the Second Half of 2010 and Early 2011
The Federal Open Market Committee (FOMC) maintained a target range for the federal funds rate of 0 to 1/4 percent throughout the second half of 2010 and into 2011 (figure 58). In the statement accompanying each regularly scheduled FOMC meeting, the Committee noted that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, were likely to warrant exceptionally low levels of the federal funds rate for an extended period. With the unemployment rate elevated and measures of underlying inflation somewhat low relative to levels that the Committee judged to be consistent, over the long run, with its dual mandate of maximum employment and price stability, the FOMC took steps during the second half of 2010 to provide additional monetary accommodation in order to promote a stronger pace of economic recovery and to help ensure that inflation, over time, returns to levels consistent with its mandate. In August, the FOMC announced that it would keep constant the Federal Reserve's holdings of longer-term securities at their then-current level by reinvesting principal payments from agency debt and agency mortgage-backed securities (MBS) in longer-term Treasury securities. Then, in November, the FOMC announced that it intended to purchase an additional $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee noted that it would regularly review the pace of its securities purchases and the overall size of the asset purchase program in light of incoming information.
The information reviewed at the August 10 FOMC meeting indicated that the pace of the economic recovery had slowed in recent months and that inflation remained subdued. Private employment had increased slowly in June and July, and industrial production was little changed in June after a large increase in May. Consumer spending continued to rise at a modest rate in June. However, housing activity dropped back, and nonresidential construction remained weak. In addition, the trade deficit widened sharply in May. Conditions in financial markets had become somewhat more supportive of economic growth since the June meeting, in part reflecting perceptions of diminished risk of financial dislocations in Europe. Moreover, participants saw some indications that credit conditions for households and smaller businesses were beginning to improve, albeit gradually. A further decline in energy prices and unchanged prices for core goods and services led to a fall in headline consumer prices in June.
Against this backdrop, the Committee agreed to make no change in its target range for the federal funds rate at the August meeting. The economic expansion was seen as continuing, and most members believed that inflation was likely to stabilize in coming quarters at rates near recent low readings and then gradually rise toward levels they considered more consistent with the Committee's dual mandate. Nonetheless, members generally judged that the economic outlook had softened somewhat more than they had anticipated, and some saw increased downside risks to the outlook for both economic growth and inflation. The Committee noted that the decline in mortgage rates since the spring was generating increased mortgage refinancing activity, which would accelerate repayments of principal on MBS held in the System Open Market Account (SOMA), and that private investors would have to hold more longer-term securities as the Federal Reserve's holdings ran off, making longer-term interest rates somewhat higher than they would have been otherwise. The Committee concluded that it would be appropriate to begin reinvesting principal payments received from agency debt and MBS held in the SOMA by purchasing longer-term Treasury securities; such an action would keep constant the face value of securities held in the SOMA and thus avoid the upward pressure on longer-term interest rates that might result if those holdings were allowed to decline.
As of the September 21 FOMC meeting, the data continued to suggest that the economic expansion was decelerating and that inflation remained low. Private businesses increased employment modestly in August, but the length of the workweek was unchanged and the unemployment rate remained elevated. The rise in business outlays for equipment and software seemed to have moderated following outsized gains in the first half of the year. Housing activity weakened further, and nonresidential construction remained depressed. Industrial production advanced at a solid pace in July and rose further in August. Consumer spending continued to increase at a moderate rate in July and appeared to be moving up again in August. After falling in the previous three months, headline consumer prices had risen in July and August as energy prices retraced some of their earlier declines, and prices for core goods and services edged up slightly. Credit was viewed by participants as remaining readily available for larger corporations with access to capital markets, and some reports suggested that credit conditions had begun to improve for smaller firms. Asset prices had been relatively sensitive to incoming economic data over the intermeeting period but generally ended the period little changed on net. Stresses in European financial markets were seen by participants as broadly contained but were thought to bear watching going forward. Although participants did not expect that the economy would reenter a recession, many expressed concern that output growth, and the associated progress in reducing the level of unemployment, could be slow for some time. Participants noted a number of factors that were restraining economic growth, including low levels of household and business confidence, heightened risk aversion, and the still-weak financial conditions of some households and small businesses.
