Part 1: Recent Economic and Financial Developments
Monetary Policy Report submitted to the Congress on July 13, 2018, pursuant to section 2B of the Federal Reserve Act
Domestic Developments
The labor market strengthened further during the first half of the year...
Labor market conditions have continued to strengthen so far in 2018. According to the Bureau of Labor Statistics (BLS), gains in total nonfarm payroll employment averaged 215,000 per month over the first half of the year. That pace is up from the average monthly pace of job gains in 2017 and is considerably faster than what is needed to provide jobs for new entrants into the labor force (figure 1).1 Indeed, the unemployment rate edged down from 4.1 percent in December to 4.0 percent in June (figure 2). This rate is below all Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level and is about 1/2 percentage point below the median of those estimates.2 The unemployment rate in June is close to the lows last reached in 2000.
The labor force participation rate (LFPR), which is the share of individuals aged 16 and older who are either working or actively looking for work, was 62.9 percent in June and has changed little, on net, since late 2013 (figure 3). The aging of the population is an important contributor to a downward trend in the overall participation rate. In particular, members of the baby-boom cohort are increasingly moving into their retirement years, a time when labor force participation is typically low. Indeed, the share of the civilian population aged 65 and over in the United States climbed from 16 percent in 2000 to 19 percent in 2017 and is projected to rise to 24 percent by 2026. Given this trend, the flat trajectory of the LFPR during the past few years is consistent with strengthening labor market conditions. Similarly, the LFPR for individuals between 25 and 54 years old--which is much less sensitive to population aging--has been rising for the past several years. (The box "The Labor Force Participation Rate for Prime-Age Individuals" examines the prospects for further increases in participation for these individuals.) The employment-to-population ratio for individuals 16 and over--the share of the total population who are working--was 60.4 percent in June and has been gradually increasing since 2011, reflecting the combination of the declining unemployment rate and the flat LFPR.
Other indicators are also consistent with a strong labor market. As reported in the Job Openings and Labor Turnover Survey (JOLTS), the rate of job openings has remained quite elevated.3 The rate of quits has stayed high in the JOLTS, an indication that workers are able to successfully switch jobs when they wish to. In addition, the JOLTS layoff rate has been low, and the number of people filing initial claims for unemployment insurance benefits has remained near its lowest level in decades. Other survey evidence indicates that households perceive jobs as plentiful and that businesses see vacancies as hard to fill. Another indicator, the share of workers who are working part time but would prefer to be employed full time--which is part of the U-6 measure of labor underutilization from the BLS--fell further in the first six months of the year and now stands close to its pre-recession level (as shown in figure 2).
The Labor Force Participation Rate for Prime-Age Individuals
The overall labor force participation rate (LFPR) has generally been trending lower since 2000, and while the aging of the baby-boom generation into retirement ages provides an important reason for that decline, it is not the only reason. Another contributing factor, as shown in figure A, is that the LFPRs of prime-age men and women (those between 25 and 54 years old) trended lower through 2013 even though prime-age LFPRs are largely unaffected by the aging of the population: The prime-age male LFPR has been declining for six decades, and the prime-age female LFPR has drifted lower since 2000 after a multidecade increase. Nevertheless, prime-age LFPRs have moved up notably and consistently since 2013, as improving labor market conditions have drawn some individuals back into the labor force and encouraged others not to leave. These recent increases in the prime-age LFPR, in the context of the longer-run trend decline, raise the question of how much additional scope there is for further increases in prime-age labor force participation.
To gauge whether further increases are possible, a useful starting point is understanding the factors behind the longer-run decline in the prime-age LFPR, as these factors may limit additional increases if they continue to exert some downward pressure. One factor may be a secular decline in the demand for workers with lower levels of education. Indeed, as shown in figure B, the long-run declines in prime-age LFPR are much larger among adults without a college degree than among college-educated adults. Research suggests that increases in automation, such as the use of robotics, and various aspects of globalization have spurred the elimination of some types of jobs--in particular, some manufacturing jobs that have historically been held by workers without a college education--and emerging jobs may require a different set of skills. These developments may have led some workers to become discouraged over the lack of suitable job opportunities and drop out of the labor force.1 The rising share of college-educated workers, which may partly reflect individuals responding over time to the declining demand for jobs that require less education, has likely prevented even steeper declines in the prime-age LFPR, as better-educated workers have higher LFPRs and may be more adaptable to unforeseen disruptions in particular jobs or industries.
Another potential factor may be that an increasing share of the prime-age population has some difficulty working because of physical or mental disabilities. For example, figure C shows that about 5 percent of both prime-age men and women report that they are out of the labor force and do not want a job due to disability or illness; those shares have trended higher over the past several decades. Other research suggests that increased opioid use may be associated with a lower prime-age LFPR, although it is unclear how much of the decline in the prime-age LFPR can be directly explained by opioid use or whether increases in opioid use are an indirect result of poor employment opportunities.2
Caregiving responsibilities play an important role in explaining why LFPRs for prime-age women are lower than for men, and they may play an increasing role in explaining declining prime-age LFPRs for men as well. As shown in figure C, roughly 15 percent of prime-age women report being out of the labor force for caregiving reasons--by far the largest reason for prime-age women to report not wanting a job--but this share has been fairly flat over time. In contrast, while a much smaller fraction of men are out of the labor force for caregiving reasons, that share has trended up in recent decades, likely reflecting some shift in household responsibilities as women participate in the workforce in greater numbers. For some--especially those for whom childcare costs are not a major concern--not participating in the labor force may represent an unconstrained choice to care for other members of their families. For others, however, this decision may reflect a lack of affordable childcare.
