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Board of Governors of the Federal Reserve System

Part 1: Recent Economic and Financial Developments

Monetary Policy Report submitted to the Congress on February 11, 2014, pursuant to section 2B of the Federal Reserve Act

The labor market continued to improve over the second half of last year. Job gains have averaged about 175,000 per month since June, and the unemployment rate fell from 7.5 percent in June 2013 to 6.6 percent in January of this year. Even so, the unemployment rate remains well above Federal Open Market Committee (FOMC) participants' estimates of the long-run sustainable rate. Inflation remained low, as the price index for personal consumption expenditures (PCE) increased at an annual rate of 1 percent from June to December--noticeably below the FOMC's longer-run goal of 2 percent. However, transitory influences appear to have been partly responsible for the low readings on inflation last year, and measures of inflation expectations remained steady and near longer-run averages. Growth in economic activity picked up in the second half of 2013. Real gross domestic product (GDP) is estimated to have risen at an annual rate of 3-3/4 percent, up from a 1-3/4 percent rate of increase in the first half. Fiscal policy--which was unusually restrictive in 2013 as a whole--likely started to exert somewhat less restraint on economic growth in the second half of the year. In addition, household net worth rose further as key asset prices continued to increase, credit became more available while interest rates remained low, and economic conditions in the rest of the world improved overall in spite of recent turbulence in emerging financial markets. Consumer spending, business investment, and exports all increased more rapidly in the latter part of last year. In contrast, the recovery in the housing sector appeared to pause in the second half of last year following increases in mortgage interest rates in the spring and summer.

Domestic Developments

The labor market continued to improve,...

The labor market continued to improve over the second half of 2013. Payroll employment has increased an average of about 175,000 per month since June, roughly similar to the average gain over the first half of last year (figure 1). In addition, the unemployment rate declined from 7.5 percent in June to 6.6 percent in January of this year (figure 2). A variety of alternative measures of labor force underutilization--which include, in addition to the unemployed, those classified as discouraged, other individuals who are out of work and classified as marginally attached to the labor force, and individuals who have a job but would like to work more hours--have also improved in the past several months. Since August 2012--the month before the Committee began its current asset purchase program--total payroll employment has increased a cumulative 3-1/4 million, and the unemployment rate has declined 1-1/2 percentage points.

...although labor force participation remained weak,...

While the unemployment rate and total payroll employment have improved further, the labor force participation rate has continued to move lower on net (figure 3). As a result, the employment-to-population ratio, a measure that combines the unemployment rate and the labor force participation rate, has changed little during the past year. Although much of the decline in participation likely reflects changing demographics--most notably the increasing share in the population of older people, who have lower-than-average participation rates--and would have occurred even if the labor market had been stronger, some of the weakness in participation is also likely due to workers' perceptions of relatively poor job opportunities.

...considerable slack in labor markets remains,...

Despite its recent declines, the unemployment rate remains well above FOMC participants' estimates of the long-run sustainable rate of unemployment and well above rates that prevailed prior to the recent recession. Moreover, beyond labor force participation, some other aspects of the labor market remain of concern. For example, the share of the unemployed who have been out of work longer than six months and the percentage of the workforce that is working part time but would like to work full time have declined only modestly over the recovery (figure 4). In addition, the quit rate--an indicator of workers' confidence in the availability of other jobs--remains low.

...and gains in compensation have been slow

The relatively weak labor market has also been evident in the behavior of wages, as the modest gains in labor compensation seen earlier in the recovery continued last year. The 12-month change in the employment cost index for private industry workers, which measures both wages and the cost to employers of providing benefits, has remained close to 2 percent throughout most of the recovery (figure 5). Similarly, average hourly earnings for all employees--the timeliest measure of wage developments--increased close to 2 percent over the 12 months ending in January, about the same pace as over the preceding year. Compensation per hour in the nonfarm business sector--a measure derived from the labor compensation data in the national income and product accounts (NIPA)--can be quite volatile even at annual frequencies, but, over the past three years, this measure has increased at an annual average pace of 2-1/4 percent, well below the average pace prior to the recent recession.

Productivity growth has also been relatively weak over the recovery. From the end of 2009 to the end of 2013, annual growth in output per hour in the nonfarm business sector averaged only 1-1/4 percent, considerably slower than the average rate before the recent recession (figure 6). However, with the recent strengthening in the pace of economic activity, productivity growth rose to an annual rate of nearly 3-1/2 percent over the second half of last year.

Inflation was low...

Inflation remained low in the second half of 2013, with the PCE price index increasing at an annual rate of only 1 percent from June to December, similar to the increase in the first half and noticeably below the FOMC's long-run objective of 2 percent (figure 7). Core PCE prices--or prices of PCE goods and services excluding food and energy--also increased at an annual rate of about 1 percent over the second half of 2013. Other measures of core consumer price inflation, such as the core consumer price index, were also low last year relative to norms prevailing in the years prior to the recent recession, though not as low as core PCE inflation.

Some of the recent softness in core PCE price inflation reflects factors that appear to have been transitory. In particular, after increasing at an average annual rate of 1-3/4 percent from the end of 2009 to the end of 2012, non-oil import prices fell 1-1/4 percent in 2013, pushed down by the effects of dollar appreciation and declining commodity prices during the first half of last year. These factors have abated since last summer, as the broad nominal value of the dollar has moved up only a little, on net, and the fall in overall nonfuel commodity prices has eased. In addition, during the final part of 2013, prices for a few industrial metals reversed part of their earlier declines, supported by a positive turnaround in Chinese demand.

Moreover, despite the relatively meager gains in wages, recent increases in the cost of labor needed to produce a unit of output (unit labor costs)--which reflects movements in both labor compensation and productivity and is a useful gauge of the influence of labor-related production costs on inflation--do not suggest an unusual amount of downward pressure on inflation. Unit labor costs increased at an annual rate of 1-1/2 percent over the past two years, just a little below their average prior to the recent recession.

