Part 2: Monetary Policy
Monetary Policy Report submitted to the Congress on July 5, 2019, pursuant to section 2B of the Federal Reserve Act
The FOMC maintained its target range for the federal funds rate
From late 2015 through the end of 2018, the Federal Open Market Committee (FOMC) gradually increased its target range for the federal funds rate as the economy continued to make progress toward the Committee's congressionally mandated objectives of maximum employment and price stability. In its meetings over the first half of 2019, the Committee judged that the stance of monetary policy was appropriate to achieve its dual mandate, and it decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent (figure 45). These decisions reflected incoming information showing the solid fundamentals of the U.S. economy supporting continued growth and strong employment.
Looking ahead, the FOMC will act as appropriate to sustain the expansion, with a strong labor market and inflation near its 2 percent objective
At its meetings since the beginning of the year, the Committee stated that it continued to view a sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective as the most likely outcomes.
At the June meeting, however, the Committee noted that uncertainties about the outlook had increased.15 Since the beginning of May, the tenor of incoming information on economic activity, on balance, has become somewhat more downbeat, and uncertainties about the economic outlook have increased. Growth indicators from around the world have disappointed, on net, raising concerns about the strength of the global economy. Meanwhile, contacts in business and agriculture have reported heightened concerns over trade developments. In light of these uncertainties and muted inflation pressures, the Committee indicated that it will act as appropriate to sustain the expansion, with a strong labor market and inflation near its objective. The Committee is firmly committed to its symmetric 2 percent inflation objective. In the Committee's economic projections released after the June meeting, participants generally revised down their individual assessments of the appropriate path for the policy rate from their assessments at the time of the March meeting (see Part 3 of this report for more details).
Future changes in the federal funds rate will depend on the economic outlook and risks to the outlook as informed by incoming data
The FOMC has continued to emphasize that the actual path of monetary policy will depend on the evolution of the economic outlook and risks to the outlook as informed by incoming data. Specifically, in deciding on the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and symmetric 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
In addition to weighing a wide range of economic and financial data and information received from business contacts and other informed parties around the country, policymakers regularly consult prescriptions for the interest rate arising from various monetary policy rules. These rule prescriptions can serve as useful guidelines to the FOMC in the course of arriving at its policy decisions. Nonetheless, numerous practical considerations make clear that the FOMC cannot mechanically set the policy rate by following the prescriptions of any specific rule. The FOMC's framework for conducting monetary policy involves a systematic approach in keeping with key principles of good monetary policy but allows for more flexibility than is implied by simple policy rules (see the box "Monetary Policy Rules and Their Interactions with the Economy").
Monetary Policy Rules and Their Interactions with the Economy
Monetary policy rules are mathematical formulas that relate a policy interest rate, such as the federal funds rate, to a small number of other economic variables—typically including the deviation of inflation from its target value and a measure of resource slack in the economy. The prescriptions for the policy interest rate from these rules can provide helpful guidance for the Federal Open Market Committee (FOMC). This discussion presents five policy rules—illustrative of the many rules that have received attention in the research literature—and provides examples of two ways to compute historical prescriptions of policy rules. The two ways differ in terms of whether the implications of the rule prescriptions feed through to the macroeconomy and potentially back to the policy rule prescriptions themselves. The presentation highlights the uses and limitations of each way for informing the FOMC's systematic conduct of monetary policy.
Historical Prescriptions of Policy Rules
The effectiveness of monetary policy is enhanced when it is well understood by the public.1 In simple models of the economy, good economic performance can be achieved by following a monetary policy rule that fosters public understanding and that incorporates key principles of good monetary policy.2 One such principle is that monetary policy should respond in a predictable way to changes in economic conditions. A second principle is that monetary policy should be accommodative when inflation is below policymakers' longer-run inflation objective and employment is below its maximum sustainable level; conversely, monetary policy should be restrictive when the opposite holds. A third principle is that, to stabilize inflation, the policy rate should be adjusted over time by more than one-for-one in response to persistent increases or decreases in inflation.
Economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule. Other rules include the "balanced approach" rule, the "adjusted Taylor (1993)" rule, the "price level" rule, and the "first difference" rule (figure A).3 These policy rules embody the three key principles of good monetary policy and take into account estimates of how far the economy is from the Federal Reserve's dual-mandate goals of maximum employment and price stability. Four of the five rules include the difference between the rate of unemployment that is sustainable in the longer run and the current unemployment rate (the unemployment rate gap); the first-difference rule includes the change in the unemployment gap rather than its level.4 In addition, four of the five rules include the difference between recent inflation and the FOMC's longer-run objective (2 percent as measured by the annual change in the price index for personal consumption expenditures (PCE)), while the price-level rule includes the gap between the level of prices today and the level of prices that would have been realized if inflation had been constant at 2 percent from a specified starting year.5 The price-level rule thereby takes account of the deviation of inflation from the long-run objective in earlier periods as well as the current period, whereas the other rules do not make up past misses of the inflation objective.
The adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below zero, and that following the prescriptions of the standard Taylor (1993) rule after a recession during which the federal funds rate has fallen to its lower bound may therefore not provide enough policy accommodation. To make up for the cumulative shortfall in accommodation, the adjusted rule prescribes only a gradual return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule after the economy begins to recover. Similarly, the price-level rule specified in figure A recognizes that the federal funds rate cannot be reduced materially below zero. If inflation runs below the 2 percent objective during periods when the price-level rule prescribes setting the federal funds rate well below zero, the rule will, over time, call for more accommodation to make up for the past inflation shortfall.
Policymakers regularly examine the historical prescriptions of different policy rules to help understand the past stance of monetary policy and to inform their current policy decisions. The most straightforward way to compute such prescriptions is to use historical values for the unemployment rate and inflation, as well as estimates of the longer-run value of the interest rate and the longer-run value of the unemployment rate, in each policy rule.6 The policy prescriptions from the various rules based on this approach provide different prescriptions for the federal funds rate, as shown in figure B. Presented in this way, each point on the lines in the figure is a snapshot of what the policy rules would have prescribed, given the economic conditions of that time. Because there is no definitive standard for favoring one rule over another, consulting a range of rules is generally preferable to relying on any particular rule. Although almost all of the simple policy rules would have called for values for the federal funds rate that were increasing in recent years, the prescribed values vary widely across rules.
Historical Prescription of the Taylor (1993) Rule with Feedback
One key consideration in evaluating monetary policy rules based solely on historical data is that the policy prescriptions from the rules do not take into account the fact that the economy would have evolved differently if the federal funds rate had followed the alternative paths prescribed by the rules. For example, if the FOMC had followed a policy rule in the past that prescribed higher values for the federal funds rate than actually occurred, the unemployment rate would likely have been higher and inflation lower than they actually turned out to be. In turn, these different outcomes for unemployment and inflation would have fed back into the policy rule, resulting in policy prescriptions that differ from those based on the historical data and shown in figure B. Proper consideration of these feedback effects requires using an economic model, which is a mathematical representation of how economic activity, inflation, the policy interest rate, and other variables interact over time. With such a model, one can assess how inflation and the unemployment rate might have evolved if a particular policy rule had been followed over some historical period in a way that incorporates these feedback effects. Federal Reserve staff regularly use models of the U.S. economy to study how economic outcomes could have differed if monetary policy had followed various rules.
Figure C provides one illustrative example of how accounting for feedback effects can alter the prescriptions from a particular rule over a given period. The figure compares the historical prescriptions of the Taylor (1993) rule calculated without feedback—as in the earlier section—with the prescriptions from the same rule incorporating feedback effects. The rule prescriptions with feedback effects result from an empirical simulation of the FRB/US model.7 The simulation begins in the first quarter of 2001, a period when the prescription of the Taylor (1993) rule without feedback roughly coincides with the historical value of the federal funds rate. The three panels in the figure display the paths for the federal funds rate (top panel), the unemployment rate (middle panel), and four-quarter PCE inflation (bottom panel). The historical data are shown by the black lines. The gray dashed line in the top panel shows the historical prescription of the Taylor (1993) rule without any feedback, the same as the gray dashed line shown in figure B, and the blue dashed-and-dotted line shows the prescriptions with feedback effects. Because monetary policy affects the economy only with a delay, the paths of the unemployment rate and the inflation rate are not much different from their historical values over the first year of the simulation, despite the fact that the Taylor (1993) rule calls for much higher interest rates than actually observed over that period. By 2002, however, the higher rate path under the Taylor (1993) rule causes the economy to slow, resulting in a higher unemployment rate and lower inflation—the blue dashed-and-dotted lines in the middle and bottom panels of figure C, respectively—compared with the historical values. Consequently, the policy rate path in the simulation diverges from the rate path prescribed when feedback effects are not included. Indeed, by the middle of 2003, the value of the federal funds rate is substantially higher in the calculation without feedback effects than it is in the FRB/US model simulation that incorporates feedback from the economy. This difference highlights the limitations in assessing policy rules over history if the prescriptions from the rules are notably different from the historical policy rate path and the effects of the prescriptions of such rules for the economy are not taken into account.