The Committee agreed at the September meeting to maintain the target range for the federal funds rate of 0 to 1/4 percent and to leave unchanged the level of its combined holdings of Treasury securities, agency debt, and agency MBS in the SOMA. In addition, members agreed that the statement to be released following the meeting should be adjusted to clarify their assessment that underlying inflation had been running below levels that the Committee judged to be consistent with its dual mandate for maximum employment and price stability. The clarification was intended, in part, to help anchor inflation expectations and to reinforce the indication that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for an extended period. In light of the considerable uncertainty about the trajectory of the economy, members saw merit in accumulating further information before reaching a decision about providing additional monetary stimulus. In addition, members wanted to consider further the most effective framework for calibrating and communicating any additional steps to provide such stimulus. They noted that unless the pace of economic recovery strengthened or underlying inflation moved up toward levels consistent with the FOMC's mandate, the Committee would consider taking appropriate action soon.
On October 15, the Committee met by videoconference to discuss issues associated with its monetary policy framework, including alternative ways to express and communicate the Committee's objectives, possibilities for supplementing the Committee's communication about its policy decisions, the merits of making smaller and more-frequent adjustments in the Federal Reserve's intended securities holdings rather than larger and less-frequent adjustments, and the potential costs and benefits of targeting a term interest rate. The agenda did not encompass consideration of any policy actions, and none were taken.
The information reviewed at the November 2–3 FOMC meeting continued to indicate that the economic recovery was proceeding at a modest rate, with only a gradual improvement in labor market conditions. Moreover, measures of underlying inflation were somewhat low relative to levels that the Committee judged to be consistent, over the longer run, with its dual mandate. Consumer spending, business investment in equipment and software, and exports posted further gains in the third quarter, and nonfarm inventory investment stepped up. However, construction activity in both the residential and nonresidential sectors remained depressed, and a significant portion of the rise in domestic demand was again met by imports. U.S. industrial production slowed noticeably in August and September, hiring remained modest, and the unemployment rate stayed elevated. While participants considered it quite unlikely that the economy would slide back into recession, they noted that continued slow growth and high levels of resource slack could leave the economic expansion vulnerable to negative shocks. Participants saw financial conditions as having become more supportive of economic growth over the course of the intermeeting period; most, though not all, of the change appeared to reflect investors' increased anticipation of a further easing of monetary policy. Headline consumer price inflation had been subdued in recent months, despite a rise in energy prices, as core consumer price inflation trended lower.
Though the economic recovery was continuing, FOMC members considered progress toward meeting the Committee's dual mandate of maximum employment and price stability as having been disappointingly slow. Moreover, members generally thought that progress was likely to remain slow. Accordingly, most members judged it appropriate to provide additional policy accommodation. In their discussion of monetary policy for the period immediately ahead, Committee members agreed to maintain the target range for the federal funds rate at 0 to 1/4 percent and to continue the Committee's existing policy of reinvesting principal payments from its securities holdings into longer-term Treasury securities. The Committee also announced its intention to purchase a further $600 billion of longer-term Treasury securities at a pace of about $75 billion per month through the second quarter of 2011. Purchases of additional Treasury securities were expected to put downward pressure on longer-term interest rates, boost asset prices, and lead to a modest reduction in the foreign exchange value of the dollar. These changes in financial conditions were expected to promote a somewhat stronger recovery in output and employment while also helping return inflation, over time, to levels consistent with the Committee's mandate.
The data presented at the December 14 FOMC meeting indicated that economic activity was increasing at a moderate rate but that the unemployment rate remained elevated. The pace of consumer spending picked up in October and November, exports rose rapidly in October, and the recovery in business spending on equipment and software appeared to be continuing. In contrast, residential and nonresidential construction activity was still depressed. Manufacturing production registered a solid gain in October. Nonfarm businesses continued to add workers in October and November, and the average workweek moved up. The fiscal package agreed to by the Administration and the Congress was generally expected by participants to support the pace of recovery in 2011. Participants noted that interest rates at intermediate and longer maturities had risen substantially over the intermeeting period, while credit spreads were roughly unchanged and equity prices had risen moderately. Financial pressures in peripheral Europe had increased, leading to a financial assistance package for Ireland. Longer-run inflation expectations were stable, but core inflation continued to trend lower. Overall, the information received during the intermeeting period pointed to some improvement in the near-term outlook, and participants expected economic growth to pick up somewhat going forward. A number of factors, however, were seen as likely to continue restraining the recovery, including the depressed housing market, employers' continued reluctance to add to payrolls, and ongoing efforts by some households and businesses to reduce leverage. Moreover, the recovery remained subject to some downside risks, such as the possibility of a more extended period of weak activity and lower prices in the housing sector as well as potential financial and economic spillovers if the banking and sovereign debt problems in Europe were to worsen further.
