Part 1: Recent Economic and Financial Developments

Monetary Policy Report submitted to the Congress on February 23, 2018, pursuant to section 2B of the Federal Reserve Act

Domestic Developments

The labor market strengthened further during the second half of 2017 and early this year

Payroll employment has continued to post solid gains, averaging 182,000 per month in the seven months starting in July 2017, about the same pace as in the first half of 2017.2 Although net job creation last year was slightly slower than in 2016, it has remained considerably faster than what is needed, on average, to absorb new entrants to the labor force and is therefore consistent with the view that the labor market has strengthened further (figure 1). The strength of the labor market is also evident in the decline in the unemployment rate to 4.1 percent in January, 1/4 percentage point below its level in June 2017 and about 1/2 percentage point below the median of Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level (figure 2).

Other indicators also suggest that labor market conditions have continued to tighten. The labor force participation rate (LFPR)--that is, the share of adults either working or actively looking for work--was 62.7 percent in January. The LFPR is little changed, on net, since early 2014 (figure 3). However, the average age of the population is continuing to increase. In particular, the members of the baby-boom cohort increasingly are moving into their retirement years, a time when labor force participation typically is low. That development implies that a sustained period in which the demand for and supply of labor were in balance would be associated with a downward trend in the overall participation rate. Accordingly, the flat profile of the LFPR during the past few years is consistent with an overall picture of improving labor market conditions. In line with this perspective, the LFPR for individuals aged 25 to 54--which is much less sensitive to population aging--has been rising since 2015. The employment-to-population ratio for individuals 16 and older--that is, the share of people who are working--was 60.1 percent in January and has been increasing since 2011; this gain primarily reflects the decline in the unemployment rate. (The box "How Tight Is the Labor Market?" describes the available measures of labor market slack in more detail.)

Other indicators are also consistent with continuing strong labor demand. The number of people filing initial claims for unemployment insurance has remained near its lowest level in decades.3 As reported in the Job Openings and Labor Turnover Survey, the rate of job openings remained elevated in the second half of 2017, while the rate of layoffs remained low. In addition, the rate of quits stayed high, an indication that workers are able to obtain a new job when they seek one.

How Tight Is the Labor Market?

Any assessment of labor market tightness is inherently uncertain, as it involves comparing current labor market conditions with an estimate of conditions that would prevail under full employment, where the latter circumstance cannot be directly observed or measured and can change over time. Many economists would describe the labor market as being at full employment when the unemployment rate has reached an "equilibrium" level, sometimes called the natural rate of unemployment or the longer-run normal rate of unemployment. In judging the level of full employment, one may also consider additional margins of labor utilization--including the labor force participation rate (LFPR), the share of workers employed part time who would like to be working full time, and individuals who are classified as marginally attached to the labor force--as compared with trends in these measures. While the uncertainty around the "normal" trends in all of these variables is substantial, the labor market in early 2018 appears to be near or a little beyond full employment.

The unemployment rate is now somewhat below most estimates of its natural rate. Specifically, the unemployment rate in January, at 4.1 percent, is 1/2 percentage point below the median of Federal Open Market Committee (FOMC) participants' estimates of the longer-run normal rate of unemployment, which was reported to have been 4.6 percent as of the December 2017 FOMC meeting. The unemployment rate is also about 1/2 percentage point below the Congressional Budget Office's (CBO) current estimate of the natural rate; by this measure, the labor market is about as tight as it was in the late 1980s but less tight than in the late 1990s (figure A). That said, the median of FOMC participants' estimates of the longer-run normal rate of unemployment and the CBO's estimate of the natural rate of unemployment have both been revised down by about 1 percentage point over the past few years, one indication of the substantial uncertainty surrounding estimates of the "full employment" rate of unemployment.1

As discussed in the main text, the LFPR has been roughly unchanged, on net, over the past four years, representing an important cyclical improvement relative to its declining trend. While estimates of the trend LFPR are subject to substantial uncertainty and differ among analysts, the current level of the LFPR is relatively close to many estimates of its trend.2 The fact that the LFPR for prime-age men remains below its pre-recession levels might suggest that slack remains along this dimension; however, the lower level of the LFPR for prime-age men primarily seems to reflect the continuation of a decades-long secular decline rather than a cyclical shortfall in their LFPR. In addition, the U-6 measure of labor utilization--which includes the unemployed, those marginally attached to the labor force, and those employed part time who would like full-time work--rose even more steeply than the unemployment rate during and immediately after the recession and has since recovered to near its pre-recession level. Although there is substantial uncertainty about the trends in each of the components of U-6, its current level can be cautiously interpreted as consistent with a labor market close to full employment.

One can also look at less-direct indicators of labor market tightness. For example, the share of small businesses with at least one job opening that they view as hard to fill is now close to its record levels in the late 1990s (as seen in the black line in figure B), consistent with the notion that as the labor market tightens, businesses find it increasingly difficult to hire additional workers. Similarly, survey measures of households' perceptions about job availability are currently at high levels, as shown by the blue line in figure B.

However, despite reports that employers are now having more difficulties finding qualified workers, hiring has continued apace. Although payroll employment gains have gradually slowed over time from about 250,000 per month, on average, in 2014 to about 180,000 per month, on average, in 2017, job growth remains consistent with further strengthening in the labor market.3 Finally, the pace of wage gains has been moderate; while wage gains have likely been held down by the sluggish pace of productivity growth in recent years, serious labor shortages would probably bring about larger increases than have been observed thus far.

