Part 1: Recent Economic and Financial Developments

Monetary Policy Report submitted to the Congress on July 9, 2021, pursuant to section 2B of the Federal Reserve Act

Domestic Developments

The labor market improved substantially in the first half of the year as the economy reopened and activity rebounded

Payroll employment increased by 3.2 million jobs in the first half of 2021, driven by a 1.6 million job gain in the leisure and hospitality sector, where the largest employment losses occurred last year. Despite the substantial improvement in the labor market, employment remained well below its pre-pandemic level (figure 1). In addition, although the unemployment rate declined 0.8 percentage point in the first half of the year, to 5.9 percent in June, it remained well above its pre-pandemic level (figure 2). This figure understates the shortfall in employment, particularly as factors related to the pandemic appear to be weighing on participation in the labor market.

A brisk increase in labor demand outpaced the return of labor supply...

With economic activity rebounding, labor demand rose briskly in the spring, while the supply of labor struggled to keep up. Employers reported widespread hiring difficulties, job openings jumped to about 30 percent above the average level for 2019, and the ratio of job openings to job seekers surged (figure 3). With a dwindling pool of temporarily laid-off workers to recall, hiring increasingly involved reallocation of workers across firms and industries, a more time-consuming process. In addition, enhanced unemployment benefits have allowed potential workers to be more selective and reduce the intensity of their job search. Faced with a challenging environment for hiring, many employers raised wages to attract new workers and lengthened the workweeks of existing employees.

. . . which was restrained by ongoing effects of the pandemic...

Several pandemic-related factors continued to weigh on labor supply in the spring. The share of working-age adults either employed or actively seeking work—the labor force participation rate—has remained low after falling dramatically with the onset of the pandemic and stood at 61.6 percent in June (figure 4). With less than half of the population fully vaccinated for COVID-19 and inoculation rates far lower in some places, safety in the workplace remained a salient issue for many potential workers, and caregiving demands were still elevated for many households. Furthermore, a surge in retirements both last year and this year, possibly in response to health-related concerns or job loss induced by the pandemic, reduced the pool of potential hires for employers (figure 5).

. . . and much slack remains in the labor market...

Although the unemployment rate has moved down sharply from its pandemic high, broad measures of labor conditions continue to point to substantial slack in the labor market. The employment-to-population ratio, which encompasses both unemployment and labor force participation, remains well below the trend observed in recent years, at 58.0 percent in June. Adjusted to include workers who have exited the labor force since the start of the pandemic and workers on temporary layoff misclassified as nonparticipants, the unemployment rate was about 8.7 percent in June.1

. . . especially for some groups that have been particularly hard hit by the crisis

Further progress has been made since the turn of the year in reversing the pandemic-induced spike in unemployment for all racial and ethnic groups (figure 6). That said, improvement in the labor market has been uneven. The effect of the pandemic on employment was largest for workers with lower wages, for workers with lower educational attainment, and for African Americans and Hispanics, and these hard-hit groups still have the most ground left to regain. And the pandemic seems to have taken a particularly large toll on the labor force participation of mothers, especially Hispanic mothers. (See the box "The Uneven Recovery in Labor Force Participation.")

The Uneven Recovery in Labor Force Participation

By many measures, the labor market has only partially recovered from the depths of the pandemic-driven recession. This discussion presents comparisons of recent readings on labor market conditions to those just before the pandemic. However, the reactions of businesses and workers to the pandemic may have long-lasting effects on the structure of the labor market. For example, the pandemic seems to have accelerated the adoption of new technologies by firms and the pace of retirements by workers. The post-pandemic labor market and the characteristics of maximum employment may well be different from those of early 2020.

As shown in the top bar of figure A, in June the percentage of the population aged 16 and older that is employed—or the employment-to-population (EPOP) ratio—was about 3 percentage points below its pre-pandemic (February 2020) level. This figure decomposes the decline in the EPOP ratio into the amount attributable to a decline in the percentage of the population working or actively looking for work, or the labor force participation rate (LFPR, light-blue bar), and an increase in unemployment (dark-blue bar).1 About one-half of the decline in the EPOP ratio since February 2020 reflects a decline in the LFPR, which in June was 1-3/4 percentage points below its pre-pandemic level, while the rest is due to elevated unemployment.

Differences in these measures across various demographic groups existed even before the recession, and they widened after the start of the pandemic. While they have generally narrowed somewhat over the past year, the figure illustrates that differences across groups relative to pre-pandemic levels remain significant: EPOP ratios are more depressed for those without a college education relative to the college educated and for Hispanics relative to others, with much of these differences reflecting larger declines in the LFPRs of these groups.2 The EPOP ratio is depressed more for those aged 25 to 54 relative to other ages, while the LFPR has fallen by more for those aged 55 or older.

While the unemployment rate has moved down gradually but steadily since peaking in April 2020, improvements in the LFPR have been less consistent, and since August 2020, the LFPR has fluctuated in a narrow, low range despite broader improvement in labor market conditions. The LFPRs for most of the groups shown in figure A also remain well below pre-pandemic levels. The rest of this discussion covers three reasons why the recovery in the LFPR remains incomplete, and that also may help explain why the recovery has been weaker for some groups than others—namely, a surge in retirements, heightened caregiving responsibilities, and individuals' fears of contracting COVID-19. In addition, expansions to the availability, amount, and duration of unemployment insurance (UI) benefits have given many individuals the financial means to be more selective when finding a new job, especially if pandemic- or individual-specific factors have limited their ability to quickly reenter the labor force.

Retirements: Even in the absence of the pandemic, the aging of the baby boomer cohort would likely have implied an increase in the share of the population that is retired relative to pre-pandemic levels of around 0.3 percentage point.3 However, the share of the population in the Current Population Survey (CPS) that indicates being out of the labor force and retired jumped at the start of the pandemic and, as shown in figure B, has increased by 1 percentage point since early 2020—accounting for more than one-half of the 1.7 percentage point decline in the aggregate LFPR over this period.4 Among individuals aged 55 and older, the increase has been larger for women than for men and larger for Hispanics and Asians than for whites and Blacks.

B. Percent of the population not in the labor force and retired, change from January and February 2020 to April and May 2021
Group Not in the labor force Not in the labor force and retired
All individuals aged 16 and older 1.7 1.0
Aged 55 and older 1.7 1.9
Men 1.9 1.8
Women 1.5 2.0
White 1.8 1.8
Black or African American .9 1.8
Asian 3.8 4.2
Hispanic or Latino 2.5 2.9

Note: Federal Reserve Board staff estimates from microdata in the Current Population Survey (CPS). Estimates are not seasonally adjusted. Small sample sizes preclude reliable estimates for Native Americans and other groups not included in the table.

Source: Census Bureau, CPS.

Caregiving responsibilities: Figure C shows that nonparticipation in the labor force associated with caregiving has increased 0.7 percentage point.5 This increase likely reflects in part the difficulties imposed on parents and other caregivers from in-person education not being fully available to many K–12 students, and some of these parents may have decided to stop working or looking for work to help care for their children and facilitate their virtual education.6

C. Percent of the population not in the labor force and caregiving, change from January and February 2020 to April and May 2021
Group Not in the labor force Not in the labor force and caregiving
All individuals aged 16 and older 1.7 .7
Women aged 25 to 54 without children 1.8 1.0
Mothers aged 25 to 54 with only children aged 5 and younger 1.4 1.4
Mothers aged 25 to 54 with children aged 6 to 17 2.6 2.6
White 2.7 2.5
Black or African American 2.8 3.6
Asian 2.3 1.3
Hispanic or Latino 5.0 4.0
Fathers aged 25 to 54 with children aged 6 to 17 .7 .6

Note: Federal Reserve Board staff estimates from microdata in the Current Population Survey (CPS). Estimates are not seasonally adjusted. Individuals not in the labor force and caregiving are those who are not in the labor force and report "taking care of house or family" as their current situation. Small sample sizes preclude reliable estimates for Native Americans and other groups not included in the table.