While model simulations can capture the effects of policy rules on the economy and what those economic effects imply for the settings of the policy rate, there are important limitations to such exercises. Each simulation is tied to a particular economic model, and changes in the model can change the prescriptions from the given policy rule. Models are necessarily simplifications of reality, and there is no agreed-upon "best" model representation of the U.S. economy. Indeed, there is substantial diversity among the models favored by economists for this kind of analysis. Finally, in the real world, the structure of the economy changes over time, so an economic model used for studying a historical episode such as the one featured here may not be relevant for future policy considerations.
Model-based simulations with feedback add an important dimension to our understanding of the effects of policy rules. However, it is important to stress that the usefulness of such rules for obtaining and communicating current and future policy rate prescriptions is still limited by a range of practical considerations, even beyond the concerns about which specific model to use. Monetary policy rules feature only a small number of variables and thus exclude many important indicators that are consulted by policymakers. The policy rules here, for example, do not include measures of financial and credit market conditions, indicators of consumer and business sentiment, and data on expectations; these factors are often very informative for the future course of the economy. Moreover, simple policy rules do not take into account possible risks to the economic outlook, which may justify a policy response over and above what would be implied by the most likely outcomes for the economy.8
1. For a discussion of how the public's understanding of monetary policy matters for the effectiveness of monetary policy, see Janet L. Yellen (2012), "Revolution and Evolution in Central Bank Communications," speech delivered at the Haas School of Business, University of California at Berkeley, Berkeley, Calif., November 13, https://www.federalreserve.gov/newsevents/speech/yellen20121113a.htm. Return to text
2. For a discussion regarding principles for the conduct of monetary policy, see Board of Governors of the Federal Reserve System (2018), "Monetary Policy Principles and Practice," Board of Governors, https://www.federalreserve.gov/monetarypolicy/monetary-policy-principles-and-practice.htm. Return to text
3. The Taylor (1993) rule was suggested in John B. Taylor (1993), "Discretion versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 195–214. The balanced-approach rule was analyzed in John B. Taylor (1999), "A Historical Analysis of Monetary Policy Rules," in John B. Taylor, ed., Monetary Policy Rules (Chicago: University of Chicago Press), pp. 319–41. The adjusted Taylor (1993) rule was studied in David Reifschneider and John C. Williams (2000), "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, vol. 32 (November), pp. 936–66. A price-level rule was discussed in Robert E. Hall (1984), "Monetary Strategy with an Elastic Price Standard," in Price Stability and Public Policy, proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 2–3 (Kansas City: Federal Reserve Bank of Kansas City), pp. 137–59, https://www.kansascityfed.org/publicat/sympos/1984/s84.pdf. Finally, the first-difference rule is based on a rule suggested by Athanasios Orphanides (2003), "Historical Monetary Policy Analysis and the Taylor Rule," Journal of Monetary Economics, vol. 50 (July), pp. 983–1022. A comprehensive review of policy rules is in John B. Taylor and John C. Williams (2011), "Simple and Robust Rules for Monetary Policy," in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol. 3B (Amsterdam: North-Holland), pp. 829–59. The same volume of the Handbook of Monetary Economics also discusses approaches other than policy rules for deriving policy rate prescriptions. Return to text
4. The Taylor (1993) rule represented slack in resource utilization using an output gap (the difference between the current level of real gross domestic product (GDP) and the level that GDP would be if the economy were operating at maximum employment, measured in percent of the latter. The rules in figure A represent slack in resource utilization using the unemployment gap instead, because that gap better captures the FOMC's statutory goal to promote maximum employment. However, movements in these alternative measures of resource utilization are highly correlated. For more information, see the note below figure A. Return to text
5. Calculating the prescriptions of the price-level rule requires selecting a starting year for the price level from which to cumulate the 2 percent annual rate of inflation. Figure B uses 1998 as the starting year. Around that time, the underlying trend of inflation and longer-term inflation expectations stabilized at a level consistent with PCE price inflation being close to 2 percent. Return to text