It is possible that labor shortages have arisen in certain pockets of the economy, which could be an early indication of bottlenecks that are not yet readily apparent in the aggregate labor market. However, even at the industry level it is difficult to see much evidence of emerging supply constraints.4 In some industries, such as trade and transportation as well as leisure and hospitality, employment growth has slowed markedly and it has taken longer for businesses to find workers in recent years, yet wage growth has remained steady or slowed.

Finally, while the aggregate labor market appears to be modestly tight at the moment, not all individuals have benefited equally from these developments. As discussed in the main text, noticeable differences in labor market outcomes remain present across racial and ethnic groups. Moreover, the labor market improvement in recent years has not been sufficient to make important progress in narrowing income inequality. Finally, regional disparities are also striking, and in certain aspects these disparities have widened in recent years; for example, the employment-to-population ratio for prime-age individuals has recovered less for those outside of metro areas than for those in metro areas (figure C).5

1. As another indication of this uncertainty, the range of FOMC participants' estimates of the longer-run normal rate of unemployment was 4.3 to 5.0 percent in December 2017. Return to text

2. For a variety of approaches to assessing the level of trend LFPR and the associated range of estimates, see Stephanie Aaronson, Tomaz Cajner, Bruce Fallick, Felix Galbis-Reig, Christopher Smith, and William Wascher (2014), "Labor Force Participation: Recent Developments and Future Prospects," Brookings Papers on Economic Activity, Fall, pp. 197-275, Estimates of trend LFPR are also provided by the CBO in their recurring publication The Budget and Economic Outlook and its updates. Return to text

3. Payroll gains in the range of about 90,000 to 120,000 per month are estimated to be consistent with a constant unemployment rate and a decline in the labor force participation rate in line with its demographically driven trend. Return to text

4. The analysis behind this statement considered six broad industries--construction, manufacturing, trade and transportation, health and education, leisure and hospitality, and professional and business services. Return to text

5. See Alison Weingarden (2017), "Labor Market Outcomes in Metropolitan and Non-metropolitan Areas: Signs of Growing Disparities," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, September 25), Return to text

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Unemployment rates have declined across demographic groups, but unemployment remains high for some groups

Unemployment rates have trended downward across racial and ethnic groups (figure 4). The decline in the unemployment rate for blacks or African Americans over the past few years has been particularly notable. This broad pattern is typical: The unemployment rates for blacks and Hispanics tend to rise considerably more than the rates for whites and Asians during recessions, and then they decline more rapidly during expansions. Yet even with the recent narrowing, the disparities in unemployment rates across demographic groups remain substantial and largely the same as before the recession. The unemployment rate for whites has averaged 3.7 percent since the middle of 2017 and the rate for Asians has been about 3.3 percent, while the unemployment rates for Hispanics or Latinos (5.0 percent) and blacks (7.3 percent) have been substantially higher. In addition, the labor force participation rates for blacks, Hispanics, and Asians have generally been lower than those for whites of the same age group. As the labor market has strengthened over the past few years, the participation rates for prime-age individuals in each of these groups have risen.

Growth of labor compensation has been moderate...

Despite the strong labor market, the available indicators generally suggest that the growth of hourly compensation has been moderate. Growth of compensation per hour in the business sector--a broad-based measure of wages, salaries, and benefits that is quite volatile--was 2-1/4 percent over the four quarters ending in 2017:Q4 (figure 5), well above the low reading in 2016 but about in line with the average annual increase from 2010 to 2015.4 The employment cost index--which also measures both wages and the cost to employers of providing benefits--was up about 2-1/2 percent in the fourth quarter of 2017 relative to its year-ago level, roughly 1/2 percentage point faster than its gain a year earlier. Among measures that do not take account of benefits, average hourly earnings rose slightly less than 3 percent through January of this year, a gain that was somewhat faster than the average increase in the preceding few years. Similarly, the measure of wage growth computed by the Federal Reserve Bank of Atlanta that tracks median 12-month wage growth of individuals reporting to the Current Population Survey showed an increase of about 3 percent in January, similar to its readings from the past three years and above the average increase in the preceding few years.5

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

These moderate 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 a little more than 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). Considerable debate remains about the reasons for the general slowdown in productivity growth and whether it will persist. The slowdown may be partly attributable to the sharp pullback in capital investment during the most recent recession and the relatively long period of modest growth in investment that followed, but a reduced pace of capital deepening can explain only a portion of the step-down. Beyond that, some economists think that more recent technological advances, such as information technology, have been less revolutionary than earlier general-purpose technologies, such as electricity and internal combustion. Others have pointed to a slowdown in the speed at which capital and labor are reallocated toward their most productive uses, which is reflected in fewer business start-ups and a reduced pace of hiring and investment by the most innovative firms. Still others argue that there have been important innovations in many fields in recent years, from energy to medicine, often underpinned by ongoing advances in information technology, which augurs well for productivity growth going forward. However, those economists note that such productivity gains may appear only slowly as new firms emerge to exploit the new technologies and as incumbent firms invest in new vintages of capital and restructure their businesses.

Price inflation remains below 2 percent, but the monthly readings picked up toward the end of 2017

Consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures (PCE), remained below the FOMC's longer-run objective of 2 percent during most of 2017. The PCE price index increased 1.7 percent over the 12 months ending in December 2017, about the same as in 2016 (figure 7). Core inflation, which typically provides a better indication than the headline measure of where overall inflation will be in the future, was 1.5 percent over the 12 months ending in December 2017--0.4 percentage point lower than it had been one year earlier.

