Part 3: Monetary Policy: Recent Developments and OutlookMonetary Policy Report submitted to the Congress on July 21, 2010, pursuant to section 2B of the Federal Reserve Act
Monetary Policy over the First Half of 2010
The Federal Open Market Committee (FOMC) maintained a target range for the federal funds rate of 0 to 1/4 percent throughout the first half of 2010 in order to continue to promote economic recovery and price stability (figure 57). In the statement accompanying each regularly scheduled FOMC meeting, the Committee noted that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, were likely to warrant exceptionally low levels of the federal funds rate for an extended period. At the end of March, the Federal Reserve concluded its purchases of agency mortgage-backed securities (MBS) and agency debt under its large-scale asset purchase programs, which were undertaken to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets. Also, in light of improved functioning of financial markets, by the end of June the Federal Reserve had closed all of the special liquidity facilities that it had created to support markets during the crisis. However, in response to the reemergence of strains in U.S. dollar short-term funding markets in Europe, the Federal Reserve and five foreign central banks announced in May the reestablishment of temporary U.S. dollar liquidity swap facilities.
At its January 26–27 meeting, the Committee agreed that the incoming information, though mixed, indicated that overall economic activity had strengthened in recent months, about in line with expectations. Consumer spending was well maintained in the fourth quarter, and business expenditures on equipment and software appeared to expand substantially. However, the improvement in the housing market had slowed, and spending on nonresidential structures continued to fall. Available data suggested that the pace of inventory liquidation had diminished considerably in the fourth quarter, providing a sizable boost to economic activity, and especially to industrial production. In the labor market, layoffs subsided noticeably in the final months of 2009, but the unemployment rate remained elevated and hiring stayed quite limited. The weakness in labor markets continued to be an important concern for the Committee; moreover, the prospects for job growth remained a significant source of uncertainty in the economic outlook, particularly for consumer spending. Financial market conditions were supportive of economic growth. Nonetheless, net debt financing by nonfinancial businesses was near zero in the fourth quarter after being negative in the third, consistent with sluggish demand for credit and tight lending standards and terms at banks. Increases in energy prices pushed up headline consumer price inflation, but core consumer price inflation remained subdued.
In their discussion of monetary policy for the period ahead, Committee members agreed that neither the economic outlook nor financial conditions had changed appreciably since the December meeting and that no changes to the Committee's large-scale asset purchase programs or to its target range for the federal funds rate of 0 to 1/4 percent were called for. Further, policymakers reiterated their anticipation that economic conditions were likely to warrant exceptionally low rates for an extended period. The Committee affirmed its intention to purchase a total of $1.25 trillion of agency MBS and about $175 billion of agency debt by the end of the first quarter and to gradually slow the pace of these purchases to promote a smooth transition in markets. Committee members agreed that with substantial improvements in most financial markets, including interbank markets, the statement following the meeting would indicate that on February 1, 2010, the Federal Reserve would close several special liquidity facilities and that the temporary swap lines with foreign central banks would expire. In addition, the statement would say that the Federal Reserve was in the process of winding down the Term Auction Facility (TAF) and that the final auction would take place in March 2010.
As had been announced, on February 1, 2010, the Federal Reserve closed the Primary Dealer Credit Facility, the Term Securities Lending Facility, the Commercial Paper Funding Facility, and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. The temporary swap lines with foreign central banks expired on the same day. On February 18, 2010, the Federal Reserve announced a further normalization of the terms of loans made under the primary credit facility. The rate charged on these loans was increased from 1/2 percent to 3/4 percent, effective on February 19, and the typical maximum maturity for such loans was shortened to overnight, effective on March 18, 2010. The Federal Reserve also announced on February 18 that the minimum bid rate on the final TAF auction on March 8 had been raised to 50 basis points, 1/4 percentage point higher than in previous auctions. The Federal Reserve noted that the modifications were not expected to lead to tighter financial conditions for households and businesses and did not signal any change in the outlook for the economy or for monetary policy.
