Monetary Policy Report submitted to the Congress on July 9, 2021, pursuant to section 2B of the Federal Reserve Act
Over the first half of 2021, progress on vaccinations has led to a reopening of the economy and strong economic growth, supported by accommodative monetary and fiscal policy. However, the effects of the COVID-19 pandemic have continued to weigh on the U.S. economy, and employment has remained well below pre-pandemic levels. Furthermore, shortages of material inputs and difficulties in hiring have held down activity in a number of industries. In part because of these bottlenecks and other largely transitory factors, PCE (personal consumption expenditures) prices rose 3.9 percent over the 12 months ending in May.
Over the first half of the year, the Federal Open Market Committee (FOMC) held its policy rate near zero and continued to purchase Treasury securities and agency mortgage-backed securities to support the economic recovery. These measures, along with the Committee's guidance on interest rates and the Federal Reserve's balance sheet, will help ensure that monetary policy continues to deliver powerful support to the economy until the recovery is complete.
Recent Economic and Financial Developments
The labor market. The labor market continued to recover over the first six months of 2021. Job gains averaged 540,000 per month, and the unemployment rate moved down from 6.7 percent in December to 5.9 percent in June. Although labor market improvement has been rapid, the unemployment rate remained elevated in June, and labor force participation has not moved up from the low rates that have prevailed for much of the past year. A surge in labor demand that has outpaced the recovery in labor supply has resulted in a jump in job vacancies and a step-up in wage gains in recent months.
Inflation. Consumer price inflation, as measured by the 12-month change in the PCE price index, moved up from 1.2 percent at the end of last year to 3.9 percent in May. The 12-month measure of inflation that excludes food and energy items (so-called core inflation) was 3.4 percent in May, up from 1.4 percent at the end of last year. Some of the strength in recent 12-month inflation readings reflects the comparison of current prices with prices that sank at the onset of the pandemic as households curtailed spending—a transitory result of "base effects." More lasting but likely still temporary upward pressure on inflation has come from prices for goods experiencing supply chain bottlenecks, such as motor vehicles and appliances. In addition, prices for some services, such as airfares and lodging, have moved up sharply in recent months toward more normal levels as demand has recovered. Both survey-based and market-based measures of longer-term inflation expectations have risen since the end of last year, largely reversing the downward drift in those measures in recent years, and are in a range that is broadly consistent with the FOMC's longer-run inflation objective.
Economic activity. In the first quarter, real gross domestic product (GDP) increased 6.4 percent, propelled by a surge in household consumption and a solid increase in business investment but restrained by a substantial drawdown in inventories as firms contended with production bottlenecks. Data for the second quarter suggest a further robust increase in demand. Against a backdrop of elevated household savings, accommodative financial conditions, ongoing fiscal support, and the reopening of the economy, the strength in household spending has persisted, reflecting continued strong spending on durable goods and solid progress toward more normal levels of spending on services.
Financial conditions. Since mid-February, equity prices and yields on nominal Treasury securities at longer maturities increased, as the rapid deployment of highly effective COVID-19 vaccines in the United States and the support provided by fiscal policy boosted optimism regarding the economic outlook. Despite having increased since February, mortgage rates for households remain near historical lows. Overall financing conditions for businesses and households eased further since February, as market-based lending conditions remained accommodative and bank-lending conditions eased markedly. Large firms, as well as those households that have solid credit ratings, continued to experience ample access to financing. However, financing conditions remained tight for small businesses and households with low credit scores.
Financial stability. While some financial vulnerabilities have increased since the previous Monetary Policy Report, the institutions at the core of the financial system remain resilient. Asset valuations have generally risen across risky asset classes with improving fundamentals as well as increased investor risk appetite, including in equity and corporate bond markets. Vulnerabilities from both business and household debt have continued to decline in 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, business-sector debt outstanding remains high relative to income, and some businesses and households are still under considerable strain. In the financial sector, leverage at banks and broker-dealers remains low, while available measures of leverage at hedge funds increased into early 2021 and are high. Issuance volumes of collateralized loan obligations and asset-backed securities recovered strongly through the first quarter of 2021, while issuance of non-agency commercial mortgage-backed securities was weak in that quarter. Funding risks at domestic banks continued to be low in the first quarter, but structural vulnerabilities persist at some types of money market funds and bank-loan and bond mutual funds. (See the box "Developments Related to Financial Stability" in Part 1.)