Consumer energy and food prices changed relatively little over the second half of 2013. The spot price of Brent crude oil, after peaking in late August at nearly $120 per barrel, has been relatively stable in recent months, trading at about $110 per barrel since mid-September, as a continued increase in North American crude oil production has helped buffer the effects of some supply disruptions elsewhere (figure 8). Meanwhile, strong harvests have put downward pressure on food commodity prices, and, as a result, consumer food prices--which reflect both commodity prices and processing costs--were little changed in the second half of last year.

...but inflation expectations changed little

The Federal Reserve monitors the public's expectations of inflation, in part because these expectations may influence wage- and price-setting behavior and thus actual inflation. Despite the weakness in recent inflation data, survey- and market-based measures of longer-term inflation expectations changed little, on net, over the second half of last year and have remained fairly stable in recent years. Median expected inflation over the next 5 to 10 years, as reported in the Thomson Reuters/University of Michigan Surveys of Consumers, was 2.9 percent in January, within the narrow range of the past decade (figure 9).1 In the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, the median expectation for the annual rate of increase in the PCE price index over the next 10 years was 2 percent in the fourth quarter of 2013, similar to its level in recent years. Meanwhile, measures of medium- and longer-term inflation compensation derived from differences between yields on nominal and inflation-protected Treasury securities have remained within their respective ranges observed over the past several years (figure 10).

Growth in economic activity picked up

Real GDP is estimated to have increased at an annual rate of 3-3/4 percent over the second half of last year, up from a reported 1-3/4 percent pace in the first half (figure 11). Gross domestic income, or GDI, an alternative measure of economic output, increased a little more than 3 percent over the four quarters ending in the third quarter of last year (the most recent data available), 1 percentage point faster than the increase in GDP over this period (figure 12).2

Some of the strength in GDP growth in the second half of 2013 reflected a pickup in the pace of inventory investment, a factor that cannot continue indefinitely. But other likely more persistent factors influencing demand shifted in a more favorable direction as well. In particular, restraint from fiscal policy likely started to diminish in the latter part of last year. In addition, further increases in the prices of corporate equities and housing boosted household net worth, while credit became more broadly available to households and businesses and interest rates remained low. Moreover, the boom in oil and gas production continued. Finally, economic conditions in the rest of the world improved overall, notwithstanding recent market turmoil in some emerging market economies (EMEs). As a result, consumer spending, business investment, and exports all increased more rapidly in the latter part of the year, more than offsetting a slowing in the pace of residential investment.

Fiscal policy was a notable headwind in 2013,...

Relative to prior recoveries, fiscal policy in recent years has been unusually restrictive, and the drag on GDP growth in 2013 was particularly large. The expiration of the temporary payroll tax cut and tax increases for high-income households at the beginning of 2013 restrained consumer spending. Moreover, federal purchases were pushed down by the sequestration, budget caps on discretionary spending, and the drawdown in foreign military operations. As a result, real federal purchases, as measured in the NIPA, fell at an annual rate of more than 7 percent over the second half of the year (figure 13). Due to the government shutdown in October, which temporarily held down purchases in the fourth quarter, this decline was somewhat steeper than in the first half.3

The federal budget deficit declined as a share of GDP for the fourth consecutive year in fiscal year 2013, reaching about 4 percent of GDP. Although down from nearly 10 percent in fiscal 2009, the fiscal 2013 deficit is still 1-1/2 percentage points higher than its 50-year average. Federal receipts rose in fiscal 2013 but still were only 16-3/4 percent of GDP; federal outlays, while falling, remained elevated at 20-3/4 percent of GDP in the past fiscal year (figure 14). With the deficit still elevated, the debt-to-GDP ratio increased from 69 percent at the end of fiscal 2012 to 71 percent at the end of fiscal 2013 (figure 15).

...but fiscal drag appears to be easing

Although the expiration of emergency unemployment compensation at the beginning of this year will impose some fiscal restraint, fiscal policy is in the process of becoming less restrictive for GDP growth. Most importantly, the drag on growth in consumer spending from the tax increases at the beginning of 2013 has likely begun to wane. In addition, the Bipartisan Budget Act of 2013 will ease the limits on spending associated with the sequestration, and an increase in transfers from the Affordable Care Act should provide a boost to demand beginning this year. Also, fiscal conditions at the state and local levels of government have improved, and real purchases by such governments are estimated to have edged up in 2013 after several years of declines.

Consumer spending rose faster, supported by improvements in labor markets,...

After increasing at an annual rate of 2 percent in the first half of 2013, real PCE rose at a 2-3/4 percent rate over the second half (figure 16). Real disposable personal income--which had been pushed lower by the tax increases in the first quarter of 2013--moved up in the final three quarters of the year. Continued job gains helped improve the economic prospects of many households last year and boosted aggregate income growth. And the net rise in consumer sentiment in recent months suggests that greater optimism about the economy on the part of households should support consumer spending in early 2014 (figure 17). well as increases in household net worth and low interest rates

Consumer spending was also likely supported by a significant increase in household net worth in the second half of last year, as prices of corporate equities and housing continued to rise. (For further information, see the box "Recent Changes in Household Wealth.") In addition, consumer credit for auto purchases (including loans to borrowers with subprime credit scores) and for education has remained broadly available. Moreover, interest rates for auto loans have stayed low (figure 18). And spending on consumer durables--which is quite sensitive to interest rates--rose at an annual rate of nearly 7 percent in the second half of the year. Nevertheless, standards and terms for credit card debt have remained tight, and, partly as a result, credit card balances changed relatively little over the second half.

Recent Changes in Household Wealth

American households' aggregate wealth fell more than $10 trillion in 2008 as home equity, the value of corporate stock, and other forms of net wealth all declined, but household wealth has increased in each of the five years since then (figure A).1 Much of the recent increase in net worth reflects capital gains on corporate equity and real estate held by households. Since the end of 2008, stock market wealth has increased over $10 trillion, more than the amount that was lost during the recession. Home equity has recovered more slowly, rising about $3-1/2 trillion in the past two years, which is about half the amount lost between 2006 and 2011. The increase in home equity affects a larger number of households than the increase in stock wealth because housing assets are distributed more broadly across the population than is stock ownership. More information about the distribution of household wealth will be available upon completion of the Federal Reserve Board's 2013 Survey of Consumer Finances.