Both measures of inflation reflected some weak readings in the spring and summer of 2017. A portion of those weak readings seemed attributable to idiosyncratic events, such as a steep 1-month decline in the price index for wireless telephone services. However, the monthly readings on core inflation were somewhat higher during the last few months of 2017, in contrast to the more typical pattern that has prevailed in recent years in which readings around the end of the year have tended to be slightly below average. Moreover, 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 that may be less sensitive to idiosyncratic price movements--was 1.7 percent in December 2017 and has slowed by less than core PCE price inflation over the past 12 months.6 (For more discussion of inflation both in the United States and abroad, see the box "Low Inflation in the Advanced Economies.")

Low Inflation in the Advanced Economies

Inflation has been persistently low in recent years across many advanced economies. In the United States, both overall inflation and core (excluding food and energy prices) inflation, as measured by the price index for personal consumption expenditures, have run below 2 percent for most of the period since 2008 (figure A). In other advanced economies, measures of core inflation have run even lower in some cases, with core inflation in the euro area currently at around 1 percent and in Japan at close to zero (figure B).

What explains this period of low inflation? Across the advanced economies, the main factors holding inflation down likely include the extended period of economic slack following the Great Recession and the falling prices of oil and other commodities from around mid-2014 to early 2016. In the United States, inflation also has been held down by the rise in the foreign exchange value of the dollar from mid-2014 through 2016. The low core U.S. inflation in 2017 has been more of a puzzle (albeit modest in magnitude) and harder to associate with an identifiable cause.1 As is discussed in the December 2017 Summary of Economic Projections (Part 3 of this report), most Federal Reserve policymakers view these recent low inflation readings as likely to prove transitory and project U.S. inflation this year to move closer to their 2 percent objective. Many private forecasters appear to share this view.

But our understanding of the forces that drive inflation is imperfect, and the fact that many advanced economies are experiencing low inflation at the same time suggests that other, possibly more persistent, factors may be at work. As one possibility, the natural rate of unemployment--the rate at which labor markets exert neither upward nor downward pressure on inflation--is highly uncertain, and it could be lower in many economies than most economists estimate. Alternatively, inflation expectations could be lower than suggested by the available indicators.

More-fundamental changes in the global economy could also be contributing to the recent stretch of lower inflation. First, anecdotal reports suggest that technological changes could be reducing pricing power in many industries, holding down inflation as that occurs.2 For example, the increased prevalence of Internet shopping allows consumers to compare prices more easily across sellers, possibly implying greater competition that could be putting downward pressure on consumer prices (figure C). While this hypothesis is certainly plausible, it does not easily square with the observation that, at least within the United States, profit margins have been high (figure D).3

Second, some observers have pointed to global developments as helping to explain persistent low inflation across countries. These developments include economic slack abroad or the integration of emerging economies into the world economy, leading to increased competition or downward pressures on wages.4 But the evidence that global slack can help explain inflation in a given country, beyond its effect on commodity and import prices, is mixed at best.5 Moreover, measures of integration, such as global trade as a fraction of gross domestic product or the participation in global value chains, appear to have leveled off in recent years.

A number of other explanations for low global inflation have been advanced as well. These explanations include some tentative evidence suggesting that the aging of the population could be exerting downward pressure on trend inflation, perhaps because retirees may tend to be more price conscious than other consumers.6 Others have pointed to a slowdown in medical services price increases across countries, possibly associated with either health-care reform or fiscal austerity.7 This slowdown has had a material effect on U.S. inflation, though the extent to which these declines will persist is uncertain.

In summary, while standard economic models appear to explain much of the post-Great Recession period of low inflation, they do not preclude other explanations. Even as most policymakers expect inflation in their economies to move back to their targets over time, they remain attentive to the possibility that factors not included in those models, such as those described here, may keep inflation low. At the same time, they are attentive to the opposite risk of inflation moving undesirably high, should tightening demand conditions lead to faster rises in wages and prices than currently anticipated.

1. For additional discussion of the reasons for low inflation in the United States, see Janet Yellen (2017), "Inflation, Uncertainty, and Monetary Policy," speech delivered at "Prospects for Growth: Reassessing the Fundamentals," 59th Annual Meeting of the National Association for Business Economics, Cleveland, Ohio, September 26, Return to text

2. Goldman Sachs (2017), "The Amazon Effect in Perspective," U.S. Economics Analyst (New York: Goldman Sachs, September 30). Return to text

3. See Council of Economic Advisers (2016), "Benefits of Competition and Indicators of Market Power," Council of Economic Advisers Issue Brief (Washington: CEA, April), Return to text

4. See Claudio Borio and Andrew Filardo (2007), "Globalisation and Inflation: New Cross-Country Evidence on the Global Determinants of Domestic Inflation," BIS Working Papers 227 (Basel, Switzerland: Bank for International Settlements, May),; and Raphael Auer, Claudio Borio, and Andrew Filardo (2017), "The Globalisation of Inflation: The Growing Importance of Global Value Chains," BIS Working Papers 602 (Basel, Switzerland: Bank for International Settlements, January), Return to text

5. See Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez (2010), "Some Simple Tests of the Globalization and Inflation Hypothesis," International Finance,vol. 13 (Winter), pp. 343-75; and European Central Bank (2017), "Domestic and Global Drivers of Inflation in the Euro Area," ECB Economic Bulletin, no.4 (June), pp. 72-96, Return to text

6. See Jong-Won Yoon, Jinill Kim, and Jungjin Lee (2014), "Impact of Demographic Changes on Inflation and the Macroeconomy," IMF Working Paper WP/14/210 (Washington: International Monetary Fund, November), However, other evidence suggests increased inflationary pressure from an aging population; see Mikael Juselius and Előd Takáts (2015), "Can Demography Affect Inflation and Monetary Policy?" BIS Working Papers485 (Basel, Switzerland: Bank for International Settlements, February), Return to text

