Part 1: Recent Economic and Financial Developments

Monetary Policy Report submitted to the Congress on July 7, 2017, pursuant to section 2B of the Federal Reserve Act

Domestic Developments

The labor market tightened further during the first half of the year...

Labor market conditions continued to strengthen in the first five months of this year. On average, payrolls expanded 162,000 per month between January and May, a little slower than the average monthly employment gain in 2016 but still more than enough to absorb new entrants to the labor force and therefore consistent with a further tightening of the labor market (figure 1). The unemployment rate has declined 0.4 percentage point since December 2016, and in May it stood at 4.3 percent, its lowest level since late 2000 and modestly below the median of Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level.

The labor force participation rate (LFPR)--that is, the share of adults either working or actively looking for work--was 62.7 percent in May and is little changed, on net, since early 2014 (figure 2). Along with other factors, the aging of the population implies a downward trend in participation, so the flattening out of the LFPR during the past few years is consistent with an overall picture of improving labor market conditions. The employment-to-population ratio--that is, the share of the population that is working--was 60 percent in May and has been increasing for the past couple of years, reflecting the combination of the declining unemployment rate and the flat LFPR.

The strengthening condition of the labor market is evident in other measures as well. The number of people filing initial claims for unemployment insurance has fallen to the lowest level in decades. In addition, as reported in the Job Openings and Labor Turnover Survey, the rate of job openings remained elevated in the first part of the year, while the rate of layoffs remained low; both are signs that firms' demand for labor is still solid. In addition, the rate of quits stayed high, an indication that workers are confident in their ability to obtain a new job. Another measure, the share of workers who are working part time but would prefer to be employed full time--which is part of the U-6 measure of underutilization from the Bureau of Labor Statistics--fell noticeably further in the first five months of 2017 (figure 3).

...though unemployment rates remain elevated for some demographic groups

Although the aggregate unemployment rate was at a 16-year low in May, there are substantial disparities across demographic groups (figure 4). Notably, the unemployment rate for whites averaged 4 percent during the first five months of the year, and the rate for Asians was about 3-1/2 percent. However, the unemployment rates for Hispanics (5.4 percent) and African Americans (7.8 percent) were substantially higher. The differences in the unemployment rates across racial and ethnic groups are long-standing, and they also vary over the business cycle. Indeed, the unemployment rates for blacks and Hispanics both rose considerably more than the rates for whites and Asians during the Great Recession, and their subsequent declines have been more rapid. On balance, however, the differences in unemployment rates across the groups have not narrowed relative to the pre-recession period. (For additional discussion on differences in economic outcomes by race and ethnicity, see the box "Does Education Determine Who Climbs the Economic Ladder?")

Does Education Determine Who Climbs the Economic Ladder?

The persistent gaps in economic outcomes by race and ethnicity in the United States raise important questions about how people ascend the economic ladder. Education, particularly a college degree, is often seen as a path to improved economic opportunities. Past research has shown that human capital in the form of education and experience can explain about one-third of the variation in wages across individuals.1 However, while education continues to be an important determinant of whether one can climb the economic ladder, sizable differences in economic outcomes across race and ethnicity remain even after controlling for educational attainment.

Data on earnings for two cohorts of young adult workers (aged 25 to 34) approximately a generation apart confirm both the gaps in economic outcomes and the lack of substantial upward progress for disadvantaged groups over the past quarter-century (figure A). People of this age typically have limited years of work experience, but most have completed their schooling. Therefore, focusing on young adults allows us to better isolate the effect of education from the influence of other variables, including experience. Furthermore, research has shown that the level of wages received early in an individual's career persists over time and influences that individual's wage trajectory for years to come.2 The figure shows the fraction of each group that has reached the top quartile of earnings for young adults as a whole. The black dashed line at 25 percent marks the fraction of each group that would be in this top quartile if each group were equally represented in proportion to its population size.3

Non-Hispanic whites, for example, are overrepresented in the top 25 percent of the earnings distribution of young adults for both cohorts, with just under 30 percent of the group in the top quartile in both the 1991-95 and 2011-15 periods. Black or African American young adults are underrepresented in the top quartile in both periods, at about 15 percent. Hispanics are likewise underrepresented, and again there has been little improvement over time. Asians stand out in terms of both high representation and changes over time, though these measures obscure the very high levels of inequality within this group.4

Overall, the representation of black and Hispanic workers in the top earnings quartile continues to lag in the later period. This lag in representation occurs despite the gains in educational attainment--the critical driver of improved incomes--that blacks and Hispanics have achieved over time. For both blacks and Hispanics, the share achieving a bachelor's degree or higher has doubled over the period of study (figure B). However, even with these improvements, the educational attainment gap between each of those groups and whites persists, because the fraction of whites attaining a bachelor's degree has also increased substantially in the past quarter-century.

Across all groups, it is true that completing a bachelor's degree or higher roughly doubles one's chances of reaching the top 25 percent of earners (figure C). This relationship strongly corroborates the conventional wisdom that, for many individuals, a college education can indeed represent a path to improved economic opportunities. However, even within this group, representation is substantially unequal, with college-educated white and Asian people much more likely to achieve the top quartile of income than their black or African American and Hispanic or Latino peers.

Here the interpretation of changes over time is a bit more nuanced, because the overall increase in college attainment among young adults implies increased competition for crossing into the top quartile of earnings. In the 1991-95 period, 35 percent of those in the top income quartile had only a bachelor's degree, and an additional 14 percent had gone on to receive a graduate degree. By the period from 2011 to 2015, these shares had risen to 42 percent and 24 percent, respectively, suggesting that the average skill level needed to reach the top quartile of income has increased between generations.