Source: Census Bureau, CPS.

Consistent with a considerable effect from students' virtual education, estimates from the figure also show that the increase in nonparticipation for caregiving reasons has been larger for mothers aged 25 to 54 with children aged 6 to 17 (2.6 percentage points) than for women without their own children in the home (1.0 percentage point), women who only have children aged 5 and younger (1.4 percentage points), and fathers (0.6 percentage point) and accounts for all of the decline in the LFPR for mothers.7 The increase in nonparticipation for caregiving has been especially large for Black and Hispanic mothers, and it accounts for much of the larger decline in the LFPR for these groups.8

Fear of the COVID-19 virus: Individuals' fears of contracting the COVID-19 virus are likely also still depressing labor force participation somewhat and may in part be reflected in the factors previously discussed; COVID-19 fears may be especially relevant for those who would otherwise be working on-site in high-contact industries and occupations—and even for some fully vaccinated individuals, such as older and immunocompromised workers who are at higher risk for severe illness or death from COVID-19. Consistent with the importance of this reason, data from the Census Bureau's Household Pulse Survey show that between May 26 and June 7, 2021, about 1 percent of the population reported not working or having recently looked for work because of fears of COVID-19.9 This share was higher for Blacks and Hispanics, those aged 18 to 24, and individuals with no college education, which aligns with demographic differences in the share of individuals employed in high-contact industries before COVID-19 and with differences in individuals' ability to work from home.

Expanded unemployment insurance: The pandemic recession prompted an unprecedented expansion in the availability and level of support of UI. A suite of federal programs has extended benefits to groups normally ineligible for UI, increased the potential duration of benefits, and boosted the weekly benefit amounts received by UI claimants.10 Complementing the new programs, many states broadened UI eligibility at the start of the pandemic by temporarily suspending work search requirements and relaxing other eligibility criteria. While the income support from expanded UI and other fiscal stimulus likely led some jobseekers to search less intensively or to be more selective in accepting job offers, the effects of these programs on labor force participation are not clear.11 The support from enhanced UI has been especially consequential for lower-wage workers, who have borne the brunt of recent job losses and who have benefited most from broader coverage and higher benefit levels.12

The path ahead: Many of the factors constraining labor force participation should gradually abate in the coming months, and, as they do, the overall participation rate should rise and the demographic disparities in labor force participation that widened during the pandemic will likely continue to narrow. Fears of getting or spreading COVID-19 are likely to recede if vaccination rates continue to climb and if caseloads continue to diminish, and caregiving responsibilities should ease if most students return to in-person instruction in the fall. With federal pandemic UI programs slated to end in September and many states withdrawing from them in advance of their nationwide expiration, any effects of enhanced UI benefits on labor force participation will likely wane soon as well. The spate of retirements spurred by the pandemic will continue to weigh on labor force participation for some time, but this factor should leave a gradually diminishing imprint over the next few years, because these workers were likely poised to retire soon even in the absence of the pandemic. The full effect of the pandemic on the structure of the labor market remains to be seen, and the characteristics of maximum employment may well be different from those of early 2020.

1. The unemployment series in figure A shows changes in the number of unemployed workers as a percentage of the civilian population aged 16 or older. This measure differs from the unemployment rate, which is the number of unemployed individuals as a percentage of the civilian labor force. Return to text

2. For further discussion of factors contributing to these differences, see the box "Disparities in Job Loss during the Pandemic" in Board of Governors of the Federal Reserve System (2021), Monetary Policy Report (Washington: Board of Governors, February), pp. 12–14, Return to text

3. For estimates of the effect of population aging on the LFPR in the decade before the start of the pandemic, see, for example, Joshua Montes (2018), "CBO's Projection of Labor Force Participation Rates," Working Paper 2018-04 (Washington: Congressional Budget Office, March), Return to text

4. The Federal Reserve Board staff estimates presented in figures B and C are derived from non–labor force participants' responses in the CPS to the question "What best describes your current situation at this time?"; some possible responses include "in retirement," "disabled," "in school," and "taking care of house or family." These figures do not correspond exactly with figure A because figures B and C use data through May 2021 (which is the latest month for which CPS microdata were available at the time of writing) and show data that are not seasonally adjusted. Figures B and C display two-month averages because these data can have considerable noise at monthly frequency. Return to text

5. Nonparticipation in the labor force associated with caregiving is measured as nonparticipants in the CPS who report "taking care of house or family" as their current situation. Return to text

6. Indeed, according to the Return to Learn Tracker (R2L), even as of June 7, 2021, only 54 percent of districts provided fully in-person education. More information is available on the R2L website at Return to text

7. The increase in nonparticipation due to caregiving concerns for women with younger children may reflect the lack of available childcare facilities during much of the pandemic. For adults without their own school-age children, the increase may reflect that some of these individuals have also likely had to stop working or looking for work in order to assist with children of relatives or with elderly or disabled relatives rather than risk care outside of the home. Indeed, the increase in nonparticipation for caregiving reasons among women who are not mothers is larger for those with other adult household members who report being disabled or are aged 65 or older. Return to text

8. These differences may in part reflect that the groups with larger increases in nonparticipation due to caregiving were less likely to work in telecommute-capable occupations before COVID-19; for example, based on May 2021 Federal Reserve Board staff estimates from the CPS, 19 percent of white mothers aged 25 to 54 with kids aged 6 to 17 report telecommuting due to COVID, compared with 15 percent of Black mothers and 12 percent of Hispanic mothers. It may also reflect that in-person education was less common in school districts with a larger share of Black and Hispanic students; for example, data from the Return to Learn Tracker for June 7 show that fully in-person education was more common in majority-white school districts than majority-Black or majority-Hispanic school districts. Return to text

9. The data are Federal Reserve Board staff calculations from week 31 of the Household Pulse Survey Public Use File. The percentage not working due to fears of COVID-19 is measured as the percentage of respondents who say that their main reason for not working was concern about "getting or spreading the coronavirus." The data can be found on the Census Bureau's website at Return to text

10. These programs are Pandemic Unemployment Assistance (PUA), which provides benefits to pandemic-affected individuals with insufficient wage and salary earnings to qualify for regular UI benefits; Pandemic Emergency Unemployment Compensation (PEUC), which provides additional weeks of coverage to workers who exhaust their regular UI benefits; and Federal Pandemic Unemployment Compensation (FPUC), which currently provides $300 in supplemental benefits to all UI claimants, including those in the PUA and PEUC programs. See Tomaz Cajner, Andrew Figura, Brendan M. Price, David Ratner, and Alison Weingarden (2020), "Reconciling Unemployment Claims with Job Losses in the First Months of the COVID-19 Crisis," Finance and Economics Discussion Series 2020-055 (Washington: Board of Governors of the Federal Reserve System, July), Return to text

11. Research into the labor market effects of pandemic UI policy has largely centered on FPUC, rather than the broader set of state and federal policy changes, and has focused on employment rather than labor market participation. Several recent studies have found that $600 weekly benefit increases under FPUC had at most a modest effect on employment last year, in part because UI generosity has less effect on hiring when the labor market is slack. (See, for example, Nicolas Petrosky-Nadeau and Robert G. Valletta (2021), "UI Generosity and Job Acceptance: Effects of the 2020 CARES Act," Working Paper Series 2021-13 (San Francisco: Federal Reserve Bank of San Francisco, June), Less is known about the possible effects of FPUC, PEUC, and PUA on labor force participation, particularly in the tighter labor market conditions prevailing in 2021. Return to text

12. The $300 FPUC supplement to weekly UI benefits replaces a larger portion of lost earnings for workers displaced from lower-wage jobs, while PUA has made benefits available to self-employed workers, labor market entrants, and other groups with limited earnings histories. Return to text

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Wages have risen sharply as the economy has reopened...

