Part 2: Monetary PolicyMonetary Policy Report submitted to the Congress on July 15, 2014, pursuant to section 2B of the Federal Reserve Act
To support further progress toward maximum employment and price stability, monetary policy has remained highly accommodative. The Federal Reserve kept the target federal funds rate at its effective lower bound, updated its forward guidance regarding the path of the federal funds rate, and added to its sizable holdings of longer-term securities, albeit at a reduced pace. The Federal Reserve has also continued to plan for the eventual normalization of monetary policy.
The Federal Open Market Committee continued to use large-scale asset purchases and forward rate guidance to support further progress toward maximum employment and price stability
The Committee has continued to judge that a highly accommodative stance of monetary policy remains warranted to support progress toward its dual mandate of maximum employment and price stability. With the target range for the federal funds rate remaining at its effective lower bound, the Federal Open Market Committee (FOMC) has made further use of nontraditional policy tools to provide appropriate monetary stimulus (figure 41). In particular, the FOMC has used large-scale asset purchases to put downward pressure on longer-term interest rates and to ease financial conditions more broadly so as to promote the more rapid achievement of its dual objectives. In addition, the FOMC has provided guidance about the likely future path of the federal funds rate in an effort to give greater clarity to the public about its policy outlook and intentions. In light of the cumulative progress toward its monetary policy objectives and the outlook for further progress over coming years, the Committee made adjustments during the first half of 2014 to both its asset purchase program and its forward guidance about the path of the federal funds rate.
The FOMC made further measured reductions in the pace of its asset purchases...
During the first half of 2014, the Committee made further measured reductions in the pace of its asset purchases, following the initial modest reduction announced at the December 2013 meeting.11 These actions reflected the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program in the fall of 2012 as well as the Committee's judgment that there was sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective.
Specifically, at its four meetings in the first half of 2014, the Committee reduced the monthly pace of its purchases of agency mortgage-backed securities (MBS) and of longer-term Treasury securities by $5 billion each. Accordingly, beginning in July, the Committee is adding to its holdings of agency MBS at a pace of $15 billion per month (compared with $35 billion per month at the beginning of the year) and is adding to its holdings of longer-term Treasury securities at a pace of $20 billion per month (compared with $40 billion per month at the beginning of the year). The FOMC also maintained its existing policy of reinvesting principal payments from its holdings of agency debt and agency MBS in agency MBS and of rolling over maturing Treasury securities at auction.
While making measured reductions in the pace of its purchases, the Committee noted that its sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help make broader financial conditions more accommodative. More accommodative financial conditions, in turn, should promote a stronger economic recovery, a further improvement in labor market conditions, and a return of inflation, over time, toward the Committee's 2 percent objective.
At each of its meetings so far this year, the FOMC reiterated that it would closely monitor incoming information on economic and financial developments, and that it would continue asset purchases and employ its other policy tools as appropriate until the outlook for the labor market had improved substantially in a context of price stability. The Committee also noted that if incoming information broadly supports its expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, it would likely reduce the pace of asset purchases in further measured steps at future meetings. However, the Committee also emphasized that asset purchases are not on a preset course, and that decisions about their pace would remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.
...updated its forward guidance with a qualitative description of the factors that will influence its decision to begin raising the federal funds rate...
As 2014 began, the Committee's forward guidance included quantitative thresholds, stating that the exceptionally low target range for the federal funds rate of 0 to 1/4 percent would be appropriate at least as long as the unemployment rate remained above 6-1/2 percent, inflation between one and two years ahead was projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continued to be well anchored.12 The Committee also indicated that in determining how long to maintain a highly accommodative stance of monetary policy, it would consider not only the unemployment rate but also other indicators, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. Based on its assessment of these factors, the Committee noted that it likely would be appropriate to maintain the current target range for the federal funds rate well past the time the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.
At the time of the March meeting, with the unemployment rate quickly approaching the threshold of 6-1/2 percent, the FOMC decided to update its forward guidance by providing a qualitative description of the factors that would influence its decision regarding the appropriate time of the first increase in the target federal funds rate from its current 0 to 1/4 percent target range.13 The Committee agreed that while reliance on a single indicator--the unemployment rate--had been useful for communications purposes when employment conditions were much further from mandate-consistent levels, with labor market conditions improving, the Committee would base its judgment concerning progress in the labor market on a much broader set of indicators from that point forward. Specifically, the Committee indicated that in determining how long to maintain the current target range, it would assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment would take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. Based on its assessment of these factors, the Committee indicated that it likely would be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continued to run below the Committee's 2 percent longer-run goal and provided that longer-term inflation expectations remained well anchored. To help forestall misinterpretation of the new forward guidance, the Committee noted that the change in its guidance did not indicate any change in its policy intentions as set forth in its recent statements.
