Part 2: Monetary Policy
Monetary Policy Report submitted to the Congress on July 7, 2017, pursuant to section 2B of the Federal Reserve Act
The Federal Open Market Committee raised the federal funds rate target range in March and June
Over the past year and a half, the Federal Open Market Committee (FOMC) has been gradually increasing its target range for the federal funds rate as the economy continued to make progress toward the Committee's objectives of maximum employment and price stability. After having raised the target range for the federal funds rate last December, the Committee decided to raise the target range again in March and in June, bringing it to 1 to 1-1/4 percent (figure 44).5 The FOMC's decisions reflected the progress the economy has made, and is expected to make, toward the Committee's objectives.
When the Committee met in March, it decided to raise the target range for the federal funds rate to 3/4 to 1 percent. Available information suggested that the labor market had continued to strengthen even as growth in economic activity slowed during the first quarter. Inflation measured on a 12-month basis had moved up appreciably and was close to the Committee's 2 percent longer-run objective. Core inflation, which excludes volatile energy and food prices, continued to run somewhat below 2 percent.
The data available at the time of the June FOMC meeting suggested a rebound in economic activity in the second quarter, leaving the projected average pace of growth over the first half of the year at a moderate level. The labor market had continued to strengthen, with the unemployment rate falling nearly 1/2 percentage point since the beginning of the year to 4.3 percent in May, a low level by historical standards and modestly below the median of FOMC participants' estimates of its longer-run normal level. Inflation measured on a 12-month basis had declined over the previous few months but was still up significantly since last summer. Like the headline inflation measure, core inflation was running somewhat below 2 percent. With employment expected to remain near its maximum sustainable level, the Committee continued to expect that inflation would move up and stabilize around 2 percent over the next couple of years, in line with the Committee's longer-run objective. In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target another 1/4 percentage point to a range of 1 to 1-1/4 percent.
Monetary policy continues to support economic growth
Even with the gradual reductions in the amount of policy accommodation to date, the Committee judges that the stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation. In particular, the federal funds rate appears to remain somewhat below its neutral level--that is, the level of the federal funds rate that is neither expansionary nor contractionary.
In evaluating the stance of monetary policy, policymakers routinely consult prescriptions from a variety of policy rules, which can serve as useful benchmarks. However, the use and interpretation of such prescriptions require careful judgments about the choice and measurement of the inputs to these rules as well as the implications of the many considerations these rules do not take into account (see the box "Monetary Policy Rules and Their Role in the Federal Reserve's Policy Process").
Monetary Policy Rules and Their Role in the Federal Reserve's Policy Process
Monetary policy rules are formulas that prescribe a tight link between a small number of economic variables--typically including the gap between actual and target inflation along with an estimate of resource slack in the economy--and the setting of a policy rate, such as the federal funds rate.1 While policy rules can provide helpful guidance for policymakers, their interpretation requires careful judgment about the measurement of the inputs to these rules and the implications of the many considerations these rules do not take into account.
Policy rules can incorporate key principles of good monetary policy. One key principle is that monetary policy should respond in a predictable way to changes in economic conditions. A second key principle is that monetary policy should be accommodative when inflation is below the desired level and employment is below its maximum sustainable level; conversely, monetary policy should be restrictive when the opposite holds. A third key principle is that, to stabilize inflation, the policy rate should be adjusted by more than one-for-one in response to persistent increases or decreases in inflation.
Economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule as well as other rules discussed later: the "balanced approach" rule, the "adjusted Taylor (1993)" rule, the "change" rule, and the "first difference" rule (figure A).2 These policy rules generally embody the three key principles of good monetary policy noted earlier. Each rule takes into account two gaps--the difference between inflation and its objective (2 percent as measured by the price index for personal consumption expenditures (PCE), in the case of the Federal Reserve) as well as the difference between the rate of unemployment in the longer run (u LR) and the current unemployment rate.3 Unlike the other rules, the first-difference rule considers the change in the unemployment gap rather than its level.
The Taylor (1993), balanced-approach, and adjusted Taylor (1993) rules provide prescriptions for the level of the federal funds rate and require an estimate of the neutral real interest rate in the longer run (r LR)--that is, the level of the real federal funds rate that is expected to be consistent with sustaining maximum employment and stable inflation in the longer run.4 In contrast, the change and first-difference rules prescribe how the level of the federal funds rate at a given time should be altered from its previous level--that is, they indicate how the existing rate should change over time. The adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below zero, implying that interest rate policy alone may not be able to provide enough policy accommodation during periods when the unadjusted Taylor (1993) rule prescribes setting the federal funds rate below zero. To make up for the cumulative shortfall in accommodation ( Zt,) the adjusted rule prescribes only a gradual return of the policy rate to the (positive) levels prescribed by the unadjusted Taylor (1993) rule as the economy recovers.