Amid the transition to a more normal pace of economic activity, labor market pressures have led to a step-up in wage gains so far this year. Total hourly compensation as measured by the employment cost index rose at an annual rate of 4.0 percent over the first three months of the year, lifting the 12-month change up to 2.8 percent (figure 7). More timely indicators show continuing large wage gains, though swings in the composition of the workforce make these difficult to interpret.2 In particular, average hourly earnings exhibited very large monthly increases in April, May, and June despite being held down in those months by large job gains in industries with below-average wages. Compensation per hour in the business sector, a broad-based but volatile measure of wages, salaries, and benefits, rose 8 percent through the first quarter, bolstered significantly by changes in the composition of the workforce.3

. . . and price inflation has stepped up, boosted by returning demand and by supply bottlenecks...

As measured by the 12-month change in the price index for personal consumption expenditures (PCE), inflation jumped from 1.2 percent in December 2020 to 3.9 percent in May, well above the FOMC's longer-run objective of 2 percent (figure 8). The closely watched core PCE price index, which excludes more volatile components, rose 3.4 percent over the 12 months ending in May. The price acceleration appears to have arisen largely from a small number of categories, as suggested by muted movements in the Dallas trimmed mean index, which removes the largest price changes.4 For example, sharp price increases for goods have been concentrated among a subset of products experiencing strong demand coupled with supply chain bottlenecks. In addition, as demand for services has returned to normal, some prices have bounced back from levels depressed following the onset of the pandemic. (See the box "Recent Inflation Developments.")

Recent Inflation Developments

Since the beginning of this year, personal consumption expenditures (PCE) inflation—as measured by 12-month percent changes—has increased markedly, reaching 3.9 percent in May (figure 8 in the main text). The sharp increase in inflation this year reflects both a rebound in prices from pandemic-induced price declines last spring and imbalances between demand and supply associated with a strong increase in aggregate demand amid supply chain bottlenecks, hiring difficulties, and other capacity constraints.

As global demand has surged, prices for crude oil and other traded commodities, such as livestock, crops, and metals, have increased notably (figures 9 and 10 in the main text). Commodity prices started to rebound during the second half of last year as the global economy partially reopened and have continued to rise this year, in some cases reaching multiyear highs. These prices most directly affect food and energy consumer prices (the blue and black lines, respectively, in figure A). However, readings from manufacturing surveys and anecdotes reported in the Federal Reserve's Beige Book suggest rising costs for raw materials have contributed to inflation for other goods as well (the red line in figure A). More recently, prices of some commodities, such as lumber, have come down from their peaks in the spring or have flattened out, suggesting that inflation pressures from commodities might ease in the coming months or even reverse.

Supply chain bottlenecks are another factor pushing up consumer prices this year. As the economy reopened and as consumer demand for goods surged, many producers have reported shortages of critical parts and packaging materials, as well as delivery delays. (See the box "Supply Chain Bottlenecks in U.S. Manufacturing and Trade.") Supply chain bottlenecks have been particularly constraining in the motor vehicle sector, where global shortages of semiconductors and other parts have curtailed production, at the same time that demand by households and rental companies has been strong. Prices for motor vehicles—particularly used vehicles—have jumped in recent months and are currently at levels well above their pre-COVID-19 trends (figure B, top-left panel). Strong demand amid supply chain bottlenecks has also boosted prices for other durable goods in recent months, but the pattern is not quite as pronounced as it is for motor vehicles (figure B, top-right panel). In fact, the rise in prices connected to the motor vehicle sector—including prices for new and used vehicle purchases and vehicle rental services—accounts for almost one-third of the increase in PCE prices in April and May.

Regarding services prices, demand for certain non-energy services that were severely curtailed by social distancing during the pandemic has surged this spring as the vaccines have become widely available (the green line in figure A). Just as the drop in demand last year led to a step-down in prices for categories related to travel and group activities, the resurgence in demand for these services is pushing up prices this year. As two prominent examples, airline fares and prices for hotel accommodations have jumped since the beginning of the year but so far remain somewhat below their pre-COVID trends (figure B, bottom panels).

Even as demand for services appears to be strong and growing, many service-sector businesses have reported difficulties in finding workers quickly enough to ramp up their operations accordingly. These reports are consistent with most available measures of wage growth, which have stepped up notably since the beginning of the year. Wage gains have been especially large in the leisure and hospitality sector and in other service industries that have relatively low average wages, which has likely contributed to the rise in inflation for certain categories of spending, such as food away from home.

Overall, an important part of the rise in inflation this spring appears to be due to a surge in demand, including the rebound in travel-related spending, running up against short-run production bottlenecks and hiring difficulties. As these extraordinary circumstances pass, supply and demand should become better aligned, and inflation is widely expected to move down toward the FOMC's 2 percent longer-run goal. (For a more detailed discussion of recent developments in inflation expectations, see the box "Assessing the Recent Rise in Inflation Expectations.")

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. . . with further upward pressure on inflation from rising import prices

Increased import prices also contributed to the step-up in consumer price inflation in the first half of 2021, boosted by commodity prices, which rose in response to strong demand for goods. The effects of higher import prices have been exacerbated by bottlenecks abroad that have raised transport costs (figure 9). (See the box "Supply Chain Bottlenecks in U.S. Manufacturing and Trade.")

After a sharp recovery in late 2020 and early 2021, oil prices have risen over $10 per barrel in the past few months, a substantial increase but less dramatic than some of the increases for nonfuel commodity prices. Even though oil consumption is still well below pre-pandemic levels, oil production is also down, and oil prices are now above pre-pandemic levels (figure 10). Oil demand continues to be held back by the slow recovery in travel and commuting. Meanwhile, OPEC (Organization of the Petroleum Exporting Countries) and its partners, notably Russia, have only slowly increased their production toward pre-pandemic levels, offsetting the effect of weak demand.

Supply Chain Bottlenecks in U.S. Manufacturing and Trade

The strong U.S. demand for goods has been faced with a supply chain that has struggled to keep pace. With the onset of the pandemic in the spring of 2020, many manufacturers sharply curtailed production in expectation of a long downturn and a drawn-out recovery. Companies laid off workers, idled plants, and canceled orders for materials. In many cases, however, the pause in demand was much shorter and the rebound in demand was much stronger than anticipated, and by late 2020, factories in some industries were scrambling to find the workers, parts, and materials to fill a rush of new orders. As demand for goods surged in the second half of 2020, U.S. import volumes shot up to record levels and have remained elevated. The massive influx of goods combined with COVID-19-related staffing issues have overwhelmed U.S. ports, resulting in additional challenges for manufacturers that experience extended wait times for imported parts.

Ample evidence—including widespread anecdotes of shortages mentioned in the press and in the Federal Reserve's Beige Book—points to broad and sometimes deep supply chain disruptions across the manufacturing sector. The challenges in procuring materials are also reflected in reports from the Institute for Supply Management on order backlogs, which recently reached historical highs at the same time as customer inventories were at historical lows (figure A).1 Additionally, roughly one-fourth of all manufacturers cannot produce at full capacity because of an insufficient supply of materials, labor, or both (figure B).2 Amid strong demand, these shortages have put upward pressure on the prices manufacturers pay for parts and materials (figure C).

A few key manufacturing industries have experienced pronounced supply disruptions or shortfalls. Perhaps most notably, the burst in demand for consumer electronics contributed to full order books, long lead times, and shortages of semiconductors; these shortages led to widespread shutdowns and slowdowns at several U.S. motor vehicle assembly plants.3 Lumber supply has also fallen short, as last year's increase in remodeling projects and new home construction outpaced production at sawmills. Meanwhile, supply bottlenecks for steel emerged last fall after a resurgence in orders surprised mill operators that had not yet fully restarted steelmaking equipment idled in the early days of the pandemic.4 Finally, extremely cold temperatures in mid-February caused extensive damage to several petrochemical facilities along the Gulf Coast, resulting in acute shortages; the outages resolved slowly, and only in early May did operations essentially return to normal.