Taken together, these observations show that educational attainment can help young adults improve their lifetime earning potential. However, increased levels of educational attainment across all groups have created greater competition for positions at the top of the economic ladder. Even among those with college degrees, important differences remain in representation at the top of the income distribution by race and ethnicity. The relationship between educational attainment and economic outcomes is complex and heterogeneous across people, suggesting that the specific nature of that attainment--the types of degrees received and the specific schools attended, among other factors--may matter much more than previously thought.5

1. Pedro Carneiro and James J. Heckman (2003), "Human Capital Policy," in Benjamin M. Friedman, ed., Inequality in America: What Role for Human Capital Policies? (Cambridge, Mass.: MIT Press), pp. 77-239. Return to text

2. See, for example, past research that shows that the average starting wage faced by a cohort is correlated with wages later on, such as George Baker, Michael Gibbs, and Bengt Holmstrom (1994), "The Wage Policy of a Firm," Quarterly Journal of Economics, vol. 109 (November), pp. 921-55. Furthermore, research also shows that higher national unemployment rates faced by a cohort are also correlated with lower wages later on; for instance, see Paul Beaudry and John DiNardo (1991), "The Effect of Implicit Contracts on the Movement of Wages over the Business Cycle: Evidence from Micro Data," Journal of Political Economy, vol. 99 (August), pp. 665-88; and Lisa B. Kahn (2010), "The Long-Term Labor Market Consequences of Graduating from College in a Bad Economy," Labour Economics, vol. 17 (April), pp. 303-16. Return to text

3. In other words, if 25 percent of a group reached the top quartile, then that group's share of the top quartile would be the same as its share in the full population. Return to text

4. See, for example, Christian E. Weller and Jeffrey Thompson (2016), Wealth Inequality among Asian Americans Greater Than among Whites, Center for American Progress (Washington: CFAP, December 20),
Note that it is possible for the within-group representation in the top quartile to improve for all groups because the composition of the young adult population by race and ethnicity is itself changing, with whites becoming a much smaller share and all other groups being stable or increasing as a share of the total population. Return to text

5. See, in particular, Raj Chetty, John Friedman, Emmanuel Saez, Nicholas Turner, and Danny Yagan (2017), "Mobility Report Cards: The Role of Colleges in Intergenerational Mobility," paper, Equality of Activity Project (Stanford, Calif.: Stanford University, EOAP), Return to text

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Growth of labor compensation has been modest...

Indicators of hourly compensation suggest that wage growth has remained modest. Growth of compensation per hour in the business sector--a broad-based measure of wages, salaries, and benefits--has slowed in recent quarters and was 2-1/4 percent over the four quarters ending in 2017:Q1 (figure 5).1 This measure can be quite volatile even at annual frequencies (and a smoothed version is shown in figure 5 for that reason). The employment cost index--which also measures both wages and the cost to employers of providing benefits--also was up 2-1/4 percent in the first quarter relative to its year-ago level, about 1/2 percentage point faster than its gain of a year earlier. Among measures limited to wages, average hourly earnings growth--at 2-1/2 percent through May--was little changed from a year ago, and a compensation measure computed by the Federal Reserve Bank of Atlanta that tracks median 12-month wage growth of individuals reporting to the Current Population Survey was about 3-1/2 percent in May, also similar to its reading from a year earlier.

...and likely restrained by slow growth of labor productivity

These modest rates of compensation gain likely reflect the offsetting influences of a tightening labor market and persistently weak productivity growth. Since 2008, labor productivity has increased only about 1 percent per year, on average, well below the average pace from 1996 through 2007 and also below the gains in the 1974-95 period (figure 6). For most of the period since 2011, labor productivity growth has been particularly weak, although it has turned up in recent quarters. The longer-term softness in productivity growth may be partly attributable to the sharp pullback in capital investment during the most recent recession and the relatively modest rebound that followed. But there may be other explanations, too, and considerable debate remains about the reasons for the general slowdown in productivity growth. (For a more comprehensive discussion of productivity, see the box "Productivity Developments in the Advanced Economies.")

Productivity Developments in the Advanced Economies

The slow pace of U.S. productivity growth has attracted much attention of late, with vigorous debate on whether the slowdown represents the lingering, but temporary, effect of the Global Financial Crisis (GFC) or marks the start of an era of prolonged lower economic growth. This discussion reviews recent productivity developments in the United States and the major advanced foreign economies (AFEs) and outlines possible causes of the slowdown.1

Over the past decade, labor productivity growth in advanced economies has weakened markedly (figure A). Labor productivity growth in the United States has averaged only 1 percent since 2005, about half the pace of the years 1990 to 2004.2 Productivity growth has been even weaker in the AFEs, with the United Kingdom experiencing a meager 1/2 percent growth. As shown in the table, the widespread slowdown in labor productivity growth reflects weak capital deepening and, more importantly, very poor performance of total factor productivity (TFP)--a measure of how efficiently labor and capital are combined to produce output.3 TFP across the advanced economies has stagnated in the past decade against historical average growth of about 3/4 percent.

Accounting for labor productivity growth, 2005-2016
  Labor productivity growth Contribution of capital deepening Contribution of total factor productivity
United States 1 .7 .3
Canada .9 1 -.1
Japan .9 .9 0
Euro area .7 .8 0
United Kingdom .5 .5 0
Cross-country average
2005-2016 .8 .8 0
1990-2004 1.9 1.2 .7

Note: Average annual rates.

Source: The Conference Board, Total Economy Database.

A number of potential explanations have been put forward for the abysmal performance of TFP. Some authors emphasize structural factors that predate the GFC. For example, Gordon (2012) sees recent technological advances such as information technology (IT) as less revolutionary than earlier general-purpose technologies like electricity and internal combustion.4 Relatedly, Fernald (2015) provides evidence that the effects of the IT revolution--an important factor boosting productivity since the 1990s--began to fade in the early 2000s.5 There are signs, however, that the influence of IT is still spreading, as exemplified by the surge in cloud-computing technology investments in recent years, and we may not yet have reaped the full benefits of this major technological innovation. Under this more optimistic view, slow TFP growth may reflect a temporary "productive pause" as firms spend resources on activities such as equipment retooling, reorganization of management practices, and workforce training. After all, it took several decades for the full effect of electricity to materialize.6

Other explanations blame the weak TFP growth on the unusual severity of the GFC. Some empirical evidence suggests that the "Schumpeterian" process in which workers move toward higher-productivity firms--a key source of productivity growth following previous recessions--has been greatly impaired since the GFC.7 In addition, measures of innovation such as research and development (R&D) spending fell sharply during the GFC, as shown in figure B, partly in response to tight financial conditions and weak demand. Declines in R&D tend to induce gradual and persistent declines in TFP, suggesting that the recent low TFP growth may in part be traced to GFC-induced weakness in R&D.8 In this view, the recent pickup in R&D spending could anticipate some normalization in productivity growth. Finally, the slowdown in TFP growth may also be related to the slowdown of global trade in the wake of the GFC. Conventional trade theories suggest that greater trade integration should bring productivity gains by facilitating the diffusion of new technologies and by allowing countries to specialize in the production of goods for which they have a comparative advantage. After decades of steady increases, however, trade integration appears to have plateaued in recent years (figure C).