Additionally, the share of the population--particularly black men--with a history of incarceration has increased over time. Individuals who have previously been incarcerated often have trouble finding work, in part because many employers choose not to hire people with such a background and likely also in part because incarceration prevents people from accumulating work experience and developing skills valuable to employers. Discrimination could also help explain the lack of participation for some minority groups, as they recognize that such discrimination limits their job opportunities.
International comparisons may help clarify the importance of some of those factors. Since 1990, the prime-age LFPR in the United States has declined considerably for both men and women relative to other advanced countries. Some factors, like automation and globalization, have affected all advanced economies to some degree and for some time, yet diverging long-run trends in prime-age labor force participation have still occurred. Research suggests that part of the relative decline in the United States is explained by differential changes in work-family policies across countries. Other parts of the divergence may be explained by other policies, including policies designed toward keeping those affected by automation and globalization attached to the labor force, or other factors--such as incarceration or opioid use--that differ across those countries.3
Although many of the factors behind the multidecade decline in the prime-age LFPR may persist, some continuation of the increases in the LFPR over the past few years nevertheless seems possible, especially if labor market conditions remain favorable. Indeed, as shown in figure C, although the share of nonparticipating prime-age men and women who self-report as wanting a job (despite not having actively searched for a job recently) has been declining since 2010, that share for men remains between 1/4 and 1/2 percentage point above its 2007 level and earlier expansion peaks. Furthermore, prime-age men and women who had previously reported being out of the labor force and not wanting a job due to disability or illness have been entering the labor force at increasing rates in recent years.
Looking forward, how can policymakers support additional improvements in the prime-age LFPR? Favorable labor market conditions can likely help, and monetary policy can therefore play a role through supporting strong cyclical conditions as part of its maximum-employment objective. However, structural factors (in contrast with cyclical ones) are also important to address; policies to address such factors are beyond the scope of monetary policy.
1. For evidence on displacement from technological changes, see David H. Autor, David Dorn, and Gordon H. Hanson (2015), "Untangling Trade and Technology: Evidence from Local Labor Markets," Economic Journal,vol.125 (May), pp. 621-46; Daron Acemoglu and Pascual Restrepo (2017), "Robots and Jobs: Evidence from U.S. Labor Markets," NBER Working Paper Series 23285 (Cambridge, Mass.: National Bureau of Economic Research, March), www.nber.org/papers/w23285; and Daron Acemoglu and Pascual Restrepo (2018), "Artificial Intelligence, Automation, and Work," NBER Working Paper Series 24196 (Cambridge, Mass.: National Bureau of Economic Research, January), www.nber.org/papers/w24196. For evidence on globalization--in particular, import competition since the 2000s--see David H. Autor, David Dorn, and Gordon H. Hanson (2013), "The China Syndrome: Local Labor Market Effects of Import Competition in the United States," American Economic Review,vol. 103 (October), pp. 2121-68. A discussion of these and other explanations is also provided in Katharine G. Abraham and Melissa S. Kearney (2018), "Explaining the Decline in the U.S. Employment-to-Population Ratio: A Review of the Evidence," NBER Working Paper Series 24333 (Cambridge, Mass.: National Bureau of Economic Research, February), www.nber.org/papers/w24333. Return to text
2. Evidence that opioid use could be significant for understanding the declining LFPR is provided by Alan B. Krueger (2017), "Where Have All the Workers Gone? An Inquiry into the Decline of the U.S. Labor Force Participation Rate," Brookings Papers on Economic Activity, Fall, pp. 1-82, https://www.brookings.edu/wp-content/uploads/2018/02/kruegertextfa17bpea.pdf, while little relationship between opioid prescriptions and employment at the county level is found in Janet Currie, Jonas Y. Jin, and Molly Schnell (2018), "U.S. Employment and Opioids: Is There a Connection?" NBER Working Paper Series 24440 (Cambridge, Mass.: National Bureau of Economic Research, March), www.nber.org/papers/w24440. Some evidence on whether the opioid epidemic varies with local economic conditions is provided by Jeff Larrimore, Alex Durante, Kimberly Kreiss, Ellen Merry, Christina Park, and Claudia Sahm (2018), "Shedding Light on Our Economic and Financial Lives," FEDS Notes, https://www.federalreserve.gov/econres/notes/feds-notes/shedding-light-on-our-economic-and-financial-lives-20180522.htm. Return to text
3. For recent trends on prime-age LFPRs in the United States compared with other developed countries, see Organisation for Economic Co-operation and Development (2018), OECD Economic Surveys: United States 2018 (Paris: OECD Publishing), dx.doi.org/10.1787/eco_surveys-usa-2018-en. For a description of policy differences across countries and how this may affect differences in LFPR, see International Monetary Fund (2018), "Labor Force Participation in Advanced Economies: Drivers and Prospects," chapter 2 in World Economic Outlook: Cyclical Upswing, Structural Change (Washington: IMF, April), pp.71-128. For evidence on how work-family policies may affect prime-age LFPRs in the United States relative to other OECD countries, see Francine D. Blau and LawrenceM. Kahn (2013), "Female Labor Supply: Why Is the United States Falling Behind?" American Economic Review, vol. 103 (May), pp. 251-56. Return to text
Return to text...and unemployment rates have fallen for all major demographic groups
The continued decline in the unemployment rate has been reflected in the experiences of multiple racial and ethnic groups (figure 4). The unemployment rates for blacks or African Americans and Hispanics tend to rise considerably more than rates for whites and Asians during recessions but decline more rapidly during expansions. Indeed, the declines in the unemployment rates for blacks and Hispanics have been particularly striking, and the rates have recently been at or near their lowest readings since these series began in the early 1970s. Although differences in unemployment rates across ethnic and racial groups have narrowed in recent years, they remain substantial and similar to pre-recession levels. The rise in LFPRs for prime-age individuals over the past few years has also been evident in each of these racial and ethnic groups, with increases again particularly notable for African Americans. Even so, the LFPR for whites remains higher than that for the other groups (figure 5).4
Increases in labor compensation have been moderate...