One reason home equity has increased is that house prices have risen in many areas; another is that aggregate mortgage debt has fallen because of foreclosures, paydowns, and other factors cited later. As shown in figure B, residential mortgage debt outstanding has fallen over $1 trillion since the end of 2007, making mortgages the major contributor to the phenomenon known as household deleveraging. In contrast to mortgages, consumer credit has expanded in each of the past four years. A detailed breakdown of consumer credit is shown in figure C. In recent years, growth in consumer credit has been driven by student loans and auto loans, while aggregate credit card balances have been relatively flat.

Despite the marked improvements in aggregate household net worth since the recession, many households' wealth positions have not recovered. Weak labor market conditions and the precipitous drop in home prices continue to weigh on many households' net worth. Figure D shows that a significant percentage of homeowners with a mortgage continue to be "underwater"--that is, they owe more than their homes are worth--and, for many, the depth of that negative equity is still substantial.

Nonetheless, the share of homeowners with negative equity is decreasing. By one estimate, roughly one in eight homeowners with a mortgage was underwater as of the third quarter of 2013--about half the share from two years earlier, though still significantly higher than the level that prevailed before house prices started falling in 2006.2 Three primary factors have contributed to the decline in negative equity over the past two years. First, home prices have increased significantly. Second, homeowners' outstanding mortgage balances have been declining because of scheduled amortization, cash-in refinances, and mortgage modifications. Third, foreclosures and short sales have extinguished some homeowner liability.

Continued improvements in the home equity positions of households could have broader consequences for the economy. First, these improvements could help with the transmission of monetary policy. Banks are more willing to refinance mortgages when homeowners have positive equity, so improving home equity may allow more homeowners to take advantage of the current low interest rates. Second, because negative equity is associated with higher rates of foreclosure, these improvements should reduce the number of future foreclosures and the associated economic and social costs. Third, to the extent that households are able to borrow against their home equity to fund outlays, including those to finance small businesses, having more homeowners with positive equity could increase aggregate demand. Finally, because homeowners with negative equity may be less willing or able to sell their homes at market prices, declines in the negative equity share could help improve the operation of the housing market and increase mobility.


1. The 2013 bar in the figure shows changes through the third quarter, the most recent quarter for which data are available. House prices and stock prices increased further in the fourth quarter, suggesting that the total increase in household net worth for 2013 will have been larger than the amount shown here. Return to text

2. These estimates are from CoreLogic. Alternative estimates from Zillow show a somewhat larger share of underwater households, but one that also has been declining since early 2012. Return to text

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Business investment picked up...

Business fixed investment (BFI) rose at an annual rate of 4-1/4 percent in the second half of 2013 after changing little in the first half. Investment in equipment and intangible capital rose at an annual rate of nearly 4 percent, while investment in nonresidential structures increased close to 6 percent (figure 19). On balance, national and regional surveys of purchasing managers suggest that orders for new equipment continued to increase at the turn of the year. However, still-high vacancy rates and relatively tight financing conditions likely continued to limit building investment; despite the recent increases, investment in buildings remains well below the peaks reached prior to the most recent recession.

The relatively modest rate of increase in the demand for business output has likely restrained BFI in recent quarters. In 2012 and the first half of 2013, business output increased at an annual rate of only 2-1/2 percent. However, the acceleration in overall economic activity in the second half of 2013 may provide more impetus for business investment in the period ahead. financing conditions for businesses were generally quite favorable

Moreover, the financial condition of nonfinancial firms remained strong in the second half of 2013, with profitability high and the default rate on nonfinancial corporate bonds close to zero. Interest rates on corporate bonds, while up since the spring, have stayed low relative to historical norms (figure 20). And net issuance of nonfinancial corporate debt appears to have remained strong in the second half of the year (figure 21). In addition, in recent quarters an increasing portion of the aggregate proceeds from the issuance of speculative-grade debt was reportedly intended for uses beyond the refinancing of existing debt.

Conditions in business loan markets also continued to improve. According to the Federal Reserve Board's January 2014 Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), a modest net fraction of respondents indicated they had eased standards on commercial and industrial (C&I) loans over the second half of 2013.4 In addition, according to the Federal Reserve Board's November 2013 Survey of Terms of Business Lending, loan rate spreads over banks' cost of funds have continued to decline. Financing conditions for small businesses also improved: Reductions in loan spreads have been most notable for the types of loans likely made to small businesses--that is, loans of $1 million or less or those originated by small domestic banks (figure 22). Standards on commercial real estate (CRE) loans extended by banks also eased over the second half of last year, moving back toward longer-run norms, according to the SLOOS. Still, standards for construction and land development loans, a subset of CRE loans, likely remained relatively tight.

Exports strengthened

Export demand also provided significant support to domestic economic activity in the second half of 2013 (figure 23). Real exports of goods and services rose at an annual rate of 7-1/2 percent, consistent with improving foreign GDP growth in the latter part of the year and buoyed by soaring sales both of petroleum products--associated with the boom in U.S. oil production--and of agricultural goods. Across the major destinations, the robust increase in exports was supported by higher shipments to Canada, China, and other Asian emerging economies.

The growth of real imports of goods and services stepped down to an annual rate of 1-1/2 percent in the second half of last year. Among the major categories, imports of non-oil goods and services rose more moderately, while oil imports continued to decline.

Altogether, real net trade added an estimated 3/4 percentage point to GDP growth over the second half of 2013, whereas in the first half it made a small negative contribution. Owing in part to the improvement in net petroleum trade, the nominal trade deficit shrank, on balance, over the second half of 2013. That decrease contributed to the narrowing of the current account deficit to 2-1/4 percent of GDP in the third quarter, a level generally not seen since the late 1990s (figure 24).

