Part 2: Monetary Policy
Monetary Policy Report submitted to the Congress on March 1, 2024, pursuant to section 2B of the Federal Reserve Act
After one additional increase in July, the Federal Open Market Committee has held the federal funds rate steady...
The Federal Open Market Committee (FOMC) has maintained the target range for the federal funds rate at 5-1/4 to 5-1/2 percent since its July 2023 meeting (figure 41). The Committee views the policy rate as likely at its peak for this tightening cycle; since early 2022, the FOMC raised the target range a total of 525 basis points. The FOMC's policy tightening actions have reflected its commitment to return inflation to its 2 percent objective. Restoring price stability is essential to achieve a sustained period of strong labor market conditions that benefit all.
As labor market tightness has eased and progress on inflation has continued, the risks to achieving the Committee's employment and inflation goals have been moving into better balance. Even so, the Committee remains highly attentive to inflation risks and is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials, like food, housing, and transportation. In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.
...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.8 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 debt and agency mortgage-backed securities. As a result of these actions, the SOMA holdings of Treasury and agency securities have declined about $1.4 trillion since the start of balance sheet reduction to around $7.1 trillion, a level equivalent to about 25 percent of U.S. nominal gross domestic product as compared with a peak of 35 percent reached at the end of 2021 (figure 42). Despite this decline in SOMA holdings, reserve balances increased $217 billion, to a level of around $3.5 trillion, as the corresponding decline in the Federal Reserve's liabilities was concentrated in usage of the overnight reverse repurchase agreement facility. (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 at amounts consistent with implementing 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 that 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 an ample level. 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 (SOMA) portfolio, consistent with its plans for reducing the size of the Federal Reserve's balance sheet. Since the time of the June 2023 report, total Federal Reserve assets have decreased $806 billion, leaving the total size of the balance sheet at $7.6 trillion, $1.3 trillion smaller since the reduction in the size of the SOMA portfolio began in June 2022 (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
| February 21, 2024 | June 14, 2023 | Change (since June 2023) | Change (since Fed's balance sheet reduction began on June 1, 2022) | |
|---|---|---|---|---|
| Assets | ||||
| Total securities | ||||
| Treasury securities | 4,661 | 5,160 | -499 | -1,109 |
| Agency debt and MBS | 2,417 | 2,561 | -144 | -293 |
| Net unamortized premiums | 274 | 298 | -24 | -63 |
| Repurchase agreements | 0 | 0 | 0 | 0 |
| Loans and lending facilities | ||||
| PPPLF | 3 | 8 | -5 | -17 |
| Discount window | 2 | 4 | -2 | 2 |
| BTFP | 164 | 102 | 62 | 164 |
| Other credit extensions | 0 | 180 | -180 | 0 |
| Other loans and lending facilities | 15 | 28 | -13 | -20 |
| Central bank liquidity swaps | 0 | 0 | 0 | 0 |
| Other assets | 44 | 48 | -4 | 2 |
| Total assets | 7,582 | 8,388 | -806 | -1,333 |
| Liabilities | ||||
| Federal Reserve notes | 2,280 | 2,292 | -12 | 50 |
| Reserves held by depository institutions | 3,523 | 3,306 | 217 | 166 |
| Reverse repurchase agreements | ||||
| Foreign official and international accounts | 340 | 328 | 12 | 74 |
| Others | 575 | 2,109 | -1,534 | -1,390 |
| U.S. Treasury General Account | 789 | 135 | 654 | 8 |
| Other deposits | 164 | 220 | -56 | -84 |
| Other liabilities and capital | -89 | -2 | -87 | -157 |
| Total liabilities and capital | 7,582 | 8,388 | -806 | -1,333 |
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."
While the reduction in the size of the SOMA portfolio has continued as planned, amid the banking-sector developments of spring 2023, the Federal Reserve provided liquidity to help ensure the stability of the banking system and the ongoing provision of money and credit to the economy.1 Loans under the Bank Term Funding Program—which made additional funding and liquidity available to eligible depository institutions to support American businesses and households and which will cease making new loans as scheduled on March 11, 2024—have increased $62 billion since June 2023 (figure A).2
Despite the ongoing reduction in the Federal Reserve's securities holdings, reserve balances—the largest liability item on the Federal Reserve's balance sheet—have increased $217 billion since June 2023, given other changes in the composition of the Federal Reserve's liabilities over this period.3 Since June 2023, usage of the overnight reverse repurchase agreement (ON RRP) facility has declined $1.5 trillion, while balances in the Treasury General Account have increased $654 billion (figures A and C). On net, changes in these and other nonreserve liabilities have resulted in an increase in reserve balances.
After remaining above $2 trillion during the first half of 2023, usage of the ON RRP facility has declined to about $575 billion amid the ongoing reduction in the Federal Reserve's balance sheet and the substantial increase in net supply of Treasury securities. Reduced usage of the ON RRP facility largely reflects money market funds shifting their portfolio toward higher-yielding investments, including Treasury bills and private-market repurchase agreements.