Members noted that, while incoming information over the intermeeting period had increased their confidence that the economic recovery would be sustained, progress toward the Committee's dual objectives of maximum employment and price stability continued to be modest, and unemployment and inflation appeared likely to deviate from the Committee's objectives for some time. Accordingly, in their discussion of monetary policy for the period immediately ahead, Committee members agreed to continue expanding the Federal Reserve's holdings of longer-term securities as announced in November. The Committee also decided to maintain the target range for the federal funds rate at 0 to 1/4 percent and to reiterate its expectation that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for an extended period. While the economic outlook was seen as improving, members generally felt that the change in the outlook was not sufficient to warrant any adjustments to the asset purchase program, and some noted that more time was needed to accumulate information on the economy before considering any adjustment. Members emphasized that the pace and overall size of the purchase program would be contingent on economic and financial developments; however, some indicated that they had a fairly high threshold for making changes to the program.
On December 21, the Federal Reserve announced an extension through August 1, 2011, of its temporary U.S. dollar liquidity swap arrangements with the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank. The authorization of the swap arrangements had previously been set to expire on January 31, 2011.
The data reviewed at the January 25–26 FOMC meeting indicated that the economic recovery was gaining a firmer footing, though the expansion had not yet been sufficient to bring about a significant improvement in labor market conditions. Consumer spending had risen strongly late in 2010, and the ongoing expansion in business outlays for equipment and software appeared to have been sustained in recent months. Industrial production had increased solidly in November and December. However, construction activity in both the residential and nonresidential sectors remained weak. Modest gains in employment had continued, but the unemployment rate remained elevated. Conditions in financial markets were viewed by participants as having improved somewhat further over the intermeeting period, as equity prices had risen and credit spreads on the debt of nonfinancial corporations had continued to narrow while yields on longer-term nominal Treasury securities were little changed. Credit conditions were still tight for smaller, bank-dependent firms, although bank loan growth had picked up in some sectors. Despite further increases in commodity prices, measures of underlying inflation remained subdued and longer-run inflation expectations were stable.
The information received over the intermeeting period had increased members' confidence that the economic recovery would be sustained, and the downside risks to both economic growth and inflation were viewed as having diminished. Nevertheless, members noted that the pace of the recovery was insufficient to bring about a significant improvement in labor market conditions, and that measures of underlying inflation were trending downward. Moreover, the economic projections submitted for this meeting indicated that unemployment was expected to remain above, and inflation to remain somewhat below, levels consistent with the Committee's objectives for some time. Accordingly, the Committee decided to maintain its existing policy of reinvesting principal payments from its securities holdings and reaffirmed its intention to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. Members emphasized that the Committee would continue to regularly review the pace of its securities purchases and the overall size of the asset purchase program. In addition, the Committee maintained the target range of 0 to 1/4 percent for the federal funds rate and reiterated its expectation that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for an extended period.
Tools for the Withdrawal of Monetary Policy Accommodation
Although the FOMC continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period, ultimately the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflationary pressures as the economy recovers. The Federal Reserve has the tools it needs to remove policy accommodation at the appropriate time. One tool is the interest rate paid on reserve balances. By increasing the rate paid on reserves, the Federal Reserve will be able to put significant upward pressure on short-term market interest rates because banks will not supply short-term funds to the money markets at rates significantly below what they can earn by simply leaving funds on deposit at the Federal Reserve Banks. Two other tools, executing term reverse repurchase agreements (RRPs) with the primary dealers and other counterparties and issuing term deposits to depository institutions through the Term Deposit Facility (TDF), can be used to reduce the large quantity of reserves held by the banking system; such a reduction would improve the Federal Reserve's control of financial conditions by tightening the relationship between the interest rate paid on reserves and other short-term interest rates. The Federal Reserve could also reduce the quantity of reserves in the banking system by redeeming maturing and prepaid securities held by the Federal Reserve without reinvesting the proceeds or by selling some of its securities holdings.
During the second half of 2010, the Federal Reserve Bank of New York (FRBNY) conducted a series of small-scale triparty RRP transactions with primary dealers using all eligible collateral types, including, for the first time, agency debt and agency MBS from the SOMA portfolio.14 The Federal Reserve also conducted a series of small-scale triparty RRP transactions with a set of counterparties that had been expanded to include approved money market mutual funds, using Treasury securities, agency debt, and agency MBS as collateral.
On September 8, the Federal Reserve Board authorized a program of regularly scheduled small-value offerings of term deposits under the TDF.15 The auctions, which are to occur about every other month, are intended to ensure the operational readiness of the TDF and to increase the familiarity of eligible participants with the auction procedures. Since September, the Federal Reserve has conducted three auctions, each of which offered $5 billion in 28-day deposits. All of these auctions were well subscribed.