...and added information regarding the likely behavior of the target federal funds rate after the rate is raised above its effective lower bound
The Committee also stated that, when it decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. In addition, the Committee indicated its anticipation that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Committee participants have noted that a prolonged period of low interest rates could lead investors to take on excessive risk, potentially posing risks to longer-term financial stability. The Federal Reserve will continue to monitor the financial system for any signs of the buildup of such risks and will take appropriate steps to address such risks as needed (see the box "Developments Related to Financial Stability" in Part 1).
The Committee's large-scale asset purchases led to a further increase in the size of the Federal Reserve's balance sheet
As a result of the FOMC's ongoing large-scale asset purchase program, Federal Reserve assets have increased further since the end of last year (figure 42). Holdings of U.S. Treasury securities in the System Open Market Account (SOMA) increased $200 billion to $2.4 trillion, and holdings of agency debt and MBS increased $160 billion, on net, to $1.7 trillion.14 On the liability side of the balance sheet, the increase in the Federal Reserve's assets was largely matched by increases in reserve balances, currency in circulation, deposits with Federal Reserve banks, and reverse repurchase agreements.
Given the Federal Reserve's large and growing balance sheet, interest income on the SOMA portfolio continued to support substantial remittances to the U.S. Treasury. Last year, remittances totaled $80 billion, and remittances over the first quarter of this year remained very high. Cumulative remittances to the Treasury from 2008 through the first quarter of 2014 exceeded $420 billion.15
The Federal Reserve continued to plan for the eventual normalization of monetary policy
At its April meeting, the FOMC discussed issues associated with the eventual normalization of the stance and conduct of monetary policy during a period when the Federal Reserve's balance sheet will be very large.16 The Committee's discussion of this topic was undertaken as part of prudent planning and did not imply that normalization will begin soon. The Committee discussed various tools that could be used to raise short-term interest rates--and to control the level of short-term interest rates once they are above the effective lower bound--even while the balance sheet of the Federal Reserve remains very large. Those tools included the rate of interest paid on excess reserve balances, fixed-rate overnight reverse repurchase agreement (ON RRP) operations, term reverse repurchase agreements, and the Term Deposit Facility (TDF). Participants considered how various combinations of tools could have different implications for the degree of control over short-term interest rates, the Federal Reserve's balance sheet and remittances to the Treasury, the functioning of the federal funds market, and financial stability in both normal times and periods of stress.
At the June FOMC meeting, participants continued their discussion of normalization issues and considered some possible strategies for implementing and communicating monetary policy during that process.17 Most participants agreed that adjustments in the rate of interest on excess reserves (IOER) should play a central role during the normalization process. It was generally agreed that an ON RRP facility with an interest rate set below the IOER rate could play a useful supporting role by helping to firm the floor under money market interest rates. A few participants commented that the Committee should also be prepared to use its other policy tools, including term deposits and term reverse repurchase agreements, if necessary. Most participants thought that the federal funds rate should continue to play a role in the Committee's operating framework and communications during normalization, with many of them indicating a preference for continuing to announce a target range. While generally agreeing that an ON RRP facility could play an important role in the policy normalization process, participants discussed several possible concerns about using such a facility, including the potential for substantial shifts in investments toward the facility and away from financial and nonfinancial firms in times of financial stress, the potential expansion of the Federal Reserve's role in financial intermediation, and the extent to which monetary policy operations might be conducted with nontraditional counterparties. Participants discussed design features that could help address these concerns. Several participants emphasized that, although the ON RRP rate would be useful in controlling short-term interest rates during normalization, they did not anticipate that such a facility would be a permanent part of the Committee's longer-run operating framework. Overall, participants generally expressed a preference for a simple and clear approach to normalization, and it was observed that it would be useful for the Committee to develop its plans and communicate them to the public later this year, well before the first steps in normalizing policy become appropriate, and to maintain flexibility about the evolution of the normalization process as well as the Committee's longer-run operating framework.
