Part 1: Recent Economic and Financial Developments

Monetary Policy Report submitted to the Congress on February 22, 2019, pursuant to section 2B of the Federal Reserve Act

Domestic Developments

The labor market strengthened further during the second half of 2018 and early this year...

Payroll employment gains have remained strong, averaging 224,000 per month since June 2018 (figure 1). This pace is similar to the pace in the first half of last year, and it is faster than the average pace of job gains in 2016 and 2017.

The strong pace of job gains over this period has primarily been manifest in a rising labor force participation rate (LFPR)--the share of the population that is either working or actively looking for work--rather than a declining unemployment rate.1 Since June 2018, the LFPR has moved up about 1/4 percentage point and was 63.2 percent in January--a bit higher than the narrow range it has maintained in recent years (figure 2). The improvement is especially notable because the aging of the population--and, in particular, the movement of members of the baby-boom cohort into their retirement years--has otherwise imparted a downward influence on the LFPR. Indeed, the LFPR for individuals between 25 and 54 years old--which is much less sensitive to population aging--has improved considerably more than the overall LFPR, including a 1/2 percentage point rise since June 2018.2

At the same time, the unemployment rate has remained little changed and has generally been running a little under 4 percent.3 Nevertheless, the unemployment rate remains at a historically low level and is 1/2 percentage point below the median of the Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level (figure 3).4 Combining the movements in both unemployment and labor force participation, the employment-to-population ratio for individuals 16 and over--the share of that segment of the population who are working--was 60.7 percent in January and has been gradually increasing since 2011.

Other indicators are also consistent with a strong labor market. As reported in the Job Openings and Labor Turnover Survey (JOLTS), the job openings rate has moved higher since the first half of 2018, and in December, it was at its highest level since the data began in 2000. The quits rate in the JOLTS is also near the top of its historical range, an indication that workers have become more confident that they can successfully switch jobs when they wish to. In addition, the JOLTS layoff rate has remained low, and the number of people filing initial claims for unemployment insurance benefits has also remained low. Survey evidence indicates that households perceive jobs as plentiful and that businesses see vacancies as hard to fill.

. . . and unemployment rates have fallen for all major demographic groups over the past several years

The flattening in unemployment since mid-2018 has been evident across racial and ethnic groups (figure 4). Even so, over the past several years, the decline in the unemployment rates for blacks or African Americans and for Hispanics has been particularly notable, and the unemployment rates for these groups are near their lowest readings since these series began in the early 1970s. Differences in unemployment rates across ethnic and racial groups have narrowed in recent years, as they typically do during economic expansions, after having widened during the recession; on net, unemployment rates for African Americans and Hispanics remain substantially above those for whites and Asians, with differentials generally a bit below pre-recession levels.

The rise in LFPRs for prime-age individuals over the past few years has also been apparent in each of these racial and ethnic groups. Nonetheless, the LFPR for whites remains higher than that for other groups (figure 5). Important differences in economic outcomes persist across other characteristics as well (see, for example, the box "Employment Disparities between Rural and Urban Areas," which highlights that there has been less improvement since 2010 in the LFPR and employment-to-population ratio for prime-age individuals in rural areas compared with urban areas).

Employment Disparities between Rural and Urban Areas

The U.S. labor market has recovered substantially since 2010. For people in their prime working years (ages 25 to 54), the unemployment rate has moved down steadily to levels below the previous business cycle peak in 2007, the labor force participation rate (LFPR) has retraced much of its decline, and the share of the population who are employed--known as the employment-to-population ratio, or EPOP ratio--has returned to about its level before the recession. However, the labor market recovery has been uneven across the country, with "rural" (or nonmetro) areas showing markedly less improvement than cities and their surroundings (metro areas).1

The extent of the initial decline and subsequent improvement in the EPOP ratio varied by metropolitan status. The gap between the EPOP ratios in rural and larger urban areas is now noticeably wider than it was before the recession, and the cyclical recovery started later in rural areas. Specifically, as shown in figure A, the prime-age EPOP is now slightly above its pre-recession level in larger urban areas, whereas it is just below its pre-recession average in smaller urban areas and much below its pre-recession level in rural areas.2

The EPOP ratio can usefully be viewed as summarizing both the LFPR--that is, the share of the population that either has a job or is actively looking for work--and the unemployment rate, which measures the share of the labor force without a job and actively searching.3 The divergence in rural and urban EPOP ratios during the economic expansion almost entirely reflects divergences in LFPRs rather than in unemployment rates (figures B and C). In particular, the rural and urban unemployment rates have tracked each other fairly closely in this expansion, though they have diverged a little in the past few years. In contrast, the difference between rural and urban LFPRs has widened significantly over the past decade.

On average, people in rural areas tend to have fewer years of schooling than people in urban areas, and because the EPOP ratio tends to be lower for individuals with less education, this demographic difference has contributed to the persistent rural-urban divide. However, these educational differences do not appear responsible for the fact that the gap between rural and urban EPOP ratios have widened. Figure D shows that, in recent years, rural and urban EPOP ratios diverged substantially even within educational categories, similar to the divergence in EPOPs more generally. The left panel of figure D shows that the EPOP ratio of non-college-educated adults ages 25 to 54 has been much lower in rural areas than in urban ones beginning in 2012. The right panel of figure D shows that the EPOP ratio of college-educated adults used to be higher in rural areas than in urban ones, but that is no longer so. Thus, the recent widening of the rural-urban disparity in EPOP ratios has not been primarily driven by differences in years of education.