7. See Tim Mahedy and Adam Shapiro (2017), "What's Down with Inflation?" FRBSF Economic Letter 2017-35 (San Francisco: Federal Reserve Bank of San Francisco, November),; and Goldman Sachs (2017), "What Can We Learn from Lower Inflation Abroad?" U.S. Economics Analyst (New York: Goldman Sachs, November 12). Return to text

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Oil and metals prices increased notably

Headline inflation was a little higher than core inflation last year, which reflected a rise in consumer energy prices. The price of crude oil rose from $48 per barrel at the end of June to a peak of about $70 per barrel early in the year and, even after recent declines, remains more than 30 percent above its mid-2017 level (figure 8). The upswing in oil prices appears to have been driven primarily by strengthening global demand as well as OPEC's decision to further extend its November 2016 production cuts through the end of 2018. The higher oil prices fed through to moderate increases in the cost of gasoline and heating oil.

Inflation momentum was also supported by nonfuel import prices, which rose throughout 2017 in part because of dollar depreciation (figure 9). That development marked a turn from the past several years, during which nonfuel import prices declined or held flat. In addition to the decline in the dollar, nonfuel import prices were driven higher by a substantial increase in the price of industrial metals. Despite recent volatility, metals prices remain higher, on net, boosted primarily by improved prospects for global demand and also by government policies that restrained production in China.

In contrast, headline inflation has been held down by consumer food prices, which increased only about 1/2 percent in 2017 after having declined in 2016. Food prices have been restrained by softness in the prices of farm commodities, which in turn has reflected robust supply in the United States and abroad. Although the harvests for many crops in the United States declined in 2017, they were larger than had been expected earlier in the year.

Survey-based measures of inflation expectations have been generally stable...

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 generally stable. In the 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 has been around 2 percent for the past several years (figure 10). In the University of Michigan Surveys of Consumers, the median value for inflation expectations over the next 5 to 10 years--which had drifted downward starting in 2014--has held about flat since the end of 2016 at a level that is a few tenths lower than had prevailed through 2014.

...and market-based measures of inflation compensation have increased in recent months but remain relatively low

Inflation expectations can also be gauged by market-based measures of inflation compensation, though the inference is not straightforward because market-based measures can be importantly affected by changes in premiums that provide compensation for bearing inflation and liquidity risks. 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 increased since June, returning to levels seen in early 2017, but nevertheless remain relatively low (figure 11).7 The TIPS-based measure of 5-to-10-year-forward inflation compensation and the analogous measure of inflation swaps are now slightly lower than 2-1/4 percent and 2-1/2 percent, respectively, with both measures below the ranges that persisted for most of the 10 years before the start of the notable declines in mid-2014.

Real gross domestic product growth picked up in the second half of 2017

Real gross domestic product (GDP) is reported to have risen at an annual rate of nearly 3 percent in the second half of 2017 after increasing slightly more than 2 percent in the first half of 2017 (figure 12). Much of that faster growth reflects the stabilization of inventory investment, which had slowed considerably in the first half of last year. Private domestic final purchases--that is, final purchases by U.S. households and businesses, which tend to provide a better indication of future GDP growth than most other components of overall spending--rose at a solid annual rate of about 3-1/2 percent in the second half of the year, similar to the first-half pace.

The economic expansion continues to be supported by steady job gains, rising household wealth, favorable consumer sentiment, strong economic growth abroad, and accommodative financial conditions, including the still low cost of borrowing and easy access to credit for many households and businesses. In addition to these factors, very upbeat business sentiment appears to have supported solid growth over the past year.

Ongoing improvement in the labor market and gains in wealth continue to support consumer spending...

Supported by ongoing improvement in the labor market, real consumer spending rose at a solid annual rate of 3 percent in the second half of 2017, a somewhat faster pace than in the first half. Real disposable personal income--that is, income after taxes and adjusted for price changes--increased at a modest average rate of 1 percent in 2016 and 2017, as real wages changed little over this period (figure 13). With spending growth estimated to have outpaced income growth, the personal saving rate has declined considerably since the end of 2015 (figure 14).

Consumer spending has also been supported by further increases in household net wealth. Broad measures of U.S. equity prices rose robustly last year, though markets have been volatile in recent weeks; house prices have also continued to climb, strengthening the wealth of homeowners (figure 15). As a result of the increases in home and equity prices, aggregate household net worth rose appreciably in 2017. In fact, at the end of the third quarter of 2017, household net worth was 6.7 times the value of disposable income, the highest-ever reading for that ratio, which dates back to 1947 (figure 16).

...borrowing conditions for consumers remain generally favorable...

Consumer credit expanded in 2017 at about the same pace as in 2016 (figure 17). Financing conditions for most types of consumer loans are generally favorable. However, banks have continued to tighten standards on credit card and auto loans for borrowers with low credit scores, possibly in response to some upward drift in delinquency rates for those borrowers. 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.

Although household borrowing continued to increase last year, 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--remained low by historical standards.

...and consumer confidence is strong

Consumers have remained optimistic about their economic situation. As measured by the Michigan survey, consumer sentiment was solid throughout 2017, likely reflecting rising income, job gains, and low inflation (figure 18). Furthermore, the share of households expecting real income to rise over the next year or two has continued to strengthen and now exceeds its pre-recession level.

