Part 2: Monetary Policy
Monetary Policy Report submitted to the Congress on February 23, 2018, pursuant to section 2B of the Federal Reserve Act
The Federal Open Market Committee raised the federal funds rate target range in December
For more than two years, the Federal Open Market Committee (FOMC) has been gradually increasing its target range for the federal funds rate as the labor market strengthened and headwinds in the aftermath of the recession continued to abate. After having raised the target range for the federal funds rate twice in the first half of 2017, the Committee raised it again in December, bringing the target range to 1-1/4 to 1-1/2 percent (figure 43).10 As on previous occasions, the decision to increase the federal funds rate in December reflected realized and expected labor market conditions and inflation relative to the FOMC's objectives. Information available at that time indicated that economic activity had been rising at a solid rate and the labor market had continued to strengthen. In addition, although inflation had continued to run below the FOMC's 2 percent longer-run objective, the Committee expected that it would stabilize around that target over the medium term. At its most recent meeting, which concluded on January 31, the Committee kept the target range for the federal funds rate unchanged.11
Monetary policy continues to support economic growth
Even with the gradual increases in the federal funds rate to date, the Committee judges that the stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation. The federal funds rate remains somewhat below most estimates of its neutral rate--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
What are monetary policy rules?
Monetary policy rules are formulas that prescribe the setting of a policy rate, such as the federal funds rate, that should prevail in relation to the values of a small number of other variables--typically including the gap between actual and target inflation along with an estimate of resource slack in the economy. Policy rules can provide helpful guidance for policymakers. Indeed, since 2004, prescriptions from policy rules have been part of the information regularly reported to the Federal Open Market Committee (FOMC) ahead of its meetings.1 However, interpretation of the prescriptions of policy rules requires careful judgment about the measurement of the inputs to the rules and the implications of the many considerations the 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 that will be discussed later: the "balanced approach" rule, the "adjusted Taylor (1993)" rule, the "price level" rule, and the "first difference" rule (figure A, shown at the end of the box).2 These policy rules generally embody the three key principles of good monetary policy noted earlier. Each rule takes into account estimates of how far away the economy is from achieving the Federal Reserve's dual-mandate goals of maximum employment and price stability. Specifically, most of the rules include the difference between the rate of unemployment that is sustainable in the longer run (u LR) and the current unemployment rate (the unemployment gap); the first-difference rule includes the change in the unemployment gap rather than its level.3 In addition, most of the rules include the difference between inflation and its longer-run objective (2 percent as measured by the annual change in the price index for personal consumption expenditures (PCE), in the case of the Federal Reserve), while the price-level rule includes the gap between the level of prices today and the level of prices that would be observed if inflation had been constant at 2 percent from a specified starting year.
The Taylor (1993), balanced-approach, adjusted Taylor (1993), and price-level 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 in the longer run with sustained maximum employment and stable inflation.4 In contrast, the first-difference rule prescribes how the level of the federal funds rate at a given time should be altered from its previous level--that is, it indicates how the existing rate should be increased or decreased in a particular period.
The adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below zero, and that following the prescriptions of the Taylor (1993) rule after a period when interest rates have been constrained may not provide enough policy accommodation. 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.
In four of the rules, the interest rate responds to deviations of inflation from its longer-run value of 2 percent; in the price-level rule, however, the interest rate responds to the price-level gap (PLgapt). This gap measures how far the price level is from where it would have been had it been increasing at 2 percent each year.5 The price-level rule thereby takes account of deviations of inflation from the longer-run objective in earlier periods as well in the current period. Thus, if inflation has been running persistently above the central bank's objective, the price-level rule would prescribe a higher policy interest rate than rules that use the current inflation gap. Likewise, if inflation has been running persistently below the central bank's objective, a price-level rule would prescribe setting the policy rate lower than rules that use the current inflation gap. The purpose of this dependence on previous inflation behavior is to bring the price level back into line with where it would be if it had been running at a constant 2 percent per year. Like the adjusted Taylor (1993) rule, the price-level rule recognizes that the federal funds rate cannot be reduced materially below zero. If inflation runs below the 2 percent objective during periods when the rule prescribes setting the federal funds rate well below zero, the price-level rule will make up for past inflation shortfalls as the economy recovers.
The adjusted Taylor (1993) and price-level rules may prescribe more appropriate policy settings than the other rules following a period when the policy rate falls below zero. However, all of the rules shown are highly simplified and do not capture the substantial complexity of the U.S. economy. Furthermore, 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 B). 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. Policy rules must be adjusted to take into account these changes in the projected values of longer-run rates as they occur over time.