Nevertheless, because the recovery in the EPOP ratio for non-college-educated adults in rural areas has been particularly weak, it is likely that broader macroeconomic trends--including the ongoing shift in labor demand that has favored individuals with more education--have had more adverse consequences for the populations in rural areas than in urban areas. For example, manufacturing, where employment has stagnated, accounts for a larger share of employment in rural areas than in urban areas, while fast-growing services industries, such as health-care and professional services that tend to employ workers with more education, are more concentrated in urban areas. Indeed, employment in manufacturing has not yet fully recovered from the recession. And, despite the strength in the past two years, the share of total employment in manufacturing has remained near its post-recession low.

The fact that most of the EPOP divergence is seen in labor force participation rather than unemployment rates suggests that many rural workers who experienced a permanent job loss, perhaps due to a factory closing, decided to eventually exit the labor force rather than continue their job search. Some individuals who had been working, despite ongoing health problems, may have responded to job loss and poor reemployment opportunities by applying for Social Security Disability Insurance (SSDI) benefits, and, in fact, take-up increased a little more in rural areas than it did in urban ones over the past decade.4

When regions are faced with adverse changes in labor demand, some residents may respond by migrating to more prosperous areas. The more out-migration that occurs from areas with relatively fewer labor market opportunities, the smaller should be the observed decline in local-area EPOPs.5 However, some research suggests that the average migration response to adverse demand shocks has decreased in recent decades, which could amplify the labor market effects of local shocks and lead to persistent disparities in EPOP ratios across areas.6

1. For convenience, we refer to metropolitan counties with strong commuting ties to an urbanized center as "urban" and nonmetropolitan counties that lack such ties as "rural." Return to text

2. For all figures in this discussion, the raw data are from the U.S. Census Bureau, Current Population Survey; note that the Bureau of Labor Statistics is involved in the survey process for the Current Population Survey. Calculations of the series shown are as described in 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), The figures show 12-month moving averages of the monthly time-series. Return to text

3. Specifically, the EPOP ratio equals (LFPR) x (1 - unemployment rate), where LFPR is defined as "labor force/population" and the unemployment rate is defined as "persons unemployed/labor force." These numbers are multiplied by 100 for presentation purposes in the figures. Return to text

4. This increase could reflect growing public health problems (which expands the pool of individuals who qualify for SSDI) and sluggish labor demand in rural areas (which increases the propensity of individuals to apply for SSDI benefits). Return to text

5. Although a higher rate of rural out-migration would help close the EPOP gap, depopulation might exacerbate economic difficulties for those who remain in rural areas. Return to text

6. See, for example, Mai Dao, Davide Furceri, and Prakash Loungani (2017), "Regional Labor Market Adjustment in the United States: Trend and Cycle," Review of Economics and Statistics, vol. 99 (May), pp. 243-57. Return to text

Return to text
Increases in labor compensation have picked up recently but remain moderate by historical standards...

Most available indicators suggest that growth of hourly compensation has stepped up further since June 2018 after having firmed somewhat over the past few years; however, growth rates remain moderate compared with those that prevailed in the decade before the recession. Compensation per hour in the business sector--a broad-based measure of wages and benefits, but one that is quite volatile--rose 2-1/4 percent over the four quarters ending in 2018:Q3, about the same as the average annual increase over the past seven years or so (figure 6). The employment cost index, a less volatile measure of both wages and the cost to employers of providing benefits, increased 3 percent over the same period, while average hourly earnings--which do not take account of benefits--increased 3.2 percent over the 12 months ending in January of this year; the annual increases in both of these measures were the strongest in nearly 10 years. 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 3.7 percent in January, near the upper end of its readings in the past three years and well above the average increase in the preceding few years.5

. . . and have likely been restrained by slow growth of labor productivity over much of the expansion

These moderate rates of compensation gains likely reflect the offsetting influences of a strong labor market and productivity growth that has been weak through much of the expansion. From 2008 to 2017, labor productivity increased a little more than 1 percent per year, on average, well below the average pace from 1996 to 2007 of nearly 3 percent and also below the average gain in the 1974-95 period (figure 7). Although considerable debate remains about the reasons for the slowdown over this period, 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. More recently, however, labor productivity is estimated to have increased almost 2 percent at an annual rate in the first three quarters of 2018--still moderate relative to earlier periods, but its fastest three-quarter gain since 2010. While it is uncertain whether this faster rate of growth will persist, a sustained pickup in productivity growth, as well as additional labor market strengthening, would likely support stronger gains in labor compensation.

Price inflation is close to 2 percent

Consumer price inflation has fluctuated around the FOMC's objective of 2 percent, largely reflecting movements in energy prices. As measured by the 12-month change in the price index for personal consumption expenditures (PCE), inflation is estimated to have been 1.7 percent in December after being above 2 percent for much of 2018 (figure 8).6 Core PCE inflation--that is, inflation excluding consumer food and energy prices--is estimated to have been 1.9 percent in December. Because food and energy prices are often quite volatile, core inflation typically provides a better indication than the total measure of where overall inflation will be in the future. Total inflation was below core inflation for the year as a whole not only because of softness in energy prices, but also because food price inflation has remained relatively low.

