Monetary Policy Report submitted to the Congress on February 14, 2017, pursuant to section 2B of the Federal Reserve Act
Labor market conditions continued to strengthen over the second half of 2016. Payroll employment has continued to post solid gains, averaging 200,000 per month since last June, a touch higher than the pace in the first half of 2016, though down modestly from its 225,000-per-month pace in 2015. The unemployment rate has declined slightly since mid-2016; the 4.8 percent reading in January of this year was in line with the median of Federal Open Market Committee (FOMC) participants’ estimates of its longer-run normal level. The labor force participation rate has edged higher, on net, since midyear despite a structural trend that is moving down as a result of changing demographics of the population. In addition, wage growth seems to have picked up somewhat relative to its pace of a few years ago.
Consumer price inflation moved higher last year but remained below the FOMC’s longer-run objective of 2 percent. The price index for personal consumption expenditures (PCE) increased 1.6 percent over the 12 months ending in December, 1 percentage point more than in 2015, importantly reflecting that energy prices have turned back up and declines in non-oil import prices have waned. The PCE price index excluding food and energy items, which provides a better indication than the headline index of where overall inflation will be in the future, rose 1.7 percent over the 12 months ending in December, about 1/4 percentage point more than its increase in 2015. Meanwhile, survey-based measures of longer-run inflation expectations have remained generally stable, though some are at relatively low levels; market-based measures of inflation compensation have moved up in recent months but also are at low levels.
Real gross domestic product is estimated to have increased at an annual rate of 2 3/4 percent in the second half of the year after rising only 1 percent in the first half. Consumer spending has been expanding at a moderate pace, supported by solid income gains and the ongoing effects of increases in wealth. The housing market has continued its gradual recovery, and fiscal policy at all levels of government has provided a modest boost to economic activity. Business investment had been weak for much of 2016 but posted larger gains toward the end of the year. Notwithstanding a transitory surge of exports in the third quarter, the underlying pace of exports has remained weak, a reflection of the appreciation of the dollar in recent years and the subdued pace of foreign economic growth.
Domestic financial conditions have generally been supportive of economic growth since mid-2016 and remain so despite increases in interest rates in recent months. Long-term Treasury yields and mortgage rates moved up from their low levels earlier last year but are still quite low by historical standards. Broad measures of stock prices rose, and the financial sector outperformed the broader equity market. Spreads of yields of both speculative- and investment-grade corporate bonds over yields of comparable-maturity Treasury securities declined from levels that were somewhat elevated relative to the past several years. Even with an ongoing easing in mortgage credit standards, mortgage credit is still relatively difficult to access for borrowers with low credit scores, undocumented income, or high debt-to-income ratios. Student and auto loans are broadly available, including to borrowers with nonprime credit scores, and the availability of credit card loans for such borrowers appears to have expanded somewhat over the past several quarters. In foreign financial markets, meanwhile, equities, bond yields, and the exchange value of the U.S. dollar have all risen, and risk spreads have generally declined since June.
Financial vulnerabilities in the U.S. financial system overall have continued to be moderate since mid-2016. U.S. banks are well capitalized and have sizable liquidity buffers. Funding markets functioned smoothly as money market mutual fund reforms took effect in October. The ratio of household debt to income has changed little in recent quarters and is still far below the peak level it reached about a decade ago. Nonfinancial corporate business leverage has remained elevated by historical standards even though outstanding riskier corporate debt declined slightly last year. In addition, valuation pressures in some asset classes increased, particularly late last year. The Federal Reserve has continued to take steps to strengthen the financial system, including finalizing a rule that imposes total loss-absorbing capacity and long-term debt requirements on the largest internationally active bank holding companies as well as concluding an extensive review of its stress-testing and capital planning programs.
In December, the FOMC raised the target for the federal funds rate to a range of 1/2 to 3/4 percent after maintaining it at 1/4 to 1/2 percent for a year. The decision to increase the federal funds rate reflected realized and expected labor market conditions and inflation. With the stance of monetary policy remaining accommodative, the Committee has anticipated some further strengthening in labor market conditions and a return of inflation to the Committee’s 2 percent objective.
The Committee has continued to emphasize that, in determining the timing and size of future adjustments to the target range for the federal funds rate, it will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. The Committee has expected that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate, and that the federal funds rate will likely remain, for some time, below levels that are expected to prevail in the longer run. Consistent with this outlook, in the most recent Summary of Economic Projections (SEP), which was compiled at the time of the December meeting of the FOMC, most participants projected that the appropriate level of the federal funds rate would be below its longer-run level through 2018. (The December SEP is included as Part 3 of this report.)
With respect to its securities holdings, the Committee has stated that it will continue to reinvest principal payments from its securities portfolio, and that it expects to maintain this policy until normalization of the level of the federal funds rate is well under way. This policy of keeping the Committee’s holdings of longer-term securities at sizable levels should help sustain accommodative financial conditions.
Statement on Longer-Run Goals and Monetary Policy Strategy
Adopted effective January 24, 2012; as amended effective January 31, 2017
The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.
Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee’s policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee’s goals.
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances. The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants’ estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC’s Summary of Economic Projections. For example, in the most recent projections, the median of FOMC participants’ estimates of the longer-run normal rate of unemployment was 4.8 percent.
In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.
The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January.