Board of Governors of the Federal Reserve System

Monetary Policy and Economic Developments

The Federal Reserve conducts the nation's monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. This section reviews U.S. monetary policy and economic developments in 2021, with excerpts and select figures from the Monetary Policy Report published in February 2022 and July 2021.¹ The report, submitted semiannually to the Congress, is delivered concurrently with testimony from the Federal Reserve Board Chair.²

February 2022 Summary

U.S. economic activity posted further impressive gains in the second half of last year, but inflation rose to its highest level since the early 1980s. The labor market tightened substantially further amid high demand for workers and constrained supply, with the unemployment rate reaching the median of Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level and nominal wages rising at their fastest pace in decades. With demand strong, and amid ongoing supply chain bottlenecks and constrained labor supply, inflation increased appreciably last year, running well above the FOMC's longer-run objective of 2 percent and broadening out to a wider range of items. As 2022 began, the rapid spread of the Omicron variant appeared to be causing a slowdown in some sectors of the economy, but with Omicron cases having declined sharply since mid-January, the slowdown is expected to be brief.

Over the second half of last year, the FOMC held its policy rate near zero to support the continued economic recovery. The Committee began phasing out net asset purchases in November and accelerated the pace of the phaseout in December; net asset purchases will end in early March. With inflation well above the FOMC's longer-run objective and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.

Recent Economic and Financial Developments

Economic activity and the labor market. In the second half of 2021, gross domestic product (GDP) growth slowed somewhat from its brisk first-half pace but nevertheless rose at a solid annualized rate of 4.6 percent. Average monthly job gains remained robust at 575,000 in the second half (figure 2.1). The unemployment rate has plummeted almost 2 percentage points since June and, at 4 percent in January, has reached the median of FOMC participants' estimates of its longer-run normal level. Moreover, unemployment declines have been widespread across demographic groups (figure 2.2). That said, labor force participation only crept up last year and remains constrained. The tight labor supply, in conjunction with a continued surge in labor demand, has resulted in strong nominal wage growth, especially for low-wage workers. Supply bottlenecks also continued to significantly limit activity throughout the second half, while the Delta and Omicron waves led to notable, but apparently temporary, slowdowns in activity.

Inflation. The personal consumption expenditures (PCE) price index rose 5.8 percent over the 12 months ending in December, and the index that excludes food and energy items (so-called core inflation) was up 4.9 percent—the highest readings for both measures in roughly 40 years (figure 2.3). Upward pressure on inflation from prices of goods experiencing both supply chain bottlenecks and strong demand, such as motor vehicles and furniture, has persisted, and elevated inflation has broadened out to a wider range of items. Services inflation has also stepped up further, reflecting strong wage growth in some service sectors and a significant increase in housing rents. While measures of near-term inflation expectations moved substantially higher over the course of last year, measures of longer-term inflation expectations have moved up only modestly; they remain in the range observed over the decade before the pandemic and thus appear broadly consistent with the FOMC's longer-run inflation objective of 2 percent.

Financial conditions. Yields on nominal Treasury securities across maturities increased notably since mid-2021, with much of the increase having occurred in the past couple of months, as the expected timing for the beginning of the removal of monetary policy accommodation has moved forward significantly. Equity prices decreased slightly, on net, and corporate bond yields rose but remain low, with stable corporate credit quality. Financing conditions for consumer credit continue to be largely accommodative except for borrowers with low credit scores. Mortgage rates for households remain low despite recent increases. Bank lending standards have eased across most loan categories, and bank credit has expanded. All told, financing conditions have been accommodative for businesses and households.

Financial stability. While some financial vulnerabilities remain elevated, the large banks at the core of the financial system continue to be resilient. Measures of valuation pressures on risky assets remain high compared with historical values. Nonfinancial-sector leverage has broadly declined, and credit growth in the household sector has been driven almost exclusively by residential mortgages and auto loans to prime-rated borrowers. Vulnerabilities from financial-sector leverage are within their historical range, with relatively lower leverage at banks partially offset by higher leverage at life insurers and hedge funds. Funding markets remain stable. Domestic banks continue to maintain significant levels of high-quality liquid assets, while assets under management at prime and tax-exempt money market funds have declined further since mid-2021. The Federal Reserve continues to evaluate the potential systemic risks posed by hedge funds and digital assets and is closely monitoring the transition away from LIBOR. (See the box "Developments Related to Financial Stability" on pages 34–35 of the February 2022 Monetary Policy Report.)