Recent Steps to Increase Transparency
Transparency is an essential principle of modern central banking because it appropriately contributes to the accountability of central banks to the government and the public and because it can enhance the effectiveness of central banks in achieving macroeconomic objectives. The Federal Reserve provides detailed information concerning the conduct of monetary policy.16 During the financial crisis, the Federal Reserve developed a public website that contains extensive information on its credit and liquidity programs, and, in 2009, the Federal Reserve began issuing detailed monthly reports on these programs.17
Recently, the Federal Reserve has taken further steps to enhance its transparency and expand the amount of information it provides to the public. First, on December 1, the Federal Reserve posted detailed information on its public website about the individual credit and other transactions conducted to stabilize markets during the financial crisis, restore the flow of credit to American families and businesses, and support economic recovery and job creation in the aftermath of the crisis.18 As mandated by the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd–Frank Act), transaction-level details from December 1, 2007, to July 21, 2010, were provided about entities that participated in the agency MBS purchase program, used Federal Reserve liquidity swap lines, borrowed through the Term Auction Facility, or received loans or other financial assistance through a program authorized under section 13(3) of the Federal Reserve Act. Many of these transactions were conducted through a variety of broad-based lending facilities and provided liquidity to financial institutions and markets through fully secured, mostly short-term loans. Other transactions involved purchases of agency MBS and supported mortgage and housing markets; these transactions lowered longer-term interest rates and fostered economic growth. Dollar liquidity swap lines with foreign central banks posed no financial risk to the Federal Reserve because the Federal Reserve's counterparties were the foreign central banks themselves, not the institutions to which the foreign central banks then lent the funds; these swap facilities helped stabilize dollar funding markets abroad, thus contributing to the restoration of stability in U.S. markets. Other transactions provided liquidity to particular institutions whose disorderly failure could have severely stressed an already fragile financial system.
A second step toward enhanced transparency involves disclosures going forward. The Dodd–Frank Act established a framework for the disclosure of information on credit extended after July 21, 2010, through the discount window under section 10B of the Federal Reserve Act or from a section 13(3) facility, as well as information on all open market operation (OMO) transactions. Generally, this framework requires the Federal Reserve to publicly disclose certain information about discount window borrowers and OMO counterparties approximately two years after the relevant loan or transaction; information about borrowers under future section 13(3) facilities will be disclosed one year after the authorization for the facility is terminated. The information to be disclosed includes the name and identifying details of each borrower or counterparty, the amount borrowed, the interest rate paid, and information identifying the types and amounts of collateral pledged or assets transferred in connection with the borrowing or transaction.
Finally, the Federal Reserve has also increased transparency with respect to the implementation of monetary policy. In particular, the Federal Reserve took steps to provide additional information about its security purchase operations with the objective of encouraging wider participation in such operations. The FRBNY publishes, on an ongoing basis, schedules of purchase operations expected to take place over the next four weeks; details provided include lists of operation dates, settlement dates, security types to be purchased, the maturity date range of eligible issues, and an expected range for the size of each operation. Results of each purchase operation are published shortly after it has concluded. In addition, the FRBNY has commenced publication of information on the prices paid for individual securities in its purchase operations.19
14. In a triparty repurchase agreement, both parties to the agreement must have cash and collateral accounts at the same triparty agent, which is by definition also a clearing bank. The triparty agent will ensure that collateral pledged is sufficient and meets eligibility requirements, and all parties agree to use collateral prices supplied by the triparty agent. Return to text
16. Immediately following each meeting, the FOMC releases a statement that lays out the rationale for the policy decision. Detailed minutes of each FOMC meeting are made public three weeks following the meeting. Lightly edited transcripts of FOMC meetings are released to the public with a five-year lag. FOMC statements, minutes, and transcripts, as well as other related information, are available on the Federal Reserve Board's website. See Board of Governors of the Federal Reserve System, "Federal Open Market Committee," webpage, www.federalreserve.gov/monetarypolicy/fomc.htm. Return to text
17. See Board of Governors of the Federal Reserve System, "Credit and Liquidity Programs and the Balance Sheet," webpage, www.federalreserve.gov/monetarypolicy/bst.htm; and Board of Governors of the Federal Reserve System, "Monthly Report on Credit and Liquidity Programs and the Balance Sheet," webpage, www.federalreserve.gov/monetarypolicy/clbsreports.htm. Return to text
18. These data are available at Board of Governors of the Federal Reserve System, "Regulatory Reform: Usage of Federal Reserve Credit and Liquidity Facilities," webpage, www.federalreserve.gov/newsevents/reform_transaction.htm. Return to text
19. General information on OMOs, including links to the prices paid in recent purchases of Treasury securities, is available on the FRBNY's website at www.newyorkfed.org/markets/pomo/display/index.cfm. Return to text