Logjams at some of the nation's ports—particularly on the West Coast—resulted from the unprecedented volume of imports and were compounded by limitations on labor attributable to COVID-19 precautions and to isolated outbreaks among dock workers. For example, since the fall of 2020, the Port of Los Angeles, the nation's busiest port, has had more ships to unload than it could easily accommodate. Typically, ships have little to no wait before they reach a berth at the port, but since last October, on average, more than 10 ships have been waiting at anchor at any given time (figure D). While this number has retreated from its peak, ships are still spending an extended time in the port. Continued high import volumes have hampered the port's progress in resolving congestion even as the quick pace of vaccinations in the United States has allowed the port to resume processing incoming containers at full capacity.

In addition to the congestion at ports, carriers have raised shipping rates and imposed large surcharges on containers sent to the United States.5 These delays and elevated costs have likely discouraged additional imports of low-value, high-volume products, contributing to higher prices and reduced inputs for U.S. manufacturers. Relatedly, the higher inbound rates have created a challenge for U.S. exports in the form of a container shortage. Shipping rates for U.S. exports have risen by much less than rates for inbound shipments, so carriers find it more profitable at times to quickly return empty containers for another inbound U.S. delivery than to receive modest revenue from taking on U.S. exports. Thus, although the number of inbound loaded containers skyrocketed in the second half of last year, the number of outbound loaded containers stayed below pre-pandemic levels until March 2021 (figure E).

In summary, trade and production bottlenecks have been an important factor as the economy emerges from the pandemic. As producers and the distribution network work through these bottlenecks, production is expected to pick up and price pressures to ease—for example, lumber prices have come down from their late-spring peaks. The time frame for the resolution of these bottlenecks is uncertain, as they reflect both the global supply chain and some industry-specific reasons for the tight conditions.

1. The Institute for Supply Management survey asks respondents whether their customers' inventories are currently "too high," "too low," or "about right." Values below 50 indicate more respondents perceived customers' inventories as "too low" than "too high." Similarly, respondents are asked to compare the current month's backlog of orders with the previous month's backlog; values above 50 suggest more respondents reported higher backlogs than reported lower backlogs. Return to text

2. Labor shortages appear increasingly problematic. Although manufacturers have long expressed challenges in attracting and retaining workers, the most recent reading from the Bureau of Labor Statistics reported 814,000 job openings in the sector, nearly double the 2017–19 average. Return to text

3. The semiconductor shortage was exacerbated when a chip factory in Japan closed for about a month in the spring after being damaged by a fire; the company announced that it expects shipments to return to pre-fire levels in late July. Return to text

4. More than half of the nation's blast furnaces were idled last year, and a few were permanently shuttered; the vast majority of the idled furnaces were restarted by this spring. Return to text

5. Air freight rates have also risen sharply, as many goods normally shipped by sea are being transported by air to avoid extended delays. Furthermore, pandemic-related restrictions on international travel have limited the number of international flights, reducing the supply of cargo space for air shipments and further increasing prices. Return to text

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Survey-reported inflation expectations and market-based inflation compensation measures have moved up in recent months

Survey-based measures of inflation expectations at medium- and longer-term horizons have moved up over the first half of the year. These measures, which exhibited a downward drift in recent years, have returned to levels last observed 5 to 10 years ago. Similarly, market measures of longer-term inflation compensation—including inflation swaps and the yield gap between nominal Treasury securities and Treasury Inflation-Protected Securities—continued to climb in 2021, returning to the range observed in the 2010–14 period. (See the box "Assessing the Recent Rise in Inflation Expectations.")

Assessing the Recent Rise in Inflation Expectations

The sharp rise in inflation so far this year (see the box "Recent Inflation Developments") has raised the question of whether the recent elevated pace of price increases (1) will abate, as the effects of the strong rebound in aggregate demand and accompanying supply chain bottlenecks fade, without calling for a change in the path of monetary policy or (2) will instead be followed by a period of higher inflation pressures and call for a change in the stance of monetary policy. The latter situation could arise if longer-term inflation expectations were to rise persistently above levels consistent with the Federal Open Market Committee's (FOMC) longer-run inflation goal. Inflation expectations are often seen as a driver of actual inflation, which is why a fundamental aspect of the FOMC's monetary policy framework is for longer-term inflation expectations to be well anchored at the Committee's 2 percent longer-run inflation objective.1 In monitoring the inflation outlook, the FOMC considers a variety of financial and economic data in order to gauge whether inflation expectations are consistent with meeting its inflation objective. Recent readings on these measures indicate that inflation is expected to return to levels consistent with the Committee's 2 percent longer-run inflation objective after a period of temporarily higher inflation. That said, some measures suggest that the upside risks to the inflation outlook in the near term have increased.

Information concerning inflation expectations can be obtained from various sources, including financial instruments linked to inflation and surveys of financial market participants, professional forecasters, households, and businesses. For example, the compensation that investors require to hold certain financial instruments whose payouts are linked to inflation sheds light on financial market participants' expectations regarding inflation. Inflation compensation implied by the yields on Treasury securities, known as the Treasury Inflation-Protected Securities (TIPS) breakeven inflation rate, is defined as the difference between yields on conventional Treasury securities and yields on TIPS, which are linked to actual outcomes regarding headline consumer price index (CPI) inflation. An alternative market-based measure of inflation compensation can be derived from inflation swaps, which are contracts in which two parties agree to swap fixed nominal payments for floating cash flows that are tied to cumulative CPI inflation over some horizon.

Longer-horizon TIPS- and swaps-based measures of inflation compensation have both moved up since the start of the year. The TIPS-based measure of 10-year inflation compensation increased from an annual rate close to 2 percent in the beginning of 2021 to somewhat above 2-1/4 percent in early July. Over the same period, the swaps-based measure increased from around 2-1/4 percent to 2-1/2 percent. To shed further light on how the recent economic developments are influencing investors' views on the inflation rate likely to prevail at different horizons, it is useful to split the recent rise in inflation compensation over the next 10 years into changes in inflation compensation for the next year and for subsequent 1-year periods starting at times between 1 and 9 years from now. The result of this exercise suggests that market-based measures of inflation compensation over the next year have increased about 1-1/2 percentage points since early 2021, reaching levels above 3 percent in early July. Measures of inflation compensation for the period beyond the next year have also moved up but by a much smaller amount than have measures of 1-year inflation compensation. In particular, inflation compensation beyond five years has reversed the large declines seen earlier in the pandemic, bouncing back to levels consistent with those observed before 2014, when measures of longer-term inflation compensation ran modestly above 2 percent on a CPI basis, and before these measures showed signs that CPI inflation expectations may have drifted down (figure A).

If the recent readings on inflation compensation could be interpreted as direct measures of expected CPI inflation, they would suggest that investors currently anticipate that average CPI inflation will temporarily run somewhat above 3 percent over the next year before moving back down. Over the longer run, assuming no wedge between inflation compensation and inflation expectations, market-based measures indicate that investors are expecting CPI inflation to settle at around 2-1/4 percent. This pattern is consistent with expectations of CPI inflation moving to levels in line with the FOMC's longer-run inflation goal of 2 percent PCE (personal consumption expenditures) inflation.2

TIPS- and swaps-based measures of inflation compensation, however, reflect not only expected inflation, but also other factors, including the inflation risk premium and possibly other premiums driven by liquidity differences and shifts in demand and supply of TIPS relative to those of nominal Treasury securities. The presence of these additional factors can make it difficult to ascertain the information regarding expected inflation embedded in market-based measures of inflation compensation.3 Survey-based measures, in contrast, provide information about inflation expectations that is not obscured by the presence of these risk premiums.

Information about inflation expectations obtained from surveys of financial market participants, economists, and professional forecasters tells a story similar to that of market-based measures. Since the turn of the year, projections of PCE inflation for 2021 as a whole, obtained from information in the Blue Chip Financial Forecasts, the Survey of Professional Forecasters, and the Survey of Primary Dealers, increased substantially to well above 2 percent. Over the same period, the projections of PCE inflation beyond 2022 appear, in comparison, to be little changed at levels just over 2 percent (figure B). This pattern suggests that these forecasters expect the recent jump in inflation to be transitory and that survey respondents do not appear to have revised their views regarding the longer-term inflation rate in response to the recent strong readings on inflation.

