Part 2: Monetary Policy
Monetary Policy Report submitted to the Congress on June 16, 2023, pursuant to section 2B of the Federal Reserve Act
The Federal Open Market Committee continued to increase the federal funds rate...
With inflation still well above the Federal Open Market Committee's (FOMC) 2 percent objective and with labor market conditions remaining very tight, the FOMC continued to raise the target range for the federal funds rate. Since January, the FOMC raised the target range 75 basis points, from 4-1/4 to 4-1/2 percent to 5 to 5-1/4 percent (figure 45). Credit conditions had already tightened in response to the FOMC's policy actions and appeared to tighten further following the emergence of banking-sector strains in March. In light of the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation, the FOMC slowed the pace of policy firming relative to late 2022, raising the target range 25 basis points at its January, March, and May meetings, and held the range steady at its June meeting. In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the FOMC will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments. The FOMC indicated that it will continue to monitor the implications of incoming information for the economic outlook and would be prepared to adjust the stance of monetary policy if risks emerge that could impede the attainment of the FOMC's goals.
...and has continued the process of significantly reducing its holdings of Treasury and agency securities
The FOMC began reducing its securities holdings in June 2022 and, since then, has continued to implement its plan for significantly reducing the size of the Federal Reserve's balance sheet in a predictable manner.16 Since September 2022, principal payments from securities held in the System Open Market Account (SOMA) have been reinvested only to the extent that they exceeded monthly caps of $60 billion per month for Treasury securities and $35 billion per month for agency mortgage-backed securities. As a result of these actions, holdings of Treasury and agency securities in the SOMA have declined by about $420 billion since the start of January to around $7.7 trillion, a level equivalent to about 29 percent of U.S. nominal gross domestic product (figure 46). Despite this decline in SOMA holdings, reserve balances have risen by about $330 billion to around $3.3 trillion, mainly because of increased liquidity provision to banks and lower balances in the Treasury General Account. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets.")
The FOMC has stated that it intends to maintain securities holdings in amounts needed to implement monetary policy efficiently and effectively in its ample-reserves regime. To ensure a smooth transition, the FOMC intends to slow and then stop reductions in its securities holdings when reserve balances are somewhat above the level the FOMC judges to be consistent with ample reserves. Once balance sheet runoff has ceased, reserve balances will likely continue to decline at a slower pace—reflecting growth in other Federal Reserve liabilities—until the FOMC judges that reserve balances are at the level required for efficiently implementing monetary policy. Thereafter, the FOMC will manage securities holdings as needed to maintain ample reserves over time.
Developments in the Federal Reserve's Balance Sheet and Money Markets
The Federal Open Market Committee (FOMC) continued to reduce the size of the Federal Reserve's System Open Market Account portfolio. Since the time of the previous report, total securities have declined $226 billion to about $7.7 trillion. Amid banking-sector developments, depository institutions (DIs) borrowed from the discount window and the Federal Reserve introduced a new facility in mid-March, the Bank Term Funding Program (BTFP), making additional funding available to eligible DIs to help ensure banks have the ability to meet the needs of all their depositors. Driven by this increase in loans, total assets have increased $49 billion, leaving the total size of the balance sheet at about $8.4 trillion (figures A and B). This discussion reviews recent developments in the Federal Reserve's balance sheet and money market conditions.
A. Balance sheet comparison
Billions of dollars
| June 7, 2023 | March 1, 2023 | Change | |
|---|---|---|---|
| Assets | |||
| Total securities | |||
| Treasury securities | 5,162 | 5,336 | −174 |
| Agency debt and MBS | 2,560 | 2,612 | −52 |
| Net unamortized premiums | 298 | 308 | −10 |
| Repurchase agreements | 0 | 0 | 0 |
| Loans and lending facilities | |||
| PPPLF | 8 | 11 | −3 |
| Discount window | 3 | 4 | −1 |
| BTFP | 100 | 0 | 100 |
| Other credit extensions | 185 | 0 | 185 |
| Other loans and lending facilities | 28 | 30 | −2 |
| Central bank liquidity swaps | 0 | 0 | 0 |
| Other assets | 44 | 38 | 6 |
| Total assets | 8,389 | 8,340 | 49 |
| Liabilities | |||
| Federal Reserve notes | 2,293 | 2,254 | 39 |
| Reserves held by depository institutions | 3,306 | 3,028 | 278 |
| Reverse repurchase agreements | |||
| Foreign official and international accounts | 347 | 367 | −20 |
| Others | 2,162 | 2,134 | 28 |
| U.S. Treasury General Account | 77 | 351 | −274 |
| Other deposits | 208 | 180 | 28 |
| Other liabilities and capital | −4 | 26 | −30 |
| Total liabilities and capital | 8,389 | 8,340 | 49 |
Note: MBS is mortgage-backed securities. PPPLF is Paycheck Protection Program Liquidity Facility. BTFP is Bank Term Funding Program. Components may not sum to totals because of rounding.