The small number of variables involved in policy rules makes them easy to use. However, the U.S. economy is highly complex, and these rules, by their very nature, do not capture that complexity. For example, while the unemployment rate is an important measure of the state of the labor market, it often lags business cycle developments and does not provide a complete measure of slack or tightness. In practice, Federal Open Market Committee (FOMC) policymakers examine a great deal of information about the labor market to gauge its health; this information includes broader measures of labor underutilization, the labor force participation rate, employment, hours worked, and the rates of job openings, hiring, layoffs, and quits, as well as anecdotal information not easily reduced to numerical indexes.5
Another issue related to the implementation of rules involves the measurement of the variables that drive the prescriptions generated by the rules. For example, there are many measures of inflation, and they do not always move together or by the same amount. The broadest measure of inflation, shown by the percent change in the gross domestic product price index, displays notable differences from measures that gauge changes in consumer prices (figure B). Even measures that focus on the prices paid by consumers differ importantly. For example, inflation as measured by the consumer price index (or CPI) has generally been somewhat higher historically than inflation measured using the PCE price index (the index to which the FOMC's 2 percent longer-run inflation objective refers). Core inflation, meaning inflation excluding changes in food and energy prices, is less volatile than headline inflation and is often used in estimating monetary policy rules because it has historically been a good predictor of future headline inflation (figure C).
In addition, both the level of the neutral real interest rate in the longer run and the level of the unemployment rate that is sustainable in the longer run are difficult to estimate precisely, and estimates made in real time may differ substantially from estimates made later on, after the relevant economic data have been revised and additional data have become available.6 For example, since 2000, respondents to the Blue Chip survey have markedly reduced their projections of the longer-run level of the real short-term interest rate (figure D). Survey respondents have also made considerable changes over time to their estimates of the rate of unemployment in the longer run, with consequences for the unemployment gap. Revisions of this magnitude to the neutral real interest rate and the rate of unemployment in the longer run can have important implications for the federal funds rate prescribed by monetary policy rules. Sensible estimation of policy rules requires that policymakers take into account these changes in the projected values of longer-run rates as they occur over time.
Furthermore, the prescribed responsiveness of the federal funds rate to its determinants differs across policy rules. For example, the sensitivity of the federal funds rate to the unemployment gap in the balanced-approach rule is twice as large as it is in the Taylor (1993) rule. The fact that the policy interest rate responds differently to the inflation and unemployment gaps in the different policy rules means that the rules provide different tradeoffs between stabilizing inflation and stabilizing unemployment.
Finally, monetary policy rules do not take account of broader risk considerations. For example, policymakers routinely assess risks to financial stability. Furthermore, over the past few years, with the federal funds rate still close to zero, the FOMC has recognized that it would have limited scope to respond to an unexpected weakening in the economy by lowering short-term interest rates. This asymmetric risk has, in recent years, provided a sound rationale for following a more gradual path of rate increases than that prescribed by policy rules. (Asymmetric risk need not always provide a rationale for a more gradual path; if the risks were strongly tilted toward substantial and persistent overheating and too-high inflation, the asymmetric risk could argue for higher rates than prescribed by simple rules.)
How does the FOMC use monetary policy rules?