Despite the strong labor market, the available indicators generally suggest that increases in hourly labor compensation have been moderate. Compensation per hour in the business sector--a broad-based measure of wages, salaries, and benefits that is quite volatile--rose 2-3/4 percent over the four quarters ending in 2018:Q1, slightly more than the average annual increase over the preceding seven or so years (figure 6). The employment cost index--a less volatile measure of both wages and the cost to employers of providing benefits--likewise was 2-3/4 percent higher in the first quarter of 2018 relative to its year-earlier level; this increase was 1/2 percentage point faster than its gain a year earlier. Among measures that do not account for benefits, average hourly earnings rose 2-3/4 percent in June relative to 12 months earlier, a gain in line with the average increase in the preceding few years. According to the Federal Reserve Bank of Atlanta, the median 12-month wage growth of individuals reporting to the Current Population Survey increased about 3-1/4 percent in May, also similar to its readings from the past few years.5
...and likely have been restrained by slow growth of labor productivity
Those moderate rates of compensation gains likely reflect the offsetting influences of a strong 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 of 2.8 percent and also below the average gain in the 1974-95 period of 1.6 percent (figure 7). The weakness in productivity growth may be partly attributable to the sharp pullback in capital investment during the most recent recession and the relatively slow recovery that followed. However, considerable debate remains about the reasons for the recent slowdown in productivity growth and whether it will persist.6
Price inflation has picked up from the low readings in 2017
In 2017, inflation remained below the FOMC's longer-run objective of 2 percent. Partly because the softness in some price categories appeared idiosyncratic, Federal Reserve policymakers expected inflation to move higher in 2018.7 This expectation appears to be on track so far. Consumer price inflation, as measured by the 12-month percentage change in the price index for personal consumption expenditures (PCE), moved up to 2.3 percent in May (figure 8). Core PCE inflation, which excludes consumer food and energy prices that are often quite volatile and typically provides a better indication than the total measure of where overall inflation will be in the future, was 2 percent over the 12 months ending in May--0.5 percentage point higher than it had been one year earlier. The total measure exceeded core inflation because of a sizable increase in consumer energy prices. In contrast, food price inflation has continued to be low by historical standards--data through May show the PCE price index for food and beverages having increased less than 1/2 percent over the past year.
The higher readings in both total and core inflation relative to a year earlier reflect faster price increases for a wide range of goods and services this year and the dropping out of the 12-month calculation of the steep one-month decline in the price index for wireless telephone services in March last year. 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 than the core index to idiosyncratic price movements--slowed by less than core inflation over 2017 and has also increased a bit less this year. This index rose 1.8 percent over the 12 months ending in May, up a touch from the increase over the same period last year.8
Oil prices have surged amid supply concerns...
As noted, the faster pace of total inflation this year relative to core inflation reflects a substantial rise in consumer energy prices. Retail gasoline prices this year were driven higher by a rise in oil prices. The spot price of Brent crude oil rose from about $65 per barrel in December to around $75 per barrel in early July (figure 9). Although that increase took place against a backdrop of continued strength in global demand, supply concerns have become more prevalent in recent months. (For a discussion of the reasons behind the oil price increases along with a review of the effects of oil prices on U.S. economic growth, see the box "The Recent Rise in Oil Prices.")
The Recent Rise in Oil Prices
Oil prices have increased more than 50 percent over the past year, with the spot price of Brent crude oil rising from a bit below $50 per barrel to around $75 per barrel (figure A). For much of the period, further-dated futures prices remained relatively stable, in the neighborhood of $55 per barrel; however, since February, futures prices have moved up appreciably, reaching over $70 per barrel.
Both supply and demand factors have contributed to the oil price increase. In particular, the broad-based improvement in the outlook for the global economy was a key driver of the price increase in the second half of 2017. In recent months, supply concerns have become more prevalent, affecting both spot and further-dated futures prices. Despite sharply rising U.S. oil production, markets have been attuned to escalating conflict between Saudi Arabia and Iran as well as the precipitous decline in Venezuelan oil production amid the country's economic and political crisis. Prices also increased after President Trump announced on May 8 that the United States was withdrawing from the Iran nuclear deal and that sanctions against Iranian oil exports would be reinstated.
The pattern of spot and futures prices indicates that market participants generally anticipate that oil prices will decline slowly over the next few years, in part reflecting an expectation that supply, including U.S. shale oil production, will grow to meet demand. In addition, the higher prices put pressure on OPEC's November 2016 agreement with certain non-OPEC countries to restrain production. A stated aim of the agreement was to reduce the glut in global inventories, and, in recent months, inventory levels have fallen rapidly toward long-run averages. In response to both lower inventories and higher prices, OPEC leaders slightly relaxed the production agreement in June this year, reducing some of the upward pressure on prices. That said, futures prices have not returned to their early 2018 levels, implying that market participants expect some of the recent increase in prices to be long lasting.