Even if financial market participants and professional forecasters see inflation returning to levels close to 2 percent after a bout of higher inflation as the most likely outcome, they still could have judged that the likelihood of higher inflation had increased. Probability distributions of future inflation derived from surveys provide information on how respondents' views about the likelihood of various outcomes for inflation have evolved. Since the turn of the year, the probability distribution of PCE inflation for 2022 derived from the Survey of Professional Forecasters suggests that the average respondent now appears to attach lower probabilities to outcomes of inflation below 2 percent, and somewhat higher odds of inflation running above 3 percent, which suggests that respondents' perceived upside risks to inflation in the near term have shifted up somewhat.4

Finally, survey-based measures of households' inflation expectations have also moved up in recent months. And, similarly to the other surveys, the movements have been more pronounced in the near- to medium-term inflation expectations. In the University of Michigan Surveys of Consumers, households' expectations for inflation over the next 12 months in June were markedly higher than in February and well above the expectations for average inflation over the next 5 to 10 years (figure C). Over the same period, the median value of inflation expectations over the next 5 to 10 years picked up only slightly. Nevertheless, the latest reading is above its pre-pandemic level and stands close to levels last seen consistently in 2015 when this measure started drifting down and raised concerns that households' expectations might have slipped below the FOMC's 2 percent longer-run goal. In the Survey of Consumer Expectations, conducted by the Federal Reserve Bank of New York, the median of respondents' expected inflation rate 3 years ahead also increased sharply in May, the highest reading since the summer of 2013.

The common inflation expectations (CIE) index constructed by Federal Reserve Board staff—a series that takes many measures of inflation expectations and inflation compensation and consolidates them into a single indicator—has continued to edge up in recent quarters, more than reversing the moderate decline recorded in the middle of last year (figure D).5 Taking a somewhat longer view, the CIE has now also reversed the net decline since 2014 and has brought the index up to levels that are likely more consistent with the FOMC's longer-term goal of 2 percent PCE inflation.

1. For a discussion of the role inflation expectations play in inflation dynamics, see Janet L. Yellen (2015), "Inflation Dynamics and Monetary Policy," speech delivered at the Philip Gamble Memorial Lecture, University of Massachusetts, Amherst, September 24, Return to text

2. The Committee's 2 percent longer-run inflation objective is stated in terms of the PCE price index, and PCE inflation tends to run somewhat below CPI inflation, which is used in pricing TIPS and inflation swaps. Over the past two decades, PCE price inflation has run, on average, around 1/4 percentage point lower than CPI inflation, though this wedge has varied from year to year. Return to text

3. The Federal Reserve System staff maintains several term structure models to disentangle the various components of inflation compensation. For more details, see, for example, Michael Abrahams, Tobias Adrian, Richard K. Crump, Emanuel Moench, and Rui Yu (2016), "Decomposing Real and Nominal Yield Curves," Journal of Monetary Economics, vol. 84 (December), pp. 182–200; Jens H.E. Christensen, Jose A. Lopez, and Glenn D. Rudebusch (2010), "Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields," Journal of Money, Credit and Banking, vol. 42 (September), pp. 143–78; Stefania D'Amico, Don H. Kim, and Min Wei (2018), "Tips from TIPS: The Informational Content of Treasury Inflation-Protected Security Prices," Journal of Financial and Quantitative Analysis, vol. 53 (February), pp. 395–436; and Andrea Ajello, Luca Benzoni, and Olena Chyruk (2020), "Core and ‘Crust': Consumer Prices and the Term Structure of Interest Rates," Review of Financial Studies, vol. 33 (August), pp. 3719–65. Return to text

4. Of note, distributions of CPI inflation 5 to 10 years ahead derived from the Federal Reserve Bank of New York's Survey of Primary Dealers and Survey of Market Participants have remained stable over the year, consistent with the stability of survey-based measures of longer-run inflation expectations. Return to text

5. For more details, see Hie Joo Ahn and Chad Fulton (2021), "Research Data Series: Index of Common Inflation Expectations," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, March 5), Return to text

Return to text
Gross domestic product surged in the first half of the year...

Real gross domestic product (GDP) rose at a brisk annual rate of 6-1/2 percent in the first quarter and, with indicators suggesting another strong increase in the second quarter, appears to have now recovered to its pre-pandemic level (figure 11). Even so, supply chain bottlenecks, hiring difficulties, and other capacity constraints have damped the economic rebound to some degree this year, causing order backlogs and longer delivery times and leading producers to meet demand in part by drawing down inventories rather than from new production.

. . . driven by a sharp increase in household spending...

The rebound in GDP primarily reflects a resurgence of household spending, driven by the reopening of the economy and additional fiscal support. In particular, the easing of voluntary and mandatory social distancing has spurred an increase in services spending, such as more prevalent dining out, hotel stays, and air travel (figure 12). Still, concerns about COVID-19 continue to limit in-person interactions, and services spending has yet to reach its pre-pandemic level. Spending on goods, which quickly recovered in the second half of 2020, soared from January through May. Spending on durable goods has been especially strong, including on motor vehicles, where sales reached levels among the highest on record in March and April before being held back in May by extremely low dealer inventories.

. . . supported by rising personal income, consumer sentiment, and wealth...

The marked increase in personal consumption has been supported by increasing income, accumulated savings, rising housing and stock market wealth, low interest rates, and improving consumer sentiment (figure 13). Disposable personal income—that is, household income net of taxes—surged in the first quarter of this year, boosted by further fiscal support, including stimulus checks and enhanced unemployment insurance benefits, along with solid gains in wages and compensation. Meanwhile, the continuing brisk rise in house prices and stock prices has boosted the wealth of homeowners and equity investors (figure 14). The tremendous gains in income have led to a very elevated saving rate (figure 15). That said, these aggregate figures mask important variation across households, and many low-income households, especially those whose earnings declined as a result of the pandemic and recession, have seen their finances stretched.

. . . and ready access to credit for households with good credit profiles

Household borrowing has expanded moderately. Consumer loans have grown at a modest pace so far this year, driven by the continued expansion of auto loans (figure 16). Banks reported significant easing of lending standards on consumer loans in the first quarter of 2021 after a moderate easing in the last quarter of the previous year, though standards remain tight relative to the period just before the pandemic. Delinquency rates for nonprime auto and credit card borrowers remained well below pre-pandemic levels, likely stemming from forbearance programs and fiscal support. Mortgage credit is broadly available to high-credit-score borrowers who meet standard conforming loan criteria but continues to be tight for borrowers with lower credit scores. Historically low mortgage rates have led to elevated refinance and purchase activity, supported by accommodative credit standards for high-credit-score borrowers (figure 17).

The housing sector remains remarkably strong

Residential investment surged following the shutdown last spring and has remained at a high level since then. Low mortgage rates have boosted demand, as have adaptations to the pandemic, including working from and spending more time at home. New construction, home sales, and residential improvements have all been well above pre-pandemic levels, and demand has outpaced supply, as construction has been limited by material shortages and sales have been constrained by low inventories (figures 18 and 19). This tension has fueled a sizable rise in home prices and driven down the inventory of homes for sale to extraordinarily low levels (figure 20).

Business investment has recovered from its plunge last year and continues to rise at a solid pace...

Solid business investment in the first half of the year has been supported by the unwinding of pandemic disruptions, accommodative monetary policy and fiscal support, and the strong business outlook. Investment in equipment and intangibles has led the rise in investment, especially investment in high-technology equipment and software driven by the shift to remote work and other changes to business practices. Investment in structures in the oil and gas sector also has risen in recent quarters, spurred by a turnaround in oil prices. In contrast, investment in structures outside of the drilling and mining sector has been subdued after falling sharply last year (figure 21).