In sum, it is difficult to ascertain whether the recent subdued performance of labor productivity represents a new normal. Some of the GFC-related factors restraining productivity growth may eventually fade, leading to a rise in productivity growth from its anemic post-GFC pace. However, to the extent that longer-run factors--such as the waning effects of the IT revolution--are at work, productivity growth in the future may be noticeably below historical averages. Sustained low rates of productivity growth would greatly restrain the improvement of living standards. In addition, they would put downward pressure on the long-run neutral interest rate, making the policy rate more likely to reach its effective lower bound and thus constraining the ability of monetary policy to provide economic stimulus, even in the presence of shallow recessions.

1. Emerging market economies have also experienced declines in productivity growth in recent years, although not necessarily for the same reasons as in the advanced economies. Return to text

2. Here labor productivity is measured as overall gross domestic product per hour, in contrast to the business-sector measure shown in the main text. Productivity growth is faster in the business sector. Return to text

3. Capital deepening refers to increases in the amount of capital per worker. Return to text

4. Robert J. Gordon (2012), "Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds," NBER Working Paper Series 18315 (Cambridge, Mass.: National Bureau of Economic Research, August). Return to text

5. John G. Fernald (2015), "Productivity and Potential Output before, during, and after the Great Recession," in Jonathan A. Parker and Michael Woodford, eds., NBER Macroeconomics Annual 2014,vol. 29 (Chicago: University of Chicago Press), pp. 1-51. Return to text

6. For a description of the lengthy process of diffusion of electrification, see Paul A. David (1990), "The Dynamo and the Computer: An Historical Perspective on the Modern Productivity Paradox," American Economic Review, vol. 80 (May), pp. 355-61. Return to text

7. See Lucia Foster, Cheryl Grim, and John Haltiwanger (2016), "Reallocation in the Great Recession: Cleansing or Not?" Journal of Labor Economics, vol. 34 (S1, January), pp. S293-S331. For an analysis of the role of sectoral labor misallocation in accounting for the productivity slowdown in the United Kingdom, see Christina Patterson, Ayşegül Şahin, Giorgio Topa, and Giovanni L. Violante (2016), "Working Hard in the Wrong Place: A Mismatch-Based Explanation to the U.K. Productivity Puzzle," European Economic Review, vol. 84 (May), pp. 42-56. Return to text

8. See Patrick Moran and Albert Queralto (2017), "Innovation and the Productivity Growth Slowdown," unpublished paper, May, Return to text

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Price inflation moved up but softened in the spring and remains below 2 percent

In the early months of 2017, consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures (PCE), continued its climb from the very low levels that prevailed in 2015 and early 2016 when it was held down by falling oil and import prices. Indeed, consumer price inflation briefly reached the FOMC's 2 percent objective earlier this year before falling back to 1.4 percent in May (figure 7). Core inflation, which typically provides a better indication than the headline measure of where overall inflation will be in the future, also was 1.4 percent over the 12 months ending in May, a slightly slower rate than a year earlier. As is the case with headline inflation, the 12-month measure of core inflation had been higher earlier this year, reaching 1.8 percent. Both measures of inflation have recently been held down by steep and likely idiosyncratic price declines for a few specific categories, including wireless telephone services and prescription drugs, which do not appear to be related to the overall trends in consumer prices. The 12-month change in the trimmed mean PCE price index--an alternative indicator of underlying inflation produced by the Federal Reserve Bank of Dallas--slowed by less than overall or core PCE price inflation over the past several months.

Oil prices declined somewhat but remain well above their early 2016 lows...

After rebounding from their early 2016 lows, oil prices leveled off early this year (figure 8). Since then they have declined somewhat, despite OPEC's decision in late May to renew its November 2016 agreement to reduce its oil production, thereby extending the November production cuts through early 2018. Reflecting lower crude oil prices as well as smaller retail margins, seasonally adjusted retail gasoline prices have also declined since the beginning of the year. Nevertheless, prices of both crude oil and retail gasoline remain above their early 2016 lows, and futures prices suggest that market participants expect oil prices to rise gradually in coming years.

...while prices of imports other than energy have been bolstered by higher commodity prices

Throughout 2015, nonfuel import prices declined because of appreciation of the dollar and declines in nonfuel commodity prices (figure 9). Nonfuel import prices stabilized last year and have risen since then, as the dollar stopped appreciating and supply disruptions boosted world prices of some nonfuel commodities, especially industrial supplies and metals. In recent months, depreciation of the dollar has further pushed up non-oil import prices, which are now slightly higher than in mid-2016.

Survey-based measures of inflation expectations are little changed this year...

Expectations of inflation likely influence actual inflation by affecting wage- and price-setting decisions. Survey-based measures of inflation expectations at medium- and longer-term horizons have remained relatively stable so far in 2017. In the second-quarter 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 2.1 percent, the same as in the first quarter and little changed from the readings during 2016 (figure 10). In the University of Michigan Surveys of Consumers, the median value for inflation expectations over the next 5 to 10 years--which has been drifting downward for the past few years--has held about flat at a low level since late last year.

...while market-based measures of inflation compensation fell back somewhat

Inflation expectations can also be gauged by market-based measures of inflation compensation, though the inference is not straightforward because inflation compensation can be importantly affected by changes in premiums associated with risk and liquidity. Measures of longer-term inflation compensation--derived either from differences between yields on nominal Treasury securities and those on comparable Treasury Inflation-Protected Securities (TIPS) or from inflation swaps--have fallen back somewhat this year after having moved up in late 2016 (figure 11).2 The TIPS-based measure of 5-to-10-year-forward inflation compensation is now 1-3/4 percent, and the analogous measure of inflation swaps is now about 2 percent. Both measures are well below the 2-1/2 to 3 percent range that persisted for most of the 10 years before 2014.