Core inflation has moved up since 2017, when inflation was held down by some unusually large price declines in a few relatively small categories of spending, such as mobile phone services. The trimmed mean PCE price index, produced by the Federal Reserve Bank of Dallas, provides an alternative way to purge inflation of transitory influences, and it may be less sensitive than the core index to idiosyncratic price movements such as those noted earlier. The 12-month change in this measure did not decline as much as core PCE inflation in 2017, and it was 2.0 percent in November.7 Inflation likely has been increasingly supported by the strong labor market in an environment of stable inflation expectations; inflation last year was also boosted slightly by the tariffs that were imposed throughout 2018.

Oil prices have dropped markedly in recent months...

As noted, the slower pace of total inflation in late 2018 relative to core inflation largely reflected softening in consumer energy prices toward the end of the year. After peaking at about $86 per barrel in early October, the price of crude oil subsequently fell sharply and has averaged around $60 per barrel this year (figure 9). The recent decline in oil prices has led to moderate reductions in the cost of gasoline and heating oil. Supply factors, including surging oil production in Saudi Arabia, Russia, and the United States, appear to be most responsible for the recent price declines, but concerns about weaker global growth likely also played a role.

. . . while prices of imports other than energy have also declined

After climbing steadily since their early 2016 lows, nonfuel import prices peaked in May 2018 and declined for much of the rest of 2018 in response to dollar appreciation, lower foreign inflation, and declines in commodity prices. In particular, metal prices fell markedly in the second half of 2018, partly reflecting concerns about prospects for the global economy (figure 10). Nonfuel import prices, before accounting for the effects of tariffs on the price of imported goods, had roughly a neutral influence on U.S. price inflation in 2018.

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 over the second half of 2018. 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 very close to 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 around 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--while relatively stable around 3 percent since early 2018--is nonetheless at the top of the range it has occupied over the past couple of years.

. . . while market-based measures of inflation compensation have come down since the first half of 2018

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--moved down in the fall and are below levels that prevailed earlier in 2018 (figure 12).8 The TIPS-based measure of 5-to-10-year-forward inflation compensation and the analogous measure from inflation swaps are now about 1-3/4 percent and 2-1/4 percent, respectively, with both measures below their respective ranges that persisted for most of the 10 years before the start of the notable declines in mid-2014.9

Real gross domestic product growth was solid, on balance, in the second half of 2018

Real gross domestic product (GDP) rose at an annual rate of 3-1/2 percent in the third quarter, and available indicators point to a moderate gain in the fourth quarter.10 For the year, GDP growth appears to have been a little less than 3 percent, up from the 2-1/2 percent pace in 2017 and the 2 percent pace in the preceding two years (figure 13). Last year's growth reflects, in part, solid growth in household and business spending, on balance, as well as an increase in government purchases of goods and services; by contrast, housing-sector activity turned down last year. Private domestic final purchases--that is, final purchases by households and businesses, which tend to provide a better indication of future GDP growth than most other components of overall spending--likely posted a strong gain for the year.

Some measures of consumer and business sentiment have recently softened--likely reflecting concerns about financial market volatility, the global economic outlook, trade policy tensions, and the government shutdown--and consumer spending appears to have weakened at the end of the year. Nevertheless, the economic expansion continues to be supported by steady job gains, past increases in household wealth, expansionary fiscal policy, and still-favorable domestic financial conditions, including moderate borrowing costs and easy access to credit for many households and businesses.

Ongoing improvements in the labor market continue to support household income and consumer spending...

Real consumer spending picked up after some transitory weakness in the first half of 2018, rising at a strong annual rate of 3-1/2 percent in the third quarter and increasing robustly through November (figure 14). However, despite anecdotal reports of favorable holiday sales, retail sales were reported to have declined sharply in December. Real disposable personal income--that is, income after taxes and adjusted for price changes--looks to have increased around 3 percent over the year, boosted by ongoing improvements in the labor market and the reduction in income taxes due to the implementation of the Tax Cuts and Jobs Act (TCJA). With consumer spending rising at about the same rate as gains in disposable income in 2018 through the third quarter (the latest data available), the personal saving rate was roughly unchanged, on net, over this period (figure 15).

. . . although wealth gains have moderated and consumer confidence has recently softened

While increases in household wealth have likely continued to support consumer spending, gains in net worth slowed last year. House prices continued to move up in 2018, boosting the wealth of homeowners, but the pace of growth moderated (figure 16). U.S. equity prices are, on net, similar to their levels at the end of 2017. Still, the level of equity and housing wealth relative to income remains very high by historical standards (figure 17).11

Consumer sentiment as measured by the Michigan survey flattened out at a high level through much of 2018, and the sentiment measure from the Conference Board survey climbed through most of the year, with both measures posting their highest annual averages since 2000 (figure 18). However, consumer sentiment has turned down since around year-end, on net, with the declines primarily reflecting consumers' expectations for future conditions rather than their assessment of current conditions. Consumer attitudes about car buying have also weakened. Nevertheless, these indicators of consumers' outlook remain at generally favorable levels, likely reflecting rising income, job gains, and low inflation.