What is the expected effect of the recent rise in oil prices on the U.S. economy? To begin with, higher oil prices are likely to restrain household consumption. In particular, the increase in oil prices since last year is estimated to have translated into a roughly $300 increase in annual expenditures on gasoline for the average household, from about $2,100 to $2,400. However, as U.S. oil production has grown rapidly over the past decade, the ratio of net U.S. oil imports to U.S. gross domestic product (GDP) has declined substantially (figure B). As a result, higher oil prices now imply much less of a redistribution of purchasing power abroad than in the past, as much of the negative effect on GDP from lower household consumption is likely to be offset by increased production and investment in the growing U.S. oil sector. On net, the drag on GDP from higher oil prices is likely a small fraction of what it was a decade ago and should get smaller still if U.S. oil production continues to grow as projected-- figure C--and the net oil import share shrinks toward zero.
Indeed, if U.S. oil trade moves fully into balance, the offsetting effects of a change in the relative price of oil might be expected to net out within the domestic economy. However, even if the United States is no longer a net oil importer, to the extent that higher oil prices cause credit-constrained consumers to cut spending by more than oil producers expand their investment, this redistribution of purchasing power could still have negative effects on overall GDP.
...while prices of imports other than energy have also increased
Nonfuel import prices rose sharply in early 2018, partly reflecting the pass-through of earlier increases in commodity prices (figure 10). In particular, metals prices posted sizable gains late last year due to strong global demand but have retreated somewhat in recent weeks.
Survey-based measures of inflation expectations have been 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 so far this year. 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 11). In the University of Michigan Surveys of Consumers, the median value for inflation expectations over the next 5 to 10 years has been about 2-1/2 percent since the end of 2016, though this level is about 1/4 percentage point lower than had prevailed through 2014. In contrast, in the Survey of Consumer Expectations conducted by the Federal Reserve Bank of New York, the median of respondents' expected inflation rate three years hence has been moving up recently and is currently at the top of the range it has occupied over the past couple of years.
...while market-based measures of inflation compensation have largely moved sideways this year
Inflation expectations can also be gauged by market-based measures of inflation compensation. However, 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-maturity Treasury Inflation-Protected Securities (TIPS) or from inflation swaps--have moved sideways for the most part this year after having returned to levels seen in early 2017 (figure 12).9 The TIPS-based measure of 5-to-10-year-forward inflation compensation and the analogous measure of inflation swaps are now about 2 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-2014.10
Real gross domestic product growth slowed in the first quarter, but spending by households appears to have picked up in recent months
After having expanded at an annual rate of 3 percent in the second half of 2017, real gross domestic product (GDP) is now reported to have increased 2 percent in the first quarter of this year (figure 13). The step-down in growth during the first quarter was largely attributable to a sharp slowing in the growth of consumer spending that appears transitory, and gains in GDP appear to have rebounded in the second quarter. Meanwhile, business investment has remained strong, and net exports had little effect on output growth in the first quarter. On balance, over the first half of this year, overall economic activity appears to have expanded at a solid pace.
The economic expansion continues to be supported by favorable consumer and business sentiment, past increases in household wealth, solid economic growth abroad, and accommodative domestic financial conditions, including moderate borrowing costs and easy access to credit for many households and businesses.
Gains in income and wealth continue to support consumer spending...
Following exceptionally strong growth in the fourth quarter of 2017, consumer spending in the first quarter of this year was tepid, rising at an annual rate of 0.9 percent. The slowdown in growth was evident in outlays for motor vehicles and in retail sales more generally; moreover, unseasonably warm weather depressed spending on energy services. However, consumer spending picked up in more recent months as retail sales firmed, and PCE in April and May rose at an annual rate of 2-1/4 percent relative to the average over the first quarter (figure 14).
Real disposable personal income (DPI), a measure of after-tax income adjusted for inflation, has increased at a solid annual rate of about 3 percent so far this year. Real DPI has been supported by the reduction in income taxes owing to the implementation of the Tax Cuts and Jobs Act (TCJA) as well as the continued strength in the labor market. With consumer spending rising just a little less than the gains in disposable income so far this year, the personal saving rate has edged up after having fallen for the past two years (figure 15).
Ongoing gains in household net worth likely have also supported consumer spending. House prices, which are of particular importance for the balance sheet positions of a large set of households, have been increasing at an average annual pace of about 6 percent in recent years (figure 16).11 Although U.S. equity prices have posted modest gains, on net, so far this year, this flattening followed several years of sizable gains. Buoyed by the cumulative increases in home and equity prices, aggregate household net worth was 6.8 times household income in the first quarter, down just slightly from its ratio in the fourth quarter--the highest-ever reading for that ratio, which dates back to 1947 (figure 17).
...and borrowing conditions for consumers remain generally favorable...
Financing conditions for consumers are generally favorable and remain supportive of growth in household spending. However, banks have continued to tighten standards for credit cards and auto loans for borrowers with low credit scores, possibly in response to some upward moves in the delinquency rates of those borrowers. Mortgage credit has remained readily available for households with solid credit profiles. For borrowers with low credit scores, mortgage financing conditions have eased somewhat further but remain tight overall. In this environment, consumer credit continued to increase in the first few months of 2018, though the rate of increase moderated some from its robust pace in the previous year (figure 18).
...while consumer confidence remains strong
Consumers have remained upbeat. So far this year, the Michigan survey index of consumer sentiment has been near its highest level since 2000, likely reflecting rising income, job gains, and low inflation (figure 19). Indeed, households' expectations for real income changes over the next year or two now stand above levels preceding the previous recession.
Business investment has continued to rebound...
Investment spending by businesses has continued to increase so far this year, with notable gains for spending, both on equipment and intangibles and on nonresidential structures (figure 20). Within structures, the rise in oil prices propelled another steep ramp-up in investment in drilling and mining structures--albeit not yet back to the levels recorded from 2012 to 2014--while investment in nonresidential structures outside of the energy sector picked up after declining in 2017. Forward-looking indicators of business investment spending remain favorable on balance. Business sentiment and the profit expectations of industry analysts have been positive overall, while new orders of capital goods have advanced on net this year.