Real gross domestic product growth slowed in the first quarter, but spending by households and businesses appears to have picked up in recent months

After having moved up at an annual rate of 2-3/4 percent in the second half of 2016, real gross domestic product (GDP) is reported to have increased about 1-1/2 percent in the first quarter of this year (figure 12).3 The step-down in first-quarter growth was largely attributable to soft inventory investment and a lull in the growth of consumer spending; in contrast, net exports increased a bit, residential investment grew robustly, and spending by businesses surged. Indeed, business investment was strong enough that overall private domestic final purchases--that is, final purchases by U.S. households and businesses, which tend to carry more signal for future GDP growth than most other components of overall spending--moved up at an annual rate of about 3 percent in the first quarter. For more recent months, indicators of spending by consumers and businesses have been strong and suggest that growth of economic activity rebounded in the second quarter; thus, overall activity appears to have expanded moderately, on average, over the first half of the year.

The economic expansion continues to be supported by accommodative financial conditions, including the low cost of borrowing and easy access to credit for many households and businesses, continuing job gains, rising household wealth, and favorable consumer and business sentiment.

Gains in income and wealth continue to support consumer spending...

After increasing strongly in the second half of 2016, consumer spending in the first quarter of this year was tepid. Unseasonably warm weather depressed spending on energy services, and purchases of motor vehicles slowed from an unusually high pace late last year. However, household spending seems to have picked up in more recent months, as purchases of energy services returned to seasonal norms and retail sales firmed. All told, consumer spending increased at an annual rate of 2 percent over the first five months of this year, only a bit slower than in the past couple of years (figure 13).

Beyond spending, other indicators of consumers' economic well-being have been strong in the aggregate. The ongoing improvement in the labor market has supported further gains in real disposable personal income (DPI), a measure of income after accounting for taxes and adjusting for inflation. Real DPI increased at a solid annual rate of 3 percent over the first five months of this year.

Gains in the stock market and in house prices over the first half of the year have boosted household net wealth. Broad measures of U.S. equity prices have continued to increase in recent months after moving up considerably late last year and in the first quarter. House prices have also continued to climb, adding to the balance sheet strength of homeowners (figure 14). Indeed, nominal house price indexes are close to their peaks of the mid-2000s. However, while the ratio of house prices to rents has edged higher, it remains well below its previous peak (figure 15). As a result of the increases in home and equity prices, aggregate household net worth has risen appreciably. In fact, at the end of the first quarter of 2017, household net worth was more than six times the value of disposable income, the highest-ever reading for that ratio (figure 16).

Consumer spending has also been supported by low burdens from debt service payments. The household debt service burden--the ratio of required principal and interest payments on outstanding household debt to disposable income, measured for the household sector as a whole--has remained at a very low level by historical standards. As interest rates rise, the debt burden will move up only gradually, as most household debt is in fixed-interest products. does credit availability

Consumer credit has continued to expand this year but more moderately than in 2016 (figure 17). Financing conditions are generally favorable, with auto and student loans remaining widely available and outstanding balances continuing to expand at a robust, albeit somewhat reduced, pace. Even though delinquency rates on most types of consumer debt have remained low by historical standards, credit card and auto loan delinquencies among subprime borrowers have drifted up some. Possibly in response to this deteriorating credit performance, banks have tightened standards for credit cards and auto lending. Mortgage credit has remained readily available for households with solid credit profiles, but it was still difficult to access for households with low credit scores or harder-to-document incomes.

Consumer confidence is strong

Consumers have remained optimistic about their financial situation. As measured by the Michigan survey, consumer sentiment was solid through most of 2016, likely reflecting rising income and job gains. Sentiment moved up appreciably after the presidential election last November and has remained at a high level so far this year (figure 18). Furthermore, the share of households expecting real income to rise over the next year or two has gone up markedly in the past few months and is now in line with its pre-recession level.

Activity in the housing sector has improved modestly

Several indicators of housing activity have continued to strengthen gradually this year. Sales of existing homes have gained, on net, while house prices have continued to rise and mortgage rates have remained low, even though they are up from last year (figures 19 and 20). In addition, single-family housing starts registered a slight increase, on average, in the first five months of the year, although multifamily housing starts have slipped (figure 21). Despite the modest increase in construction activity, the months' supply of homes for sale has remained near the low levels seen in 2016, and the aggregate vacancy rate has fallen back to levels observed in the mid-2000s. Lean inventories are likely to support further gains in homebuilding activity going forward.

Business investment has turned up after a period of weakness...

Led by a surge in spending on drilling and mining structures, real outlays for business investment--that is, private nonresidential fixed investment--rose robustly at the beginning of the year after having been about flat for 2016 as a whole (figure 22). The sharp gains in drilling and mining in the first quarter mark a turnaround for the sector; energy-sector investment had declined noticeably following the drop in oil prices that began in mid-2014 and ran through early 2016. More recently, rapid increases in the number of drilling rigs in operation suggest that investment in this area remained strong in the second quarter of this year.

Moreover, business spending on equipment and intangibles (such as research and development) advanced solidly at the beginning of the year after having been roughly flat in 2016. Furthermore, indicators of business spending are generally upbeat: Orders and shipments of capital goods have posted net gains in recent months, and indexes of business sentiment and activity remain elevated after having improved significantly late last year.

...while corporate financing conditions have remained accommodative

Aggregate flows of credit to large nonfinancial firms have remained solid, supported in part by continued low interest rates (figure 23). The gross issuance of corporate bonds was robust during the first half of 2017, and yields on both speculative- and investment-grade corporate bonds remained low by historical standards (figure 24). Gross equity issuance by nonfinancial firms stayed solid, on average, as seasoned equity offerings continued at a robust pace and the pace of initial public offerings picked up from the low levels seen in 2016.

Despite the pickup in business investment, demand for business loans was subdued early this year, and outstanding commercial and industrial (C&I) loans on banks' books contracted in the first quarter. In the April Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), banks reported a broad-based decline in demand for C&I loans during the first quarter of 2017 even as lending standards on such loans were reported to be basically unchanged.4 Banks also reported weaker demand for commercial real estate loans as well as a continued tightening of standards on such loans. However, lending to large nonfinancial firms appeared to be strengthening somewhat during the second quarter. Meanwhile, measures of small business credit demand remained weak amid stable supply.