In the briefing materials prepared for FOMC meetings, Federal Reserve staff regularly report prescriptions for the current setting of the federal funds rate from a number of monetary policy rules.7 FOMC policymakers discussed prescriptions from monetary policy rules as long ago as 1995 and have consulted them routinely since 2004. The materials that FOMC policymakers see also include forecasts of how the federal funds rate and key macro indicators would evolve, under each of the rules, several years into the future. Policymakers weigh this information, along with other information bearing on the economic outlook.8
Different monetary policy rules often offer quite different prescriptions for the federal funds rate; moreover, there is no obvious metric for favoring one rule over another. While monetary policy rules often agree about the direction (up or down) in which policymakers should move the federal funds rate, they frequently disagree about the appropriate level of that rate. Historical prescriptions from policy rules differ from one another and also differ from the Committee's target for the federal funds rate, as shown in figure E. (These prescriptions are calculated using both the actual data and the estimates of the neutral real interest rate in the longer run and of the rate of unemployment in the longer run--data and estimates that were available to FOMC policymakers at the time.) Moreover, the rules sometimes prescribe setting short-term interest rates well below zero--a setting that is not feasible. With the exception of the adjusted Taylor (1993) rule, which imposes a lower limit of zero, all of the rules shown in figure E called for the federal funds rate to turn negative in 2009 and to stay below zero for several years thereafter. Thus, these rules indicated that the Federal Reserve should provide more monetary stimulus than could be achieved by setting the federal funds rate at zero. While all of the policy rules have called for higher values of the federal funds rate in recent years, the pace of tightening that the rules prescribe has varied widely. Prescriptions from these rules for the level of the federal funds rate in the first quarter of 2017 ranged from 37 basis points (change rule) to 2.5 percent (balanced-approach rule).9
1. There is a lengthy academic and intellectual debate about using rules to guide monetary policy; prominent examples of rules heavily discussed in the literature and influential on policymaking in earlier periods include the gold standard and Milton Friedman's constant money growth rule. Return to text
2. The Taylor (1993) rule was first suggested in John B. Taylor (1993), "Discretion versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 195-214. The balanced-approach rule was analyzed in John B. Taylor (1999), "A Historical Analysis of Monetary Policy Rules," in John B. Taylor, ed., Monetary Policy Rules (Chicago: University of Chicago Press), pp. 319-41. The adjusted Taylor (1993) rule was studied in David Reifschneider and John C. Williams (2000), "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit, and Banking, vol. 32 (November), pp. 936-66. The change rule was discussed in John B. Taylor (1999), "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by the European Central Bank," Journal of Monetary Economics, vol. 43 (June), pp. 655-79. Finally, the first-difference rule was introduced by Athanasios Orphanides (2003), "Historical Monetary Policy Analysis and the Taylor Rule," Journal of Monetary Economics, vol. 50 (July), pp. 983-1022. A comprehensive review of policy rules is in John B. Taylor and John C. Williams (2011), "Simple and Robust Rules for Monetary Policy," in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol.3B (Amsterdam: North-Holland), pp. 829-59. The same volume of the Handbook of Monetary Economics also discusses approaches other than policy rules for deriving policy rate prescriptions. Return to text
3. The Taylor (1993) rule represented slack in resource utilization using an output gap (the difference between the current level of real gross domestic product (GDP) and what GDP would be if the economy was operating at maximum employment). The rules in figure A represent slack in resource utilization using the unemployment gap instead, because that gap better captures the Federal Open Market Committee's statutory goal to promote maximum employment. Movements in these alternative measures of resource utilization are highly correlated. For more information, see the note below figure A. Return to text
4. Taylor-type rules--including John Taylor's original rule--have often been estimated assuming that the value of the neutral real interest rate in the longer run, r LR, is equal to 2 percent, which roughly corresponds to the average historical value of the real federal funds rate before the financial crisis. Return to text
5. For a discussion of these and other metrics of the labor market, see Hess Chung, Bruce Fallick, Christopher Nekarda, and David Ratner (2014), "Assessing the Change in Labor Market Conditions," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 22), https://www.federalreserve.gov/econresdata/notes/feds-notes/2014/assessing-the-change-in-labor-market-conditions-20140522.html. Return to text
6. The change and first-difference rules shown in figure A reduce the need for good estimates of longer-run rates because they do not require an estimate of the neutral real interest rate in the longer run. However, these rules have their own shortcomings. For example, research suggests that such rules will result in greater volatility in employment and inflation relative to what would be obtained under the Taylor (1993) and balanced-approach rules unless the estimates of the neutral real federal funds rate in the longer run and the rate of unemployment in the longer run are sufficiently far from their true values. Return to text
7. Prescriptions from monetary policy rules are included in the Board staff's Tealbook (previously the Bluebook); the precise set of rules presented has changed from time to time. The transcripts and briefing materials for FOMC meetings through 2011 are available on the Board's website at https://www.federalreserve.gov/monetarypolicy/fomc_historical.htm. In the materials from 2011, the policy rule prescriptions are contained in the Monetary Policy Strategies section of Tealbook B. Return to text
8. The briefing materials that FOMC policymakers review regularly include the Board staff's baseline forecast for the economy and model simulations of a variety of alternative scenarios intended to provide a sense of the effects of other plausible developments that were not included in the staff's baseline forecast. Return to text
9. As noted earlier, the adjusted rule limits increases in the federal funds rate for a time during economic recoveries to make up for past shortfalls in accommodation caused by the zero lower limit on interest rates. This principle can also be applied to the prescriptions of the other rules. If applied to the balanced-approach rule, for example, it would have called for the federal funds rate to have remained at zero at least through the first quarter of 2017. Return to textReturn to text
Future changes in the federal funds rate will depend on the economic outlook as informed by incoming data
The FOMC 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. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.