International developments. Foreign GDP has continued to recover briskly, on balance, despite successive waves of the pandemic, which have been mirrored in slowdowns and rebounds in economic activity. This recovery has been supported by vaccination rates that have steadily increased in both advanced foreign economies (AFEs) and emerging market economies (EMEs). Inflation rose notably in many economies in the second half of last year, importantly boosted by higher energy and other commodity prices as well as supply chain constraints. Several emerging market foreign central banks and a few advanced-economy foreign central banks have raised policy rates, though foreign monetary and fiscal policies have generally continued to be accommodative.

Foreign financial conditions have tightened modestly but are generally contained. In AFEs, sovereign yields have increased since the first half of last year on firming expectations for higher policy rates. The change in financial conditions in EMEs has been relatively muted in the face of the shift in monetary policy in some advanced economies. The trade-weighted value of the dollar appreciated modestly, on net, over the past six months. Recent geopolitical tensions related to the Russia–Ukraine situation are a source of uncertainty in global financial and commodity markets.

Monetary Policy

Interest rate policy. The FOMC has continued to keep the target range for the federal funds rate at 0 to 1/4 percent since the previous Monetary Policy Report (figure 2.4). With inflation well above the Committee's 2 percent longer-run goal and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.

Balance sheet policy. From June 2020 until November 2021, the Federal Reserve expanded its holdings of Treasury securities by $80 billion per month and its holdings of agency mortgage-backed securities by $40 billion per month. In December 2020, the Committee indicated that it would continue to increase its holdings of securities at least at this pace until the economy had made substantial further progress toward its maximum-employment and price-stability goals. Last November, the Committee judged that this criterion had been achieved and began to reduce the monthly pace of its net asset purchases. In December, in light of inflation developments and further improvements in the labor market, the Committee announced it would double the pace of reductions in its monthly net asset purchases. At its January meeting, the FOMC decided to continue to reduce its net asset purchases at this accelerated pace, which will bring them to an end in early March, and issued a statement of principles for its planned approach for significantly reducing the size of the Federal Reserve's balance sheet.³ A number of participants at the meeting commented that conditions would likely warrant beginning to reduce the size of the balance sheet sometime later this year.⁴

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee is firmly committed to its price-stability and maximum-employment goals and is prepared to use its tools to prevent higher inflation from becoming entrenched while promoting a sustainable expansion and strong labor market.

Special Topics

Low labor supply. Labor supply has been slow to rebound even as labor demand has been remarkably strong. The labor force participation rate remains well below estimates of its longer-run trend, principally reflecting a wave of retirements among older individuals and increases in the number of people out of the labor force and engaged in caregiving responsibilities. The ongoing pandemic has also affected labor supply through fear of the virus or the need to quarantine. Moreover, savings buffers accumulated during the pandemic may have enabled some people to remain out of the labor force. (See the box "The Limited Recovery of Labor Supply" on pages 8–9 of the February 2022 Monetary Policy Report.)

Wage and employment growth across jobs and workers. Wage and employment gains were widespread across jobs and industries last year, with the lowest-wage jobs experiencing the largest gains in both median wages and employment. Wage growth in the leisure and hospitality industry accelerated sharply, which, together with a lagging employment rebound and high job openings, suggests a lack of available workers in the industry. Median wages also increased across racial and ethnic groups, leaving differences in wage levels across groups little changed relative to 2019. (See the box "Differences in Wage and Employment Growth across Jobs and Workers" on pages 11–12 of the February 2022 Monetary Policy Report.)