U.S. exports grew at a faster pace

In the first quarter of 2017, U.S. real exports increased briskly and broadly following moderate growth in the second half of last year that was driven by a surge in agricultural exports (figure 25). At the same time, real import growth declined somewhat from its strong pace in the second half of last year. As a result, real net exports contributed slightly to U.S. real GDP growth in the first quarter. Available trade data through May suggest that the growth of real exports slowed to a modest pace in the second quarter. Nevertheless, the average pace of export growth appears to have stepped up in the first half of 2017 compared with last year, partly reflecting stronger growth abroad and a diminishing drag from earlier dollar appreciation. All told, the available data for the first half of this year suggest that net exports added a touch to U.S. real GDP growth and that the nominal trade deficit widened slightly relative to GDP (figure 26).

Federal fiscal policy had a roughly neutral effect on economic growth...

Federal purchases moved sideways in 2016, and policy actions had little effect on federal taxes or transfers (figure 27). Under currently enacted legislation, federal fiscal policy will likely again have a roughly neutral influence on the growth in real GDP this year.

After narrowing significantly for several years, the federal unified deficit has widened from about 2-1/2 percent of GDP in fiscal year 2015 to 3-1/4 percent currently. Although expenditures as a share of GDP have been relatively stable over this period at a little under 21 percent, receipts moved lower in 2016 and have edged down further so far this year to roughly 17-1/2 percent of GDP (figure 28). The ratio of federal debt held by the public to nominal GDP is quite elevated relative to historical norms. Nevertheless, the deficit remains small enough to roughly stabilize this ratio in the neighborhood of 75 percent (figure 29).

...and the fiscal position of most state and local governments is stable

The fiscal position of most state and local governments is stable, although there is a range of experiences across these governments. Many state governments are experiencing lackluster revenue growth, as income tax collections have been only edging up, on average, in recent quarters. In contrast, house price gains have continued to push up property tax revenues at the local level. Employment growth in the state and local government sector has been anemic so far this year following a pace of hiring in 2016 that was the strongest since 2008. Outlays for construction by these governments have been declining (figure 30).

Financial Developments

The expected path for the federal funds rate flattened

The path for the expected federal funds rate implied by market quotes on interest rate derivatives has flattened, on net, since the end of December, moving higher for 2017 but slightly lower further out (figure 31). The expected policy path moved up at the beginning of the year, reportedly reflecting investor perceptions that expansionary fiscal policy would likely be forthcoming over the near term, but subsequently fell amid some waning of these expectations as well as FOMC communications that were interpreted as signaling a somewhat slower pace of policy rate increases than had been anticipated.

Survey-based measures of the expected path of policy also moved up for 2017. Most of the respondents to the Federal Reserve Bank of New York's Survey of Primary Dealers and Survey of Market Participants--which were conducted just before the June FOMC meeting--projected an additional 25 basis point increase in the FOMC's target range for the federal funds rate, relative to what they projected in surveys conducted before the December FOMC meeting, as the most likely outcome for this year. Expectations for the number of rate hikes in 2018 were about unchanged. Market-based measures of uncertainty about the policy rate approximately one to two years ahead decreased slightly, on balance, from their year-end levels.

Longer-term nominal Treasury yields remain low

After rising significantly during the second half of 2016, yields on medium- and longer-term nominal Treasury securities have decreased 5 to 25 basis points, on net, so far in 2017 (figure 32). The decrease in longer-term nominal yields since the beginning of the year largely reflects declines in inflation compensation due in part to soft incoming data on inflation, with real yields little changed on net. Consistent with the changes in Treasury yields, yields on 30-year agency mortgage-backed securities (MBS)--an important determinant of mortgage interest rates--decreased slightly over the first half of the year (figure 33). Treasury and MBS yields picked up somewhat in late June, driven in part by increases in government yields overseas. However, yields remain quite low by historical standards.

Broad equity price indexes increased further...

Broad U.S. equity indexes continued to increase during the period (figure 34). Equity prices were reportedly supported by lower interest rates and increased optimism that corporate earnings will continue to strengthen this year. Stock prices of companies in the technology sector increased notably on net. After rising significantly toward the end of last year, stock prices of banks performed about in line with the broader market during the first half of 2017. The implied volatility of the S&P 500 index one month ahead--the VIX--decreased, on net, ending the period close to the bottom of its historical range. (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability.")

Developments Related to Financial Stability

Vulnerabilities in the U.S. financial system remain moderate on balance. Capital and liquidity ratios at most large U.S. banks continue to be at historical highs, and reliance on short-term wholesale funding at these institutions has continued to decline. Valuation pressures across a range of assets and several indicators of investor risk appetite have increased further since mid-February, but apparent high risk appetite in asset markets has not led to increased borrowing in the nonfinancial sector. Debt owed by nonfinancial corporations remains elevated, although it has been flat or falling in the past two years. Household debt as a share of gross domestic product has remained subdued, and new borrowing has been driven primarily by households with strong credit histories.

The strong capital position of the financial sector has contributed to the improved resilience of the U.S. financial system. Regulatory capital ratios at most bank holding companies have continued to be historically high, mainly as a result of the higher regulatory capital requirements. At the same time, measures of bank profitability have increased modestly on a year-on-year basis. Regulatory capital ratios at insurance companies are also high by historical standards.

Vulnerabilities stemming from maturity and liquidity transformation in the financial sector remain low. High-quality liquid asset holdings at all large domestic bank holding companies are above regulatory liquidity coverage ratio requirements. Moreover, banks have continued to replace short-term wholesale funding, such as commercial paper held by money market mutual funds (also referred to as money market funds, or MMFs), with relatively more stable core deposits. The use of Federal Home Loan Bank (FHLB) advances as a source of funding for the banks, which had increased notably through 2016, has fallen slightly in the first quarter of 2017 (figure A). The MMF reforms, designed by the Securities and Exchange Commission and fully implemented in October 2016, have led to a shift of about $1.2 trillion in assets from prime funds--which can hold a range of risky instruments, including commercial paper issued by banks--to government funds, which can hold only assets collateralized by Treasury and agency securities. This shift has reduced the risk of runs on MMFs. However, run risk could increase if investors shift out of MMFs into more opaque and fragile alternative vehicles. Thus, continued monitoring of this sector is important. The FHLBs have increased their issuance of short-maturity liabilities, mainly to government funds. However, the FHLBs have not reduced the maturity of their own assets, which increases their liquidity mismatch and potential vulnerability to funding strains. This mismatch has also been highlighted by the Federal Housing Finance Agency, which continues to evaluate ways to formalize its supervisory expectations regarding the appropriate amount of short-term funding of long-term assets by the FHLBs.1