Source: Federal Reserve Board, Statistical Release H.4.1, "Factors Affecting Reserve Balances."
Amid banking-sector developments, discount window borrowing by DIs peaked at just over $150 billion in mid-March before declining to $3 billion as other credit extensions—which consist of loans that were extended to DIs that were subsequently placed into Federal Deposit Insurance Corporation (FDIC) receivership, including DIs established by the FDIC—increased to $185 billion.1 Furthermore, to support American businesses and households, the Federal Reserve Board made additional funding available to eligible DIs through the creation of the new BTFP under the authority of section 13(3) of the Federal Reserve Act, with approval of the Secretary of the Treasury.2 The BTFP offers loans of up to one year in length to banks, savings associations, credit unions, and other eligible DIs against collateral such as U.S. Treasury securities, U.S. agency securities, and U.S. agency mortgage-backed securities.3 Loans under the BTFP are secured by eligible collateral valued at par—that is, the face amount of the securities—and can be requested until at least March 11, 2024. Currently, the Federal Reserve has $100 billion of BTFP loans outstanding to eligible counterparties. Federal Reserve lending at the discount window, under the BTFP, and through other credit extensions has led to a small increase in total assets since March.
Usage of the overnight reverse repurchase agreement (ON RRP) facility averaged around $2.2 trillion since the beginning of March amid abundant liquidity in the banking system and limited Treasury bill supply (figure C). In addition, uncertainty about the economic outlook—and, as a result, about the magnitude and pace of policy rate increases—continued to contribute to a preference for short-duration assets, like those provided by the ON RRP facility. ON RRP usage dropped slightly in the immediate aftermath of banking-sector stress in mid-March, as money market mutual funds diverted some of their funds to other investments, such as Federal Home Loan Bank discount notes.4 The ON RRP facility is intended to help keep the effective federal funds rate within the target range. The facility continued to serve this intended purpose, and the Federal Reserve's administered rates—interest on reserve balances and the ON RRP offering rate—were highly effective at maintaining the effective federal funds rate within the target range as the FOMC has tightened the stance of monetary policy.
Reserve balances—the largest liability of the Federal Reserve's balance sheet—have increased by about $278 billion since March 2023, driven by the increase in Federal Reserve lending to DIs and a $274 billion decline in the Treasury General Account.5
Net income of the Federal Reserve continued to be negative, and the deferred asset that the Federal Reserve balance sheet now reports—as the Federal Reserve no longer has positive net income to remit to the Treasury Department—grew by about $30 billion to $68 billion since the previous report. The deferred asset is equal to the cumulative shortfall of net income and represents the amount of future net income that will need to be realized before remittances to the Treasury resume.6 Negative net income and the associated deferred asset do not affect the Federal Reserve's conduct of monetary policy or its ability to meet its financial obligations.7
1. The Federal Reserve Banks' loans to these DIs are secured by pledged collateral, and the FDIC provides repayment guarantees. Return to text
2. On March 12, with the announcement of the BTFP, changes were announced for the discount window. These changes included the application of the same margins used for the securities eligible for the BTFP, further increasing the lendable value of collateral at the discount window. Return to text
3. The collateral eligible under the BTFP includes any collateral that is eligible for purchase by the Federal Reserve Banks in open market operations (see 12 C.F.R. § 201.108(b)). Return to text
4. In order to meet funding needs, Federal Home Loan Banks (FHLBs) increased the supply of FHLB discount notes in the immediate aftermath of the banking-sector stress in mid-March. Return to text
5. Reserve balances consist of deposits held at the Federal Reserve Banks by DIs, such as commercial banks, savings banks, credit unions, thrift institutions, and U.S. branches and agencies of foreign banks. Reserve balances allow DIs to facilitate daily payment flows, both in ordinary times and in stress scenarios, without borrowing funds or selling assets. Return to text
6. Although remittances are suspended at the time of this report, over the past decade and a half, the Federal Reserve has remitted over $1 trillion to the Treasury. Return to text
7. Net income is expected to again turn positive as interest expenses fall, and remittances will resume once the temporary deferred asset falls to zero. As a result of the ongoing reduction in the size of the Federal Reserve's balance sheet, it is expected that interest expenses will fall over time in line with the decline in the Federal Reserve's liabilities. Return to text
The FOMC will continue to monitor the implications of incoming information for the economic outlook
The FOMC is strongly committed to returning inflation to its 2 percent objective. In assessing the appropriate stance of monetary policy, the FOMC will continue to monitor the implications of incoming information for the economic outlook. The FOMC's assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments. The FOMC has noted that it is also prepared to adjust any of the details of its approach to reducing the size of the balance sheet in light of economic and financial developments.