The current account deficit continued to be financed by strong financial inflows in the third quarter of 2013, mostly in the form of purchases of Treasury and corporate securities by both foreign official and foreign private investors (figure 25). Partial monthly data suggest that these trends likely continued in the fourth quarter. U.S. investors continued to finance direct investment projects abroad at a rapid pace in the third quarter. Although U.S. purchases of foreign securities edged down in the summer, consistent with stresses observed in emerging markets, they appear to have rebounded in the final part of the year.

The recovery in housing investment paused with the backup in interest rates...

After increasing at close to a 15 percent annual rate in 2012 and the first part of 2013, residential investment was little changed in the second half of last year. Mortgage interest rates increased about 1 percentage point, to around 4-1/4 percent, over May and June of last year and have remained near this level since then (figure 26). Soon after the increase, mortgage refinancing dropped sharply, while home sales declined somewhat and the issuance of new single-family housing permits leveled off (figure 27). However, relative to historical norms, mortgage rates remain low, and housing is still quite affordable. Moreover, steady growth in jobs is likely continuing to support growth in housing demand, and, because new home construction is still well below levels consistent with population growth, the potential for further growth in the housing sector is considerable.

...and mortgage credit continued to be tight,...

Lending policies for home purchase remained quite tight overall, but there are some indications that mortgage credit is starting to become more widely available. A modest net fraction of SLOOS respondents reported having eased standards on prime residential loans during the second half of last year. And, in a sign that lending conditions for home refinance are becoming less restrictive, the credit scores of individuals refinancing mortgages at the end of last year were lower, on average, than scores for individuals refinancing earlier in the year. However, credit scores of individuals receiving mortgages for home purchases have yet to drop (figure 28).

...but house prices continued to rise

Home prices continued to rise in the second half of the year, although somewhat less quickly than in the first half (figure 29). Over the 12 months ending in December, home prices increased 11 percent. Much of the recent gain in home prices has been concentrated in areas that saw the largest declines in prices during the recession and early recovery, as prices in these areas likely dropped below levels consistent with the rents these homes could bring, spurring purchases by large and small investors who have converted some homes into rental properties.

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Financial Developments

The expected path for the federal funds rate through mid-2017 moved lower...

Market-based measures of the expected (or mean) future path of the federal funds rate through mid-2017 moved lower, on balance, over the second half of 2013 and early 2014, mostly reflecting FOMC communications that were broadly seen as indicating that a highly accommodative stance of monetary policy would be maintained for longer than had been expected. Measures of the expected policy path rose in the summer in conjunction with longer-term interest rates, as investors increasingly expected the Committee to start reducing the pace of asset purchases at the September FOMC meeting. However, those increases were more than retraced over the weeks surrounding the September meeting, in part because the decision to keep the pace of asset purchases unchanged and the accompanying communications by the Federal Reserve were viewed as more accommodative than investors had anticipated. Expectations for the path of the federal funds rate through mid-2016 have changed little, on net, since mid-October. Federal Reserve communications since last September, including the enhanced forward guidance included in the December and January FOMC statements, reportedly helped keep federal funds rate expectations near their earlier levels despite generally stronger-than-expected economic data and the modest reductions in the pace of Federal Reserve asset purchases announced at the December and January FOMC meetings.

The modal path of the federal funds rate--that is, the values for future federal funds rates that market participants see as most likely--derived from interest rate options also shifted down for horizons through 2017, suggesting that investors may now expect the target federal funds rate to lift off from its current range substantially later than they had expected at the end of June 2013. Similarly, the most recent Survey of Primary Dealers conducted by the Open Market Desk at the Federal Reserve Bank of New York just prior to the January FOMC meeting showed that dealers' expectations of the date of liftoff have moved out about two quarters since the middle of last year, to the fourth quarter of 2015. 5

...while yields on longer-term securities increased but remained low by historical standards

Despite the lower expected path of the federal funds rate, yields on longer-term Treasury securities and agency mortgage-backed securities (MBS) rose moderately over the second half of 2013 (figures 30 and 31). These increases likely reflected economic data that were generally better than investors expected, as well as market adjustments to rising expectations that the Committee would start reducing the pace of its asset purchases, a step that was taken at the December FOMC meeting. Subsequently, yields declined amid flight-to-safety flows in response to recent emerging market turbulence (see the box "Financial Stress and Vulnerabilities in the Emerging Market Economies"). On net, yields on 5-, 10-, and 30-year nominal Treasury securities have increased between about 10 and 20 basis points from their levels at the end of June 2013. Yields on 30-year agency MBS edged up, on balance, over the same period.

Nonetheless, yields on longer-term securities continue to be low by historical standards. Those low levels reflect several factors, including subdued inflation expectations as well as market perceptions of a still-modest global economic outlook. In addition, term premiums--the extra return investors expect to obtain from holding longer-term securities as opposed to holding and rolling over a sequence of short-term securities for the same period--while above the historically low levels observed prior to the bond market selloff in the summer, remained within the low range they have occupied since the onset of the financial crisis, reflecting both the FOMC's large-scale asset purchases and strong demand for longer-term securities from global investors.

Indicators of Treasury market functioning were solid, on balance, over the second half of 2013 and early in 2014. For example, available data suggest that bid-asked spreads in the Treasury market stayed in line with recent averages. Moreover, Treasury auctions generally continued to be well received by investors. Liquidity conditions in the agency MBS market deteriorated somewhat for a time over the summer, amid heightened volatility, and a bit again toward year-end but have largely returned to normal levels since the turn of the year. Over the past seven months, the number of trades in the MBS market that failed to settle remained low, and implied financing rates in the "dollar roll" market--an indicator of the scarcity of agency MBS for settlement--have been stable (figure 32). 6

Short-term funding markets continued to function well, on balance, despite some strains during the debt ceiling standoff

In the fall of 2013, many short-term funding markets were adversely affected for a time by concerns about the possibility of a delay in raising the federal debt limit. The Treasury bill market experienced the largest effect as yields on bills maturing between mid-October and early November rose sharply, some bill auctions saw reduced demand, and liquidity in this market deteriorated, especially for certain securities that were seen as being at risk of delayed payment. Conditions in other short-term funding markets, such as the market for repurchase agreements (repos), were also strained for a time. However, these effects eased quickly after an agreement to raise the debt limit was reached in mid-October, and, overall, the debt ceiling standoff left no permanent imprint on short-term funding markets.