Valuation pressures have increased further across a range of assets, including Treasury securities, equities, corporate bonds, and commercial real estate (CRE). Term premiums on Treasury securities continue to be in the lower part of their historical distribution. A sudden rise in term premiums to more normal levels poses a downside risk to long-maturity Treasury prices, which could in turn affect the prices of other assets. Forward equity price-to-earnings ratios rose a bit further and are now at their highest levels since the early 2000s, while a measure of the risk premium embedded in high-yield corporate bond spreads declined a touch from an already low level, implying high asset valuations in this market as well. Prices of CRE have continued to advance at a rapid clip amid slowing rent growth and rising interest rates, though there are signs of tightening credit conditions in CRE markets. In contrast, farmland prices have declined, albeit more slowly than prevailing rents, implying that farmland price-to-rent ratios have continued to move up to very high levels. In derivatives markets, investor compensation for bearing near-term volatility risk has remained low, suggesting a sustained investor risk appetite.

The ratio of private nonfinancial (household and nonfinancial business) debt to gross domestic product, shown in figure B, remains below the estimates of its long-term upward trend. The debt-to-income ratio of households has changed little over the past few years and remains at a relatively low level. Moreover, new borrowing is concentrated among borrowers with high credit scores. In contrast, the leverage of nonfinancial corporations continues to be notably elevated. New borrowing is concentrated among firms with stronger balance sheets, and the total outstanding amount of speculative-grade bonds and leveraged loans edged down, especially in the oil sector.

As part of its effort to reduce regulatory burden while promoting the financial stability of the United States, the Federal Reserve Board has taken two key steps since mid-February. First, member agencies of the Federal Financial Institutions Examination Council, including the Board, issued a joint report to the Congress under the Economic Growth and Regulatory Paperwork Reduction Act of 1996 detailing their review of regulations affecting smaller financial institutions, such as community banks, and describing burden-reducing actions the agencies plan to take.2 Second, the Board and the Federal Deposit Insurance Corporation jointly announced the completion of their evaluation of the 2015 resolution plans of 16 domestic banks and separately issued resolution plan guidance to 4 foreign banks.3 The agencies identified shortcomings in one domestic firm's resolution plan, which must be satisfactorily addressed in the firm's 2017 plan by December 31. For foreign banking organizations, resolution plans are focused on their U.S. operations, and guidance issued to these organizations reflects the significant restructuring they have undertaken to form intermediary holding companies.

1. See Melvin L. Watt (2017), "Prepared Remarks," speech delivered at the 2017 Federal Home Loan Bank Directors' Conference, Washington, May 23, Return to text

2. See Board of Governors of the Federal Reserve System (2017), "Banking Agencies Issue Joint Report to Congress under the Economic Growth and Regulatory Paperwork Reduction Act of 1996," press release, March 21, Return to text

3. See Board of Governors of the Federal Reserve System (2017), "Agencies Complete Resolution Plan Evaluation of 16 Domestic Firms; Provide Resolution Plan Guidance to Four Foreign Banking Organizations," press release, March 24, Return to text

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...and risk spreads on corporate bonds decreased

Bond spreads for investment- and speculative-grade firms decreased, and spreads for speculative-grade firms now stand near the bottom of their historical ranges.

Treasury and mortgage securities markets have functioned well

Available indicators of Treasury market functioning remained stable over the first half of 2017. A variety of liquidity metrics--including bid-ask spreads, bid sizes, and estimates of transaction costs--either improved or remained unchanged over the period, displaying no notable signs of liquidity pressures. The agency MBS market also continued to function well. (For a detailed discussion of corporate bond market functioning, see the box "Recent Developments in Corporate Bond Market Liquidity.")

Recent Developments in Corporate Bond Market Liquidity

Market liquidity refers to the extent to which investors can rapidly execute sizable securities transactions at a low cost and with a limited price effect. A high degree of market liquidity facilitates informationally efficient market pricing and lowers the returns required by investors to hold financial assets; it therefore decreases the cost of valuable economic projects and so contributes to the efficient allocation of capital. Moreover, liquidity conditions that are resilient in the face of economic and financial shocks reduce the risk of excess volatility and fire sale losses, thus helping mitigate systemic risk.

Financial institutions that serve as "market makers," by posting prices and standing ready to buy or sell, are critical to healthy liquidity in the markets for certain assets, including corporate bonds. A series of changes, including regulatory reforms, since the Global Financial Crisis have likely altered financial institutions' incentives to provide liquidity, raising concerns about decreased liquidity in these markets, especially during periods of market stress. However, the available evidence does not point to any substantial impairment in liquidity in major financial markets in recent years. In addition, financial markets have generally performed well during recent episodes of financial stress.1 Even in instances in which liquidity conditions in certain markets appear to have deteriorated, the effects have been mild and suggest limited economic consequences. In the remainder of this discussion, we illustrate these points with emphasis on the market for corporate bonds.

In recent years, market participants have been particularly concerned with liquidity conditions in the corporate bond market because the securities are traded less frequently, and the liquidity provision has relied more heavily on dealer intermediation, than in many other markets. However, a range of conventional metrics of liquidity indicate that liquidity strains in corporate bond markets have been minimal. Figure A shows that the estimated mean effective bid-ask spread for U.S. corporate bonds has remained low in recent years. Before the financial crisis, bid-ask spreads averaged about 1 percent of the price of the bond. This measure of trading costs skyrocketed during the financial crisis but has returned to the range seen before the crisis. Measures of the effect of trades on prices follow a similar pattern and have been fairly stable in recent years.2 In addition, other measures related to factors associated with market liquidity, such as trends in average trade size and turnover, also suggest market liquidity conditions are benign.3

That said, some recent work suggests that these traditional measures of transaction costs might exaggerate the degree of liquidity in part because dealers have increasingly shifted from acting as principals to acting as agents to reduce their risk exposure, resulting in tighter bid-ask spreads.4 Indeed, many market participants have expressed a concern that declines in dealer inventories may reflect in part a reduced willingness or capacity of the primary dealers to make markets, which may in turn lead to lower liquidity.