Accounting for risks to the economic outlook
Monetary policy rules do not take account of broader risk considerations. In the years following the financial crisis, 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.7 In these circumstances, increasing the policy rate quickly in order to have room to cut rates during an economic downturn could be counterproductive because it would make the downturn more likely to happen.
Estimates of the neutral real interest rate in the longer run (such as those in figure B), taken together with the FOMC's inflation objective of 2 percent, suggest that the neutral level of the federal funds rate that can be expected to prevail in the longer run is currently around 3 percent, well below the average federal funds rate of 6 percent from 1960 to 2007. With the neutral federal funds rate so low, there is a likelihood that the policy interest rate will hit its lower limit of zero more frequently than in the past. Historically, the FOMC has cut the federal funds rate by 5 percentage points, on average, during downturns in the economy--cutting the policy rate by this much starting from a neutral level of 3 percent would not be feasible. Under these circumstances, the prescriptions from many policy rules would lead to poor economic performance, with inflation averaging below the Committee's 2 percent objective.8 Rules that try to offset the cumulative shortfall of accommodation posed by the zero bound on interest rates, such as the adjusted Taylor (1993) rule, or make up the cumulative shortfall in the level of prices, such as the price-level rule, are intended to help achieve average inflation at or near 2 percent over time.9
Different monetary policy rules often offer quite different prescriptions for the federal funds rate, and there is no unambiguous 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 C. (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) and price-level rules, which impose a lower limit of zero, all of the rules shown in figure C 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. Almost all of the policy rules have called for rising values of the federal funds rate in recent years, but 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 fourth quarter of 2017 ranged from 0 basis points (price-level rule) to 3.0 percent (balanced-approach rule).10
1. 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 2012 are available on the Board's website at https://www.federalreserve.gov/monetarypolicy/fomc_historical.htm. In the materials from 2012, the policy rule prescriptions are contained in the Monetary Policy Strategies section of Tealbook B. The briefing materials that FOMC policymakers review regularly also 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
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. A price-level rule was discussed in Robert E. Hall (1984), "Monetary Strategy with an Elastic Price Standard," in Price Stability and Public Policy,proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 2-3 (Kansas City: Federal Reserve Bank of Kansas City), pp. 137-59, https://www.kansascityfed.org/publicat/sympos/1984/s84.pdf. 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 FOMC'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. Estimation of the price-level rule requires selecting a starting year for the price level from which to cumulate the 2 percent annual inflation. For the U.S. economy, 1998 is used as the starting year; around that time, the underlying trend of inflation and longer-term inflation expectations stabilized at a level consistent with PCE price inflation being close to 2 percent. Return to text
6. The first-difference rule shown in figure A reduces the need for good estimates of longer-run rates because it does not require an estimate of the neutral real interest rate in the longer run. However, this rule has its own shortcomings. For example, research suggests that this sort of rule 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. 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. Return to text
8. For further discussion of these issues, see Michael T. Kiley and John M. Roberts (2017), "Monetary Policy in a Low Interest Rate World," Brookings Papers on Economic Activity, Spring, pp. 317-72, https://www.brookings.edu/wp-content/uploads/2017/08/kileytextsp17bpea.pdf. Return to text
9. Economists have found that a "makeup" policy can be the best response in theory when the policy interest rate is constrained at zero. See Ben S. Bernanke (2017), "Monetary Policy in a New Era," paper presented at "Rethinking Macroeconomic Policy," a conference held at the Peterson Institute for International Economics, Washington, October 12-13, https://www.brookings.edu/wp-content/uploads/2017/10/bernanke_rethinking_macro_final.pdf; and Michael Woodford (1999), "Commentary: How Should Monetary Policy Be Conducted in an Era of Price Stability?" in New Challenges for Monetary Policy, proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 26-28 (Kansas City: Federal Reserve Bank of Kansas City), pp. 277-316, https://www.kansascityfed.org/publications/research/escp/symposiums/escp-1999. Return to text
10. As noted earlier, the price-level rule makes up for the cumulative shortfall in the price level when inflation runs below 2 percent. Because inflation has been below 2 percent in recent years, the price-level rule calls for the federal funds rate to remain at zero. Return to textReturn to text
Future changes in the federal funds rate will depend on the economic outlook as informed by incoming data
The Committee has continued to emphasize that, in determining the timing and size of future adjustments to the target range for the federal funds rate, it will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. 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 FOMC has emphasized that it will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal, as inflation has been running persistently below the 2 percent longer-run objective.