The data reviewed at the March 16 FOMC meeting suggested that economic activity expanded at a moderate pace in early 2010. Business investment in equipment and software seemed to have picked up, and consumer spending increased further in January. Private employment would likely have turned up in February but for the snowstorms that affected the East Coast. Meeting participants agreed that available indicators suggested that the labor market appeared to be stabilizing. Output in the manufacturing sector continued to trend higher as firms increased production to meet strengthening final demand and to slow the pace of inventory liquidation. On the downside, housing activity remained flat and nonresidential construction weakened further. Meanwhile, a sizable increase in energy prices had pushed up headline consumer price inflation in recent months; in contrast, core consumer price inflation was quite low. Participants agreed that financial market conditions remained supportive of economic growth. Spreads in short-term funding markets were near pre-crisis levels, and risk spreads on corporate bonds and measures of implied volatility in equity markets were broadly consistent with historical norms given the outlook for the economy. Participants were also reassured by the absence of any signs of renewed strains in financial market functioning as a consequence of the Federal Reserve's winding down of its special liquidity facilities. However, bank lending was still contracting, and interest rates on many bank loans had risen further in recent months.
Against this backdrop, Committee members agreed that it would be appropriate to maintain the target range of 0 to 1/4 percent for the federal funds rate and to complete the Committee's previously announced purchases of $1.25 trillion of agency MBS and about $175 billion of agency debt by the end of March. Nearly all members judged that it was appropriate to reiterate in the Committee's statement the expectation that economic conditions--including low levels of resource utilization, subdued inflation trends, and stable inflation expectations--were likely to warrant exceptionally low levels of the federal funds rate for an extended period. In light of the improved functioning of financial markets, Committee members agreed that it would be appropriate for the statement to indicate that the previously announced schedule for closing the Term Asset-Backed Securities Loan Facility (TALF) was being maintained. On March 31, the TALF closed for loans backed by collateral other than newly issued commercial MBS.
The information reviewed at the April 27–28 FOMC meeting suggested that, on balance, the economic recovery was proceeding at a moderate pace and that the deterioration in the labor market was likely coming to an end. Consumer spending continued to post solid gains in the first three months of the year, and business investment in equipment and software appeared to have increased significantly further in the first quarter. In addition, growth of manufacturing output remained brisk, and gains became more broadly based across industries. However, residential construction, while having edged up, was still depressed, construction of nonresidential buildings remained on a steep downward trajectory, and state and local governments continued to retrench. Consumer price inflation remained low. Meeting participants expected that business investment would be supported by improved conditions in financial markets. Large firms with access to capital markets appeared to be having little difficulty in obtaining credit, and in many cases they also had ample retained earnings with which to fund their operations and investment. However, many participants noted that, while financial market conditions had generally improved, bank lending was still contracting and that smaller firms in particular continued to face substantial difficulty in obtaining bank loans. Members saw an escalation of financial strains in Europe as a risk to the outlook, although the attendant effects on global market conditions were only beginning to be felt.
Members agreed that no adjustments to the federal funds rate target range were warranted at the meeting. On balance, the economic outlook had changed little since the March meeting. Even though the recovery appeared to be continuing and was expected to strengthen gradually over time, most members projected that economic slack would continue to be elevated for some time, with inflation remaining below rates that would be consistent in the longer run with the Federal Reserve's dual objectives of maximum employment and price stability. In addition, nearly all members judged that it was appropriate to reiterate the expectation that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for an extended period. In light of the improved functioning of financial markets, Committee members again agreed that it would be appropriate for the statement to indicate that the previously announced schedule for closing the TALF was being maintained.
On May 9, 2010, the Committee met by conference call to discuss developments in global financial markets and possible policy responses. Over the previous several months, financial market concerns about the ability of Greece and some other euro-area countries to contain their sizable budget deficits and finance their debt had increased. Conditions in short-term funding markets in Europe had deteriorated, and global financial markets more generally had been volatile and less supportive of economic growth.
In connection with the possible implementation by the European authorities of a number of measures to promote fiscal sustainability and support financial market functioning, some major central banks had requested that dollar liquidity swap lines with the Federal Reserve be reestablished. The Committee agreed that such arrangements could be helpful in limiting the strains in dollar funding markets and the adverse implications of recent developments for the U.S. economy. In order to promote the transparency of these arrangements, participants also agreed that it would be appropriate for the Federal Reserve to publish the swap contracts and to release on a weekly basis the amounts of draws under the swap lines by central bank counterparty. It was recognized that the Committee would need to consider the implications of swap lines for bank reserves and overall management of the Federal Reserve's balance sheet. Participants noted the importance of appropriate consultation with U.S. government officials and emphasized that a reestablishment of the lines should be contingent on strong and effective actions by authorities in Europe to address fiscal sustainability and support financial markets.