Figure B shows that primary dealers' inventories of corporate bonds (including foreign bonds issued in the United States), which are predominantly used for market making, indeed began to decline sharply following the Bear Stearns collapse in March 2008 and fell further after Lehman Brothers failed in October 2008. Such a sharp decline in dealer inventories may be the result of dealers' actions on their own, reflecting changes in risk preferences in reaction to the financial crisis. In addition, changing regulations--such as the Volcker rule and the supplementary leverage ratio, which aimed to make the financial system safer and sounder--and changes in technology may have contributed to the continued trend of lower dealer inventories.5

The factors affecting a dealer's willingness or capacity to facilitate trading may also affect other activities such as arbitrage trading, which equates prices for financing arrangements with economically similar risks. Therefore, impediments in arbitrage may also indicate market illiquidity. One widely studied no-arbitrage relationship is the so-called CDS-bond basis, the difference between bonds' credit default swap (CDS) spreads and bond-implied credit spreads.6 Figure C shows that the CDS-bond basis for corporate bonds was close to zero before the crisis, widened dramatically during the crisis (indicating a significant unrealized arbitrage opportunity), and has returned to a level closer to, but still below, zero in recent years. More recently, the CDS-bond basis has narrowed further.

Overall, the degree to which dealer balance sheet constraints affect corporate bond market liquidity depends not only on dealers' capacity and willingness to provide liquidity, but also on the extent to which nonbank financial institutions such as hedge funds, mutual funds, and insurance companies fill any lost market-making capacity. Other factors such as changes in technology, risk preferences, and investor composition also interact to shape the trading environment.7 There are indications that market structure has changed in recent years, and trades in certain situations and market segments might have been more costly at times. But markets have also adjusted, and some measures of dislocation have lessened with these adjustments. In summary, liquidity conditions have been quite good overall since the Global Financial Crisis. The sharp deterioration of market liquidity during 2007 and 2008 illustrates clearly that the most significant risk has been distress at financial institutions. Any modest potential effects of regulation on liquidity should be balanced with the gains to resilience at large financial institutions associated with regulation.

1. For a discussion of the behavior of bond prices during recent flash events (that is, extremely rapid and large price moves during very short periods), see Jerome H. Powell (2015), "Structure and Liquidity in Treasury Markets," speech delivered at the Brookings Institution, Washington, August 3, Return to text

2. See Yakov Amihud (2002), "Illiquidity and Stock Returns: Cross-Section and Time-Series Effects," Journal of Financial Markets, vol. 5 (January), pp. 31-56. The Amihud price effect measure is defined as the ratio of the percentage change in price (in absolute value) and the daily trading volume. Return to text

3. For detailed definitions of trade size and turnover in the context of corporate bond markets, see Francesco Trebbi and Kairong Xiao (2015), "Regulation and Market Liquidity," NBER Working Paper Series 21739 (Cambridge, Mass.: National Bureau of Economic Research, November). Return to text

4. See Jaewon Choi and Yesol Huh (2016), "Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs," unpublished paper, July (revised January 2017), The authors suggest that transactions in which dealers act simply as brokers (that is, agents), rather than as intermediaries that hold assets on their balance sheets (principals), could reflect price concessions that dealers make to entice counterparties into the other side of a trade so that the dealers will not need to hold the traded assets. Return to text

5. See Tobias Adrian, Nina Boyarchenko, and Or Shachar (forthcoming), "Dealer Balance Sheets and Bond Liquidity Provision," Journal of Monetary Economics. They find that dealers subject to stricter regulations after the crisis are less able to intermediate customer trades in the corporate bond market. Also see Jack Bao, Maureen O'Hara, and Alex Zhou (2016), "The Volcker Rule and Market-Making in Times of Stress," Finance and Economics Discussion Series 2016-102 (Washington: Board of Governors of the Federal Reserve System, December), They show that recently downgraded bonds trade with a higher price effect after the introduction of the Volcker rule, although Anderson and Stulz find no such effects. See Mike Anderson and René M. Stulz (2017), "Is Post-Crisis Bond Liquidity Lower?" NBER Working Paper Series 23317 (Cambridge, Mass.:National Bureau of Economic Research, April). Return to text

6. For a more detailed discussion of the CDS-bond basis, see Nina Boyarchenko, Pooja Gupta, Nick Steele, and Jacqueline Yen (2016), "Trends in Credit Market Arbitrage," Staff Report 784 (New York: Federal Reserve Bank of New York, July; revised July 2016), Return to text

7. See Darrell Duffie (2012), "Market Making under the Proposed Volcker Rule," Working Paper 3118 (Stanford, Calif.: Stanford Graduate School of Business, January), available at He argues that the negative effect the Volcker rule may have on market liquidity in the short run may disappear in the long run as nonbanks step in to provide liquidity. See also Hendrik Bessembinder, Stacey E. Jacobsen, William F. Maxwell, and Kumar Venkataraman (2016), "Capital Commitment and Illiquidity in Corporate Bonds," unpublished paper, March, The authors find that bank dealers are less willing to provide liquidity now than in the recent past, while nonbank dealers are now more willing. Return to text

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Money market rates have moved up in line with increases in the FOMC's target range

Conditions in domestic short-term funding markets have remained stable so far in 2017. Yields on a broad set of money market instruments moved higher in response to the FOMC's policy actions in March and June. The effective federal funds rate generally traded near the middle of the target range and was closely tracked by the overnight Eurodollar rate. The spread between the three-month LIBOR (London interbank offered rate) and the OIS (overnight index swap) rate has returned to historical norms over the first half of 2017, declining from the elevated levels that prevailed at the end of last year around the implementation of the Securities and Exchange Commission money market fund reform.

Bank credit continued to expand, though at a slower pace than in 2016, and bank profitability improved

Aggregate credit provided by commercial banks continued to increase through the first quarter of 2017, though at a slower pace than in 2016, leaving the ratio of total commercial bank credit to nominal GDP slightly lower (figure 35). The expansion of core loans slowed during 2017, consistent with banks' reports in the April SLOOS of weakened demand for most loan categories and tighter lending standards for commercial real estate loans. However, the growth of core loans appeared to be picking up somewhat during the second quarter. Measures of bank profitability have continued to improve so far this year but remained below their historical averages (figure 36).

