Monetary Policy Report submitted to the Congress on February 22, 2019, pursuant to section 2B of the Federal Reserve Act
Economic activity in the United States appears to have increased at a solid pace, on balance, over the second half of 2018, and the labor market strengthened further. Inflation has been near the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent, aside from the transitory effects of recent energy price movements. In this environment, the FOMC judged that, on balance, current and prospective economic conditions called for a further gradual removal of policy accommodation. In particular, the FOMC raised the target range for the federal funds rate twice in the second half of 2018, putting its level at 2-1/4 to 2-1/2 percent following the December meeting. In light of softer global economic and financial conditions late in the year and muted inflation pressures, the FOMC indicated at its January meeting that it will be patient as it determines what future adjustments to the federal funds rate may be appropriate to support the Committee's congressionally mandated objectives of maximum employment and price stability.
Economic and Financial Developments
The labor market. The labor market has continued to strengthen since the middle of last year. Payroll employment growth has remained strong, averaging 224,000 per month since June 2018. The unemployment rate has been about unchanged over this period, averaging a little under 4 percent--a low level by historical standards--while the labor force participation rate has moved up despite the ongoing downward influence from an aging population. Wage growth has also picked up recently.
Inflation. Consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures, moved down from a little above the FOMC's objective of 2 percent in the middle of last year to an estimated 1.7 percent in December, restrained by recent declines in consumer energy prices. The 12-month measure of inflation that excludes food and energy items (so-called core inflation), which historically has been a better indicator of where overall inflation will be in the future than the headline measure that includes those items, is estimated to have been 1.9 percent in December--up 1/4 percentage point from a year ago. Survey-based measures of longer-run inflation expectations have generally been stable, though market-based measures of inflation compensation have moved down some since the first half of 2018.
Economic growth. Available indicators suggest that real gross domestic product (GDP) increased at a solid rate, on balance, in the second half of last year and rose a little under 3 percent for the year as a whole--a noticeable pickup from the pace in recent years. Consumer spending expanded at a strong rate for most of the second half, supported by robust job gains, past increases in household wealth, and higher disposable income due in part to the Tax Cuts and Jobs Act, though spending appears to have weakened toward year-end. Business investment grew as well, though growth seems to have slowed somewhat from a sizable gain in the first half. However, housing market activity declined last year amid rising mortgage interest rates and higher material and labor costs. Indicators of both consumer and business sentiment remain at favorable levels, but some measures have softened since the fall, likely a reflection of financial market volatility and increased concerns about the global outlook.
Financial conditions. Domestic financial conditions for businesses and households have become less supportive of economic growth since July. Financial market participants' appetite for risk deteriorated markedly in the latter part of last year amid investor concerns about downside risks to the growth outlook and rising trade tensions between the United States and China. As a result, Treasury yields and risky asset prices declined substantially between early October and late December in the midst of heightened volatility, although those moves partially retraced early this year. On balance since July, the expected path of the federal funds rate over the next several years shifted down, long-term Treasury yields and mortgage rates moved lower, broad measures of U.S. equity prices increased somewhat, and spreads of yields on corporate bonds over those on comparable-maturity Treasury securities widened modestly. Credit to large nonfinancial firms remained solid in the second half of 2018; corporate bond issuance slowed considerably toward the end of the year but has rebounded since then. Despite increases in interest rates for consumer loans, consumer credit expanded at a solid pace, and financing conditions for consumers largely remain supportive of growth in household spending. The foreign exchange value of the U.S. dollar strengthened slightly against the currencies of the U.S. economy's trading partners.
Financial stability. The U.S. financial system remains substantially more resilient than in the decade preceding the financial crisis. Pressures associated with asset valuations eased compared with July 2018, particularly in the equity, corporate bond, and leveraged loan markets. Regulatory capital and liquidity ratios of key financial institutions, including 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 is concentrated among prime borrowers. While 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, issuance of these loans has slowed more recently.
International Developments. Foreign economic growth stepped down significantly last year from the brisk pace in 2017. Aggregate growth in the advanced foreign economies slowed markedly, especially in the euro area, and several Latin American economies continued to underperform. The pace of economic activity in China slowed noticeably in the second half of 2018. Inflation pressures in major advanced foreign economies remain subdued, prompting central banks to maintain accommodative monetary policies.