In addition to considering a wide range of economic and financial data, the FOMC gathers information from business contacts and other informed parties around the country, as summarized in the Beige Book. To hear from a broad range of stakeholders in the U.S. economy about how monetary policy affects people's daily lives and livelihoods, the Federal Reserve has continued to gather insights through the Fed Listens initiative and the Federal Reserve System's community development outreach. Policymakers also routinely consult prescriptions for the policy interest rate provided by various monetary policy rules. These rule prescriptions can provide useful benchmarks for the FOMC. Although simple rules cannot capture all of the complexities of monetary policy, and many practical considerations make it undesirable for the FOMC to adhere strictly to the prescriptions of any specific rule, some principles of good monetary policy can be illustrated by these policy rules (see the box "Monetary Policy Rules in the Current Environment").
Monetary Policy Rules in the Current Environment
As part of their monetary policy deliberations, policymakers consult the prescriptions of a variety of simple interest rate rules without mechanically following the prescriptions of any particular rule. Simple interest rate rules relate a policy interest rate, such as the federal funds rate, to a small number of other economic variables—typically including the current deviation of inflation from its target value and a measure of resource slack in the economy.
Since 2021, inflation has run well above the Federal Open Market Committee's (FOMC) 2 percent longer-run objective, and labor market conditions have been very tight over the past year. As a result, the simple monetary policy rules considered in this discussion have called for elevated levels of the federal funds rate. Reflecting the continued, unacceptably high level of inflation, the FOMC has raised the target range for the federal funds rate by 5 percentage points in just over a year and has reduced its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a historically rapid pace.
Selected Policy Rules: Descriptions
In many economic models, desirable economic outcomes can be achieved if monetary policy responds in a predictable way to changes in economic conditions. In recognition of this idea, economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule, the "balanced approach" rule, the "adjusted Taylor (1993)" rule, and the "first difference" rule.1 Figure A shows these rules, along with a "balanced-approach (shortfalls)" rule, which responds to the unemployment rate only when it is higher than its longer-run level.2 All of these simple rules shown embody key design principles of good monetary policy, including that the policy rate should be adjusted forcefully enough over time to ensure a return of inflation to the central bank's longer-run objective and to anchor longer-term inflation expectations at levels consistent with that objective.
All five rules feature the difference between inflation and the FOMC's longer-run objective of 2 percent. The five rules use the unemployment rate gap, measured as the difference between an estimate of the rate of unemployment in the longer run ($$ u_t^{LR}$$) and the current unemployment rate; the first-difference rule includes the change in the unemployment rate gap rather than its level.3 All but the first-difference rule include an estimate of the neutral real interest rate in the longer run ($$ r_t^{LR}$$).4
Unlike the other simple rules featured here, the adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below the effective lower bound (ELB). By contrast, during the pandemic-induced recession, the standard Taylor (1993) rule prescribed policy rates that were sharply lower than the ELB. To make up for the cumulative shortfall in policy accommodation following a recession during which the federal funds rate is constrained by its ELB, the adjusted Taylor (1993) rule prescribes delaying the return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule until after the economy begins to recover.