Broadening of inflation. Higher PCE price inflation broadened out over the course of 2021, with the share of products experiencing notable price increases moving appreciably higher. The broadening was evident in both goods and services, though most of last year's very high inflation readings were concentrated in goods, a reflection of the strong demand and supply bottlenecks that have particularly affected these items. (See the box "How Widespread Has the Rise in Inflation Been?" on pages 15–17 of the February 2022 Monetary Policy Report.)

Supply bottlenecks. Supply chain bottlenecks have plagued the economy for much of the past year. Against a backdrop of robust demand for goods, global distribution networks have been strained, and domestic manufacturers have had trouble finding the materials and labor needed to fill orders for their products. U.S. ports have been congested amid record volumes of shipping, and delivery times for materials have remained elevated. Supply shortages of semiconductors have been particularly acute and have weighed heavily on motor vehicle production and sales. While there are some signs of improvement, general supply chain bottlenecks are not expected to resolve for some time. (See the box "Supply Chain Bottlenecks in U.S. Manufacturing and Trade" on pages 19–21 of the February 2022 Monetary Policy Report.)

Developments in the Federal Reserve's balance sheet. The size of the Federal Reserve's balance sheet continued to grow, albeit at a slower rate given the reduced monthly pace of net asset purchases since November. However, reserve balances—the largest liability on the Federal Reserve's balance sheet—were little changed, on net, reflecting growth in nonreserve liabilities such as currency and overnight reverse repurchase agreements (ON RRP). The elevated level of reserves continued to put broad downward pressure on short-term interest rates, while the decline in Treasury bill supply over 2021 has contributed to a shortage of short-term investments. Amid these developments, the ON RRP facility continued to serve its intended purpose of helping to provide a floor under short-term interest rates and support effective implementation of monetary policy. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets" on pages 44–45 of the February 2022 Monetary Policy Report.)

July 2021 Summary

Over the first half of 2021, progress on vaccinations has led to a reopening of the economy and strong economic growth, supported by accommodative monetary and fiscal policy. However, the effects of the COVID-19 pandemic have continued to weigh on the U.S. economy, and employment has remained well below pre-pandemic levels. Furthermore, shortages of material inputs and difficulties in hiring have held down activity in a number of industries. In part because of these bottlenecks and other largely transitory factors, personal consumption expenditures (PCE) prices rose 3.9 percent over the 12 months ending in May.

Over the first half of the year, the Federal Open Market Committee (FOMC) held its policy rate near zero and continued to purchase Treasury securities and agency mortgage-backed securities to support the economic recovery. These measures, along with the Committee's guidance on interest rates and the Federal Reserve's balance sheet, will help ensure that monetary policy continues to deliver powerful support to the economy until the recovery is complete.

Recent Economic and Financial Developments

The labor market. The labor market continued to recover over the first six months of 2021. Job gains averaged 540,000 per month, and the unemployment rate moved down from 6.7 percent in December to 5.9 percent in June. Although labor market improvement has been rapid, the unemployment rate remained elevated in June, and labor force participation has not moved up from the low rates that have prevailed for much of the past year. A surge in labor demand that has outpaced the recovery in labor supply has resulted in a jump in job vacancies and a step-up in wage gains in recent months.

Inflation. Consumer price inflation, as measured by the 12-month change in the PCE price index, moved up from 1.2 percent at the end of last year to 3.9 percent in May. The 12-month measure of inflation that excludes food and energy items (so-called core inflation) was 3.4 percent in May, up from 1.4 percent at the end of last year. Some of the strength in recent 12-month inflation readings reflects the comparison of current prices with prices that sank at the onset of the pandemic as households curtailed spending—a transitory result of "base effects." More lasting but likely still temporary upward pressure on inflation has come from prices for goods experiencing supply chain bottlenecks, such as motor vehicles and appliances. In addition, prices for some services, such as airfares and lodging, have moved up sharply in recent months toward more normal levels as demand has recovered. Both survey-based and market-based measures of longer-term inflation expectations have risen since the end of last year, largely reversing the downward drift in those measures in recent years, and are in a range that is broadly consistent with the FOMC's longer-run inflation objective.