Activity in the housing sector has improved modestly

Real residential investment spending increased around 2 percent in 2017, about the same modest gain that was seen in 2016. Housing activity was soft in the spring and summer, possibly reflecting the rise in mortgage interest rates early in the year, and then picked up toward the end of the year. For the year as a whole, sales of new and existing homes gained, and single-family housing starts increased (figures 19 and 20). In contrast, multifamily housing starts continued to edge down from the solid pace seen in 2016. Going forward, lean inventories are likely to support further gains in homebuilding activity, as the months' supply of homes for sale has remained near low levels.

Business investment has continued to rebound...

Real outlays for business investment--that is, private nonresidential fixed investment--rose at an annual rate of about 6 percent in the second half of 2017, a bit below the gain in the first half but still notably faster than the unusually weak pace recorded in 2016 (figure 21). Business spending on equipment and intangibles (such as research and development) advanced at a solid pace in the second half of the year, and forward-looking indicators of business spending are generally favorable: Orders and shipments of capital goods have posted net gains in recent months, and indicators of business sentiment and activity remain very upbeat. That said, business outlays on structures turned down in the second half of 2017, as investment growth in drilling and mining structures retreated from a very rapid pace in the first half and investment in other nonresidential structures declined.

...while corporate financing conditions have remained accommodative

Aggregate flows of credit to large nonfinancial firms remained solid through the third quarter, supported in part by continued low interest rates (figure 22). The gross issuance of corporate bonds stayed robust during the second half of 2017, and yields on both investment-grade and high-yield corporate bonds remained low by historical standards (figure 23).

Despite solid growth in business investment, outstanding commercial and industrial (C&I) loans on banks' books continued to rise only modestly in the third quarter of 2017. Respondents to the Senior Loan Officer Opinion Survey on Bank Lending Practices, or SLOOS, reported that demand for C&I loans declined in the third quarter and was little changed in the fourth quarter even as lending standards and terms on such loans eased.8 Respondents attributed this decline in demand in part to firms drawing on internally generated funds or using alternative sources of financing. Financing conditions for small businesses appear to have remained favorable, and although credit growth has remained sluggish, survey data suggest this sluggishness is largely due to continued weak demand for credit by small businesses.

Net exports subtracted from GDP growth in the fourth quarter after providing a modest addition during the rest of the year

U.S. real exports expanded at a moderate pace in the second half of last year after having increased more rapidly in the first half, supported by solid foreign growth (figure 24). At the same time, real imports surged in the fourth quarter following a slight contraction in the third quarter. As a result, real net exports moved from modestly lifting U.S. real GDP growth during the first three quarters of 2017 to subtracting more than 1 percentage point in the fourth quarter. Although the nominal trade and current account deficits narrowed in the third quarter of 2017, the trade deficit widened in the fourth quarter (figure 25).

Federal fiscal policy actions had a roughly neutral effect on economic growth in 2017...

Federal government purchases rose 1 percent in 2017, and policy actions had little effect on federal taxes or transfers (figure 26). Under currently enacted legislation, which includes the Tax Cuts and Jobs Act (TCJA) and the Bipartisan Budget Act, federal fiscal policy will likely provide a moderate boost to GDP growth this year.9

The federal unified deficit continued to widen in fiscal year 2017, reaching 3-1/2 percent of nominal GDP. Although expenditures as a share of GDP were relatively stable at a little under 21 percent, receipts moved lower in 2017 to roughly 17 percent of GDP (figure 27). The ratio of federal debt held by the public to nominal GDP was 75-1/4 percent at the end of fiscal year 2017 and remains quite elevated relative to historical norms (figure 28).

...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 only edged up, on average, in recent quarters. In contrast, house price gains have continued to push up property tax revenues at the local level. Employment in the state and local government sector only inched up in 2017, while outlays for construction by these governments continued to decline on net (figure 29).

Financial Developments

The expected path of the federal funds rate has moved up

The path of the expected federal funds rate implied by market quotes on interest rate derivatives has moved up on net since the middle of last year amid an improving global growth outlook (figure 30). Part of the upward shift occurred around FOMC communications in the fall that were interpreted as implying a somewhat quicker pace of policy rate increases than had been previously anticipated. The expected policy path also moved higher around the time when the U.S. tax legislation was finalized.

Survey-based measures of the expected path of the policy rate have been generally little changed on net, suggesting that part of the rise in the market-implied path reflected higher term premiums. In the Federal Reserve Bank of New York's Survey of Primary Dealers and Survey of Market Participants, which were conducted just before the January 2018 FOMC meeting, the median respondents expected three 25 basis point increases in the FOMC's target range for the federal funds rate as the most likely outcome for this year, unchanged from what they had expected in surveys conducted before the June FOMC meeting. Market-based measures of uncertainty about the policy rate approximately one to two years ahead have, on balance, edged up from their levels in the middle of 2017.

The nominal Treasury yield curve has shifted up

The nominal Treasury yield curve has shifted up on net since the middle of 2017, owing to greater optimism about the global growth outlook and investors' perceptions of higher odds for the removal of monetary policy accommodation (figure 31). Yields on shorter-term nominal Treasury securities increased relatively more than those on longer-term nominal Treasury securities, thus resulting in some flattening of the yield curve. According to market participants, among the factors contributing to this outcome has been the Treasury Department's stated intention to increase its reliance on issuance of short-dated securities, as discussed in the two most recent releases of the Treasury's quarterly financing statement.

Consistent with the changes in Treasury yields, yields on 30-year agency mortgage-backed securities (MBS)--an important determinant of mortgage interest rates--increased but remain quite low by historical standards (figure 32).

Broad equity price indexes have increased further...