Borrowing conditions for consumers remain generally favorable despite interest rates being near the high end of their post-recession range

Despite increases in interest rates for consumer loans and some reported further tightening in credit card lending standards, financing conditions for consumers largely remain supportive of growth in household spending, and consumer credit growth in 2018 expanded further at a solid pace (figure 19). Mortgage credit has continued to be readily available for households with solid credit profiles. For borrowers with low credit scores, mortgage underwriting standards have eased somewhat since the first half of 2018 but remain noticeably tighter than before the recession. Financing conditions in the student loan market remain stable, with over 90 percent of such credit being extended by the federal government. Delinquencies on such loans, though staying elevated, continued to improve gradually on net.

Business investment growth has moderated after strong gains early in 2018...

Investment spending by businesses rose rapidly in the first half of last year, and the available data are consistent with growth having slowed in the second half (figure 20). The apparent slowdown reflects, in part, more moderate growth in investment in equipment and intangibles as well as a likely decline in investment in nonresidential structures after strong gains earlier in the year. Forward-looking indicators of business spending--such as business sentiment, capital spending plans, and profit expectations from industry analysts--have softened recently but remain positive overall. And while new orders of capital goods flattened out toward the end of last year, the backlog of unfilled orders for this equipment has continued to rise.

. . . as corporate financing conditions tightened somewhat but remained accommodative overall

Spreads of yields on nonfinancial corporate bonds over those on comparable-maturity Treasury securities widened modestly, on balance, since the middle of 2018 as investors' risk appetite appeared to recede some. Nonetheless, a net decrease in Treasury yields over the past several months has left interest rates on corporate bonds still low by historical standards, and financing conditions appear to have remained accommodative overall. Aggregate net flows of credit to large nonfinancial firms remained solid in the third quarter (figure 21). The gross issuance of corporate bonds and new issuance of leveraged loans both fell considerably toward the end of the year but have since rebounded, mirroring movements in financial market volatility.

Respondents to the January Senior Loan Officer Opinion Survey on Bank Lending Practices, or SLOOS, reported that lending standards for commercial and industrial (C&I) loans remained basically unchanged in the fourth quarter after having reported easing standards over the past several quarters. However, banks reported tightening lending standards on all categories of commercial real estate (CRE) loans in the fourth quarter on net.

Meanwhile, financing conditions for small businesses have remained generally accommodative. Lending volumes to small businesses rebounded a bit in recent months, and indicators of recent loan performance stayed strong.

Activity in the housing sector has been declining

Residential investment declined in 2018, as housing starts held about flat and sales of existing homes moved lower (figures 22 and 23). The drop in residential investment reflects rising mortgage rates--which remain higher than in 2017 despite coming down some recently--as well as higher material and labor building costs, which have likely restrained new home construction. Consumers' perceptions of homebuying conditions deteriorated sharply over 2018, consistent with the decline in the affordability of housing associated with both higher mortgage rates and still-rising house prices (figure 24).

Net exports likely subtracted from GDP growth in 2018

After a strong performance in the first half of last year supported by robust exports of agricultural products, real exports declined in the third quarter, and available indicators suggest only a partial rebound in the fourth quarter (figure 25). At the same time, growth in real imports seems to have picked up in the second half of 2018. As a result, real net exports--which lifted U.S. real GDP growth during the first half of 2018--appear to have subtracted from growth in the second half. For the year as a whole, net exports likely subtracted a little from real GDP growth, similar to 2016 and 2017. The nominal trade deficit and the current account deficit in 2018 were little changed as a percent of GDP from 2017 (figure 26).

Federal fiscal policy actions boosted economic growth in 2018...

Fiscal policy at the federal level boosted GDP growth in 2018, both because of lower income and business taxes from the TCJA and because federal purchases appear to have risen significantly faster than in 2017 as a result of the Bipartisan Budget Act of 2018 (figure 27).12 The partial government shutdown, which was in effect from December 22 through January 25, likely held down GDP growth in the first quarter of this year somewhat, largely because of the lost work of furloughed federal government workers and temporarily affected federal contractors.

The federal unified deficit widened in fiscal year 2018 to 3-3/4 percent of nominal GDP because receipts moved lower, to roughly 16-1/2 percent of GDP (figure 28). Expenditures edged down, to 20-1/4 percent of GDP, but remain above the levels that prevailed in the decade before the start of the 2007-09 recession. The ratio of federal debt held by the public to nominal GDP equaled 78 percent at the end of fiscal 2018 and remains quite elevated relative to historical norms (figure 29). The Congressional Budget Office projects that this ratio will rise over the next several years.

. . . 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. After several years of slow growth, revenue gains of state governments strengthened notably as sales and income tax collections have picked up over the past few quarters. At the local level, property tax collections continue to rise at a solid clip, pushed higher by past house price gains. After declining a bit in 2017, real state and local government purchases grew moderately last year, driven largely by a boost in construction but also reflecting modest growth in employment at these governments.

Financial Developments

The expected path of the federal funds rate over the next several years has moved down

Despite the further strengthening in the labor market and continued expansion in the U.S. economy, market-based measures of the expected path for the federal funds rate over the next several years have declined, on net, since the middle of last year (figure 30). Various factors contributed to this shift, including increased investor concerns about downside risks to the global economic outlook and rising trade tensions, as well as FOMC communications that were viewed as signaling patience and greater flexibility in the conduct of monetary policy in response to adverse macroeconomic or financial market developments.