. . . amid financing conditions that remain accommodative for nonfinancial corporations

Financing conditions for nonfinancial firms through capital markets have remained broadly accommodative since the start of the year and continued to be supported by historically low interest rates. The gross issuance of nonfinancial corporate bonds continued to be solid during the first part of year and was particularly strong in March for investment-grade firms (figure 22). Corporate bond yields have remained at historically low levels, and corporate bond spreads have narrowed to very low levels, supported in part by signs of improvement in the credit quality of nonfinancial firms.

In contrast, net bank lending to businesses has been subdued so far this year. For commercial and industrial loans, increasing new loan originations have been obscured to some degree by balance reductions due to forgiveness of loans under the Paycheck Protection Program (PPP). Commercial real estate loans have remained little changed, held down in part by weak growth in construction and land development loans amid tighter credit standards earlier in the year.

For small businesses, privately financed lending has climbed smartly since the turn of the year, as the PPP has increased access to credit. Outside of the PPP, credit availability for small businesses remains fairly tight, demand for such credit is weak, and default risk is still elevated. Small business loan performance has improved, and the share of small businesses expecting to require additional financial assistance has moved down, though hotels and restaurants report ongoing stress.

Exports have partly recovered as imports have continued to increase

U.S. exports have moved higher in recent months but still remain below pre-pandemic levels (figure 23). Despite the robust recovery for goods exports, the overall contribution to GDP from exports has been held down by the continuing depressed level of service exports given ongoing restraint in international travel. In contrast to the relatively modest recovery of exports, imports have soared since last summer, boosted by strong demand for both immediate consumption and rebuilding inventories. High levels of imports have strained the ability of the international logistics channel to deliver goods to U.S. customers in a timely fashion. Given the recent strength of imports relative to the milder recovery in exports, both the nominal trade deficit and current account deficit, relative to GDP, widened since 2019 (figure 24).

Federal fiscal actions provided substantial support to economic activity while also significantly raising the budget deficit

Federal fiscal policies enacted in response to the pandemic, most recently the American Rescue Plan, continue to fuel the economic recovery now under way. Stimulus checks have boosted most household incomes, and supplemental unemployment insurance has supported households affected by job loss. Increased grants-in-aid to state and local governments and business programs have supported aggregate demand as well. The Congressional Budget Office estimates that pandemic-related fiscal policies enacted to date will increase federal expenditures or reduce federal revenues by over $5 trillion over 10 years, with much of the effect on the deficit occurring in fiscal years 2020 and 2021.5 These discretionary fiscal measures, combined with the automatic stabilizers—the reduction in tax receipts and increase in transfers that occur as a consequence of depressed economic activity—caused the federal deficit to surge to 15 percent of nominal GDP in fiscal 2020 (figure 25). Federal debt held by the public jumped to around 100 percent of nominal GDP—the highest debt-to-GDP ratio since 1947—and is expected to rise further this fiscal year (figure 26).6

Challenges to state and local government financing have been mitigated by federal aid

The pandemic pushed down state and local government tax collections and induced additional COVID-related expenses. In response, federal policymakers provided a historic level of fiscal support to state and local governments, covering budget shortfalls in aggregate, although some governments continue to confront pandemic-related fiscal stress. Moreover, the drag on state tax receipts from the pandemic is abating, as revenues have moved up smartly so far this year (figure 27). Property tax receipts—the primary tax source for local governments—have increased steadily during the pandemic. State and local government payrolls, though, have only edged up from their lows at the onset of the pandemic, and they remain 5 percent below pre-pandemic levels, including notably lower education employment (figure 28). Finally, municipal bond market conditions continued to be generally accommodative this year. Issuance has been robust, as yields remained historically low and bond spreads relative to Treasury securities have declined moderately so far this year.

Financial Developments

The path of the federal funds rate expected to prevail over the next year remains near zero

Market-based measures of the path that the federal funds rate is expected to take over the next few years remain below 0.25 percent until the fourth quarter of 2022, about two quarters earlier than in February (figure 29).7 The shift in the path followed news of the rapid deployment in the United States of highly effective COVID-19 vaccines, the reopening of contact-intensive sectors of the economy, and expectations that further support for aggregate demand would be coming from fiscal policy.

Survey-based measures of the expected path of the policy rate shifted up somewhat since the start of the year. According to the results of two surveys that the Federal Reserve Bank of New York conducted in June—the Survey of Primary Dealers and the Survey of Market Participants—the median respondent of each survey views the most likely path of the federal funds rate as remaining in its current range of 0 to 1/4 percent until the third quarter of 2023, a quarter earlier than in March.8

Longer-term nominal Treasury yields were little changed...

Yields on nominal Treasury securities at longer maturities were little changed, on net, since mid-February (figure 30). Concurrently, near-term uncertainty about longer-term interest rates—as measured by volatility of near-term swap options (swaptions) on 10-year swap interest rates—remained roughly unchanged, on net, since February.

. . . while spreads of other long-term debt to Treasury securities narrowed modestly on net

Across different categories of corporate credit, bond yields are little changed since mid-February and have remained near the lowest levels of their historical distributions. Spreads of corporate bond yields over comparable-maturity Treasury securities have narrowed modestly and stand somewhat below the levels prevailing at the onset of the pandemic, supported in part by signs of improvement in the credit quality of nonfinancial firms.

Since mid-February, yields on 30-year agency mortgage-backed securities—an important factor entering into the pricing of home mortgages—were little changed, on net, while those on comparable-maturity Treasury securities increased a bit, leaving their spread modestly lower on net (figure 31). Municipal bond spreads over rates on longer-term Treasury securities have declined moderately across credit categories since mid-February and stand at the lower end of the historical distribution, while municipal bond yields across credit categories are at about their all-time lowest historical levels.

Broad equity price indexes increased moderately

Broad stock price indexes have continued to rise since mid-February, as strong corporate earnings, optimism about the pace of vaccinations, additional fiscal stimulus, and signs of a faster pace of economic recovery outweighed concerns about high valuations, higher inflation, and prospects for the control of the virus abroad (figure 32). Prices of cyclical stocks, including those associated with companies in the basic materials, energy, and industrial sectors, outperformed broad equity price indexes. Banks' stock prices have also risen notably, on net, as the improved economic outlook and banks' reports of strong first-quarter earnings provided a further boost to investor optimism regarding the banking sector. Measures of realized and option-implied stock price volatility for the S&P 500 index—the 20-day realized volatility and the VIX, respectively—have declined somewhat and are near their historical medians (figure 33). (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability.")

Developments Related to Financial Stability

While some financial vulnerabilities have increased since February, the institutions at the core of the financial system remain resilient. This discussion reviews vulnerabilities in the U.S. financial system. The framework used by the Federal Reserve Board for assessing the resilience of the U.S. financial system focuses on financial vulnerabilities in four broad areas: asset valuations, business and household debt, leverage in the financial sector, and funding risks.

Prices of risky assets have generally increased in the first half of 2021. They have been buoyed by the rapid deployment of highly effective COVID-19 vaccines in the United States, the support provided by fiscal policy, and increased investor risk appetite. Broad equity market indexes have reached record highs in recent months, and the ratio of prices to forecasts of earnings remains high relative to its historical distribution (figure A). Option-implied volatility has been declining throughout the first half of 2021 and now stands at about its historical median. Yields on corporate bonds and leveraged loans remain low. On balance, indicators of commercial real estate (CRE) valuations remain high; however, low transaction volumes—especially for distressed properties—may mask declines in commercial property values. Supported by relatively low mortgage rates and shifting supply and demand dynamics brought about by the pandemic, house prices have increased at double-digit annual rates for several months amid strong home sales. The surge in the prices of a variety of crypto-assets also reflects in part increased risk appetite. Long-term Treasury yields have risen since mid-February but remain low by historical standards. The high asset prices in part reflect the continued low level of Treasury yields. However, valuations for some assets are elevated relative to historical norms even when using measures that account for Treasury yields (figure B). Asset prices may be vulnerable to significant declines should investor risk appetite fall, interest rates rise unexpectedly, or the recovery stall.