...while corporate financing conditions have remained accommodative
Aggregate flows of credit to large nonfinancial firms remained strong in the first quarter, supported in part by relatively low interest rates and accommodative financing conditions (figure 21). The gross issuance of corporate bonds stayed robust during the first half of 2018, while yields on both investment- and speculative-grade corporate bonds moved up notably but remained low by historical standards (figure 22). Despite strong growth in business investment, outstanding commercial and industrial (C&I) loans on banks' books rose only modestly in the first quarter, although their pace of expansion in more recent months has strengthened on average. In April, respondents to the Senior Loan Officer Opinion Survey on Bank Lending Practices, or SLOOS, reported that demand for C&I loans weakened in the first quarter even as lending standards and terms on such loans eased.12 Respondents attributed this decline in demand in part to firms drawing on internally generated funds or using alternative sources of financing. Meanwhile, growth in commercial real estate loans has moderated some but remains strong. In addition, financing conditions for small businesses appear to have remained generally accommodative, with lending standards little changed at most banks and with most firms reporting that they are able to obtain credit. Although small business credit growth has been subdued, survey data suggest this sluggishness is largely due to continued weak demand for credit by small businesses.
But activity in the housing sector has leveled off
Residential investment, which rose a modest 2-1/2 percent in 2017, appears to have largely moved sideways over the first five months of the year. The slowing in residential investment likely is partly a result of higher mortgage interest rates. Although these rates are still low by historical standards, they have moved up and are near their highest levels in seven years (figure 23). In addition, higher lumber prices and tight supplies of skilled labor and developed lots reportedly have been restraining home construction. While starts of both single-family and multifamily housing units rose in the fourth quarter, single-family starts have been little changed, on net, since then, whereas multifamily starts continued to climb earlier this year before flattening out (figure 24). Meanwhile, over the first five months of this year, new home sales have held at around the rate of late last year, but sales of existing homes have eased somewhat (figure 25). Despite the continued increases in house prices, the pace of construction has not kept up with demand. As a result, the months' supply of inventories of homes for sale has remained at a relatively low level, and the aggregate vacancy rate stands at the lowest level since 2003.
Net exports had a neutral effect on GDP growth in the first quarter
After being a small drag on U.S. real GDP growth last year, net exports had a neutral effect on growth in the first quarter. Real U.S. exports increased about 3-1/2 percent at an annual rate, as exports of automobiles and consumer goods remained robust. Real import growth slowed sharply following a surge late last year (figure 26). Nominal trade data through May suggest that export growth picked up in the second quarter, led by agricultural exports, while import growth was tepid. All told, the available data suggest that the nominal trade deficit likely narrowed relative to GDP in the second quarter (figure 27).
Fiscal policy became more expansionary this year...
Federal fiscal policy will likely provide a moderate boost to GDP growth this year. The individual and corporate tax cuts in the TCJA should lead to increased private consumption and investment, while the Bipartisan Budget Act of 2018 (BBA) enables increased federal spending on goods and services. As the effects of the BBA had yet to show through, federal government purchases posted only a modest gain in the first quarter (figure 28).
After narrowing significantly for several years, the federal unified deficit widened from about 2-1/2 percent of GDP in fiscal year 2015 to 3-1/2 percent in fiscal 2017, and it is on pace to move up further in fiscal 2018. Although expenditures as a share of GDP in 2017 were relatively stable at 21 percent, receipts moved lower to roughly 17 percent of GDP and have remained at about the same level so far this year (figure 29). The ratio of federal debt held by the public to nominal GDP was 76-1/2 percent at the end of fiscal 2017 and is quite elevated relative to historical norms (figure 30).
...and the fiscal position of most state and local governments is stable
The fiscal position of most state and local governments remains stable, although there is a range of experiences across these governments and some states are still struggling. After several years of slow growth, revenue gains of state governments have strengthened notably as sales and income tax collections have picked up over the past few quarters. In addition, house price gains have continued to push up property tax revenues at the local level. But expenditures by state and local governments have been restrained. Employment growth in this sector has been moderate, while real outlays for construction by these governments have largely been moving sideways at a relatively low level.
Financial Developments
The expected path of the federal funds rate has moved up
Market-based measures of the path of the federal funds rate continue to suggest that market participants expect further gradual increases in the federal funds rate. Relative to the end of last year, the expected policy rate path has moved up, boosted in part by investors' perception of a strengthening in the domestic economic outlook (figure 31). In particular, the policy path moved higher in response to incoming economic data so far this year, especially the employment reports, which were seen as supporting expectations for a solid pace of growth in domestic economic activity. In addition, investors reportedly interpreted FOMC communications in the first half of 2018 as signaling an upbeat economic outlook and as reinforcing expectations for further gradual removal of monetary policy accommodation.
Survey-based measures of the expected path of the policy rate over the next few years have also increased modestly since the end of last year. According to the results of the most recent Survey of Primary Dealers and Survey of Market Participants, both conducted by the Federal Reserve Bank of New York just before the June FOMC meeting, the median of respondents' projections for the path of the federal funds rate shifted up about 25 basis points for 2018 and beyond, compared with the median of assessments last December.13 Market-based measures of uncertainty about the policy rate approximately one to two years ahead increased slightly, on balance, from their levels at the end of last year.