At the conclusion of its discussion, the Committee voted unanimously to authorize the Chairman to agree to reestablish swap lines with the European Central Bank (ECB), the Bank of England, the Swiss National Bank, the Bank of Japan, and the Bank of Canada. The arrangements with the Bank of England, the ECB, the Swiss National Bank, and the Bank of Japan would provide those central banks with the capacity to conduct tenders of U.S. dollars in their local markets at fixed rates for full allotment, similar to arrangements that had been in place previously. The arrangement with the Bank of Canada would support draws of up to $30 billion, as was the case previously. The swap arrangements were authorized through January 2011.
The information reviewed at the June 22–23 FOMC meeting suggested that the economic recovery was proceeding at a moderate pace in the second quarter. Businesses continued to increase employment and lengthen workweeks in April and May, but the unemployment rate remained elevated. Industrial production registered strong and widespread gains, and business investment in equipment and software rose rapidly. Consumer spending appeared to have moved up further in April and May. However, housing starts dropped in May, and nonresidential construction remained depressed. Falling energy prices held down headline consumer prices in April and May, while core consumer prices edged up.
Financial markets had become somewhat less supportive of economic growth since the April meeting, with developments in Europe a leading cause of greater global financial market tensions. Risk spreads for many corporate borrowers had widened noticeably, equity prices had fallen appreciably, and the dollar had risen in value against a broad basket of other currencies. Participants saw these changes as likely to weigh to some degree on household and business spending over coming quarters.
The Committee agreed to make no change in its target range for the federal funds rate at the meeting. Although the economic outlook had softened somewhat, and a number of meeting participants saw the risks to the outlook as having shifted to the downside, all saw the economic expansion as likely to be strong enough to continue raising resource utilization, albeit more slowly than they had previously anticipated. In addition, they saw inflation as likely to stabilize near recent low readings in coming quarters and then gradually rise toward more desirable levels. Nearly all members again judged that it was appropriate to indicate in the statement released following the meeting that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for an extended period. Participants noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the economic outlook were to worsen appreciably.
Tools for the Withdrawal of Monetary Policy Accommodation
Although the FOMC continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period, ultimately the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflation pressures as the economy recovers. That tightening will be accomplished partly through changes that will affect the composition and size of the Federal Reserve's balance sheet.
The Federal Reserve has developed a number of tools that will facilitate the removal of policy accommodation and reduce the quantity of reserves held by the banking system at the appropriate time. These tools encompass (1) raising the interest rate paid on excess reserve balances (the IOER rate), (2) executing term reverse repurchase agreements (RRPs) with the primary dealers and other counterparties, (3) issuing term deposits to depository institutions through the Term Deposit Facility (TDF), (4) redeeming maturing and prepaid securities held by the Federal Reserve without reinvesting the proceeds, and (5) selling securities held by the Federal Reserve. All but the first of these tools would shrink the supply of reserve balances; the last two would also reduce the size of the Federal Reserve's balance sheet.
Interest on Excess Reserves Rate
In their discussion of the IOER rate at the January meeting, all participants agreed that raising that rate and the target for the federal funds rate would be a key element of a move to less-accommodative monetary policy. Most participants thought that it likely would be appropriate to reduce the supply of reserve balances, to some extent, before raising the IOER rate and the target for the federal funds rate, in part because reducing the supply of reserve balances would tighten the link between short-term market rates and the IOER rate. However, several participants noted that draining operations might be seen as a precursor to tightening and should be undertaken only when the Committee judged that an increase in its target for the federal funds rate would soon be appropriate. For the same reason, a few believed that it would be better to drain reserves concurrently with the eventual increase in the IOER and target rates.
With respect to longer-run approaches to implementing monetary policy, most policymakers saw benefits in continuing to use the federal funds rate as the operating target for implementing monetary policy, so long as other money market rates remained closely linked to the federal funds rate. Many thought that an approach in which the primary credit rate was set above the Committee's target for the federal funds rate and the IOER rate was set below that target--a corridor system--would be beneficial. Participants recognized, however, that the supply of reserve balances would need to be reduced considerably to lift the federal funds rate above the IOER rate. Participants noted that their judgments were tentative, that they would continue to discuss the ultimate operating regime, and that they might well gain useful information about longer-run approaches during the eventual withdrawal of policy accommodation.