Economic activity. In the first quarter, real gross domestic product (GDP) increased 6.4 percent, propelled by a surge in household consumption and a solid increase in business investment but restrained by a substantial drawdown in inventories as firms contended with production bottlenecks. Data for the second quarter suggest a further robust increase in demand. Against a backdrop of elevated household savings, accommodative financial conditions, ongoing fiscal support, and the reopening of the economy, the strength in household spending has persisted, reflecting continued strong spending on durable goods and solid progress toward more normal levels of spending on services.

Financial conditions. Since mid-February, equity prices and yields on nominal Treasury securities at longer maturities increased, as the rapid deployment of highly effective COVID-19 vaccines in the United States and the support provided by fiscal policy boosted optimism regarding the economic outlook. Despite having increased since February, mortgage rates for households remain near historical lows. Overall financing conditions for businesses and households eased further since February, as market-based lending conditions remained accommodative and bank-lending conditions eased markedly. Large firms, as well as those households that have solid credit ratings, continued to experience ample access to financing. However, financing conditions remained tight for small businesses and households with low credit scores.

Financial stability. While some financial vulnerabilities have increased since the previous Monetary Policy Report, the institutions at the core of the financial system remain resilient. Asset valuations have generally risen across risky asset classes with improving fundamentals as well as increased investor risk appetite, including in equity and corporate bond markets. Vulnerabilities from both business and household debt have continued to decline in the first quarter of 2021, reflecting a slower pace of business borrowing, an improvement in business earnings, and government programs that have supported business and household incomes. Even so, business-sector debt outstanding remains high relative to income, and some businesses and households are still under considerable strain. In the financial sector, leverage at banks and broker-dealers remains low, while available measures of leverage at hedge funds increased into early 2021 and are high. Issuance volumes of collateralized loan obligations and asset-backed securities recovered strongly through the first quarter of 2021, while issuance of non-agency commercial mortgage-backed securities was weak in that quarter. Funding risks at domestic banks continued to be low in the first quarter, but structural vulnerabilities persist at some types of money market funds and bank-loan and bond mutual funds. (See the box "Developments Related to Financial Stability" on pages 30–32 of the July 2021 Monetary Policy Report.)

International developments. Foreign GDP growth moderated at the start of the year, as some countries tightened public health restrictions to contain renewed COVID-19 outbreaks. Compared with last spring, many foreign economies exhibited greater resilience to public-health-related restrictions, and their governments have continued to provide fiscal support. Recent indicators suggest a pickup in activity in advanced foreign economies (AFEs) this spring following an increase in vaccination rates and an easing of restrictions. However, conditions in emerging market economies (EMEs) are more mixed, in part dependent on their success in containing outbreaks and the availability of vaccines. Inflation has been rising in many economies, as the price declines seen last spring reversed and commodity prices ramped up. Monetary and fiscal policies continue to be supportive, but some foreign central banks are adopting or signaling less-accommodative policy stances.

Foreign financial conditions generally improved or held steady. Equity prices and longer-term sovereign yields increased across AFEs, boosted by their ongoing reopening. Equity markets in EMEs were mixed, and flows into dedicated emerging market funds slowed. After trending lower since the spring of 2020, the foreign exchange value of the dollar has changed little, on net, since the start of the year.

Monetary Policy

Interest rate policy. To continue to support the economic recovery, the FOMC has kept the target range for the federal funds rate near zero and has maintained the monthly pace of its asset purchases. The Committee expects it will be appropriate to maintain the current target range for the federal funds rate until labor market conditions have reached levels consistent with its assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed that rate for some time.

Balance sheet policy. With the federal funds rate near zero, the Federal Reserve has also continued to undertake asset purchases, increasing its holdings of Treasury securities by $80 billion per month and its holdings of agency mortgage-backed securities by $40 billion per month. These purchases help foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses. The Committee expects these purchases to continue at least at this pace until substantial further progress has been made toward its maximum-employment and price-stability goals. In coming meetings, the Committee will continue to assess the economy's progress toward these goals since the Committee adopted its asset purchase guidance last December.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee is prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals.