On balance, since the end of June 2013, conditions in both secured and unsecured short-term funding markets have changed little, with many money market rates remaining near the bottom of the ranges they have occupied since the federal funds rate first reached its zero lower bound. Unsecured offshore dollar funding markets generally did not exhibit any signs of stress. Rates on asset-backed commercial paper and unsecured financial commercial paper for the most part also stayed low. In the repo market, rates for general collateral Treasury repos also were low, consistent with reduced financing activities of dealers. These rates declined noticeably at year-end, leading to increased participation in the Federal Reserve's overnight reverse repurchase agreement operations (see Part 2 of this report). Overall, year-end pressures in short-term funding markets were modest and roughly in line with experiences during other years since the financial crisis.

Broad equity price indexes increased further and risk spreads on corporate debt declined...

Boosted by improved market sentiment regarding the economic outlook and the FOMC's sustained highly accommodative monetary policy, broad measures of equity prices continued posting substantial gains through the end of 2013. Around the turn of the year, however, investor sentiment deteriorated amid resurfacing concerns about emerging financial markets, and equity prices retraced some of their earlier increases. As of early February, broad measures of equity prices were more than 10 percent higher, on net, than their levels in the middle of 2013 (figure 33). Consistent with the developments in equity markets, the spreads of yields on corporate bonds to yields on Treasury securities of comparable maturities have narrowed, on net, since the middle of 2013. Spreads on syndicated loans have also narrowed some, and issuance of leveraged loans, boosted by strong demand from collateralized loan obligations, was generally strong in the second half of 2013.

While some broad equity price indexes touched all-time highs in nominal terms since the middle of 2013 and valuation metrics in some sectors appear stretched, valuation measures for the overall market are now generally at levels not far above their historical average levels, suggesting that, in aggregate, investors are not excessively optimistic in their attitudes toward equities. Implied volatility for the S&P 500 index, as calculated from option prices, generally remained low over the period; it has risen since early January but remains below the recent high reached during the debt ceiling standoff in the fall.

...and market sentiment toward financial institutions continued to strengthen as their capital and liquidity profiles improved

Market sentiment toward the financial sector continued to strengthen in the second half of 2013, reportedly driven in large part by improvements in banks' capital and liquidity profiles, as well as further improvements in asset quality. On average, equity prices of large domestic banks and insurance companies performed roughly in line with broader equity indexes (figure 33). The spreads on the credit default swap (CDS) contracts written on the debt of these firms generally narrowed. Among nonbank financial institutions, many hedge funds significantly underperformed benchmark indexes in the second half of 2013 and, according to responses to the Federal Reserve Board's December Senior Credit Officer Opinion Survey on Dealer Financing Terms, have reduced their use of leverage on net (figure 34). 7 The industry as a whole continued to see strong inflows, however, bringing its assets under management to an all-time high by the end of 2013.

Standard measures of profitability of bank holding companies (BHCs) were little changed in the third quarter of 2013, as large reductions in income from mortgage originations and revenue from fixed-income trading, as well as a sharp increase in litigation expenses, were offset primarily by decreases in provisions for loan losses and in employee compensation. Asset quality continued to improve for BHCs, with delinquency rates declining across a range of asset classes and the industry's net charge-off rate now close to pre-crisis levels (figure 35). Net interest margins remained about unchanged over the same period. (For further discussion of the financial condition of BHCs, see the box "Developments Related to Financial Stability.") Meanwhile, aggregate credit provided by commercial banks inched up in the second half of 2013 following the rise in longer-term interest rates (figure 36). Strong growth in loan categories that are more likely to have floating interest rates or shorter maturities--including C&I, CRE, and auto loans--was partly offset by runoffs in assets that have longer duration and so are more sensitive to increases in interest rates--including residential mortgages and some securities.

Developments Related to Financial Stability

Since the previous Monetary Policy Report, the Federal Reserve and other agencies took further regulatory steps to improve the safety of the financial system, including strengthening capital regulations, proposing new quantitative liquidity requirements for large financial institutions, and issuing a final rule implementing the Volcker rule, which restricts the proprietary trading activities of such firms. Moreover, the Federal Reserve added to the number of large bank holding companies (BHCs) evaluated by annual stress tests and has begun to supervise the nonbank financial companies Prudential; American International Group, Inc., or AIG; and GE Capital as a result of their designation by the Financial Stability Oversight Council as systemically important financial institutions. The vulnerability of the financial system to adverse shocks remained at a moderate level, as capital profiles at large BHCs improved further, use of financial leverage was relatively restrained, and valuations in most asset markets were broadly in line with historical norms. The Federal Reserve will continue its comprehensive monitoring of financial vulnerabilities.

The financial strength of the banking sector improved last year. BHCs have stabilized their capital ratios at levels significantly higher than prior to the financial crisis and roughly in line with new, tougher regulatory standards. For example, the ratio of Tier 1 common equity to risk-weighted assets at all BHCs has been around 13 percent, on average, over the past two years, 4 percentage points higher than the average prior to 2009. Moreover, the aggregate rate of charge-offs and delinquent loans continued to fall, reflecting improvement in the quality of loans originated and the strengthening in household and business balance sheets that has accompanied the economic recovery. Thirty large BHCs are currently undergoing the stress tests mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), the summary results of which will be released in March. These stress tests are supervisory tools that the Federal Reserve uses to help ensure that financial institutions have robust capital-planning processes and can maintain adequate capital even following an extended period of adverse macroeconomic conditions. Last year's stress tests found that large BHCs had continued to increase their resilience to adverse economic conditions since the financial crisis, and the ongoing testing regimen encourages BHCs' efforts to further improve their capital-planning processes. In addition, large BHCs' dependence on short-term funding, which proved highly unreliable during the crisis, continued to decrease last year.