Credit conditions in municipal bond markets have generally been stable

Credit conditions in municipal bond markets have generally remained stable since year-end. Over that period, yield spreads on 20-year general obligation municipal bonds over comparable-maturity Treasury securities were little changed on balance. Puerto Rico filed to enter a court-supervised process to restructure its debt after it failed to reach an agreement with bondholders, and several credit rating agencies downgraded the bond ratings of the state of Illinois. However, these events have had no noticeable effect on broader municipal bond markets.

International Developments

Foreign financial market conditions eased

Financial market conditions in both the advanced foreign economies (AFEs) and the emerging market economies (EMEs) have generally eased since January. Better-than-expected data releases, robust corporate earnings, and the passage of risk events--such as national elections in some European countries--boosted investor confidence. Broad equity indexes in advanced and emerging foreign economies rose further (figure 37). In addition, spreads of emerging market sovereign bonds over U.S. Treasury securities narrowed, and capital flows into emerging market mutual funds picked up (figure 38). Government bond yields in the AFEs generally remained very low, partly reflecting investor expectations that substantial monetary policy accommodation would be required for some time (figure 39). In the United Kingdom, softer macroeconomic data and uncertainty about future policies and growth as the country begins the process of exiting the European Union also weighed on yields. However, AFE government bond yields picked up somewhat in late June, partly reflecting investors' focus on remarks by officials from some AFE central banks suggesting possible shifts toward less accommodative policy stances. In the euro area, bank supervisors intervened to prevent the disorderly failure of a few small to medium-sized lenders in Italy and Spain; business disruptions were minimal, and spillovers to other European banks were limited.

The dollar depreciated somewhat

Since the start of the year, the broad dollar index--a measure of the trade-weighted value of the dollar against foreign currencies--has depreciated about 5 percent, on balance, after rising more than 20 percent between mid-2014 and late 2016 (figure 40). The weakening since the start of the year partly reflected growing uncertainty about prospects for more expansionary U.S. fiscal policy as well as mounting confidence in the foreign economic outlook. The euro rose against the dollar following the French presidential election, and the Mexican peso appreciated substantially as the Mexican central bank tightened monetary policy and as investor concerns about the potential for substantial disruptions of U.S.-Mexico trade appeared to ease.

Economic activity in the AFEs grew at a solid pace

In the first quarter, real GDP grew at a solid pace in Canada, the euro area, and Japan, partly reflecting robust growth in fixed investment in all three economies (figure 41). In contrast, economic growth slowed to a tepid pace in the United Kingdom, reflecting weaker consumption growth and a decline in exports. In most AFEs, economic survey indicators, such as purchasing manager surveys, generally remained consistent with continued economic growth at a solid pace during the second quarter.

Inflation leveled off in most AFEs...

In late 2016, consumer price inflation (measured as a 12-month percent change) rose substantially in most AFEs, partly reflecting increases in energy prices (figure 42). Since then, inflation has leveled off in Japan and declined somewhat in the euro area as upward pressure from energy prices eased, core inflation stayed low, and wage growth was subdued even as unemployment rates declined further in both economies. In contrast, in the United Kingdom, headline inflation rose well above the Bank of England's (BOE) 2 percent target, largely reflecting upward pressure from the substantial sterling depreciation since the Brexit referendum in June 2016.

...and AFE central banks maintained highly accommodative monetary policies

AFE central banks kept their policy rates at historically low levels, and the Bank of Japan kept its target range for 10-year government bond yields near zero. The European Central Bank (ECB) maintained its asset purchase program, though it slightly reduced the pace of purchases, and the BOE completed the bond purchase program it announced last August. However, the Bank of Canada, BOE, and ECB have recently suggested that if growth continues to reduce resource slack, some policy accommodation could be withdrawn. The ECB remarked that the forces holding down inflation could be temporary. The BOE indicated that some monetary accommodation might need to be removed if the tradeoff between supporting employment and expediting the return of inflation to its target is reduced.

In EMEs, Asian growth was solid...

Chinese economic activity was robust in the first quarter of 2017 as a result of solid domestic and external demand (figure 43). More recent indicators suggest that growth moderated in the second quarter as Chinese authorities tightened financial conditions and as export growth slowed. In some other emerging Asian economies, growth picked up in early 2017 as a result of stronger external demand and manufacturing activity. However, growth of the region's exports, especially to China, slowed so far in the second quarter.

...and many Latin American economies continue their tepid recovery

In Mexico, growth decelerated a touch in the first quarter of 2017, partly reflecting a slowdown in private consumption following sharp hikes in domestic fuel prices. These price hikes, together with the effects of earlier peso depreciation on import prices, contributed to a sharp rise in Mexican inflation, which prompted the Bank of Mexico to further tighten monetary policy. Following a prolonged period of contraction, the Brazilian economy posted solid growth in the first quarter of 2017, partly reflecting a surge in exports and a strong harvest. However, domestic demand has remained very weak amid high unemployment and heightened political tensions, and indicators of economic activity have stepped down recently. In Brazil and some other South American economies, declining inflation has led central banks to reduce their policy interest rates.


 1. The recent data on compensation per hour reflect a decline in wages and salaries at the end of 2016, which might be the result of a shifting of bonuses or other types of income into 2017 in anticipation of a possible cut in personal income tax rates. If that is the case, the current estimate of compensation growth in the first quarter might be revised up once full data become available later this summer. Return to text

 2. Inflation compensation implied by the TIPS breakeven inflation rate is based on the difference, at comparable maturities, between yields on nominal Treasury securities and yields on TIPS, which are indexed to the headline consumer price index (CPI). Inflation swaps are contracts in which one party makes payments of certain fixed nominal amounts in exchange for cash flows that are indexed to cumulative CPI inflation over some horizon. Focusing on inflation compensation 5 to 10 years ahead is useful, particularly for monetary policy, because such forward measures encompass market participants' views about where inflation will settle in the long term after developments influencing inflation in the short term have run their course. Return to text

 3. Real gross domestic income (GDI), which is conceptually the same as GDP but is constructed from different source data, had been rising at roughly the same rate as real GDP for most of 2016. However, real GDI was held down by the very weak reading for personal income in the fourth quarter of last year, which may prove to have been transitory. Return to text

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

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Last Update: August 11, 2022