Board of Governors of the Federal Reserve System

Summary

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

Economic activity increased at a moderate pace over the first half of the year, and the jobs market continued to strengthen. Measured on a 12-month basis, inflation has softened some in the past few months. The Federal Open Market Committee (FOMC) judged that, on balance, current and prospective economic conditions called for a further gradual removal of policy accommodation. At its most recent meeting in June, the Committee boosted the target range for the federal funds rate to 1 to 1-1/4 percent. The Committee also issued additional information regarding its plans for reducing the size of its balance sheet in a gradual and predictable manner.

Economic and Financial Developments

Labor markets. The labor market has strengthened further so far this year. Over the first five months of 2017, payroll employment increased 162,000 per month, on average, somewhat slower than the average monthly increase for 2016 but still more than enough to absorb new entrants into the labor force. The unemployment rate fell from 4.7 percent in December to 4.3 percent in May--modestly below the median of FOMC participants' estimates of its longer-run normal level. Other measures of labor utilization are also consistent with a relatively tight labor market. However, despite the broad-based strength in measures of employment, wage growth has been only modest, possibly held down by the weak pace of productivity growth in recent years.

Inflation. Consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures, briefly reached the FOMC's 2 percent objective earlier this year, but it more recently has softened. The latest reading, for May, was 1.4 percent--still up from a year earlier when falling energy prices restrained overall consumer prices. The 12-month measure of inflation that excludes food and energy items (so-called core inflation), which historically has been a better indicator than the headline figure of where overall inflation will be in the future, was also 1.4 percent over the year ending in May; this reading was a bit lower than it had been one year earlier. Measures of longer-run inflation expectations have been relatively stable, on balance, though some measures remain low by historical standards.

Economic growth. Real gross domestic product (GDP) is reported to have risen at an annual rate of about 1-1/2 percent in the first quarter of 2017, but more recent data suggest growth stepped back up in the second quarter. Consumer spending was sluggish in the early part of the year but appears to have rebounded recently, supported by job gains, rising household wealth, and favorable consumer sentiment. Business investment has turned up this year after having been weak for much of 2016, and indicators of business sentiment have been strong. The housing market continues its gradual recovery. Economic growth has also been supported by recent strength in foreign activity.

Financial conditions. On balance, domestic financial conditions for businesses and households have continued to support economic growth. Long-term nominal Treasury yields and mortgage rates have decreased so far in 2017, although yields remain somewhat above levels that prevailed last summer. Broad measures of equity prices increased further during the first half of the year. Spreads of yields on corporate bonds over comparable-maturity Treasury securities decreased. Most types of consumer loans remained widely available, while mortgage credit stayed readily available for households with solid credit profiles but was still difficult to access for households with low credit scores or harder-to-document incomes. In foreign financial markets, equity prices increased and risk spreads decreased amid generally firming economic growth and robust corporate earnings. The broad U.S. dollar index depreciated modestly against foreign currencies.

Financial stability. Vulnerabilities in the U.S. financial system remained, on balance, moderate. Contributing to the financial system's improved resilience, U.S. banks have substantial amounts of capital and liquidity. Valuation pressures across a range of assets and several indicators of investor risk appetite have increased further since mid-February. However, these developments in asset markets have not been accompanied by increased leverage in the financial sector, according to available metrics, or increased borrowing in the nonfinancial sector. Household debt as a share of GDP continues to be subdued, and debt owed by nonfinancial businesses, although elevated, has been either flat or falling in the past two years. (See the box "Developments Related to Financial Stability" in Part 1.)

Monetary Policy

Interest rate policy. Over the first half of 2017, the FOMC continued to gradually reduce the amount of monetary policy accommodation. Specifically, the Committee decided to raise the target range for the federal funds rate in March and in June, bringing it to the current range of 1 to 1-1/4 percent. Even with these rate increases, the stance of monetary policy remains accommodative, supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

The FOMC continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term. The federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. Consistent with this outlook, in the most recent Summary of Economic Projections (SEP), compiled at the time of the June FOMC meeting, most participants projected that the appropriate level of the federal funds rate would be below its longer-run level through 2018. (The June SEP is presented in Part 3 of this report.) However, as the Committee has continued to emphasize, monetary policy is not on a preset course; the actual path of the federal funds rate will depend on the evolution of the economic outlook as informed by incoming data. In particular, the Committee is monitoring inflation developments closely.

Balance sheet policy. 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. In June, the FOMC issued an Addendum to the Policy Normalization Principles and Plans that provides additional details regarding the approach the FOMC intends to follow to reduce the Federal Reserve's holdings of Treasury and agency securities in a gradual and predictable manner. The Committee currently expects to begin implementing the balance sheet normalization program this year provided that the economy evolves broadly as anticipated. (See the box "Addendum to the Policy Normalization Principles and Plans" in Part 2.)

Special Topics

Education and climbing the economic ladder. Education, particularly a college degree, is often seen as a path to improved economic opportunities. However, despite the fact that young blacks and Hispanics have increased their educational attainment over the past quarter-century, their representation in the top 25 percent of the income distribution for young people has not materially increased. In part, this outcome has occurred because educational attainment has increased for young non-Hispanic whites and Asians as well. 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. (See the box "Does Education Determine Who Climbs the Economic Ladder?" in Part 1.)

The global productivity slowdown. Over the past decade, labor productivity growth both in the United States and in other advanced economies has slowed markedly. This slowdown may reflect a waning of the effects from advances in information technology in the 1990s and early 2000s. Productivity growth may also be low because of the severity of the Global Financial Crisis, in part because spending for research and development was muted. Some of the factors restraining productivity growth may eventually fade, but it is difficult to ascertain whether the recent subdued performance of productivity represents a new normal. (See the box "Productivity Developments in the Advanced Economies" in Part 1.)

Liquidity in the corporate bond market. A series of changes, including regulatory reforms, since the Global Financial Crisis have likely altered financial institutions' incentives to provide liquidity. Many market participants are particularly concerned with liquidity in markets for corporate bonds. However, the available evidence suggests that financial markets have performed well in recent years, with minimal impairment in liquidity, either in the market for corporate bonds or in markets for other assets. (See the box "Recent Developments in Corporate Bond Market Liquidity" in Part 1.)

Monetary policy rules. Monetary policymakers consider a wide range of information on current economic conditions and the outlook before deciding on a policy stance they deem most likely to foster the FOMC's statutory mandate of maximum employment and stable prices. They also routinely consult monetary policy rules that connect prescriptions for the policy interest rate with variables associated with the dual mandate. The use of such rules requires careful judgments about the choice and measurement of the inputs into 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" in Part 2.)