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—the interest rate 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 tightened the stance of monetary policy.
The Federal Reserve's expenses have continued to exceed its income over recent months. The Federal Reserve's deferred asset increased $82 billion since last June to a level of $152 billion.4 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.5
1. The loans that were extended to depository institutions (DIs) placed into Federal Deposit Insurance Corporation (FDIC) receivership in March 2023 have been fully repaid. The Federal Reserve Banks' loans to these DIs are secured by pledged collateral, and the FDIC provides repayment guarantees. For additional information, see Board of Governors of the Federal Reserve System (2024), "Additional Information on Other Credit Extensions," webpage, January 4, https://www.federalreserve.gov/monetarypolicy/additional-information-on-other-credit-extensions.htm. Return to text
2. The Bank Term Funding Program (BTFP) was established under section 13(3) of the Federal Reserve Act with the approval of the Secretary of the Treasury. The BTFP offers loans of up to one year 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. For more details, see Board of Governors of the Federal Reserve System (2024), "Bank Term Funding Program," webpage, February 13, https://www.federalreserve.gov/financial-stability/bank-term-funding-program.htm.
The interest rate applicable to new BTFP loans has been adjusted such that the rate on new loans extended from January 25, 2024, through program expiration will be no lower than the interest rate on reserve balances in effect on the day the loan is made. This rate adjustment ensures that the BTFP continues to support the goals of the program in the current interest rate environment. After March 11, 2024, banks and other DIs will continue to have ready access to the discount window to meet liquidity needs. For additional information, see Board of Governors of the Federal Reserve System (2024), "Federal Reserve Board Announces the Bank Term Funding Program (BTFP) Will Cease Making New Loans as Scheduled on March 11," press release, January 24, https://www.federalreserve.gov/newsevents/pressreleases/monetary20240124a.htm. Return to text
3. 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
4. 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. 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
5. Net income is expected to turn positive again 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
As already indicated, the FOMC is strongly committed to returning inflation to its 2 percent objective, and, in considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. Its 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 Committee has noted that it is also prepared to adjust 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. The Federal Reserve has regular arrangements under which it hears from a broad range of participants in the U.S. economy about how monetary policy affects people's daily lives and livelihoods. In particular, the Federal Reserve has continued to gather insights into these matters 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. However, simple rules cannot capture all of the complex considerations that go into the formation of appropriate monetary policy, and many practical considerations make it undesirable for the FOMC to adhere strictly to the prescriptions of any specific rule. Nevertheless, some principles of good monetary policy can be brought out by examining these simple 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 regularly 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 above the Federal Open Market Committee's (FOMC) 2 percent longer-run objective, and labor market conditions have been tight. Although inflation remains elevated, it has eased considerably over the past year, and labor supply and demand have come into better balance. Against this backdrop, the simple monetary policy rules considered in this discussion have called for elevated levels of the federal funds rate over 2021, 2022, and the first half of 2023, but the rates prescribed by these rules have now declined to values close to the current target range for the federal funds rate at 5-1/4 to 5-1/2 percent. In support of its goals of maximum employment and inflation at the rate of 2 percent over the longer run, the FOMC has maintained the federal funds rate at 5-1/4 to 5-1/2 percent since July while continuing to reduce its holdings of Treasury securities and agency debt and agency mortgage-backed securities.
Selected Policy Rules: Descriptions
In many economic models, desirable economic outcomes can be achieved over time if monetary policy responds to changes in economic conditions in a manner that is predictable and adheres to some key design principles. 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 estimated longer-run level.2 All of the simple rules shown embody key design principles of good monetary policy, including the requirement that the policy rate should be adjusted by 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 far below zero. 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
As benchmarks for monetary policy, simple policy rules have important limitations. One of these limitations is that the simple policy rules mechanically 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. In addition, the structure of the economy and current economic conditions differ in important respects from those prevailing when the simple policy rules were originally devised and proposed. As a result, 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 explicitly take into account other important tools of monetary policy, such as balance sheet policies. Finally, simple policy rules are not forward looking and do not allow for important risk-management considerations, associated with uncertainty about economic relationships and the evolution of the economy, that factor into FOMC decisions.
Selected Policy Rules: Prescriptions
Figure B shows historical 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 of monetary policy in response to the pandemic-driven recession, followed by positive values as inflation picked up and labor market conditions strengthened. In 2022 and during the first half of 2023, 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. Because inflation has eased recently, the policy rates prescribed by these rules have now declined to values that are close to the federal funds rate.
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 provided 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 to deriving policy rate prescriptions other than through the use of simple rules. 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 has been less restrictive than that of the balanced-approach rule since 2022:Q1. 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 figure A 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 than what would be obtained under the Taylor (1993) and balanced-approach rules. Return to text
Footnotes
8. 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