At the same time, litigation expenses at large BHCs increased. During 2013, several BHCs entered into various consent orders and regulatory settlements that stemmed from their actions related to the financial crisis. Some, but not all, of the litigation was due to offerings of mortgage-backed securities (MBS). Civil and criminal penalties resulted in significant increases to noninterest expense items that diminished net profits for the year. One BHC saw its net profit turn negative in the third quarter of 2013 as a result of litigation expenses of more than $10 billion, or 18 percent of total expenses for the period. Although the analyst community believes that litigation expenses should decrease, the risk to profitability remains.

Market-based measures indicate that banks are seen by investors as stronger. Bank stock prices have continued to rise, on net, and premiums on BHC credit default swaps (CDS) remain relatively low. Similarly, systemic risk measures for these firms--which also are based on the correlations between their stock prices and the broader market--continued to decline.

More broadly, aggregate measures of financial leverage, including the use of short-term wholesale debt, have remained subdued. The provision and use of dealer-intermediated leverage to fund securities appear moderate. In addition, while issuance in private securitization markets has continued to rebound, it is far below the peak reached before the crisis. Of particular note was the growth in collateralized loan obligations that securitize pools of leveraged loans. Regulators have addressed some risks posed by shadow banking--financial intermediation outside the insured depository system; steps in this regard include requiring banks to recognize exposures to off-balance-sheet vehicles and to hold liquidity buffers when they provide credit or liquidity facilities. Still, it is important to make progress on other ongoing reform efforts to fix remaining structural vulnerabilities in short-term funding markets.

While the extended period of low interest rates has contributed to improved economic conditions, it could also lead investors to "reach for yield" through, for example, excessive leverage, duration risk, or credit risk. Prices for corporate equities have risen and spreads for corporate bonds have narrowed, but valuations for broad indexes for these markets do not appear stretched by historical standards. Some reach-for-yield behavior is evident in the lower-rated corporate debt markets. Over the past year, issuance of syndicated leveraged loans and high-yield bonds has surged and underwriting standards have deteriorated. Federal banking regulators issued supervisory guidance on leveraged lending practices, and followed up with banks in the fall, in order to mitigate the buildup of risky debt at banks.

The rise in interest rates and volatility since last spring may have led investors to adjust their risk positions. For example, estimated term premiums on longer-term Treasury securities rose, and intermediate and long-term bond mutual funds have experienced sizable outflows since the spring, after receiving strong inflows for the past several years. Increasing interest rates caused losses for real estate investment trusts specializing in agency MBS (agency REITs), which fund purchases of agency MBS mostly using relatively short-term repurchase agreements, implying extensive maturity transformation. The rise in interest rates prompted agency REITs to sell assets, reducing the overall amount of leverage used in the agency MBS market. At the largest banking firms, supervisors have been evaluating interest rate risk and are working with institutions to improve their risk-management practices so that they are prepared for unexpected changes in interest rates.

Important regulatory steps have been taken since the previous report, of which several are highlighted here. First, together with other federal agencies, the Federal Reserve issued a final rule implementing the Volcker rule designed to further reduce moral hazard in the financial system. The Volcker rule prohibits banking entities from engaging in short-term proprietary trading in securities, derivatives, commodity futures, and options on these instruments. The rule also imposes limits on banking entities' investments in hedge funds and private equity funds. Exemptions are provided for certain activities, including market making, underwriting, hedging, trading in government obligations, insurance company activities, and organizing and offering hedge funds or private equity funds for clients.

Furthermore, the Federal Reserve Board recently proposed a rule that would strengthen the liquidity positions of large and internationally active financial institutions by enforcing a quantitative liquidity requirement, called the liquidity coverage ratio, for the first time. Liquidity is essential to a bank's viability and the smooth functioning of the financial system. In conjunction with other reforms, this new rule would foster a more resilient and safer financial system.

In addition, the Federal Reserve Board, after completing the regulations to implement Basel III and Dodd-Frank Act regulatory capital reforms in July, is working to finalize the remaining enhanced prudential standards mandated by section 165 of the Dodd-Frank Act, with stricter regulatory and supervisory requirements for large BHCs and foreign banking organizations with a U.S. presence. The rules include requirements for risk-based capital, leverage, liquidity, and stress tests. The Federal Reserve also is working to propose a regulation to implement the Basel Committee on Banking Supervision risk-based capital surcharge framework for global systemically important banks.

Finally, the Federal Reserve and other financial regulatory agencies are working to move forward earlier proposals to address risks from derivatives transactions, now that a global framework for margining noncleared derivatives has been established by the Basel Committee.

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Financial conditions in the municipal bond market generally remained stable

Yields on 20-year general obligation municipal bonds rose since June 2013. However, the spreads of municipal bond yields over those of comparable-maturity Treasury securities generally fell over the same period, and CDS spreads on debt obligations of individual states were generally little changed and remained at moderate levels.

Nevertheless, significant financial strains have been evident for some issuers. For example, the City of Detroit filed for bankruptcy in July 2013, making it the largest municipal bankruptcy filing in U.S. history. In addition, the prices of bonds issued by Puerto Rico continued to reflect the substantial financial pressures facing the territory and the spreads for five-year CDS contracts written on the debt issued by the territory soared. In early February, some of the territory's bonds were downgraded to below the investment grade.

M2 rose briskly

M2 has increased at an annual rate of about 7-1/2 percent since June, faster than the pace registered in the first half of 2013. Flows into M2 picked up amid the selloff in fixed-income markets in the summer, which prompted large outflows from bond funds, as well as the uncertainty about the passage of debt limit legislation in the fall, which appeared to have led some institutional investors to shift from money fund shares to bank deposits. Following the resolution of the fiscal standoff, M2 growth slowed significantly as investors reallocated out of cash positions.