International developments. Foreign GDP growth moderated at the start of the year, as some countries tightened public health restrictions to contain renewed COVID-19 outbreaks. Compared with last spring, many foreign economies exhibited greater resilience to public-health-related restrictions, and their governments have continued to provide fiscal support. Recent indicators suggest a pickup in activity in advanced foreign economies this spring following an increase in vaccination rates and an easing of restrictions. However, conditions in emerging market economies are more mixed, in part dependent on their success in containing outbreaks and the availability of vaccines. Inflation has been rising in many economies, as the price declines seen last spring reversed and commodity prices ramped up. Monetary and fiscal policies continue to be supportive, but some foreign central banks are adopting or signaling less-accommodative policy stances.
Foreign financial conditions generally improved or held steady. Equity prices and longer-term sovereign yields increased across advanced foreign economies, boosted by their ongoing reopening. Equity markets in emerging market economies were mixed, and flows into dedicated emerging market funds slowed. After trending lower since the spring of 2020, the foreign exchange value of the dollar has changed little on net since the start of the year.
Interest rate policy. To continue to support the economic recovery, the FOMC has kept the target range for the federal funds rate near zero and has maintained the monthly pace of its asset purchases. The Committee expects it will be appropriate to maintain the current target range for the federal funds rate until labor market conditions have reached levels consistent with its assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed that rate for some time.
Balance sheet policy. With the federal funds rate near zero, the Federal Reserve has also continued to undertake asset purchases, increasing its holdings of Treasury securities by $80 billion per month and its holdings of agency mortgage-backed securities by $40 billion per month. These purchases help foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses. The Committee expects these purchases to continue at least at this pace until substantial further progress has been made toward its maximum-employment and price-stability goals. In coming meetings, the Committee will continue to assess the economy's progress toward these goals since the Committee adopted its asset purchase guidance last December.
In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee is prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals.
The uneven recovery in labor force participation. The labor force participation rate (LFPR) has improved very little since early in the recovery and remains well below pre-pandemic levels. Relative to its February 2020 level, the LFPR remains especially low for individuals without a college education, for individuals aged 55 and older, and for Hispanics and Latinos. Factors likely contributing both to the incomplete recovery of the LFPR and to differences across groups include a surge in retirements, increased caregiving responsibilities, and individuals' fear of contracting COVID-19; expansions to the availability, duration, and level of unemployment insurance benefits may also have supported individuals who withdrew from the labor force. Many of these factors should have a diminishing effect on participation in the coming months as public health conditions continue to improve and as expanded unemployment insurance expires. (See the box "The Uneven Recovery in Labor Force Participation" in Part 1.)
Recent inflation developments. Consumer price inflation has increased notably this spring as a surge in demand has run up against production bottlenecks and hiring difficulties. As these extraordinary circumstances pass, supply and demand should move closer to balance, and inflation is widely expected to move down. (See the box "Recent Inflation Developments" in Part 1.)
Supply chain bottlenecks in U.S. manufacturing and trade. Supply chain bottlenecks have hampered U.S. manufacturers' ability to procure the inputs needed to meet the surge in demand that followed widespread factory shutdowns during the first half of last year. Additionally, a massive influx of goods has exceeded the capacity of U.S. ports, extending manufacturers' wait times for imported parts. The stress on supply chains is reflected in historically high order backlogs and historically low customer inventories; these stresses, together with strong demand, have led to increased price pressures. When these bottlenecks will resolve is uncertain, as they reflect the global supply chain as well as industry-specific factors, but for some goods, such as lumber, the previous sharp increases in prices have begun to reverse. (See the box "Supply Chain Bottlenecks in U.S. Manufacturing and Trade" in Part 1.)