The Federal Reserve has continued to test the operational readiness of its policy tools, conducting daily ON RRP operations and several tests of the TDF during the first half of 2014. To date, testing has progressed smoothly, and, in recent months, short-term market rates have generally traded above the ON RRP rate. (For more discussion of the Federal Reserve's preparations for the eventual normalization of monetary policy, see the box "Planning for Monetary Policy Implementation during Normalization.")
Planning for Monetary Policy Implementation during Normalization
As noted in recent communications by the Federal Open Market Committee (FOMC), if the economy continues to evolve as anticipated, the Federal Reserve's asset purchase program will likely be concluded following the October meeting. At that time, the size of the Federal Reserve's balance sheet will stand at about $4.5 trillion, and reserve balances in the banking system will be close to $3 trillion, an extraordinarily elevated level relative to the average level of reserve balances prior to the onset of the financial crisis--about $25 billion. As a result, when the FOMC eventually chooses to begin removing policy accommodation, it will do so with a level of reserves in the banking system far in excess of that during any prior period of policy tightening.
In the past, the Federal Reserve tightened policy by draining small amounts of reserve balances through open market operations. The resulting scarcity of reserves in the banking system effectively raised the value to banks of their holdings of reserve balances as a means of satisfying reserve requirements and meeting clearing needs. The higher value of reserve balances then led banks to bid up the rate in the federal funds market and other short-term funding markets as they bolstered their reserve positions.
This traditional, quantity-based mechanism for tightening policy will not be feasible during the normalization period given the very elevated level of reserves in the banking system. Nonetheless, the Federal Reserve is confident that it has the tools necessary to tighten policy at the appropriate time. The basic tools at the Federal Reserve's disposal during the period of policy normalization include adjustments to the interest on excess reserves (IOER) rate; overnight reverse repurchase agreement (ON RRP) operations; and term operations, including the offer of term deposits issued through the Term Deposit Facility (TDF) and term reverse repurchase agreements (term RRPs).
Alternative Policy Tools
As discussed in the minutes of recent FOMC meetings, adjustments to the IOER rate will be a particularly important tool during the normalization period. Banks should be unwilling to lend to any private counterparty at a rate lower than the rate they can earn on balances maintained at the Federal Reserve. As a result, an increase in the IOER rate will put upward pressure on a range of short-term interest rates. In effect, raising the IOER rate allows the Federal Reserve to increase the value that banks place on reserve balances, which will have market effects similar to those associated with a reduction in the quantity of reserves in the traditional, quantity-based mechanism for tightening the stance of monetary policy.
As a complement to the IOER rate, the Federal Reserve could also employ ON RRP operations to put additional upward pressure on short-term interest rates. In an ON RRP operation, eligible Federal Reserve counterparties, importantly including many nonbank financial institutions, may invest funds with the Federal Reserve overnight at a given rate. Consequently, these institutions should be unwilling to lend to private counterparties in money markets at a rate below that available to them on ON RRP transactions with the Federal Reserve. As a result, ON RRP operations should complement the IOER rate in helping to establish a floor on money market interest rates. Finally, the Federal Reserve could also employ term operations--term deposits issued through the TDF and term RRPs--to help drain reserves in the banking system and put further upward pressure on short-term interest rates.
As noted in the minutes of the April and June FOMC meetings, policymakers have considered a number of possible ways that these tools could be employed in combination during the normalization period.1 These discussions have considered a range of issues, such as the extent of control over short-term interest rates, potential effects on trading in the federal funds market, financial stability considerations, costs to the Federal Reserve, and potential changes in patterns of financial intermediation. The Committee expects to provide the public with more information about its normalization plans later this year.