Reverse Repurchase Agreements
At the January meeting, staff reported on successful tests of the Federal Reserve's ability to conduct term RRPs with primary dealers by arranging several small-scale transactions using Treasury securities and agency debt as collateral; staff anticipated that the Federal Reserve would be able to execute term RRPs against MBS later in the year and would have the capability to conduct RRPs with an expanded set of counterparties shortly thereafter. The staff updated the Committee on the status of work on RRPs at subsequent meetings.
Term Deposit Facility
In late December 2009, the Federal Register published a notice requesting the public's input on a proposal for a TDF. At the January FOMC meeting, Federal Reserve staff indicated that they would analyze comments from the public in the coming weeks and then prepare a final proposal for the Board's consideration. On April 30, the Federal Reserve Board announced that it had approved amendments to Regulation D (Reserve Requirements of Depository Institutions) authorizing the Reserve Banks to offer term deposits to institutions that are eligible to receive earnings on their balances at Reserve Banks. On May 10, the Federal Reserve Board authorized up to five small-value offerings of term deposits under the TDF, which were designed to ensure the effectiveness of TDF operations and to provide eligible institutions with an opportunity to gain familiarity with the procedures. The first of these offerings, for $1 billion in 14-day term deposits, was conducted on June 14. The auction had a stop-out rate of 27 basis points and a bid-to-cover ratio of slightly more than 6. The second offering, for $2 billion in 28-day deposits, was conducted on June 28. That auction had a stop-out rate of about 27 basis points and a bid-to-cover ratio of about 5-1/2. The third, for $2 billion in 84-day term deposits, was conducted on July 12. That auction had a stop-out rate of 31 basis points and a bid-to-cover ratio of about 3-3/4.
Asset Redemptions and Sales
Over the course of the FOMC meetings conducted in the first half of 2010, participants discussed the eventual size and composition of the Federal Reserve's balance sheet and longer-run strategies for asset redemptions and sales. Participants agreed that any longer-run strategy for asset sales and redemptions should be consistent with the achievement of the Committee's objectives of maximum employment and price stability. Policymakers were also unanimous in the view that it will be appropriate to shrink the supply of reserve balances and the size of the Federal Reserve's balance sheet substantially over time. Moreover, they agreed that it will eventually be appropriate for the System Open Market Account to return its domestic holdings to only securities issued by the U.S. Treasury, as was the case before the financial crisis. Meeting participants also agreed that sales of agency debt and agency MBS should be implemented in accordance with a framework communicated well in advance and be conducted at a gradual pace that potentially could be adjusted in response to developments in economic and financial conditions.
Most participants favored deferring asset sales for some time, and a majority preferred beginning asset sales after the first increase in the FOMC's target for short-term interest rates. Such an approach would postpone any asset sales until the economic recovery was well established and would maintain short-term interest rates as the Committee's key monetary policy tool. Participants agreed that the current policy of redeeming and not replacing agency debt and agency MBS as those securities mature or are prepaid helped make progress toward the Committee's goals regarding the size and composition of the Federal Reserve's balance sheet. Many policymakers saw benefits to eventually adopting an approach of reinvesting maturing Treasury securities in bills and shorter-term coupon issues to shift the maturity composition of the Federal Reserve's portfolio toward the structure that had prevailed prior to the financial crisis. Several meeting participants thought the Federal Reserve should eventually hold a portfolio composed largely of shorter-term Treasury securities.
Participants expressed a range of views about the appropriate timing and pace of asset sales and redemptions, and Committee members did not reach final decisions about those issues over the course of the meetings in the first half of 2010. Participants agreed that it would be important to maintain flexibility regarding these issues given the uncertainties associated with the unprecedented size and composition of the Federal Reserve's balance sheet and its effects on financial conditions. For the time being, meeting participants agreed that the Federal Reserve should continue the interim approach of allowing all maturing agency debt and all prepayments of agency MBS to be redeemed without replacement while rolling over all maturing Treasury securities. At the June meeting, participants recognized that in light of the increased downside risks to an already gradual recovery from a deep recession, the Committee also needed to review its options for providing additional monetary stimulus should doing so become necessary. Participants will continue to consider the Committee's portfolio management strategy at future meetings.