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Board of Governors of the Federal Reserve System
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Board of Governors of the Federal Reserve System

Part 1: Overview: Monetary Policy and the Economic Outlook

Monetary Policy Report submitted to the Congress on July 17, 2012, pursuant to section 2B of the Federal Reserve Act

The pace of economic recovery appears to have slowed during the first half of this year, with real gross domestic product (GDP) likely having risen at only a modest pace. In the labor market, the rate of job gains has diminished recently, and, following a period of improvement, the unemployment rate has been little changed at an elevated level since January. Meanwhile, consumer price inflation over the first five months of 2012 was lower, on net, than in 2011, and longer-term inflation expectations have remained stable. A number of factors will likely restrain economic growth in the period ahead, including weak economic growth abroad and a fiscal environment that looks set to become less accommodative. Uncertainty about these factors may also restrain household and business spending. In addition, credit conditions are likely to improve only gradually, as are still-elevated inventories of vacant and foreclosed homes. Moreover, the possibility of a further material deterioration of conditions in Europe, or of a particularly severe change in U.S. fiscal conditions, poses significant downside risks to the outlook.

Against this backdrop, the Federal Open Market Committee (FOMC) took steps to provide additional monetary policy accommodation during the first half of 2012. In particular, the Committee changed its forward guidance regarding the period over which it anticipates the federal funds rate to remain at exceptionally low levels and announced a continuation of its maturity extension program (MEP) through the end of the year. These policies put downward pressure on longer-term interest rates and made broad financial conditions more accommodative than they would otherwise be, thereby supporting the economic recovery.

The European fiscal and banking crisis has remained a major source of strain on global financial markets. Early in the year, financial stresses within the euro area moderated somewhat in light of a number of policy actions: The European Central Bank (ECB) provided ample liquidity to the region's banks, euro-area leaders agreed to increase the lending capacity of their rescue facilities, and a new assistance package for Greece was approved following a restructuring of Greek sovereign debt. However, tensions within the euro area increased again in the spring as political uncertainties rekindled fears of a disorderly Greek exit from the euro area and mounting losses at Spanish banks renewed questions about the sustainability of Spain's sovereign debt and the resiliency of the euro-area banking system. As yields on the government debt of Spain and other vulnerable European countries rose toward new highs, euro-area leaders responded with additional policy measures in late June, including increasing the flexibility of the region's financial backstops and making progress toward greater cooperation in the supervision and, as necessary, recapitalization of Europe's banks. Many critical details, however, remain to be worked out against a backdrop of continued economic weakness and political strain.

Financial markets were somewhat volatile over the first half of 2012 mostly due to fluctuating views regarding the crisis in the euro area and the likely pace of economic growth at home and abroad. As investors' concerns about the situation in Europe eased early in the year and with data releases generally coming in to the upside of market expectations, broad equity price indexes rose and risk spreads in several markets narrowed. Subsequently, however, market participants pulled back from riskier assets amid renewed concerns about the euro area and evidence of slowing global economic growth. Reflecting these developments but also owing to the lengthening of the forward rate guidance, continuation of the MEP, and increased expectations by market participants of additional balance sheet actions by the Federal Reserve, yields on longer-term Treasury securities and corporate debt as well as rates on residential mortgages declined, on net, and reached historically low levels at times during the first half of the year. On balance since the beginning of the year, broad equity prices rose as corporate earnings remained fairly resilient through the first quarter.

After rising at an annual rate of 2-1/2 percent in the second half of 2011, real GDP increased at a 2 percent pace in the first quarter of 2012, and available indicators point to a still smaller gain in the second quarter. Private spending continues to be weighed down by a range of factors, including uncertainty about developments in Europe and the path for U.S. fiscal policy, concerns about the strength and sustainability of the recovery, the still-anemic state of the housing market, and the difficulties that many would-be borrowers continue to have in obtaining credit. Such considerations have made some businesses more cautious about increasing investment or materially expanding their payrolls and have led households to remain quite pessimistic about their income and employment prospects. Smoothing through the effects of unseasonably warm weather this past winter, activity in the housing sector appears to have been a little stronger so far this year. However, the level of housing activity remains low and continues to be held down by tight mortgage credit. Meanwhile, the drag on real GDP growth from government purchases is likely to persist, as budgets for state and local governments remain strained and federal fiscal policy is likely to become more restrictive in 2013.

In the labor market, gains in private payroll employment averaged 225,000 jobs per month in the first quarter, up from 165,000 jobs per month in the second half of last year, but fell back in the second quarter to just 90,000 jobs per month. Although the slowing in the pace of net job creation may have been exaggerated by issues related to swings in the weather and to seasonal adjustment difficulties associated with the timing of the sharpest job losses during the recession, those factors do not appear to fully account for the slowdown. The unemployment rate declined from about 9 percent last summer to a still-elevated 8-1/4 percent in January, and it has remained close to that level since then. Likewise, long-term joblessness has shown little net improvement this year, with the share of those unemployed persons who have been jobless for six months or longer remaining around 40 percent. Further meaningful reductions in unemployment are likely to require some pickup in the pace of economic activity.