Vulnerabilities from both business and household debt have declined through the first quarter of 2021, reflecting a slower pace of business borrowing, an improvement in business earnings, and government programs that have supported business and household incomes. Even so, some businesses and households remain under considerable strain. Business debt outstanding changed little in the second half of 2020 and first quarter of 2021, although it remains high relative to gross domestic product (figure C). Recovering earnings and the low level of interest rates have generally aided businesses' ability to carry debt. Some smaller businesses continue to face significant financial strains but have been supported by government programs, including the Paycheck Protection Program (PPP). Debt owed by households remains at a moderate level relative to income. Household borrowing continues to be heavily concentrated among borrowers with high credit scores. Moreover, government actions taken in response to the pandemic have provided significant support to household balance sheets and incomes, with many households saving more and holding more liquid assets.

In the financial sector, leverage at banks and broker-dealers remained low, while leverage at hedge funds and life insurance companies continued to be high. The common equity Tier 1 ratio for most banks increased, on net, over 2020 and into the first quarter of 2021. Measures of credit quality of bank loans have also improved in the first quarter of 2021. Moreover, the share of loan balances in loss-mitigation programs at the largest banks has declined. The shares of credit cards and auto loans in loss mitigation have seen larger declines, while the shares of residential real estate, commercial and industrial, and CRE loans remain high. Nevertheless, some uncertainty remains about the ability of borrowers in loss-mitigation programs to meet their obligations after those programs end and government support runs out. Broker-dealer leverage remained near historically low levels through the first quarter of 2021, although dealers continue to finance sizable inventories of Treasury securities. No notable effect on Treasury market functioning followed the expiration in March 2021 of temporary changes to the supplementary leverage ratio, which were implemented to ease strains in Treasury market intermediation in the initial weeks of the pandemic. Most measures of hedge fund leverage increased in the second half of 2020 into the beginning of 2021 and are now above their historical averages. A few recent episodes have highlighted the opacity of risky exposures and the need for greater transparency at hedge funds and other leveraged financial entities that can transmit stress to the financial system. The Financial Stability Oversight Council has restarted its Hedge Fund Working Group to improve data sharing, identify risks, and strengthen the financial system. Leverage at life insurance companies remains historically high as of the first quarter of 2021. Issuance volumes of non-agency securities recovered somewhat in the first quarter of 2021, although the recovery was uneven across asset classes.1 Collateralized loan obligation and asset-backed securities issuance was elevated, whereas non-agency commercial mortgage-backed securities issuance was weak.

Funding risks at domestic banks remained low, as these banks rely only modestly on short-term wholesale funding and maintain sizable holdings of high-quality liquid assets. Liquidity ratios were well above regulatory requirements at most large domestic banks as of the first quarter of 2021. Assets under management at prime and tax-exempt money market funds (MMFs) have declined since the middle of 2020, but vulnerabilities at these funds remain and call for structural fixes.

The President's Working Group on Financial Markets released a report in December 2020 outlining potential reforms to address risks from the MMF sector.2 Subsequently, the Securities and Exchange Commission issued a request for comment on these potential reforms and summarized its findings.3 If properly calibrated, some of these reforms—such as swing pricing, a minimum balance at risk, and capital buffers—could significantly reduce the run risk associated with MMFs. Meanwhile, the Money Market Mutual Fund Liquidity Facility and the Commercial Paper Funding Facility, which were deployed during the COVID-19 pandemic to backstop short-term funding markets, expired at the end of March with no material effect on these markets. Bond and bank loan mutual funds benefited from net inflows but are exposed to risks due to large holdings of illiquid assets.

A routine survey of market contacts on salient shocks to financial stability highlights several important risks. A worsening of the global pandemic could stress the financial systems in emerging markets and some European countries. Further, if global interest rates were to rise abruptly, some emerging market economies could experience additional fiscal strains. These risks, if realized, could interact with financial vulnerabilities and pose additional risks to the U.S. financial system.

Developments Associated with Facilities to Support the Economy during the COVID-19 Crisis

In the immediate wake of the pandemic, the Federal Reserve took forceful actions and established emergency lending facilities, with the approval of the Secretary of the Treasury as needed. These actions and facilities supported the flow of credit to households and businesses and served as backstop measures that have given investors confidence that support would be available should conditions deteriorate substantially.

Most of the facilities established at the onset of the pandemic expired at the end of December 2020, the beginning of January 2021, or the end of March 2021. These facilities expired with no notable effect on financial market functioning.

The termination date of the Federal Reserve's Paycheck Protection Program Liquidity Facility, which currently has $90.6 billion in loans outstanding funded to the PPP, was extended to July 30, 2021. The Federal Reserve has begun winding down the portfolio of the Secondary Market Corporate Credit Facility, an emergency lending facility that closed on December 31, 2020.4 The portfolio sales have been gradual and orderly and have aimed to minimize the potential for any adverse effect on market functioning by taking into account daily liquidity and trading conditions for exchange-traded funds and corporate bonds. To date, these sales have had no notable effect on mutual fund flows or price effects in the market.

The Federal Reserve also took actions to reduce spillovers to the U.S. economy from foreign financial stresses. Temporary U.S. dollar liquidity swap lines were established in March 2020, in addition to the preexisting standing lines, and have improved liquidity conditions in dollar funding markets in the United States and abroad by providing foreign central banks with the capacity to deliver U.S. dollar funding to institutions in their jurisdictions during times of market stress. The FIMA (Foreign and International Monetary Authorities) Repo Facility has helped support the smooth functioning of the U.S. Treasury market by providing a temporary source of U.S. dollars to a broad range of countries, many of which do not have swap line arrangements with the Federal Reserve. The Federal Reserve recently announced the extension of its temporary swap lines through December 31, 2021, which should help sustain improvements in global U.S. dollar funding markets.

1. Securitization can add leverage to the financial system through its use of "special purpose entities," which are generally subject to rules such as risk retention that are less stringent than banks' regulatory capital requirements. Return to text

2. See U.S. Department of the Treasury (2020), "President's Working Group on Financial Markets Releases Report on Money Market Funds," press release, December 22, Return to text

3. See U.S. Securities and Exchange Commission (2021), "SEC Requests Comment on Potential Money Market Fund Reform Options Highlighted in President's Working Group Report," press release, February 4, Return to text

4. See Board of Governors of the Federal Reserve System (2021), "Federal Reserve Board Announces Plans to Begin Winding Down the Portfolio of the Secondary Market Corporate Credit Facility," press release, June 2, Return to text

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

Measures of market liquidity for Treasury securities—such as measures of market depth and bid-ask spreads—remained close to pre-pandemic levels overall, particularly for shorter-dated securities. However, longer-dated Treasury securities and some portions of the mortgage-backed securities market—notably those classes of securities excluded from Federal Reserve open market purchases—remain somewhat less liquid than before the onset of the pandemic. Measures of market functioning in the corporate and municipal bond markets remained stable since February, with these markets functioning roughly as they did in the months before the pandemic. Bid-ask spreads across corporate bond credit categories have been slightly below pre-pandemic levels, and issuance of corporate bonds in primary markets has been solid. Municipal bond market liquidity—as measured by round-trip transaction costs—has come back to near pre-pandemic levels.

. . . while short-term funding market conditions remained stable

The effective federal funds rate (EFFR) and other overnight unsecured rates have seen some slight downward pressure relative to the interest rate on excess reserves since mid-February. The EFFR has nevertheless been comparatively stable, while other short-term interest rates registered more sizable declines. Secured overnight rates traded lower, with the Secured Overnight Financing Rate trading at or just above the offering rate on the overnight reverse repurchase agreement (ON RRP) facility since mid-March. Ample liquidity, arising from substantial increases in reserves, has, in conjunction with paydowns of Treasury bills, driven short-term interest rates lower. Notwithstanding the very low level of rates—including small volumes of negative-rate trading in overnight repurchase agreements on most days between mid-March and mid-June—short-term funding markets have functioned smoothly since February.