The nominal Treasury yield curve has shifted up
The nominal Treasury yield curve has shifted up and flattened somewhat further during the first half of 2018 after flattening considerably in the second half of 2017. In particular, the yields on 2- and 10-year nominal Treasury securities increased about 70 basis points and 45 basis points, respectively, from their levels at the end of 2017 (figure 32). The increase in Treasury yields seems to largely reflect investors' greater optimism about the domestic growth outlook and firming expectations for further gradual removal of monetary policy accommodation. Expectations for increases in the supply of Treasury securities following the federal budget agreement in early February also appear to have contributed to the increase in Treasury yields, while increased concerns about trade policy both domestically and abroad, political developments in Europe, and the foreign economic outlook weighed on longer-dated Treasury yields. Yields on 30-year agency mortgage-backed securities (MBS)--an important determinant of mortgage interest rates--increased about 60 basis points over the first half of the year, a bit more than the rise in the 10-year nominal Treasury yield, but remain low by historical standards (figure 33). Yields on corporate debt securities--both investment grade and high yield--rose more than Treasury yields, leaving the spreads on corporate bond yields over comparable-maturity Treasury yields notably wider than at the beginning of the year.
Broad equity indexes rose modestly amid some bouts of market volatility
After surging as much as 20 percent in 2017, broad stock market indexes rose modestly, on balance, so far this year amid some bouts of heightened volatility in financial markets (figure 34). The boost to equity prices from first-quarter earnings reports that generally beat analysts' expectations was reportedly offset by increased uncertainty about trade policy, rising interest rates, and concerns about political developments abroad. While stock prices for companies in the technology and consumer discretionary sectors rose notably, those of companies in the industrial and financial sectors declined modestly. After spiking considerably in early February, the implied volatility for the S&P 500 index--the VIX--declined and ended the period slightly above the low levels that prevailed in 2017. (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability.")
Developments Related to Financial Stability
The U.S. financial system remains substantially more resilient than during the decade before the financial crisis.1 Valuations continue to be elevated for a range of assets. In the private nonfinancial sector, the ratio of total debt to gross domestic product (GDP) is about in line with an estimate of its trend, and vulnerabilities associated with debt remain moderate on balance. While borrowing among highly levered and lower-rated firms is elevated and a future weakening in economic activity could amplify some vulnerabilities in the corporate sector, the ratio of household debt to disposable income has remained stable in recent years. Vulnerabilities associated with leverage in the financial sector appear low, reflecting in part strong capital positions of banks. However, some measures of hedge fund leverage have increased. Vulnerabilities associated with maturity and liquidity transformation continue to be low compared with levels that generally prevailed before 2008.
Valuation pressures in various asset markets remain elevated by historical standards, although they have declined somewhat since the start of the year, as corporate bond prices have fallen and higher earnings have helped rationalize equity prices. Market movements were outsized in February, around the time of the previous Monetary Policy Report. Since then, volatility has receded, although it has ended up slightly above the low levels seen in 2017. Even with higher expected earnings due in part to changes in tax law, the forward equity price-to-earnings ratio for the S&P 500 remains in the upper end of its historical distribution (figure A). Treasury term premiums have increased modestly from the beginning of the year but remain low relative to historically observed values. Corporate bond yields and their spreads to yields on comparable-maturity Treasury securities have increased notably, but they continue to be low by historical standards. In particular, speculative-grade yields and spreads lie in the bottom fifth and bottom fourth of their respective historical distributions. In leveraged loan markets, issuance has been robust, spreads have reached their lowest levels since the financial crisis, and the presence of loan covenants has decreased further. In real estate markets, commercial property valuations continue to be stretched. Capitalization rates (computed as the ratio of net operating income relative to property values) remain low, and, in recent quarters, their spreads to yields on 10-year Treasury securities have moved down considerably. Finally, valuation pressures in residential real estate markets increased modestly. Aggregate price-to-rent ratios, adjusted for an estimate of their long-run trend and the carrying cost of housing, are approaching the cycle peaks of the early 1980s and early 1990s but remain well below the levels observed on the eve of the financial crisis.
With households and businesses taken together, the ratio of total debt to GDP is about in line with estimates of its trend, although pockets of stress are evident. In the household sector, the net expansion of household debt has been in line with income growth and is concentrated among prime-rated borrowers. However, delinquency rates for some forms of consumer credit have moved up, suggesting rising strains among riskier borrowers even with unemployment very low. Banks are reportedly tightening standards on credit card and auto loans. In the nonfinancial business sector, leverage of corporate businesses remains high, as indicated by a positive sectoral credit-to-GDP gap. Net issuance of risky debt has risen in recent quarters, mainly driven by the growth in leveraged loans (figure B). While current corporate credit conditions are favorable overall, with low interest expenses and defaults, the elevated leverage in this sector could result in higher future default rates. In addition, weak protection from loan covenants could reduce early intervention by lenders and lower recovery rates for investors on default. Investors may also be exposed to significant repricing risks because bond yields and credit risk premiums are both low.
Vulnerabilities from financial-sector leverage continue to be relatively low. Core financial intermediaries, including large banks, insurance companies, and broker-dealers, appear well positioned to weather economic stress. Regulatory capital ratios for the global systemically important banks have remained well above the fully phased-in enhanced regulatory requirements and are close to historical highs. Capital levels at insurance companies and broker-dealers also remain relatively robust by historical standards. However, some indicators of hedge fund leverage in the equity market, such as the provision of total margin credit to equity investors, have risen to historically elevated levels, and in the past few quarters dealers have reportedly eased, on net, price terms to their hedge fund clients.