Consumer price inflation moved down, on net, during the first half of the year. The price index for overall personal consumption expenditures (PCE) rose rapidly in the first three months of the year, reflecting large increases in oil prices, but inflation turned down in the spring when oil prices more than reversed their earlier run-ups. In all, the PCE price index increased at an annual rate of about 1-1/2 percent over the first five months of the year, compared with a rise of 2-1/2 percent during 2011. Excluding food and energy, consumer prices rose at about a 2 percent rate over the first five months of the year, close to the pace recorded over 2011. In addition to the net decline in crude oil prices over the first half of the year, factors contributing to low consumer price inflation this year include the deceleration of non-oil import prices in the latter part of 2011, subdued labor costs associated with the weak labor market, and stable inflation expectations.

In the household sector, credit conditions have generally remained tight for all but highly rated borrowers; among other factors, this tightness reflects the uncertain economic outlook and the high unemployment rate. Total mortgage debt decreased further as the pace of mortgage applications to purchase a new home was sluggish. Refinancing activity increased over the course of the second quarter but remained below levels reached in previous refinancing booms despite historically low mortgage interest rates. The increase in refinancing was partially attributable to recent enhancements made to the Home Affordable Refinance Program that appeared to boost refinancing activity somewhat for borrowers with underwater mortgages--that is, for those who owed more on their mortgages than their homes were worth. Consumer credit expanded moderately mainly because of growth in federal student loans.

Firms in the nonfinancial corporate sector continued to raise funds at a generally moderate pace in the first half of the year. Those with access to capital markets took advantage of low interest rates to refinance existing debt. As a result, corporate debt issuance was solid over the first part of the year, although issuance of speculative-grade corporate bonds weakened notably in June as investors pulled back from riskier assets. Commercial and industrial loans on the books of banks expanded briskly, but borrowing conditions for small businesses have improved more slowly than have those for larger firms. Financing conditions for commercial real estate stayed relatively restrictive, and fundamentals in that sector showed few signs of improvement.

Market sentiment toward major global banks fluctuated in the first half of 2012. In March, the release of the results from the Comprehensive Capital Analysis and Review, which investors interpreted as indicating continued improvements in the health of domestic banks, provided a significant boost to the equity prices of U.S. financial institutions. Those gains partially reversed when market sentiment worsened in May, driven in large part by concerns about Europe and potential spillovers to the United States and its financial institutions. On balance, however, equity prices of banks rose significantly from relatively low levels at the start of the year. An index of credit default swap spreads for the large bank holding companies declined about 60 basis points, but those spreads remained at a high level. Despite the swings in market sentiment about global banking organizations, conditions in unsecured short-term dollar funding markets were fairly stable in the first half of 2012. European financial institutions have reduced their demand for dollar funding over recent quarters, and general funding pressures apparently were alleviated by the ECB's longer-term refinancing operations.

With the Committee anticipating only slow progress in bringing unemployment down toward levels that it judges to be consistent with its dual mandate and strains in global financial markets continuing to pose significant downside risks to the economic outlook, the FOMC took additional steps to augment the already highly accommodative stance for monetary policy during the first half of 2012. In January, the Committee modified its forward rate guidance, noting that economic conditions were likely to warrant exceptionally low levels for the federal funds rate at least through late 2014. And in June, the FOMC decided to continue the MEP until the end of the year rather than completing the program at the end of June as previously scheduled.

The June Summary of Economic Projections is presented in Part 4 of this report. At the time of the Committee's June meeting, FOMC participants (the 7 members of the Board of Governors and the presidents of the 12 Federal Reserve Banks) saw the economy expanding at a moderate pace over coming quarters and then picking up gradually under the assumption of appropriate monetary policy. Most participants marked down their projections for economic growth in 2012 and 2013 relative to what they anticipated in January and April largely as a result of the adverse developments in Europe and the associated effects on financial markets. Moreover, headwinds from the fiscal and financial situation in Europe, from the still-depressed housing market, and from tight credit for some borrowers were cited as likely to hold back the pace of economic expansion over the forecast period.

FOMC participants also projected slower progress in reducing unemployment than they had anticipated in January and April. Committee participants' projections for the unemployment rate had a central tendency of 8.0 to 8.2 percent in the fourth quarter of this year and then declined to 7.0 to 7.7 percent at the end of 2014; those levels are still generally well above participants' estimates of the longer-run normal rate of unemployment. Meanwhile, participants' projections for inflation had a central tendency of 1.2 to 1.7 percent for 2012 and 1.5 to 2.0 percent for both 2013 and 2014; these projections are lower, particularly in 2012, than participants reported in January and April, in part reflecting the effects of the recent drop in crude oil prices.

With the unemployment rate expected to remain elevated over the projection period and inflation generally expected to be at or under the Committee's 2 percent objective, most participants expected that, under their individual assessments of appropriate monetary policy, the federal funds rate would remain extraordinarily low for some time. In particular, 11 of the 19 participants placed the target federal funds rate at 0.75 percent or lower at the end of 2014; only 4 of them saw the appropriate rate at 2 percent or higher. All participants reported levels for the appropriate target federal funds rate at the end of 2014 that were well below their estimates of the level expected to prevail in the longer run. In addition to projecting only slow progress in bringing down unemployment, most participants saw the risks to the outlook as weighted mainly toward slower growth and higher unemployment. In particular, participants noted that strains in global financial markets, the prospect of reduced fiscal accommodation in the United States, and a general slowdown in global economic growth posed significant risks to the recovery and to a further improvement in labor market conditions.

Last update: July 17, 2012