Money market funds increased significantly their holdings of overnight repurchase agreements

Since February, assets under management of government money market funds (MMFs) have gradually increased to an all-time high of nearly $4 trillion amid the disbursement of fiscal relief payments to individuals, states, and municipalities, and as some banks have reportedly taken steps to discourage additional deposit inflows. Against the backdrop of a sizable decrease in outstanding Treasury bill supply, government MMFs reduced their holdings of Treasury and agency securities while increasing their holdings of overnight repurchase agreements, including with the Federal Reserve. This development led to record levels of usage of the Federal Reserve's ON RRP facility in late May and June. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets" in Part 2.)

Bank credit remained little changed, while lending standards eased

Total loans and leases outstanding at commercial banks remained little changed in the first half of the year (figure 34). The April Senior Loan Officer Opinion Survey on Bank Lending Practices, conducted by the Federal Reserve, reported easier standards for most business and household loans over the first quarter of the year. Bank profitability increased over the first quarter of 2021 (figure 35). Delinquency rates on bank loans remain low but may increase later in the year, as foreclosure moratoriums and payment forbearance programs are set to expire.

International Developments

The recovery abroad slowed in the first half of the year...

A resurgence of COVID-19 cases late last year led to substantial tightening in social-distancing restrictions in many foreign economies. Consequently, foreign GDP growth slowed in the last quarter of 2020 and the first quarter of 2021, as several advanced foreign economies (AFEs) experienced contractions in activity (figure 36). In most AFEs, the level of GDP in the first quarter remained below its pre-pandemic peak. However, compared with last spring, many foreign economies exhibited greater resilience to public health restrictions, and their governments have continued to provide fiscal support. Recent available indicators suggest a pickup for AFEs in GDP growth in the second quarter of this year as vaccination rates increased and restrictions were eased (figures 37 and 38).

Although the situation in the AFEs appears to be improving, conditions in emerging market economies (EMEs) are more mixed, partly reflecting differences in success in containing COVID-19 outbreaks. Also, the pace of vaccinations in many EMEs remains slow due to supply shortages and other logistical challenges. Some higher-income Asian economies, where infections have so far remained mostly under control, experienced surprisingly fast growth, boosted by increased export demand and a partial recovery in domestic consumption. Most notably, the levels of GDP in China and in other industrialized EMEs such as Taiwan—which had managed to remain fairly insulated from the virus but has seen outbreaks recently—are already roughly 8 percent above their pre-pandemic levels (figure 39). Conversely, in many Latin American countries and some South and Southeast Asian economies, infection outbreaks led to continuing or increased public health restrictions and social distancing. Reflecting these headwinds, recent economic indicators suggest a decline in growth in the second quarter of 2021 in many of these EMEs following a sharp rebound in the first quarter, with economic activity still well below pre-pandemic levels.

Unemployment rates in Europe are about 1 percentage point higher in early 2021 than before the pandemic (figure 40). This relatively muted change is partly a result of wage subsidy programs that kept workers on payrolls and employment protection regulations that limited rapid job destruction. Hours worked, however, have fallen more substantially, suggesting that the extent of economic slack in Europe may be greater than indicated by the unemployment rate. The unemployment trajectory in Canada was more similar to that in the United States, with a rapid increase early last spring followed by a steep decline subsequently.

. . . amid a pickup in inflation and continued policy support

Inflation rates abroad have increased in recent months. In many AFEs, inflation readings moved up since the beginning of the year after substantial declines last year (figure 41). The rise in inflation was largely driven by base effects due to low price levels in 2020 as well as run-ups in energy prices. In some EMEs, currency depreciation and higher food prices are also contributing to inflation pressures. Even so, core inflation readings in many AFEs still point to moderate underlying inflation pressure, suggesting that the observed rise in inflation so far this year largely reflects temporary factors.

Monetary policy abroad remained accommodative, as central banks focused on supporting growth and viewed the recent rise in inflation as transitory. Market-implied policy paths in many AFEs continue to signal a period of monetary accommodation, although paths in Canada and the United Kingdom moved higher this year (figure 42). The European Central Bank increased its pace of asset purchases in the spring, and the Bank of Japan's yield curve control policy proved effective in containing a rise in bond yields. By contrast, while still maintaining an accommodative policy rate, the Bank of Canada announced plans to end liquidity support programs and started slowing its pace of asset purchases. The Bank of England also slowed its pace of asset purchases but indicated that its policy stance remains accommodative. Monetary policy in EMEs was generally accommodative as well, but some EME central banks—including in Brazil, Russia, and Turkey—increased policy rates, citing concerns about inflationary pressures. The Bank of Mexico, while leaving its policy rate unchanged, highlighted concerns about financial market volatility and past peso depreciation.


Improved outlook led to increases in foreign yields and equity prices...

Longer-term sovereign yields and market-based inflation compensation measures increased in some major advanced economies, as the economic outlook brightened and commodity prices rose (figure 43). Despite the increase, market-based inflation compensation in many AFEs remained below the inflation target of their respective central banks. Japanese yields were little changed due to the Bank of Japan's yield curve control policy. Equity markets in AFEs generally rose despite the new wave of COVID-19 infections earlier this year, as many economies proved resilient to increased case numbers and lockdowns and the vaccine rollout allowed gradual reopening (figure 44).

Equities in emerging markets were mixed. Since the beginning of the year, equity prices in some EMEs, including South Korea, Taiwan, and Mexico, improved considerably, but equity prices in other countries, including China, underperformed (figure 45). Inflows into dedicated EME investment funds slowed this year but remained positive, and EME bond spreads moved little so far this year (figure 46).

. . . and the dollar remained little changed

After depreciating sharply in late 2020, the broad dollar index—a measure of the trade-weighted value of the dollar against foreign currencies—has changed little, on net, since the beginning of the year. It has strengthened somewhat recently, amid increases in medium-term U.S. yields (figure 47). Among AFE currencies, the dollar appreciated most against the Japanese yen, as Japanese yields moved least. Since the beginning of the year, the U.S. dollar depreciated against the Canadian dollar, which was buoyed by higher commodity prices and signs of a stronger-than-expected recovery in Canada (figure 48).


 1. Since the beginning of the pandemic, some people on temporary layoff, who should be counted as unemployed, have instead been recorded as "employed but not at work." Had these workers been correctly classified, the Bureau of Labor Statistics estimates that the unemployment rate in June would have been as much as 0.2 percentage point above the reported rate. Return to text

 2. Early in the pandemic, job losses were much larger for lower-wage workers, raising average wages and measured wage growth. This process is now being reversed as many lower-wage workers, particularly in services, have been rehired, thus lowering average wages and measured wage growth. Consequently, in the 12-month changes, large composition effects obscure the underlying movements in wages of typical workers. Return to text

 3. Over the same period, labor productivity in the business sector is estimated to have increased 4 percent, much faster than the pre-pandemic trend. Both compensation and productivity have been affected by changes in the composition of inputs and outputs that may be largely transitory. Nevertheless, some of the increases may reflect more persistent factors. Return to text

 4. The trimmed mean omits the highest and lowest price changes, removing products representing roughly half of the PCE basket by consumption share. Return to text

 5. For more information, see Congressional Budget Office (2020), The Effects of Pandemic-Related Legislation on Output (Washington: CBO, September),; Congressional Budget Office (2020), "Summary Estimate for Divisions M through FF; H.R. 133, Consolidated Appropriations Act, 2021," January 14,; and Congressional Budget Office (2021), "Estimated Budgetary Effects of H.R. 1319, American Rescue Plan Act of 2021," March 10, to text

 6. Even before accounting for the additional budget effects from the most recent fiscal policy, the American Rescue Plan, the CBO projected in February that the debt-to-GDP ratio would rise in 2021. See Congressional Budget Office (2021), The Budget and Economic Outlook: 2021 to 2031 (Washington: CBO, February), to text

 7. These measures are based on a straight read of market quotes and are not adjusted for term premiums. Return to text

 8. 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: August 11, 2022