Policy Rules: Limitations
Simple policy rules are also subject to important limitations. One important limitation is that simple policy rules were designed and tested under very different economic conditions than those faced at present. In addition, the simple policy rules respond to only a small set of economic variables and thus necessarily abstract from many of the factors that the FOMC considers when it assesses the appropriate setting of the policy rate. Another important limitation is that most simple policy rules do not take into account the ELB on interest rates, which limits the extent to which the policy rate can be lowered to support the economy. This constraint was particularly evident during the pandemic-driven recession, when the lower bound on the policy rate motivated the FOMC's other policy actions to support the economy. Relatedly, another limitation is that simple policy rules do not take into account the other tools of monetary policy, such as balance sheet policies. Finally, simple policy rules generally abstract from the risk-management considerations associated with uncertainty about economic relationships and the evolution of the economy.
Selected Policy Rules: Prescriptions
Figure B shows historical quarterly prescriptions for the federal funds rate under the five simple rules considered. For each quarterly period, the figure reports the policy rates prescribed by the rules, taking as given the prevailing economic conditions and survey-based estimates of $$ u_t^{LR}$$ and $$ r_t^{LR}$$ at the time. All of the rules considered called for a highly accommodative stance for monetary policy in response to the pandemic-driven recession, followed by values above the ELB as inflation picked up and labor market conditions strengthened. Over the past year, the prescriptions of the simple rules for the federal funds rate were between 4 and 8 percent; these values are well above the levels observed before the pandemic and reflect, in large part, elevated inflation readings. Since early 2022, the FOMC has raised the target range for the federal funds rate by 5 percentage points to attain a stance of monetary policy that will be sufficiently restrictive to return inflation to 2 percent over time.
1. The Taylor (1993) rule was introduced in John B. Taylor (1993), "Discretion versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 195–214. The balanced-approach rule was analyzed in John B. Taylor (1999), "A Historical Analysis of Monetary Policy Rules," in John B. Taylor, ed., Monetary Policy Rules (Chicago: University of Chicago Press), pp. 319–41. The adjusted Taylor (1993) rule was studied in David Reifschneider and John C. Williams (2000), "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, vol. 32 (November), pp. 936–66. The first-difference rule is based on a rule suggested by Athanasios Orphanides (2003), "Historical Monetary Policy Analysis and the Taylor Rule," Journal of Monetary Economics, vol. 50 (July), pp. 983–1022. A review of policy rules is in John B. Taylor and John C. Williams (2011), "Simple and Robust Rules for Monetary Policy," in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol. 3B (Amsterdam: North-Holland), pp. 829–59. The same volume of the Handbook of Monetary Economics also discusses approaches other than policy rules for deriving policy rate prescriptions. Return to text
2. The balanced-approach (shortfalls) rule responds asymmetrically to unemployment rates above or below their estimated longer-run value: When unemployment is above that value, the policy rates are identical to those prescribed by the balanced-approach rule, whereas when unemployment is below that value, policy rates do not rise because of further declines in the unemployment rate. As a result, the prescription of the balanced-approach (shortfalls) rule in 2023:Q1 is less restrictive than that of the balanced-approach rule. Return to text
3. Implementations of simple rules often use the output gap as a measure of resource slack in the economy. The rules described in figureA instead use the unemployment rate gap because that gap better captures the FOMC's statutory goal to promote maximum employment. Movements in these alternative measures of resource utilization tend to be highly correlated. For more information, see the note below figure A. Return to text
4. The neutral real interest rate in the longer run ($$ r_t^{LR}$$) is the level of the real federal funds rate that is expected to be consistent, in the longer run, with maximum employment and stable inflation. Like $$ u_t^{LR}$$, $$ r_t^{LR}$$ is determined largely by nonmonetary factors. The first-difference rule shown in figure A does not require an estimate of $$ r_t^{LR}$$, a feature that is touted by proponents of such rules as providing an element of robustness. However, this rule has its own shortcomings. For example, research suggests that this sort of rule often results in greater volatility in employment and inflation relative to what would be obtained under the Taylor (1993) and balanced-approach rules. Return to text
Footnotes
16. See the May 4, 2022, press release regarding the Plans for Reducing the Size of the Federal Reserve's Balance Sheet, available on the Board's website at https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504b.htm. Return to text