Inflation expectations. To avoid sustained periods of unusually low or high inflation, 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. Even though the pace of price increases has jumped in the first half of this year, recent readings on various measures of inflation expectations indicate that inflation is expected to return to levels broadly consistent with the FOMC's 2 percent longer-run inflation objective after a period of temporarily higher inflation. That said, upside risks to the inflation outlook in the near term have increased. (See the box "Assessing the Recent Rise in Inflation Expectations" in Part 1.)
Monetary policy rules. Simple monetary policy rules, which relate a policy interest rate to a small number of other economic variables, can provide useful guidance to policymakers. Many of the rules have prescribed strongly negative values of the federal funds rate since the start of the pandemic-driven recession. Because of the effective lower bound for the federal funds rate, the Federal Reserve's other monetary policy tools—namely, forward guidance and asset purchases—have been critical for providing the necessary support to the economy through this challenging period. (See the box "Monetary Policy Rules, the Effective Lower Bound, and the Economic Recovery" in Part 2.)
The Federal Reserve's balance sheet. Since January, the growth in reserves, the drawdown of the Treasury General Account, and the surge in usage of the overnight reverse repurchase agreement (ON RRP) facility have significantly affected the composition of the Federal Reserve's liabilities. Against a backdrop of low short-term market interest rates and ample liquidity, the use of the ON RRP facility has increased substantially since April and has reached a recent high of nearly $1 trillion, compared with usage near zero in February. Factors contributing to this increase included the decline in Treasury bill supply, downward pressure on money market rates, and the recent technical adjustment to the Federal Reserve's administered rates. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets" in Part 2.)
Statement on Longer-Run Goals and Monetary Policy Strategy
Adopted effective January 24, 2012; as amended effective January 26, 2021
The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.
Employment, inflation, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Monetary policy plays an important role in stabilizing the economy in response to these disturbances. The Committee's primary means of adjusting the stance of monetary policy is through changes in the target range for the federal funds rate. The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average. Therefore, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past. Owing in part to the proximity of interest rates to the effective lower bound, the Committee judges that downward risks to employment and inflation have increased. The Committee is prepared to use its full range of tools to achieve its maximum employment and price stability goals.
The maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time owing largely to nonmonetary factors that affect the structure and dynamics of the labor market. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the shortfalls of employment from its maximum level, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments.
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. The Committee judges that longer-term inflation expectations that are well anchored at 2 percent foster price stability and moderate long-term interest rates and enhance the Committee's ability to promote maximum employment in the face of significant economic disturbances. In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.
Monetary policy actions tend to influence economic activity, employment, and prices with a lag. In setting monetary policy, the Committee seeks over time to mitigate shortfalls of employment from the Committee's assessment of its maximum level and deviations of inflation from its longer-run goal. Moreover, sustainably achieving maximum employment and price stability depends on a stable financial system. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.
The Committee's employment and inflation objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it takes into account the employment shortfalls and inflation deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.
The Committee intends to review these principles and to make adjustments as appropriate at its annual organizational meeting each January, and to undertake roughly every 5 years a thorough public review of its monetary policy strategy, tools, and communication practices.
Note: This report reflects information that was publicly available as of noon EDT on July 7, 2021.
Unless otherwise stated, the time series in the figures extend through, for daily data, July 6, 2021; for monthly data, May 2021; and, for quarterly data, 2021:Q1. In bar charts, except as noted, the change for a given period is measured to its final quarter from the final quarter of the preceding period.
For figures 20, 32, and 44, note that the S&P/Case-Shiller U.S. National Home Price Index, the S&P 500 Index, and the Dow Jones Bank Index are products of S&P Dow Jones Indices LLC and/or its affiliates and have been licensed for use by the Board. Copyright © 2021 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution, reproduction, and/or photocopying in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC's indices, please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor's Financial Services LLC, and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates, nor their third-party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent, and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates, nor their third-party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.
For figure 22, neither DTCC Solutions LLC nor any of its affiliates shall be responsible for any errors or omissions in any DTCC data included in this publication, regardless of the cause, and, in no event, shall DTCC or any of its affiliates be liable for any direct, indirect, special, or consequential damages, costs, expenses, legal fees, or losses (including lost income or lost profit, trading losses, and opportunity costs) in connection with this publication.