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International Developments

Bond yields rose sharply in some emerging market economies, but were flat to down in most advanced foreign economies

Foreign long-term bond yields rose significantly from May of last year through most of the summer, as expectations of an imminent reduction in the pace of large-scale asset purchases by the Federal Reserve intensified (figure 37). In many EMEs, yields stabilized after the September FOMC meeting. However, in a handful of vulnerable EMEs, sovereign yields continued to exhibit outsized increases--particularly in Brazil and Turkey--and, more recently, EME yields generally moved up as several EMEs experienced heightened financial stresses (see the box "Financial Stress and Vulnerabilities in the Emerging Market Economies"). Rates in the advanced foreign economies (AFEs) rose slightly on balance during the second half of 2013, with improved economic conditions generally supporting yields. In particular, bond yields increased in the United Kingdom as unemployment fell more quickly than anticipated. In the euro area, yields were little changed, as below-target inflation led the European Central Bank (ECB) to cut its main refinancing rate a further 25 basis points in November. In contrast, Japanese government bond yields were down modestly, on net, since mid-July, in part as market participants anticipated that the Bank of Japan (BOJ) would expand the size of its asset purchase program. Over the past two weeks, however, AFE sovereign yields in general declined somewhat, as market participants pulled back from risky assets.

Financial Stress and Vulnerabilities in the Emerging Market Economies

Many emerging market economies (EMEs) have experienced heightened financial stresses since April of last year. EME-dedicated international bond and equity funds sustained substantial outflows, and many EME currencies depreciated sharply against the dollar figure A). At the same time, EME government bond yields rose abruptly and by much more than U.S. Treasury bond yields. Financial conditions in the EMEs generally stabilized after September, but financial stresses have flared up again in recent weeks, with many currencies experiencing another bout of depreciation.

The stresses that arose in the middle of last year appeared to be triggered to a significant degree by Federal Reserve communications indicating that the Federal Reserve would likely start reducing its large-scale asset purchases later in the year. Some of the selloff in EME assets may have been due to the unwinding of carry trades that investors had entered into earlier to take advantage of higher EME interest rates than those prevailing in the advanced economies. These trades appeared profitable so long as EME currencies remained stable or were expected to appreciate. But when anticipations of a slowing in the pace of Federal Reserve asset purchases led to higher U.S. interest rates as well as higher market volatility, these trades may have been quickly reversed, engendering sharper declines in EME currencies and asset prices.

In December, when the Federal Reserve actually announced a reduction in asset purchases, the reaction of financial markets in the EMEs was relatively muted. Then, in late January, volatility in these markets returned. Unlike last summer, there was little change in expectations regarding U.S. monetary policy during this time. Rather, a few adverse developments--including a weaker-than-expected reading on Chinese manufacturing, a devaluation of the Argentine peso, and Turkey's intervention to support its currency--triggered the renewed turbulence in the EME financial markets. This turbulence appeared to spill over to bond and equity markets in advanced economies, as market participants pulled back from risky assets.

Both last year and more recently, the deterioration in financial conditions varied across the EMEs, suggesting that, even as the selloff of EME assets was in part driven by common factors, investors nonetheless were also responding to differences in these economies' situations. Brazil, India, Indonesia, South Africa, and Turkey are among the economies that appear to have been the most affected. For example, the currencies of Brazil, India, and Turkey dropped sharply in the middle of last year, whereas the currencies of Korea and Taiwan were more resilient (as shown in figure A). And in recent weeks, although EME currencies sold off broadly, EME bond yields tended to increase the most in economies that saw the largest rises during 2013.

To a considerable extent, investors appear to have been differentiating among EMEs based on their economic vulnerabilities. The scatterplot in figure B shows the link between the degree of relative vulnerability across EMEs as implied by a simple index (plotted on the horizontal axis) and one measure of financial market stress, the percent change in the value of EME currencies against the dollar since the end of April (plotted on the vertical axis). The index is constructed for a sample of 15 EMEs and is based on six indicators: (1) the ratio of the current account balance to gross domestic product (GDP), (2) the ratio of gross government debt to GDP, (3) average annual inflation over the past three years, (4) the change over the past five years of bank credit to the private sector as a share of GDP, (5) the ratio of total external debt to annualized exports, and (6) the ratio of foreign exchange reserves to GDP. 1 By construction, higher values of the index indicate a greater degree of vulnerability. The figure indicates that those economies that appear relatively more vulnerable according to the index also experienced larger currency depreciations. Moreover, the more vulnerable EMEs have also suffered larger increases in government bond yields since late April (not shown). This evidence is consistent with the view that reducing the extent of economic vulnerabilities is important if EMEs are to become more resilient to external shocks, including those emanating from financial developments in the advanced economies.

Indeed, policymakers in many EMEs made sustained efforts, following the crises of the 1990s, to improve their policy frameworks and reduce their vulnerabilities to external funding shocks. These efforts included taming rampant inflation, allowing greater exchange rate flexibility, reducing external indebtedness, and building holdings of foreign exchange reserves. As a result, the degree of vulnerability across economies appears to be materially lower compared with past episodes of widespread EME crisis, even for those economies that currently appear relatively more vulnerable. These improvements should leave many EMEs better positioned than in the past to manage volatility in financial markets.

That said, a number of EMEs continue to harbor significant economic and financial vulnerabilities, and even economies in somewhat stronger positions face the challenge of bolstering investor confidence in a jittery environment. To be sure, in response to bouts of turbulence since last summer, authorities in EMEs have taken steps to stabilize their markets and enhance their resilience. For example, some central banks interrupted their plans to continue easing in the middle of last year, fearing further outflows of capital and additional disruptive currency depreciations that could exacerbate inflationary pressures. Brazil, India, and Turkey, among other EMEs, have raised their policy rates since then. In addition, some EME central banks have intervened in foreign exchange markets to support their currencies. To help stabilize financial markets, Brazil and Indonesia relaxed some of the restrictions on capital inflows that they imposed during the recovery from the global financial crisis, when inflows surged. India and Indonesia also imposed measures, such as import restrictions, to curb their current account deficits.

Nevertheless, beyond these stopgap measures, continued progress implementing monetary, fiscal, and structural reforms will be needed in some EMEs to help remedy fundamental vulnerabilities, put the EMEs on a firmer footing, and make them more resilient to a range of economic shocks. Such reforms will take time, and global investors will be watching their progress closely.