Survey-based measures of the expected path of the policy rate through 2020 also shifted down, on net, relative to the levels observed in the first half of 2018. 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 January FOMC meeting, the median of respondents' modal projections for the path of the federal funds rate implies two additional 25 basis point rate increases in 2019. Relative to the December survey, these increases are expected to occur later in 2019. Looking further ahead, respondents to the January survey forecast no rate increases in 2020 and in 2021.13 Meanwhile, market-based measures of uncertainty about the policy rate approximately one to two years ahead were little changed, on balance, from their levels at the end of last June.

The nominal Treasury yield curve continued to flatten

The nominal Treasury yield curve flattened somewhat further since the first half of 2018, with the 2-year nominal Treasury yield little changed and the 5- and 10-year nominal Treasury yields declining about 25 basis points on net (figure 31). At the same time, yields on inflation-protected Treasury securities edged up, leaving market-based measures of inflation compensation moderately lower. In explaining movements in Treasury yields since mid-2018, market participants have pointed to developments related to the global economic outlook and trade tensions, FOMC communications, and fluctuations in oil prices. Option-implied volatility on swap rates--an indicator of uncertainty about Treasury yields--declined slightly on net.

Consistent with changes in yields on nominal Treasury securities, yields on 30-year agency mortgage-backed securities (MBS)--an important determinant of mortgage interest rates--decreased about 20 basis points, on balance, since the middle of last year and remain low by historical standards (figure 32). Meanwhile, yields on both investment-grade and high-yield corporate debt declined a bit (figure 33). As a result, the spreads on corporate bond yields over comparable-maturity Treasury yields are modestly wider than at the end of June. The cumulative increases over the past year have left spreads for high-yield and investment-grade corporate bonds close to their historical medians, with both spreads notably above the very low levels that prevailed a year ago.

Broad equity price indexes increased somewhat

Broad U.S. stock market indexes increased somewhat since the middle of last year, on net, amid substantial volatility (figure 34). Concerns over the sustainability of corporate earnings growth, the global growth outlook, international trade tensions, and some Federal Reserve communications that were perceived as less accommodative than expected weighed on investor sentiment for a time. There were considerable differences in stock returns across sectors, reflecting their varying degrees of sensitivities to energy price declines, trade tensions, and rising interest rates. In particular, stock prices of companies in the utilities sector--which tend to benefit from falling interest rates--and in the health-care sector outperformed broader indexes. Conversely, stock prices in the energy sector substantially underperformed the broad indexes, as oil prices dropped sharply. Basic materials--a sector that was particularly sensitive to concerns about the global growth outlook and trade tensions--also underperformed. Bank stock prices declined slightly, on net, as the yield curve flattened and funding costs rose. Measures of implied and realized stock price volatility for the S&P 500 index--the VIX and the 20-day realized volatility--increased sharply in the fourth quarter of last year to near the high levels observed in early February 2018 amid sharp equity price declines. These volatility measures partially retraced following the turn of the year, with the VIX returning to near the 30th percentile of its historical distribution and with realized volatility ending the period close to the 70th percentile of its historical range (figure 35). (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability.")

Developments Related to Financial Stability
The Federal Reserve Board's financial stability monitoring framework

The framework used by the Federal Reserve Board to monitor financial stability distinguishes between shocks to and vulnerabilities of the financial system. Shocks, such as sudden changes to financial or economic conditions, are typically surprises and are inherently difficult to predict, whereas vulnerabilities tend to build up over time and are the aspects of the financial system that are most expected to cause widespread problems in times of stress. Some vulnerabilities are cyclical in nature, rising and falling over time, while others are structural, stemming from longer-term forces shaping the nature of credit intermediation. As a result, the framework focuses primarily on monitoring vulnerabilities and emphasizes four broad categories based on academic research.1

  1. Elevated valuation pressures are signaled by asset prices that are high relative to economic fundamentals or historical norms and are often driven by an increased willingness of investors to take on risk. As such, elevated valuation pressures imply a greater possibility of outsized drops in asset prices.
  2. Excessive borrowing by businesses and households leaves them vulnerable to distress if their incomes decline or the assets they own fall in value.
  3. Excessive leverage within the financial sector increases the risk that financial institutions will not have the ability to absorb losses when hit by adverse shocks.
  4. Funding risks expose the financial system to the possibility that investors will "run" by withdrawing their funds from a particular institution or sector. Facing a run, financial institutions may need to sell assets quickly at "fire sale" prices, thereby incurring substantial losses and potentially even becoming insolvent. Historians and economists often refer to widespread investor runs as "financial panics."

While this framework provides a systematic way to assess financial stability, some potential risks do not fit neatly into it because they are novel or difficult to quantify, such as cybersecurity or developments in crypto-assets. In addition, some vulnerabilities are difficult to measure with currently available data, and the set of vulnerabilities may evolve over time. Given these limitations, we continually rely on ongoing research by the Federal Reserve staff, academics, and other experts.