Special Topics

The uneven recovery in labor force participation. The labor force participation rate (LFPR) has improved very little since early in the recovery and remains well below pre-pandemic levels. Relative to its February 2020 level, the LFPR remains especially low for individuals without a college education, for individuals aged 55 and older, and for Hispanics and Latinos. Factors likely contributing both to the incomplete recovery of the LFPR and to differences across groups include a surge in retirements, increased caregiving responsibilities, and individuals' fear of contracting COVID-19; expansions to the availability, duration, and level of unemployment insurance benefits may also have supported individuals who withdrew from the labor force. Many of these factors should have a diminishing effect on participation in the coming months as public health conditions continue to improve and as expanded unemployment insurance expires. (See the box "The Uneven Recovery in Labor Force Participation" on pages 8–10 of the July 2021 Monetary Policy Report.)

Recent inflation developments. Consumer price inflation has increased notably this spring as a surge in demand has run up against production bottlenecks and hiring difficulties. As these extraordinary circumstances pass, supply and demand should move closer to balance, and inflation is widely expected to move down. (See the box "Recent Inflation Developments" on pages 13–14 of the July 2021 Monetary Policy Report.)

Supply chain bottlenecks in U.S. manufacturing and trade. Supply chain bottlenecks have hampered U.S. manufacturers' ability to procure the inputs needed to meet the surge in demand that followed widespread factory shutdowns during the first half of last year. Additionally, a massive influx of goods has exceeded the capacity of U.S. ports, extending manufacturers' wait times for imported parts. The stress on supply chains is reflected in historically high order backlogs and historically low customer inventories; these stresses, together with strong demand, have led to increased price pressures. When these bottlenecks will resolve is uncertain, as they reflect the global supply chain as well as industry-specific factors, but for some goods, such as lumber, the previous sharp increases in prices have begun to reverse. (See the box "Supply Chain Bottlenecks in U.S. Manufacturing and Trade" on pages 15–17 of the July 2021 Monetary Policy Report.)

Inflation expectations. To avoid sustained periods of unusually low or high inflation, a fundamental aspect of the FOMC's monetary policy framework is for longer-term inflation expectations to be well anchored at the Committee's 2 percent longer-run inflation objective. Even though the pace of price increases has jumped in the first half of this year, recent readings on various measures of inflation expectations indicate that inflation is expected to return to levels broadly consistent with the FOMC's 2 percent longer-run inflation objective after a period of temporarily higher inflation. That said, upside risks to the inflation outlook in the near term have increased. (See the box "Assessing the Recent Rise in Inflation Expectations" on pages 20–22 of the July 2021 Monetary Policy Report.)

Monetary policy rules. Simple monetary policy rules, which relate a policy interest rate to a small number of other economic variables, can provide useful guidance to policymakers. Many of the rules have prescribed strongly negative values of the federal funds rate since the start of the pandemic-driven recession. Because of the effective lower bound for the federal funds rate, the Federal Reserve's other monetary policy tools—namely, forward guidance and asset purchases—have been critical for providing the necessary support to the economy through this challenging period. (See the box "Monetary Policy Rules, the Effective Lower Bound, and the Economic Recovery" on pages 42–45 of the July 2021 Monetary Policy Report.)

The Federal Reserve's balance sheet. Since January, the growth in reserves, the drawdown of the Treasury General Account, and the surge in usage of the overnight reverse repurchase agreement (ON RRP) facility have significantly affected the composition of the Federal Reserve's liabilities. Against a backdrop of low short-term market interest rates and ample liquidity, the use of the ON RRP facility has increased substantially since April and has reached a recent high of nearly $1 trillion, compared with usage near zero in February. Factors contributing to this increase included the decline in Treasury bill supply, downward pressure on money market rates, and the recent technical adjustment to the Federal Reserve's administered rates. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets" on pages 46–47 of the July 2021 Monetary Policy Report.)

Footnotes