1. The sample of 15 EMEs comprises Brazil, Chile, China, Colombia, India, Indonesia, Malaysia, Mexico, the Philippines, Russia, South Africa, South Korea, Taiwan, Thailand, and Turkey. Return to text

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The dollar has appreciated a little on net

The broad nominal value of the dollar is up a little, on net, since last summer (figure 38). The dollar depreciated against both the euro and the British pound in the second half of the year, as macroeconomic conditions improved in Europe and as financial stresses and the associated flight to safety continued to abate. However, the dollar has appreciated sharply against the Japanese yen since October, in part reflecting anticipations of an expansion in the BOJ's asset purchase program, although it retraced somewhat in recent weeks amid the recent turbulence in emerging financial markets. The U.S. dollar also appreciated against the currencies of some vulnerable EMEs amid higher long-term yields in the United States, and, more recently, as market participants expressed concerns about developments in several economies (figure A in box on EMEs). EME-dedicated bond and equity funds experienced outflows over the second half of last year and into 2014, suggesting a reduced willingness by investors to maintain exposures to EMEs. In an attempt to curb the depreciation of their currencies, central banks in some EMEs, such as Brazil and Turkey, intervened in currency markets.

During the second half of 2013, equity indexes in the AFEs added considerably to earlier gains, likely reflecting the improved economic outlook (figure 39). Over the year as a whole, equity markets in Japan outperformed other foreign indexes, increasing more than 50 percent. Since the end of last year, however, AFE equity indexes have reversed part of their earlier gains, with the decrease coinciding with heightened financial volatility in the EMEs. Equity markets in the EMEs, after underperforming those in the AFEs during the second half of last year, have also fallen more recently.

Activity in the advanced foreign economies continued to recover...

Indicators suggest that economic growth in the AFEs edged higher in the second half of 2013, supported by diminished fiscal drag and further easing of European financial stresses (figure 40). The euro area continued to pull slowly out of recession in the third quarter, with some of the most vulnerable economies returning to positive growth, but unemployment remained at record levels. Real GDP growth in the United Kingdom picked up to a robust 3 percent pace in the second half of last year, driven in part by improving household and business sentiment, and Canadian growth rebounded in the third quarter after being restrained by floods that impeded economic activity in the second quarter. Japanese GDP growth stepped down in the third quarter from the rapid 4 percent pace registered in the first half, as exports dipped and household spending moderated, but data on manufacturing and exports suggest that growth rebounded toward year-end.

Amid stronger growth and rising import prices, Japanese inflation moved above 1 percent for the first time since 2008. In contrast, 12-month rates of inflation fell below 1 percent in some other AFEs, with much of this decline reflecting falling retail energy and food prices as well as continued economic slack. With inflation low and economic activity still sluggish, monetary policy in the AFEs remains very accommodative. In addition to the ECB's cut of its main refinancing rate in November, the Bank of England issued forward guidance in August that it intends to maintain a highly stimulative policy stance until economic slack has been substantially reduced, while the BOJ continued its aggressive program of asset purchases.

...while growth in the emerging market economies moved back up from its softness earlier last year

After slowing earlier last year, economic growth in the EMEs moved back up in the third quarter, reflecting a rebound of Mexican activity from its second-quarter contraction and a pickup in emerging Asia. Recent data suggest that activity in EMEs continued to strengthen in the fourth quarter.

In China, economic growth picked up in the second half of 2013, supported in part by relatively accommodative policies and rapid credit growth earlier in the year. Since the middle of last year, the pace of credit creation has slowed, interbank interest rates have trended up, and the interbank market has experienced bouts of volatility during which interest rates spiked. In mid-November, Chinese leaders unveiled an ambitious reform agenda that aims to enhance the role of markets in the economy, address worrisome imbalances, and improve the prospects for sustainable economic growth.

The step-up in Chinese growth, along with firmer activity in the advanced economies, generally helped support economic activity in other parts of Asia. In Mexico, growth appears to have rebounded in the second half of the year, supported by higher government spending and a pickup in U.S. manufacturing activity. In recent months, Mexico continued to make progress on the government's reform agenda, with its Congress approving fiscal, energy, and financial sector reforms. By contrast, in some EMEs, such as Brazil, India, and Indonesia, shifts in market expectations about the path of U.S. monetary policy appear to have resulted in tightened financial conditions, which weighed on growth over the second half of last year.

Inflation remained subdued in most EMEs, and their central banks generally kept policy rates on hold or, as in Chile, Mexico, and Thailand, cut them to further support growth. In contrast, inflation remained elevated in a few EMEs, such as Brazil, India, Indonesia, and Turkey, due to currency depreciation as well as country-specific factors, including supply bottlenecks and tight labor market conditions in some sectors. In response to higher inflation, central banks in these countries raised rates and, in some cases, intervened in foreign exchange markets to support their currencies.

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1. The question in the Michigan survey asks about inflation generally but does not refer to any specific price index. Return to text

2. Conceptually, GDI and GDP should be equal, but because they are measured with different source data, they can send different signals about growth in U.S. economic output. Return to text

3. Through a reduction in hours worked by federal employees, the shutdown is estimated to have directly reduced real GDP growth about 1/4 percentage point at an annual rate in the fourth quarter. This influence is likely to be reversed in the first quarter of 2014. Return to text

4. The SLOOS is available on the Board's website at Return to text

5. The results of the Survey of Primary Dealers are available on the Federal Reserve Bank of New York's website at  Leaving the Board . Return to text

6. A dollar roll transaction consists of a purchase or sale of agency MBS with a simultaneous agreement to sell or purchase substantially similar securities on a specified future date. The Committee directs the Desk to engage in these transactions as necessary to facilitate settlement of the Federal Reserve's agency MBS purchases. Return to text

7. The Senior Credit Officer Opinion Survey on Dealer Financing Terms is available on the Board's website at Return to text

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Last update: February 11, 2014