Since the publication of the Federal Reserve Board's first Financial Stability Report on November 28, 2018, some areas where valuation pressures were a concern have cooled, particularly those related to below-investment-grade corporate debt.2 Regulatory capital and liquidity ratios of key financial institutions, especially large banks, are at historically high levels. Funding risks in the financial system are low relative to the period leading up to the crisis. Borrowing by households has risen roughly in line with household incomes and has been concentrated among prime borrowers. Nonetheless, debt owed by businesses is high, and credit standards, especially within segments of the loan market focused on lower-rated or unrated firms, deteriorated in the second half of 2018.

Asset valuations increased to the high end of their historical ranges in many markets over 2017 and the first half of 2018, supported by the solid economic expansion and an apparent increase in investors' appetite for risk. However, compared with July 2018, around the time of the previous Monetary Policy Report, valuation pressures have eased somewhat in the equity, corporate bond, and leveraged loan markets. Over the same period, amid substantial market volatility, the forward equity price-to-earnings ratio of S&P 500 firms, a metric of valuations in equity markets, declined a touch, on net, and it currently stands just below the top quartile of its historical distribution (figure A). Spreads on both investment- and speculative-grade corporate bonds over comparable-maturity Treasury securities widened modestly to levels close to the medians of their historical ranges since 1997 (figure B). Spreads on newly issued leveraged loans widened markedly in the fourth quarter of 2018. In real estate markets, commercial real estate prices have been growing faster than rents for several years, leaving valuations stretched.

Since the 2007-09 recession, household debt and business debt have diverged (figure C). Over the past several years, borrowing by households has stayed in line with income growth and has been concentrated among borrowers with strong credit histories. By contrast, borrowing by businesses, including riskier firms, has expanded significantly. For speculative-grade and unrated firms, the ratio of debt to assets has increased steadily since 2010 and remains near its historical peak. Further, growth in debt to businesses with lower credit ratings and with already elevated levels of borrowing, such as high-yield bonds and leveraged loans, has been substantial over the past two years (figure D). Issuance of these instruments slowed significantly in November and December 2018 because of the sharply higher spreads demanded by investors to hold them, but issuance has rebounded somewhat in early 2019.

Credit standards for new leveraged loans deteriorated over the second half of 2018. The share of newly issued large loans to corporations with high leverage--defined as those with ratios of debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) above 6--increased through 2018 to levels exceeding previous peaks observed in 2007 and 2014, when underwriting quality was notably poor. In addition, issuance of covenant-lite loans--loans with few or no traditional maintenance covenants--remained high during the second half of 2018, although this elevated level may reflect, in part, a greater prevalence of investors who do not traditionally monitor and exercise loan covenants.3 Nonetheless, the strong economy has helped sustain solid credit performance of leveraged loans in 2018, with the default rate on such loans near the low end of its historical range.

The credit quality of nonfinancial high-yield corporate bonds was roughly stable over the past several years, with the share of high-yield bonds outstanding that are rated B3/B- or below staying flat and below the financial crisis peak. In contrast, the distribution of ratings among investment-grade corporate bonds deteriorated. The share of bonds rated at the lowest investment-grade level (for example, an S&P rating of triple-B) reached near-record levels. As of December 2018, around 42 percent of corporate bonds outstanding were at the lowest end of the investment-grade segment, amounting to about $3 trillion.

Vulnerabilities from financial-sector leverage continue to be low relative to historical standards, in part because of regulatory reforms enacted since the financial crisis. Core financial intermediaries, including large banks, insurance companies, and broker-dealers, appear well positioned to weather economic stress. As of the third quarter of 2018, regulatory capital ratios for the U.S. global systemically important banks remained well above regulatory requirements and were close to historical highs. Those banks will be subject to the 2019 Dodd-Frank Act stress tests and Comprehensive Capital Assessment and Review. Consistent with the Federal Reserve Board's public framework, this year's scenarios feature a larger increase in unemployment and a deeper recession than in 2018 as well as typically large declines in financial asset prices. Capital levels at insurance companies and broker-dealers also remained relatively robust by historical standards. A range of indicators suggest that hedge fund leverage was roughly unchanged over 2018; however, comprehensive data, available with a significant time lag, from early 2018 showed that leverage remained at the upper end of its range over the past eight years.

Vulnerabilities associated with funding risk--that is, the financing of illiquid assets or long-maturity assets with short-maturity debt--continue to be low, in part because of the post-crisis implementation of liquidity regulations for banks and the 2016 money market reforms.4 Banks are holding higher levels of liquid assets, while their use of short-term wholesale funding as a share of liabilities is near historical lows. Assets under management at prime funds, institutions that proved vulnerable to runs in the past, have risen somewhat in recent months but remained far below pre-reform levels.

Potential downside risks to international financial stability include a downturn in global growth, political and policy uncertainty, an intensification of trade tensions, and broadening stress in emerging market economies (EMEs). In many advanced foreign economies, financial conditions tightened somewhat in the second half of 2018, partly reflecting a deterioration in the fiscal outlook of Italy and Brexit uncertainty. The United Kingdom and the European Union (EU) have not yet ratified the terms for the United Kingdom's March 2019 withdrawal from the EU (Brexit). Without such a withdrawal agreement, there will be no transition period for important trade and financial interactions between U.K. and EU residents, and, despite preparations for a "no-deal Brexit," a wide range of economic and financial activities could be disrupted. EMEs also experienced heightened financial stress in the second half of 2018. Although that stress has receded somewhat more recently, many EMEs continue to harbor important vulnerabilities, reflecting one or more of substantial corporate leverage, fiscal concerns, or excessive reliance on foreign funding.