6. The Taylor (1993), balanced-approach, adjusted Taylor (1993), and price-level rules all require an estimate of the neutral interest rate in the longer run. In addition, all of the rules use an estimate of the rate of unemployment in the longer run. Both of these objects are determined by structural features in the economy and are not directly observable. The box "Complexities of Monetary Policy Rules" in the July 2018 Monetary Policy Report describes the complications in assessing simple policy rules that arise from uncertainty about the neutral interest rate in the longer run. See Board of Governors of the Federal Reserve System (2018), Monetary Policy Report (Washington: Board of Governors, July), pp. 37–41, https://www.federalreserve.gov/monetarypolicy/files/20180713_mprfullreport.pdf. The current discussion uses estimates of these objects from survey data. Return to text
7. FRB/US is a large-scale macroeconomic model developed by the Board's staff for forecasting, constructing alternative scenarios, and evaluating monetary policy strategies. The model and related information are available on the Board's website at https://www.federalreserve.gov/econres/us-models-about.htm. An example of the use of FRB/US for monetary policy analysis can be found in Janet L. Yellen (2012), "Perspectives on Monetary Policy," speech delivered at the Boston Economic Club Dinner, Boston, June 6, https://www.federalreserve.gov/newsevents/speech/yellen20120606a.htm. Return to text
8. The box "Monetary Policy Rules and Their Role in the Federal Reserve's Policy Process" in the February 2018 Monetary Policy Report details the limitations of monetary policy rules in accounting for a broad set of risk considerations. See Board of Governors of the Federal Reserve System (2018), Monetary Policy Report (Washington: Board of Governors, February), pp. 35–38, https://www.federalreserve.gov/monetarypolicy/files/20180223_mprfullreport.pdf. Return to textReturn to text
Since the beginning of the year, the FOMC has issued two statements regarding monetary policy implementation and balance sheet normalization
At its January meeting, the Committee indicated that it intends to continue to implement monetary policy in a regime in which the provision of an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve's administered rates, and in which active management of the supply of reserves is not required.16 After the March FOMC meeting, the Committee issued a statement indicating that it plans to conclude the reduction of the Federal Reserve's securities holdings at the end of September.17 (The box "Framework for Monetary Policy Implementation and Normalization of the Federal Reserve's Balance Sheet" details the recent decision about policy implementation and balance sheet normalization.)
The Committee is prepared to adjust the details for completing balance sheet normalization in light of economic and financial developments, consistent with its congressionally mandated objectives of maximum employment and price stability.
The Federal Reserve's total assets have continued to decline from about $4.1 trillion last December to about $3.8 trillion at present, with holdings of Treasury securities at approximately $2.1 trillion and holdings of agency debt and agency mortgage-backed securities at approximately $1.5 trillion (figure 46).
As the Federal Reserve has continued to gradually reduce its securities holdings, the level of reserve balances in the banking system has declined. In particular, the level of reserve balances has decreased by about $150 billion since the end of last year and by about $1.3 trillion since its peak in 2014.18
Meanwhile, interest income on the Federal Reserve's securities holdings has continued to result in sizable remittances to the U.S. Treasury. Preliminary data indicate that the Federal Reserve remitted about $27 billion in the first half of 2019.
Framework for Monetary Policy Implementation and Normalization of the Federal Reserve's Balance Sheet
At its meetings in January and March of this year, the Federal Open Market Committee (FOMC) made important decisions regarding its framework for monetary policy implementation and the process of normalizing the size of its balance sheet. The issues associated with these decisions have been discussed over several FOMC meetings and have been part of an ongoing process of the Committee's deliberations.1
After indicating in previous communications that, in the longer run, the Committee intends to operate in a regime in which it holds no more securities than necessary to implement monetary policy efficiently and effectively, the FOMC decided at its January meeting to continue to implement monetary policy in a regime with an ample supply of reserves.2 Such a system, which has been in place since late 2008, does not require active management of reserves through frequent open market operations. Instead, with ample reserves in the banking system, the federal funds rate is expected to settle near the rate of interest paid on excess reserves. This system has proven to be an efficient means of controlling the policy rate and effectively transmitting the stance of policy to a wide array of other money market rates and to broader financial conditions. In the statement released after its January meeting, the FOMC also indicated that it continues to view the target range for the federal funds rate as its primary tool to adjust the stance of monetary policy. Nonetheless, the Committee is prepared to adjust the details of its plans for balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.