Broad U.S. equity indexes, despite some declines seen in recent weeks, have, on balance, increased further since June 2017, with most of the net gains occurring during the final quarter of last year (figure 33). Equity prices were reportedly supported in part by an increase in investors' confidence that changes to the federal tax law will boost corporate earnings. Stock prices generally increased across industries outside utilities and real estate, two sectors for which the increases in interest rates described earlier are likely to have weighed more heavily on stock prices; stock prices of banks rose more than the broader market. Implied volatility for the S&P 500 index, as calculated from options prices, increased notably in early February, ending the period close to the median of its historical distribution.

...while risk spreads on corporate bonds have continued to decrease

Spreads on both high-yield and investment-grade corporate bond yields over comparable-maturity Treasury yields have decreased further since the middle of last year, with spreads for high-yield bonds moving closer to the bottom of their historical ranges. The narrowing of the spreads since the middle of 2017 appears to reflect both an anticipation that the losses from defaults on these bonds will be smaller and a lower compensation being charged for bearing the risk of such losses. (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability.")

Developments Related to Financial Stability

Overall vulnerabilities in the U.S. financial system remain moderate on balance.1 Valuation pressures continue to be elevated across a range of asset classes, including equities and commercial real estate. Vulnerabilities from leverage in the financial sector appear low, reflecting in part capital and liquidity ratios of banks that have continued to improve from already strong positions. However, there are signs that nonbank financial leverage has been increasing in some areas--for example, in the provision of margin credit to equity investors such as hedge funds. Vulnerabilities from nonfinancial leverage are judged to be moderate. While household debt balances have been increasing modestly, the leverage of the business sector is elevated, particularly among speculative-grade firms. Vulnerabilities related to maturity and liquidity transformation remain low on net.

Over the second half of 2017, valuation pressures edged up from already elevated levels. In general, valuations are higher than would be expected based solely on the current level of longer-term Treasury yields. In part reflecting growing anticipation of the boost to future (after-tax) earnings from a corporate tax rate cut, price-to-earnings ratios for U.S. stocks rose through January and were close to their highest levels outside of the late 1990s (figure A); ratios dropped back somewhat in early February. In a sign of increasing valuation pressures in commercial real estate markets, net operating income relative to property values (referred to as capitalization rates) have been declining relative to Treasury yields of comparable maturity for multifamily and industrial properties. While these spreads narrowed further from already low levels, they are wider than in 2007. Even though the aggregate residential house price-to-rent ratio has been increasing faster than its long-run trend, it is only slightly elevated at present. In corporate credit markets, spreads of corporate bond yields over those of Treasury securities with comparable maturities fell, and the high-yield spread is now near the bottom of its historical distribution. Spreads on leveraged loans and collateralized loan obligations--which are a significant funding source for the corporate sector--stayed compressed. In addition, nonprice terms eased on these types of loans, indicating weaker investor protection than at the peak of the previous credit cycle in 2007. Consistent with elevated risk appetite, virtual currencies experienced sharp price increases in 2017.

Vulnerabilities related to financial-sector leverage appear low. Leverage at insurance companies and at broker-dealers is on the low end of its historical range, and most indicators of leverage at other nonbank financial firms are stable. However, there is some evidence that dealers have eased price terms to hedge funds and real estate investment trusts, and that hedge funds have gradually increased their use of leverage, in particular margin credit for equity trades. Although such easing of price terms has taken place against the backdrop of building valuation pressures, the strong capital position of bank holding companies reduces the risk that sudden drops in asset prices could significantly affect bank-affiliated dealers. Risk-based regulatory capital ratios for most of the largest bank holding companies continued to increase from already high levels.

If interest rates were to increase unexpectedly, banks' strong capital position should help absorb the consequent losses on securities. About one-third of the losses that could be experienced by banks would affect held-to-maturity securities. While these losses would not reduce regulatory capital, they could still have a variety of negative consequences--for example, by worsening banks' funding terms. The large share of deposits in bank liabilities is also likely to soften the effect of an unexpected rise in interest rates on banks, because deposit rates tend to adjust with a delay and bank profitability would improve in the meantime.

Overall vulnerabilities arising from leverage in the nonfinancial sector continue to be moderate. Continuing its pattern in recent years, household debt has expanded about in line with nominal income, and the household credit-to-GDP gap remains sizable and negative (figure B). Leverage in the nonfinancial business sector remains high, with net issuance of risky debt climbing in recent months. However, the share of the lowest-quality debt in total issuance declined, and relatively low interest expenses mitigated some of the vulnerabilities associated with elevated leverage.

In part attributable to regulations introduced since the financial crisis, vulnerabilities associated with liquidity and maturity transformation--that is, the financing of illiquid or long-maturity assets with short-maturity debt--continue to be low. The reliance of global systemically important banks (G-SIBs) on short-term wholesale funding has risen only slightly from post-crisis lows, while their holdings of high-quality liquid assets stand at high levels and exceed those required by the Liquidity Coverage Ratio. The share of core deposits in total liabilities at G‑SIBs also remains at historically high levels. More than one year after the money market fund reform, which reduced run risk as investors shifted from prime to government funds, the growth in alternative short-term investment vehicles has been limited. Regarding securitized products, although the issuance of asset-backed securities (ABS) was strong, overall issuance has remained well below pre-crisis levels for most asset classes, and securitizations appear to involve limited maturity or liquidity transformation. Nonetheless, ABS issuance was boosted by the securitization of assets that were rarely securitized in the past, such as aircraft leases and mobile phone contracts. In addition, certain nontraditional liabilities of life insurers, including funding-agreement-backed securities, have grown notably recently, although levels remain low relative to the broader market for securitizations.