The results of supervisory stress tests released in June by the Federal Reserve Board confirm that the nation's largest banks are strongly capitalized and would be able to lend to households and businesses even during a severe global recession.2 The hypothetical "severely adverse" scenario--the most stringent scenario yet used in the Board's stress tests, with the U.S. unemployment rate rising almost 6 percentage points to 10 percent--projects $578 billion in total losses for the 35 participating banks during the nine quarters tested. Since 2009, these firms have added about $800 billion in common equity capital. The Board also evaluates the capital planning processes of the participating banks, including the firms' planned capital actions, such as dividend payments and share buybacks.3 The Board did not object to the capital plans of 34 firms. Although the recent U.S. tax legislation is expected to increase banks' post-tax earnings, and hence their ability to accrete capital, it did lead to one-time losses, decreasing banks' capital ratios at the end of 2017, the jumping-off point of the stress tests. In part because of these effects, evident in text figure 36, two firms were required to maintain their capital distributions at the levels they paid in recent years. Separately, one firm will be required to address the management and analysis of its counterparty exposure under stress. The Board objected to the capital plan of one bank because of qualitative concerns.
Vulnerabilities associated with liquidity and maturity transformation--that is, the financing of illiquid assets or long-maturity assets with short-maturity debt--continue to be low, owing in part to liquidity regulations for banks and money market reform. Large banks have strong liquidity positions, because their use of core deposits as a source of funding and their holdings of high-quality liquid assets remain near historical highs, while their use of short-term wholesale funding as a share of liabilities is near historical lows. Since the money market fund reforms implemented in October 2016, assets under management at prime funds, institutions that proved vulnerable to runs in the past, have remained far below pre-reform levels. In addition, the growth in alternative short-term investment vehicles, which may have some similar vulnerabilities, continues to be limited, as investors have shifted primarily from prime funds into government funds.
Risks from abroad are moderate overall. Advanced foreign economies (AFEs), many of which have significant financial and real linkages to the United States, continue to have notable or elevated valuations in some asset markets and, in a few countries, high levels of household debt relative to GDP. These factors have contributed to some AFEs announcing or implementing macroprudential actions, including increases in countercyclical capital buffers, over the past couple of years. More generally, AFE financial sectors continue their slow pace of deleveraging that started after the global financial and euro-area sovereign debt crises. In addition, low corporate debt spreads in the past few years have yet to translate into any marked increase in leverage in most of these countries' nonfinancial corporate sectors. Some major emerging market economies continue to harbor more pronounced vulnerabilities, reflecting some combination of the following: substantial corporate leverage, fiscal concerns, or excessive reliance on foreign funding. Globally, potential downside risks to international financial markets and financial stability include political uncertainty, an intensification of trade tensions, and challenges posed by rising interest rates.
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 the largest banks. Activating the CCyB is appropriate when systemic vulnerabilities are meaningfully above normal.4 The Board is closely monitoring the level and configuration of systemic vulnerabilities described earlier.
Markets for Treasury securities, mortgage-backed securities, and municipal bonds have functioned well
On balance, indicators of Treasury market functioning remained broadly stable over the first half of 2018. A variety of liquidity metrics--including bid-ask spreads, bid sizes, and estimates of transaction costs--have displayed minimal signs of liquidity pressures overall, with the exception of a brief period of reduced liquidity in early February amid elevated financial market volatility. Liquidity conditions in the agency MBS market were also generally stable. Overall, the functioning of Treasury and agency MBS markets has not been materially affected by the implementation of the Federal Reserve's balance sheet normalization program, including the accompanying reduction in reinvestment of principal payments from the Federal Reserve's securities holdings. Credit conditions in municipal bond markets have remained stable since the turn of the year. Over that period, yield spreads on 20‑year general obligation municipal bonds over comparable-maturity Treasury securities edged up a bit.
Money market rates have moved up in line with increases in the FOMC's target range
Conditions in domestic short-term funding markets have also remained generally stable so far in 2018. Yields on a broad set of money market instruments moved higher in response to the FOMC's policy actions in March and June. Some money market rates rose during the first quarter more than what would normally occur with monetary tightening. For example, the spreads of certificates of deposit and term London interbank offered rates relative to overnight index swap (OIS) rates increased notably, reportedly reflecting increased issuance of Treasury bills and perhaps also the anticipated tax-induced repatriation of foreign earnings by U.S. corporations. The upward pressure on short-term funding rates, beyond that driven by expected monetary policy, eased in recent months, leading to a narrowing of spreads of some money market rates to OIS rates. However, the spreads remain wider than at the beginning of the year.
Bank credit continued to expand and bank profitability improved
Aggregate credit provided by commercial banks continued to increase through the first quarter of 2018 at a pace similar to the one seen in 2017. Its pace was slower than that of nominal GDP, thus leaving the ratio of total commercial bank credit to current-dollar GDP slightly lower than in the previous year (figure 35). Available data for the second quarter suggest that growth in banks' core loans continued to be moderate. Measures of bank profitability improved in the first quarter of 2018 after having experienced a temporary decline in the last quarter of 2017. Weaker fourth-quarter measures of bank profitability were partly driven by higher write-downs of deferred tax assets in response to the U.S. tax legislation (figure 36).
International Developments
Political developments and signs of moderating growth weighed on advanced foreign economy asset prices
Since February, political developments in Europe and moderation in economic growth outside of the United States weighed on some risky asset prices in advanced foreign economies (AFEs). Interest rates on sovereign bonds in several countries in the European periphery rose notably relative to core countries, and European bank shares came under pressure, as investors focused on the formation of the Italian government. Nonetheless, peripheral bond spreads remained well below their levels at the height of the euro-area crisis, and the moves partly retraced as a government was put in place. Broad stock price indexes were little changed on net (figure 37). In contrast to the United States, long-term sovereign yields and market-implied paths of policy rates in the core euro area as well as the United Kingdom declined somewhat, and rates were little changed in Japan (figure 38).