The Committee currently expects that the ongoing strength in the economy will warrant gradual increases in the federal funds rate, and that the federal funds rate will likely remain, for some time, below the levels that the Committee expects to prevail in the longer run. Consistent with this outlook, in the most recent Summary of Economic Projections, which was compiled at the time of the June FOMC meeting, most FOMC participants projected that the appropriate level of the federal funds rate would be below its longer-run level through 2018.6
The size of the Federal Reserve's balance sheet has remained stable so far this year
To help maintain accommodative financial conditions, the Committee has continued its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and rolling over maturing Treasury securities at auction. Consequently, the Federal Reserve's total assets have held steady at around $4.5 trillion, with holdings of U.S. Treasury securities at $2.5 trillion and holdings of agency debt and agency mortgage-backed securities at approximately $1.8 trillion (figure 45). Total liabilities on the Federal Reserve's balance sheet were also mostly unchanged over the first half of 2017.
The Committee intends to implement a balance sheet normalization program
In June, policymakers augmented the Committee's Policy Normalization Principles and Plans issued in September 2014 by providing additional details regarding the approach the FOMC intends to use to reduce the Federal Reserve's holdings of Treasury and agency securities once normalization of the federal funds rate is well under way.7 The Committee intends to gradually reduce the Federal Reserve's securities holdings by decreasing its reinvestment of the principal payments it receives from the securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps. Initially, these caps will be set at relatively low levels to limit the volume of securities that private investors will have to absorb. The Committee currently expects that, provided the economy evolves broadly as anticipated, it would likely begin to implement the program this year. In addition, the Committee affirmed that changing the target range for the federal funds rate remains its primary means of adjusting the stance of monetary policy (see the box "Addendum to the Policy Normalization Principles and Plans").
Addendum to the Policy Normalization Principles and Plans
Adopted effective September 16, 2014; as amended effective June 14, 2017
All participants agreed to augment the Committee's Policy Normalization Principles and Plans by providing the following additional details regarding the approach the FOMC intends to use to reduce the Federal Reserve's holdings of Treasury and agency securities once normalization of the level of the federal funds rate is well under way.1
The Committee intends to gradually reduce the Federal Reserve's securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps.
- For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.
- For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.
- The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve's securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.
- Gradually reducing the Federal Reserve's securities holdings will result in a declining supply of reserve balances. The Committee currently anticipates reducing the quantity of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system's demand for reserve balances and the Committee's decisions about how to implement monetary policy most efficiently and effectively in the future. The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.
- The Committee affirms that changing the target range for the federal funds rate is its primary means of adjusting the stance of monetary policy. However, the Committee would be prepared to resume reinvestment of principal payments received on securities held by the Federal Reserve if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee's target for the federal funds rate. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.
1. The Committee's Policy Normalization Principles and Plans were adopted on September 16, 2014, and are available at www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.pdf. On March 18, 2015, the Committee adopted an addendum to the Policy Normalization Principles and Plans, which is available at www.federalreserve.gov/monetarypolicy/files/FOMC_PolicyNormalization.20150318.pdf. Return to textReturn to text
The Federal Reserve's implementation of monetary policy has continued smoothly
The Federal Reserve successfully raised the effective federal funds rate in March and June of 2017 by increasing the interest rate paid on reserve balances along with the interest rate offered on overnight reverse repurchase agreements (ON RRPs). Specifically, the Federal Reserve increased the interest rate paid on required and excess reserve balances to 1.00 percent in March and 1.25 percent in June while increasing the ON RRP offering rate to 0.75 percent in March and 1.00 percent in June. In addition, the Board of Governors approved 1/4 percentage point increases in the discount rate (the primary credit rate) in March and June. In both March and June, the effective federal funds rate rose near the middle of its new target range amid orderly trading conditions in money markets, closely tracked by most other overnight money market rates.
Usage of the ON RRP facility, which had increased late last year as a result of higher demand by government money market funds in the wake of last October's money fund reform, has declined some, on average, in recent months. However, usage has remained somewhat above its levels of one year ago.
5. See Board of Governors of the Federal Reserve System (2017), "Federal Reserve Issues FOMC Statement," press release, March 15, https://www.federalreserve.gov/newsevents/pressreleases/monetary20170315a.htm; and Board of Governors of the Federal Reserve System (2017), "Federal Reserve Issues FOMC Statement," press release, June 14, https://www.federalreserve.gov/newsevents/pressreleases/monetary20170614a.htm. Return to text
6. See the June 2017 Summary of Economic Projections, which appeared as an addendum to the minutes of the June 13-14, 2017, meeting of the Federal Open Market Committee and is included as Part 3 of this report. Return to text
7. See Board of Governors of the Federal Reserve System (2017), "FOMC Issues Addendum to the Policy Normalization Principles and Plans," press release, June 14, https://www.federalreserve.gov/newsevents/pressreleases/monetary20170614c.htm. Return to text