Following the March FOMC meeting, the Committee announced that it intends to conclude the reduction of its aggregate securities holdings in the System Open Market Account at the end of September 2019.3 Consistent with its decision at the March FOMC meeting, the Committee slowed balance sheet runoff in May by reducing the cap for monthly redemptions of Treasury securities from $30 billion to $15 billion (left panel of figure A). In connection with its intention to cease balance sheet runoff entirely at the end of September 2019 and consistent with its aim of holding primarily Treasury securities in the longer run, the Committee also stated that it intends to continue to allow its holdings of agency securities to decline. Therefore, beginning in October 2019, principal payments received from holdings of agency debt and agency mortgage-backed securities (MBS) will be reinvested in Treasury securities through secondary-market purchases subject to a maximum amount of $20 billion per month. Purchases of Treasury securities will initially be conducted across a range of maturities to roughly match the maturity composition of Treasury securities outstanding.4 Any principal payments from agency securities holdings in excess of the monthly $20 billion maximum will continue to be reinvested into agency MBS (right panel of figure A).
When the process of normalizing the size of the Federal Reserve's balance sheet concludes at the end of September, reserves will likely be somewhat above the level necessary for an efficient and effective implementation of monetary policy. If so, the Committee plans after September to keep the size of the Federal Reserve's securities holdings roughly constant for a while. During this period, reserve balances will continue to decline gradually as currency and other nonreserve liabilities increase. Once the Committee judges that reserve balances have declined to the level consistent with the efficient and effective implementation of monetary policy, the FOMC plans to resume periodic open market operations to accommodate the normal trend growth in the demand for the Federal Reserve's liabilities.5
1. For summaries of these discussions, see the minutes from the FOMC meetings in November and December of last year as well as the minutes of this year's January and March meetings, which are available on the Board's website at https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm. Return to text
2. See the Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization, which is available on the Board's website at https://www.federalreserve.gov/monetarypolicy/policy-normalization.htm. Return to text
3. See the Balance Sheet Normalization Principles and Plans, which can be found on the Board's website at https://www.federalreserve.gov/monetarypolicy/policy-normalization.htm. Return to text
4. Details on the reinvestment of principal payments from the Federal Reserve's holdings of agency securities, including information on the distribution of Treasury purchases, are available on the Federal Reserve Bank of New York's website at https://www.newyorkfed.org/markets/treasury-reinvestments-purchases-faq.html. The FOMC will revisit the reinvestment plan in connection with its deliberations regarding the longer-run composition of the System Open Market Account portfolio. Return to text
5. In contrast to the Federal Reserve's large-scale asset purchases conducted over recent years, these periodic technical open market operations would not have any implication for the stance of monetary policy; rather, such operations would be aimed at maintaining a level of reserve balances in the banking system consistent with efficient and effective policy implementation. Return to textReturn to text
The Federal Reserve's implementation of monetary policy has continued smoothly
Since the middle of March, the effective federal funds rate has traded slightly above the interest rate paid on reserve balances. At the May meeting, the Federal Reserve made a third small technical adjustment to lower the setting of the interest rate on excess reserves by 5 basis points to a level 15 basis points below the top of the target range for the federal funds rate; this adjustment successfully fostered trading in the federal funds market at rates well within the FOMC's target range.* Overall, rates across money markets were broadly stable since the beginning of 2019, and the usage of the overnight reverse repurchase agreement facility has remained low.
The Federal Reserve has started the review of its strategic framework for monetary policy
With labor market conditions close to maximum employment and inflation near the Committee's 2 percent objective, the FOMC judged it an appropriate time for the Federal Reserve to conduct a public review of its strategic framework for monetary policy—including the policy strategy, tools, and communication practices. The goal of this assessment is to identify possible ways to improve the Committee's current policy framework in order to ensure that the Federal Reserve is best positioned going forward to achieve its statutory mandate of maximum employment and price stability.
The review includes outreach to and consultation with a broad range of people and groups interested in the U.S. economy. The Federal Reserve System is currently conducting a series of Fed Listens events around the country, typically with a town hall format, to hear perspectives from representatives of business and industry, labor leaders, community and economic development officials, academics, nonprofit organization executives, and others. Policymakers plan to report their findings to the public during the first half of 2020.
16. See the Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization, which is available on the Board's website at https://www.federalreserve.gov/monetarypolicy/policy-normalization.htm. Return to text
17. See the Balance Sheet Normalization Principles and Plans, which can be found on the Board's website at https://www.federalreserve.gov/monetarypolicy/policy-normalization.htm. Return to text
18. Since the start of the normalization program, reserve balances have dropped by approximately $700 billion. Return to text
* On July 8, 2019, the sentence was corrected to replace "the Committee" with "the Federal Reserve."