Financial conditions abroad tightened in the second half of 2018, in part reflecting political uncertainty in Europe and Latin America, trade policy developments in the United States and its trading partners, as well as concerns about moderating global growth. Although financial conditions abroad improved in recent weeks, alongside those in the United States, on balance since July 2018, global equity prices were lower, sovereign yields in many economies declined, and sovereign credit spreads in the European periphery and the most vulnerable emerging market economies increased somewhat. Market-implied paths of policy rates in advanced foreign economies generally edged down.
Interest rate policy. As the labor market continued to strengthen and economic activity expanded at a strong rate, the FOMC increased the target range for the federal funds rate gradually over the second half of 2018. Specifically, the FOMC decided to raise the federal funds rate in September and in December, bringing it to the current range of 2-1/4 to 2-1/2 percent.
In December, against the backdrop of increased concerns about global growth, trade tensions, and volatility in financial markets, the Committee indicated it would monitor global economic and financial developments and assess their implications for the economic outlook. In January, the FOMC stated that it continued to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's 2 percent objective as the most likely outcomes. Nonetheless, in light of global economic and financial developments and muted inflation pressures, the Committee noted that it will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes. FOMC communications continued to emphasize that the Committee's approach to setting the stance of policy should be importantly guided by the implications of incoming data for the economic outlook. In particular, the timing and size of future adjustments to the target range for the federal funds rate will depend on the Committee's assessment of realized and expected economic conditions relative to its maximum-employment objective and its symmetric 2 percent inflation objective.
Balance sheet policy. The FOMC continued to implement the balance sheet normalization program that has been under way since October 2017. Specifically, the FOMC reduced its holdings of Treasury and agency securities in a gradual and predictable manner by reinvesting only principal payments it received from these securities that exceeded gradually rising caps. Consequently, the Federal Reserve's total assets declined by about $260 billion since the middle of last year, ending the period close to $4 trillion.
Together with the January postmeeting statement, the Committee released an updated Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization to provide additional information about its plans to implement monetary policy over the longer run. In particular, the FOMC stated that it intends to continue to implement monetary policy in a regime with an ample supply of reserves so that active management of reserves is not required. In addition, the Committee noted that it is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.
Labor markets in urban versus rural areas. The recovery in the U.S. labor market since the end of the recession has been uneven across the country, with rural areas showing markedly less improvement than cities and their surrounding metropolitan areas. In particular, the employment-to-population ratio and labor force participation rate in rural areas remain well below their pre-recession levels, while the recovery in urban areas has been more complete. Differences in the mix of industries in rural and urban areas--a larger share of manufacturing in rural areas and a greater concentration of fast-growing services industries in urban areas--have contributed to the stronger rebound in urban areas. (See the box "Employment Disparities between Rural and Urban Areas" in Part 1.)
Monetary policy rules. In evaluating the stance of monetary policy, policymakers consider a wide range of information on the current economic conditions and the outlook. Policymakers also consult prescriptions for the policy interest rate derived from a variety of policy rules for guidance, without mechanically following the prescriptions of any specific rule. The FOMC's approach for conducting systematic monetary policy provides sufficient flexibility to address the intrinsic complexities and uncertainties in the economy while keeping monetary policy predictable and transparent. (See the box "Monetary Policy Rules and Systematic Monetary Policy" in Part 2.)
Balance sheet normalization and monetary policy implementation. Since the financial crisis, the size of the Federal Reserve's balance sheet has been determined in large part by its decisions about asset purchases for economic stimulus, with growth in total assets primarily matched by higher reserve balances of depository institutions. However, liabilities other than reserves have grown significantly over the past decade. In the longer run, the size of the balance sheet will be importantly determined by the various factors affecting the demand for Federal Reserve liabilities. (See the box "The Role of Liabilities in Determining the Size of the Federal Reserve's Balance Sheet" in Part 2.)
Federal Reserve transparency and accountability. For central banks, transparency provides an essential basis for accountability. Transparency also enhances the effectiveness of monetary policy and a central bank's efforts to promote financial stability. For these reasons, the Federal Reserve uses a wide variety of communications to explain its policymaking approach and decisions as clearly as possible. Through several new initiatives, including a review of its monetary policy framework that will include outreach to a broad range of stakeholders, the Federal Reserve seeks to enhance transparency and accountability regarding how it pursues its statutory responsibilities. (See the box "Federal Reserve Transparency: Rationale and New Initiatives" in Part 2.)
Statement on Longer-Run Goals and Monetary Policy Strategy
Adopted effective January 24, 2012; as amended effective January 29, 2019
The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.
Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances. The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants' estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC's Summary of Economic Projections. For example, in the most recent projections, the median of FOMC participants' estimates of the longer-run normal rate of unemployment was 4.4 percent.
In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.
The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January.