1. For a review of the research literature in this area and further discussion, see Tobias Adrian, Daniel Covitz, and Nellie Liang (2015), "Financial Stability Monitoring," Annual Review of Financial Economics, vol. 7 (December), pp. 357-95. Return to text

2. See Board of Governors of the Federal Reserve System (2018), Financial Stability Report (Washington: Board of Governors, November), Return to text

3. Collateralized loan obligations, which are predominantly backed by leveraged loans, have grown rapidly over the past year and, as of year-end 2018, purchase about 60 percent of leveraged loans at origination. Similarly, mutual funds hold about 20 percent of leveraged loans. Return to text

4. See U.S. Securities and Exchange Commission (2014), "SEC Adopts Money Market Fund Reform Rules," press release, July 23, Return to text

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

Available indicators of Treasury market functioning have generally remained stable since the first half of 2018, with a variety of liquidity metrics--including bid-ask spreads, bid sizes, and estimates of transaction costs--displaying few signs of liquidity pressures. 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 over the past year and a half. Credit conditions in municipal bond markets have remained stable since the middle of last year, though yield spreads on 20‑year general obligation municipal bonds over comparable-maturity Treasury securities were modestly higher on net.

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 since the beginning of the summer. Increases in the FOMC's target range were transmitted effectively through money markets, with yields on a broad set of money market instruments moving higher in response to the FOMC's policy actions in September and December. The effective federal funds rate moved to parity with the interest rate paid on reserves and was closely tracked by the overnight Eurodollar rate. Other short-term interest rates, including those on commercial paper and negotiable certificates of deposits, also moved up in light of increases in the policy rate.

Bank credit continued to expand, and bank profitability improved

Aggregate credit provided by commercial banks expanded through the second half of 2018 at a stronger pace than the one observed in the first half of last year, as the strength in C&I loan growth more than offset the moderation in the growth in CRE loans and loans to households. In the fourth quarter of last year, the pace of bank credit expansion was about in line with that of nominal GDP, leaving the ratio of total commercial bank credit to current-dollar GDP little changed relative to last June (figure 36). Overall, measures of bank profitability improved further in the third quarter despite a flattening yield curve, but they remain below their pre-crisis levels (figure 37).

International Developments

Economic activity in most foreign economies weakened in the second half of 2018

After expanding briskly in 2017, foreign GDP growth moderated in 2018. While part of this slowdown is likely due to temporary factors, it also appears to reflect weaker underlying momentum against the backdrop of somewhat tighter financial conditions, increased policy uncertainty, and ongoing debt deleveraging.

The growth slowdown was particularly pronounced in advanced foreign economies

Real GDP growth in several advanced foreign economies (AFEs) slowed markedly in the second half of the year (figure 38). This slowdown was concentrated in the manufacturing sector against the backdrop of softening global trade flows. In Japan, real GDP contracted in the second half of 2018, as economic activity, which was disrupted by a series of natural disasters in the third quarter, rebounded only partly in the fourth quarter. Growth in the euro area slowed in the second half of the year: Transportation bottlenecks and complications in meeting tighter emissions standards for new motor vehicles weighed on German economic activity, while output contracted in Italy. Although some of these headwinds appear to be fading, recent indicators--especially for the manufacturing sector--point to only a limited recovery of activity in the euro area at the start of 2019.

Inflation pressures remain contained in advanced foreign economies...

In recent months, headline inflation has fallen below central bank targets in many major AFEs, reflecting large declines in energy prices (figure 39). In the euro area and Japan, low headline inflation rates also reflect subdued core inflation. In Canada and the United Kingdom, instead, core inflation rates have been close to 2 percent.

. . . prompting central banks to withdraw accommodation only gradually

With underlying inflation still subdued, the Bank of Japan and the European Central Bank (ECB) kept their short-term policy rates at negative levels. Although the ECB concluded its asset purchase program in December, it signaled an only very gradual removal of policy accommodation going forward. The Bank of England (BOE) and the Bank of Canada, which both began raising interest rates in 2017, increased their policy rates further in the second half of 2018 but to levels that are still low by historical standards. The BOE noted that elevated uncertainty around the United Kingdom's exit from the European Union (EU) weighed on the country's economic outlook.

Political uncertainty and slower economic growth weighed on AFE asset prices

Moderation in global growth, protracted budget negotiations between the Italian government and the EU, and developments related to the United Kingdom's withdrawal from the EU weighed on AFE asset prices in the second half of 2018 (figure 40). Broad stock price indexes in the AFEs fell, interest rates on sovereign bonds in several countries in the European periphery remained elevated, and European bank shares underperformed, although these moves have partially retraced in recent weeks. Market-implied paths of policy in major AFEs and long-term sovereign bond yields declined somewhat, as economic data disappointed (figure 41).

Growth slowed in many emerging market economies

Chinese GDP growth slowed in the second half of 2018 as an earlier tightening of credit policy, aimed at restraining the buildup of debt, caused infrastructure investment to fall sharply and squeezed household spending (figure 42). However, increased concerns about a sharper-than-expected slowdown in growth, as well as prospective effects of trade policies, prompted Chinese authorities to ease monetary and fiscal policy somewhat. Elsewhere in emerging Asia, growth remained well below its 2017 pace amid headwinds from moderating global growth. Tighter financial conditions also weighed on growth in other EMEs--notably, Argentina and Turkey.