Financial vulnerabilities in foreign economies are moderate overall. Advanced foreign economies, many of which have strong financial and real linkages to the United States, continue to struggle with elevated valuations, the disposal of legacy assets, and, in some cases, worrisome rises in mortgage debt. Some major emerging market economies harbor more pronounced vulnerabilities, reflecting one or more of the following: substantial corporate leverage, fiscal concerns, or excessive reliance on foreign funding.

The countercyclical capital buffer (CCyB) is a macroprudential tool the Federal Reserve Board can use to increase the resilience of the financial system by raising capital requirements on internationally active banking organizations. The CCyB is activated when there is an elevated risk of above-normal future losses and when the banking organizations for which capital requirements would be raised by the buffer are exposed to or are contributing to this elevated risk--either directly or indirectly. The financial stability developments, assessments, and framework described and used here bear importantly on the Board's setting of the CCyB.2 In December 2017, the Board voted to affirm the CCyB at its level of 0 percent.

Over the second half of 2017, the Federal Reserve Board has taken some key steps to reduce regulatory burden while promoting the financial stability of the United States. The Federal Reserve Board, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation jointly proposed amendments to the banking agencies' commercial real estate appraisal regulations that raised the threshold price for mandating appraisals from $250,000 to $400,000, thereby reducing the number of required appraisals.3 In addition, the federal banking agencies issued a proposal to simplify aspects of community banking organizations' regulatory capital rules, with the goal of reducing regulatory burden on smaller institutions while maintaining the safety and soundness of the banking system.4

The Board requested comment on a corporate governance proposal to enhance the effectiveness of financial firms' boards of directors. The proposal refocuses the Federal Reserve's supervisory expectations for the largest firms' boards of directors on their core responsibilities and would also reduce unnecessary burden for the boards of smaller institutions.5 The Board also adopted a final rule to improve the resolvability and resilience of G-SIBs and their subsidiaries to restrictions regarding the terms of their noncleared qualified financial contracts.6 In addition, the Board proposed changes to its supervisory rating system for large financial institutions to better align with the post-crisis supervisory program for these firms; smaller institutions, including community banks, would continue to use the current rating system.7 Finally, the Board requested comment on a package of proposals that would increase the transparency of its stress-testing program. In particular, the proposals would provide more information about the models used to estimate hypothetical losses in the stress tests while maintaining the Board's ability to test the resilience of the nation's largest and most complex banks.8

1. An overview of the framework for assessing financial stability in the United States is provided in Stanley Fischer (2017), "An Assessment of Financial Stability in the United States," speech delivered at the IMF Workshop on Financial Surveillance and Communication: Best Practices from Latin America, the Caribbean, and Advanced Economies, Washington, June 27, Return to text

2. See Board of Governors of the Federal Reserve System (2016), "Regulatory Capital Rules: The Federal Reserve Board's Framework for Implementing the U.S. Basel III Countercyclical Capital Buffer," final policy statement (Docket No. R-1529), Federal Register, vol. 81 (September 16), pp. 63682-88. Return to text

3. See Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (2017), "Real Estate Appraisals," notice of proposed rulemaking and request for comment (Docket No. R-1568), Federal Register, vol. 82 (July 31), pp. 35478-93. Return to text

4. See Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (2017), "Simplifications to the Capital Rule Pursuant to the Economic Growth and Regulatory Paperwork Reduction Act of 1996," notice of proposed rulemaking (Docket No. R-1576), Federal Register, vol. 82 (October 27), pp. 49984-50044. Return to text

5. See Board of Governors of the Federal Reserve System (2017), "Federal Reserve Board Invites Public Comment on Two Proposals; Corporate Governance and Rating System for Large Financial Institutions," press release, August 3, Return to text

6. See Board of Governors of the Federal Reserve System (2017), "Restrictions on Qualified Financial Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions," final rule (Docket No. R-1538), Federal Register, vol. 82 (September 12), pp. 42882-926. Return to text

7. See Board of Governors, "Federal Reserve Board Invites Public Comment on Two Proposals," in note 5. Return to text

8. See Board of Governors of the Federal Reserve System (2017), "Federal Reserve Board Requests Comment on Package of Proposals That Would Increase the Transparency of Its Stress Testing Program," press release, December 7, Return to text

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Markets for Treasury securities, mortgage-backed securities, municipal bonds, and short-term funding have functioned well

Available indicators of Treasury market functioning have generally remained stable over the second half of 2017 and early 2018, with a variety of liquidity metrics--including bid-ask spreads, bid sizes, and estimates of transaction costs--mostly unchanged over the period. Liquidity conditions in the agency MBS market have also been generally stable. In recent months, the functioning of Treasury and agency MBS markets has not been notably affected by the implementation of the Federal Reserve's balance sheet normalization program and the resulting reduction in reinvestment of principal payments from the Federal Reserve's securities holdings. In early February, amid financial market volatility, liquidity conditions in the Treasury market deteriorated but have recovered somewhat since. Credit conditions in municipal bond markets have also remained generally stable since June 2017. Over that period, yield spreads on 20-year general obligation municipal bonds over comparable-maturity Treasury securities have narrowed on balance. Nevertheless, significant financial strains were still evident for some issuers. In particular, prices for Puerto Rico general obligation bonds fell notably after Hurricane Maria hit the island and its economic outlook deteriorated even further. However, these developments left little imprint in broader municipal bond markets. Conditions in domestic short-term funding markets have remained stable since the middle of last year.