Ongoing Testing of the Alternative Policy Tools
At the same time, as part of prudent planning, the Federal Reserve has continued to test the operational readiness of its policy tools. The testing of these normalization tools has been ongoing for some time and has evolved in terms of the offering formats, tenors and rates offered, maximum awards or allotment amounts, and eligible counterparties.2
Since September 2013, the Open Market Desk has been conducting daily fixed-rate, capped-allotment ON RRP operations as authorized by the FOMC. In general, daily take-up of ON RRPs has ranged between about $50 billion and about $340 billion since early this year, with the variation in usage primarily reflecting three factors: (1) changes in the daily counterparty allotment limit; (2) changes in the spread between market repurchase agreement rates and the rate offered in the Federal Reserve's ON RRP operations; and (3) calendar effects, including those related to month- and quarter-ends (figure A). Since the introduction of the exercise, the daily counterparty allotment limit has been gradually raised from $0.5 billion to $10 billion, the fixed rate offered on ON RRP operations has been changed within the authorized limits and currently stands at 5 basis points, and the collateral accepted in the operations has been limited to U.S. Treasury securities. Money market funds have accounted for most of the daily participants and most of the daily volume of take-up. All operations to date have proceeded smoothly. The availability of the ON RRP operations reportedly has helped establish a floor on overnight interest rates.3
The Federal Reserve's testing of the TDF has been ongoing since June 2010 and evolved in the first half of this year. The incremental changes to the terms and format of the facility this year were aimed at improving the participation of depository institutions as well as operational readiness.4 Most recently, the Federal Reserve conducted a series of eight TDF test operations, during which the maximum award amount per institution and the interest rate paid at the facility were raised gradually. As a result, the level of activity in these operations increased considerably relative to such levels in test operations conducted over recent years (figure B).
1. See Board of Governors of the Federal Reserve System (2014), "Minutes of the Federal Open Market Committee, April 29-30, 2014," press release, May 21, www.federalreserve.gov/newsevents/press/monetary/20140521a.htm; and Board of Governors of the Federal Reserve System (2014), "Minutes of the Federal Open Market Committee, June 17-18, 2014," press release, July 9, www.federalreserve.gov/newsevents/press/monetary/20140709a.htm. Return to text
2. The types of counterparties that are currently eligible to participate in the Federal Reserve's ON RRP operations include depository institutions, money market funds, government-sponsored enterprises, and primary dealers, while only depository institutions may participate in TDF operations. Results of ON RRP operations can be found on the Federal Reserve Bank of New York's website at www.newyorkfed.org/markets/omo/dmm/temp.cfm , and results of the TDF operations can be found on the Federal Reserve Board's website at www.federalreserve.gov/monetarypolicy/tdf.htm. Return to text
3. Between December 2009 and April 2013, the Open Market Desk also conducted a series of small-scale term RRP test operations. Those testing operations used a multiprice auction format and a term of two to six days; accepted collateral included U.S. Treasury securities, direct agency debt, and agency mortgage-backed securities. The number of eligible counterparties was extended over this period. The amount awarded in these test operations peaked at about $3.3billion. Return to text
4. Authority to operate the TDF comes from section 19(b)(12) of the Federal Reserve Act, which allows eligible institutions to receive earnings on balances maintained at Federal Reserve Banks and authorizes the Board of Governors to prescribe regulations concerning the payment of such earnings. Within this authority, the Board created the TDF and has adjusted the parameters of the facility from time to time. Return to text
11. See Board of Governors of the Federal Reserve System (2013), "Federal Reserve Issues FOMC Statement," press release, December 18, www.federalreserve.gov/newsevents/press/monetary/20131218a.htm. Return to text
12. See Board of Governors of the Federal Reserve System (2014), "Federal Reserve Issues FOMC Statement," press release, January 29, www.federalreserve.gov/newsevents/press/monetary/20140129a.htm. Return to text
13. See Board of Governors of the Federal Reserve System (2014), "Federal Reserve Issues FOMC Statement," press release, March 19, www.federalreserve.gov/newsevents/press/monetary/20140319a.htm. Return to text
14. The changes in the par value of SOMA holdings, noted earlier, can differ from the amount of securities purchased over the same period, largely because of lags in the settlement of the purchases. Among other assets, the outstanding amount of dollars provided through the temporary U.S. dollar liquidity swap arrangements with foreign central banks edged lower since the end of last year and remains close to zero, reflecting the continued stability in offshore U.S. dollar funding markets. Return to text
15. See Board of Governors of the Federal Reserve System (2014), Quarterly Report on Federal Reserve Balance Sheet Developments (Washington: Board of Governors, May), www.federalreserve.gov/monetarypolicy/files/quarterly_balance_sheet_developments_report_201405.pdf. Return to text
16. See Board of Governors of the Federal Reserve System (2014), "Minutes of the Federal Open Market Committee, April 29-30, 2014," press release, May 21, www.federalreserve.gov/newsevents/press/monetary/20140521a.htm. Return to text
17. See Board of Governors of the Federal Reserve System (2014), "Minutes of the Federal Open Market Committee, June 17-18, 2014," press release, July 9, www.federalreserve.gov/newsevents/press/monetary/20140709a.htm. Return to text