The Committee expects that the ongoing strength in the economy will warrant further 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 December FOMC meeting, the median of participants' assessments for the appropriate level of the midpoint of the target range for the federal funds rate at year-end rises gradually over the period from 2018 to 2020, remaining below the median projection for its longer-run level through the end of 2019.12
The size of the Federal Reserve's balance sheet has begun to decrease
The Committee had communicated for some time that it intended to reduce the size of the Federal Reserve's balance sheet once normalization of the level of the federal funds rate was well under way. At its meeting in September, the FOMC decided to initiate the balance sheet normalization program described in the June 2017 Addendum to the Policy Normalization Principles and Plans. This program is gradually and predictably reducing the Federal Reserve's securities holdings by decreasing the reinvestment of the principal payments it receives from securities held in the System Open Market Account (SOMA). Since October, such payments have been reinvested only to the extent that they exceeded gradually rising caps (figure 44).
In the fourth quarter, the Open Market Desk at the Federal Reserve Bank of New York, as directed by the Committee, reinvested principal payments from the Federal Reserve's holdings of Treasury securities maturing during each calendar month in excess of $6 billion. The Desk also reinvested in agency mortgage-backed securities (MBS) the amount of principal payments from the Federal Reserve's holdings of agency debt and agency MBS received during each calendar month in excess of $4 billion. Since January, payments of principal from maturing Treasury securities and from the Federal Reserve's holdings of agency debt and agency MBS have been reinvested to the extent that they have exceeded $12 billion and $8 billion, respectively. The Committee has indicated that the cap for Treasury securities will continue to increase in steps of $6 billion at three-month intervals until it reaches $30 billion per month, and that the cap for agency debt and agency MBS will continue to increase in steps of $4 billion at three-month intervals until it reaches $20 billion per month. These caps will remain in place until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.
The initiation of the balance sheet normalization program was widely anticipated and therefore did not elicit a notable reaction in financial markets. Subsequently, the implementation of the program has proceeded smoothly without materially affecting Treasury and MBS markets. With the caps having been set thus far at relatively low levels, the reduction in SOMA securities has represented a small fraction of the SOMA securities holdings. Consequently, the Federal Reserve's total assets have declined somewhat to about $4.4 trillion, with holdings of Treasury securities at approximately $2.4 trillion and holdings of agency debt and agency MBS at approximately $1.8 trillion (figure 45).
Interest income on the SOMA portfolio has continued to support substantial remittances to the U.S. Treasury. Preliminary financial statement results indicate that the Federal Reserve remitted about $80.2 billion of its estimated 2017 net income to the Treasury.
The Federal Reserve's implementation of monetary policy has continued smoothly
In December 2017, the Federal Reserve raised the effective federal funds rate 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 1-1/2 percent and the ON RRP offering rate to 1-1/4 percent. In addition, the Board of Governors approved an increase in the discount rate (the so-called primary credit rate) to 2 percent. Yields on a broad set of money market instruments moved higher in response to the FOMC's policy action in December. The effective federal funds rate rose in line with the increase in the FOMC's target range and generally traded near the middle of the new target range amid orderly trading conditions in money markets. Usage of the ON RRP facility has declined on net since the middle of 2017, reflecting relatively attractive yields on alternative investments.
Although the normalization of the monetary policy stance has proceeded smoothly, the Federal Reserve has continued to test the operational readiness of other policy tools as part of prudent planning. Two operations of the Term Deposit Facility were conducted in the second half of 2017; seven-day deposits were offered at both operations with a floating rate of 1 basis point over the interest rate on excess reserves. In addition, the Desk conducted several small-value exercises solely for the purpose of maintaining operational readiness.
10. See Board of Governors of the Federal Reserve System (2017), "Federal Reserve Issues FOMC Statement," press release, December 13, https://www.federalreserve.gov/newsevents/pressreleases/monetary20171213a.htm. Return to text
11. See Board of Governors of the Federal Reserve System (2018), "Federal Reserve Issues FOMC Statement," press release, January 31, https://www.federalreserve.gov/newsevents/pressreleases/monetary20180131a.htm. Return to text
12. See the December Summary of Economic Projections, which appeared as an addendum to the minutes of the December 12-13, 2017, meeting of the FOMC and is presented in Part 3 of this report. Return to text