Bank credit continued to expand and bank profitability remained stable

Aggregate credit provided by commercial banks continued to expand in the second half of 2017 at a pace similar to the one seen earlier in the year but more slowly than in 2016. Its pace was also slower than that of nominal GDP, thus leaving the ratio of total commercial bank credit to current-dollar GDP slightly lower than earlier in 2017 (figure 34). Measures of bank profitability were little changed at levels below their historical averages (figure 35).

International Developments

Economic activity in most foreign economies continued at a healthy pace in the second half of 2017

Foreign real GDP appears to have expanded notably in the second half of 2017, extending the period since mid-2016 when the pace of economic growth picked up broadly around the world.

Growth in advanced foreign economies was solid, and unemployment fell to multidecade lows...

In the advanced foreign economies (AFEs), the economic recovery has continued to firm. Real GDP in the euro area and the United Kingdom expanded at a solid pace in the second half of the year (figure 36). Economic activity also continued to expand in Japan, though real GDP growth slowed sharply in the fourth quarter. In Canada, data through November indicate that economic growth moderated somewhat in the second half following a very rapid expansion earlier in the year. Unemployment declined further as well, reaching 40-year lows in Canada and the United Kingdom, while growth in labor compensation ticked up only modestly.

...but inflation remained subdued...

Consumer price inflation rose somewhat in most AFEs, boosted by the rise in commodity prices (figure 37). However, headline and especially core inflation remained below the central banks' targets in the euro area and Japan. In contrast, U.K. inflation rose further above the Bank of England's (BOE) 2 percent target as the substantial sterling depreciation observed since the June 2016 Brexit referendum continued to provide some uplift to import prices. (For more discussion of inflation both in the United States and abroad, see the box "Low Inflation in the Advanced Economies" in the Domestic Developments section.)

...leading AFE central banks to maintain accommodative monetary policies

The Bank of Japan kept its policy rates at historically low levels, with the target for 10-year government bond yields around zero. In October, the European Central Bank extended its asset purchase program until September 2018, albeit at a reduced pace. The Bank of Canada and the BOE both raised their policy rates but also indicated that they intend to proceed gradually with further removal of policy accommodation.

In emerging Asia, growth remained solid...

Economic growth in China remained relatively strong in the second half of 2017 even as the authorities enacted policies to limit production in heavily polluting industries, tighten financial regulations, and curb house price growth (figure 38). Most other emerging Asian economies registered very strong growth in the third quarter of 2017, fueled by solid external demand, but slowed in the fourth quarter.

...while the largest Latin American economies continued to struggle

In Mexico, real GDP declined in the third quarter as two major earthquakes and a hurricane significantly disrupted economic activity, but rebounded in the fourth quarter. Following a prolonged period of contraction, the Brazilian economy continues to recover, but only at a weak pace. Private investment has remained sluggish amid corporate deleveraging and continued uncertainty about government policies, although it turned positive in the third quarter for the first time in nearly four years.

Foreign equity prices rose further on net...

Solid macroeconomic data and robust corporate earnings helped broad AFE and emerging market economies (EMEs) equity indexes extend their 2016 gains through the start of this year (figure 39). Declines since the end of January have erased some of these gains, and volatility in foreign stock markets increased. On balance, most AFE stock prices are higher, and EME equity markets significantly outperformed those of AFEs. Capital flows into emerging market mutual funds generally remained robust as higher commodity prices added to optimism about the economic outlook (figure 40).

...and government bond yields increased

Longer-term government bond yields in most AFEs were noticeably higher than their mid-2017 levels, reflecting strengthening growth and mounting prospects for the normalization of monetary policies (figure 41). In Canada, where the central bank has raised its policy interest rate 75 basis points since June, the rise in longer-term yields was particularly notable. On balance, spreads of dollar-denominated emerging market sovereign bonds over U.S. Treasury securities were stable around the levels observed in mid-2017 (as shown in figure 40).

The dollar depreciated on net

The broad dollar index--a measure of the trade-weighted value of the dollar against foreign currencies--fell roughly 5 percent in the first half of 2017. Notwithstanding some appreciation in early February, the currency has depreciated further since the end of June, partially reversing substantial appreciation realized over the period from 2014 to 2016 (figure 42). The weakness in the dollar mostly reflects a broad-based improvement in the outlook for foreign economic growth. Brexit-related headlines weighed on the British pound at times during the second half of 2017, but progress regarding the terms of the U.K. separation from the European Union boosted the currency later in the year. In contrast, the dollar appreciated against the Mexican peso, on net, amid uncertainty around North American Free Trade Agreement negotiations.


 2. The hurricanes that struck the United States during the second half of last year caused substantial variation in the month-to-month pattern of job gains, but the average performance over the period as a whole was probably substantially unaffected. Return to text

 3. Initial claims jumped in the fall of 2017 as a consequence of disruptions from the hurricanes and then returned to a low level. Return to text

 4. The compensation per hour measure of wages and salaries declined at the end of 2016, possibly reflecting the shifting of bonuses or other types of income into 2017 in anticipation of a possible cut in personal income tax rates. Return to text

 5. The Atlanta Fed's measure differs from others in that it measures the wage growth only of workers who were employed both in the current survey month and 12 months earlier. Return to text

 6. The trimmed mean index excludes whatever prices showed the largest increases or decreases in a given month; for example, the sharp decline in prices for wireless telephone services in March 2017 was excluded from this index. Return to text

 7. 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

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

 9. The Joint Committee on Taxation estimates that the TCJA will reduce average annual tax revenue by a little more than 1 percent of GDP over the next few years. This revenue estimate does not account for the potential macroeconomic effects of the legislation. Return to text

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Last Update: February 23, 2018