Heightened investor focus on vulnerabilities in emerging market economies led asset prices to come under pressure
Investor concerns about financial vulnerabilities in several emerging market economies (EMEs) intensified this spring against the backdrop of rising U.S. interest rates. Broad measures of EME sovereign bond spreads over U.S. Treasury yields widened notably, and benchmark EME equity indexes declined, as investors scrutinized macroeconomic policy approaches in several countries. Turkey and Argentina, which faced persistently high inflation, expansionary fiscal policies, and large current account deficits, were among the worst performers. Trade policy developments between the United States and its trading partners also weighed on EME asset prices, especially on stock prices in China and some emerging Asian countries. EME mutual funds saw net outflows in May and June after generally solid inflows earlier in the year (figure 39). While movements in asset prices and capital flows were notable for a number of economies, broad indicators of financial stress in EMEs remained low relative to levels seen during other periods of stress in recent years.
The dollar appreciated
After depreciating during 2017, the broad exchange value of the U.S. dollar has appreciated moderately in recent months (figure 40). Factors contributing to the appreciation of the dollar likely include moderating growth in some foreign economies combined with continued output strength and ongoing policy tightening in the United States, downside risks stemming from political developments in Europe and several EMEs, and the recent developments in trade policy. Several currencies appeared particularly sensitive to trade policy developments, including the Canadian dollar and the Mexican peso, related to the North American Free Trade Agreement negotiations, as well as the Chinese renminbi, which fell notably against the dollar in June.
The pace of economic activity moderated in the AFEs
In the first quarter, real GDP growth decelerated in all major AFEs and turned negative in Japan, down from robust rates of activity in 2017 (figure 41). Part of this slowing is a result of temporary factors, though, including unusually cold weather in Japan and the United Kingdom, labor strikes in the euro area, and disruptions in oil production in Canada. In most AFEs, economic indicators for the second quarter, including purchasing manager surveys and exports, are generally consistent with solid economic growth.
Despite tight labor markets, inflation pressures remain subdued in most AFEs...
Sustained increases in oil prices provided upward pressure on consumer price inflation across all AFEs in the first half of the year (figure 42). However, core inflation has generally remained muted in most AFEs, despite further improvement in labor market conditions. In Canada, in contrast, core inflation picked up amid solid wage growth, pushing the total inflation rate above the central bank target.
...prompting central banks to maintain highly accommodative monetary policies
With underlying inflation still subdued, the Bank of Japan and the European Central Bank (ECB) kept their policy rates at historically low levels, although the ECB indicated it would again reduce the pace of its asset purchases starting in October. The Bank of England and the Bank of Canada, which both began raising interest rates last year, signaled that further rate increases will be gradual, given a moderation in the pace of economic activity.
In emerging Asia, growth remained solid...
Economic growth in China remained solid in the first quarter of 2018, as a rebound in steel production and strong external demand bolstered a recovery in industrial activity and overall growth (figure 43). Indicators of investment and retail sales have slowed in recent months, however, suggesting that the authorities' effort to rein in credit may have softened domestic demand. Most other emerging Asian economies registered strong growth in the first quarter of 2018, partly reflecting solid external demand.
...while growth in some Latin American economies was mixed
In Mexico, real GDP surged in the first quarter as economic activity rebounded from two major earthquakes and a hurricane last year. Following a brief recovery in the first half of 2017, Brazil's economy stalled in the fourth quarter and grew tepidly in the first quarter, and a truckers' strike paralyzed economic activity in late May.
Footnotes
1. Monthly job gains in the range of 130,000 to 160,000 are consistent with an unchanged unemployment rate and an unchanged labor force participation rate. Return to text
2. See the Summary of Economic Projections in Part 3 of this report. Return to text
3. Indeed, the number of job openings now about matches the number of unemployed individuals. Return to text
4. The lower levels of labor force participation for these other groups differ importantly by sex. For African Americans, men have a lower participation rate relative to white men, while the participation rate for African American women is as high as that of white women. By contrast, the lower LFPRs for Hispanics and Asians reflect lower participation among women. 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 box "Productivity Developments in the Advanced Economies" in the July 2017 Monetary Policy Report provides more information. See Board of Governors of the Federal Reserve System (2017), Monetary Policy Report (Washington: Board of Governors, July), pp. 12-13, https://www.federalreserve.gov/monetarypolicy/2017-07-mpr-part1.htm. Return to text
7. Additional details can be found in the June 2017 Summary of Economic Projections, an addendum to the minutes of the June 2017 FOMC meeting. See Board of Governors of the Federal Reserve System (2017), "Minutes of the Federal Open Market Committee, June 13-14, 2017," press release, July 5, https://www.federalreserve.gov/newsevents/pressreleases/monetary20170705a.htm. Return to text
8. 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
9. 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 total 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
10. As these measures are based on CPI inflation, one should probably subtract about 1/4 to 1/2 percentage point--the average differential with PCE inflation over the past two decades--to infer inflation compensation on a PCE basis. Return to text
11. For the majority of households, home equity makes up the largest share of their wealth. Return to text
12. The SLOOS is available on the Board's website at https://www.federalreserve.gov/data/sloos/sloos.htm. Return to text
13. The results of the Survey of Primary Dealers and the Survey of Market Participants are available on the Federal Reserve Bank of New York's website at https://www.newyorkfed.org/markets/primarydealer_survey_questions.html and https://www.newyorkfed.org/markets/survey_market_participants, respectively. Return to text