Economic activity strengthened somewhat in Mexico and Brazil, but uncertainty about policy developments remains elevated

In Mexico, economic activity increased at a more rapid rate in the third quarter after modest advances earlier in the year. However, growth weakened again in the fourth quarter, as perceptions that the newly elected government would pursue less market-friendly policies led to a sharp tightening in financial conditions. Amid a sharp peso depreciation and above-target inflation, the Bank of Mexico raised its policy rate to 8.25 percent in December. Brazilian real GDP growth rebounded in the third quarter after being held down by a nationwide trucker's strike in May, and financial markets have rallied on expectations that Brazil's new government will pursue economic policies that support growth. However, investors continued to focus on whether the new administration would pass significant fiscal reforms.

Financial conditions in many emerging market economies were volatile but are, on net, little changed since July

Financial conditions in the EMEs generally tightened in the second half of 2018, as investor concerns about vulnerabilities in several EMEs intensified against the backdrop of higher policy uncertainty, slowing global growth, and rising U.S. interest rates. Trade policy tensions between the United States and China weighed on asset prices, especially in China and other Asian economies. Broad measures of EME sovereign bond spreads over U.S. Treasury yields rose, and benchmark EME equity indexes declined. However, financial conditions improved significantly in recent months, supported in part by more positive policy developments--including the U.S.-Mexico-Canada Agreement and progress on U.S.-China trade negotiations--and FOMC communications indicating a more gradual normalization of U.S. interest rates. EME mutual fund inflows resumed in recent months after experiencing outflows in the middle of 2018 (figure 43). While movements in asset prices and capital flows have been sizable for a number of economies, broad indicators of financial stress in EMEs are below those seen during other periods of stress in recent years.

The dollar appreciated slightly

The foreign exchange value of the U.S. dollar is bit a higher than in July (figure 44). Concerns about the global outlook, uncertainty about trade policy, and monetary policy normalization in the United States contributed to the appreciation of the dollar. The Chinese renminbi depreciated against the dollar slightly, on net, amid ongoing trade negotiations and increased concerns about growth prospects in China. The Mexican peso has been volatile amid ongoing political developments and trade negotiations but has, on net, declined only modestly against the dollar. Sharp declines in oil prices also weighed on the currencies of some energy-exporting economies.


 1. The observed pace of payroll job gains would have been sufficient to push the unemployment rate lower had the LFPR not risen. Indeed, monthly payroll gains in the range of 115,000 to 145,000 appear consistent with an unchanged unemployment rate around 4.0 percent and an unchanged LFPR around 62.9 percent (which are the June 2018 values of these rates). If instead the LFPR were declining 0.2 percentage point per year--roughly the influence of population aging--the range of job gains needed to maintain an unchanged unemployment rate would be about 40,000 per month lower. There is considerable uncertainty around these estimates, as the difference between monthly payroll gains and employment changes from the Current Population Survey (the source of the unemployment rate and LFPR) can be quite volatile over short periods. Return to text

 2. Since 2015, the increase in the prime-age LFPR for women was nearly 2 percentage points, while the increase for men was only about 1 percentage point. In January, the LFPR for prime-age women was slightly above where it stood in 2007, whereas for men it was still about 2 percentage points below. Return to text

 3. The unemployment rate in January was 4.0 percent, boosted somewhat by the partial government shutdown, as some furloughed federal workers and temporarily laid-off federal contractors are treated as unemployed in the household employment survey. Return to text

 4. See the Summary of Economic Projections in Part 3 of this report. 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 partial government shutdown has delayed publication of the Bureau of Economic Analysis's estimate for PCE price inflation in December, and the numbers reported here are estimates based on the December consumer and producer price indexes. Return to text

 7. The trimmed mean index excludes whichever prices showed the largest increases or decreases in a given month. Note that over the past 20 years, changes in the trimmed mean index have averaged about 1/4 percentage point above core PCE inflation and 0.1 percentage point above total PCE inflation. Return to text

 8. 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. Inflation compensation derived from inflation swaps typically exceeds TIPS-based compensation, but week-to-week movements in the two measures are highly correlated. Return to text

 9. As these measures are based on CPI inflation, one should probably subtract about 1/4 percentage point--the average differential with PCE inflation over the past two decades--to infer inflation compensation on a PCE basis. Return to text

 10. The initial estimate of GDP by the Bureau of Economic Analysis for the fourth quarter was delayed because of the partial government shutdown and will now be released on February 28. Return to text

 11. Indeed, in the third quarter of 2018--the most recent period for which data are available--household net worth was seven times the value of disposable income, the highest-ever reading for that ratio, which dates back to 1947. However, following the decline in stock prices since the summer, this ratio has likely fallen somewhat. Return to text

 12. The Joint Committee on Taxation estimated that the TCJA would reduce average annual tax revenue by a little more than 1 percent of GDP starting in 2018 and for several years thereafter. This revenue estimate does not account for the potential macroeconomic effects of the legislation. 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 and, respectively. Return to text

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Last Update: February 22, 2019