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Board of Governors of the Federal Reserve System

Part 1: Recent Economic and Financial Developments

Monetary Policy Report submitted to the Congress on June 21, 2016, pursuant to section 2B of the Federal Reserve Act

Labor market conditions have improved this year, though recent data suggest there has been a loss of momentum. Payroll gains averaged about 200,000 per month in the first quarter but then only 80,000 per month in April and May. The unemployment rate has edged down to 4-3/4 percent, a level that is near the midpoint of the Federal Open Market Committee (FOMC) participants' estimates of its longer-run rate. That said, a few indicators suggest that some slack in the labor market remains. Despite persistently weak productivity growth, measures of labor compensation show some tentative signs of acceleration. Overall consumer price inflation has continued to be held down by lower prices for energy and imports, but both overall inflation and inflation excluding food and energy items, a useful gauge of where overall inflation will be in the future, have picked up a bit over the past year. Some survey-based measures of longer-run inflation expectations have moved down; market-based measures of inflation compensation have declined noticeably since last summer.

Real gross domestic product (GDP) is estimated to have increased at a sluggish rate in the first quarter, but more recent data point to a noticeable step-up in the pace of growth in the second quarter. Consumer spending appears to be expanding at a moderate pace so far this year, while the housing market continues its gradual recovery, and fiscal policy at all levels of government is now modestly boosting economic activity after exerting a considerable drag in recent years. An area of concern, however, is the softening in business fixed investment in recent quarters, even beyond those sectors most directly affected by the plunge in energy prices. In addition, weak exports are providing little boost to overall output growth. Heightened global financial market volatility early this year damped confidence both domestically and abroad, but financial conditions have generally eased somewhat in recent months; in the United States, credit conditions for both households and businesses have remained generally accommodative.

Domestic Developments

Early this year, the labor market continued to improve...

The labor market continued to improve in the first few months of this year. Payrolls expanded at an average rate of around 200,000 per month from January through March, modestly below the average of 230,000 jobs per month last year but still well above the number needed to absorb the trend number of new entrants into the workforce (figure 1). The unemployment rate held at about 5 percent, where it had been since the fall, but both labor force participation and the employment-to-population ratio rose noticeably (figure 2). The rise in the labor force participation rate was encouraging because it seemed to suggest that labor supply was responding significantly to the strengthening labor market.

...but recently there may have been a loss of momentum...

The data for April and May, however, suggest that the pace of labor market improvement has slowed. Payroll growth is reported to have averaged a pace of only 80,000 per month (about 100,000 after adjustment for the effects of a strike).1 And although the unemployment rate fell to 4.7 percent in May, that decline occurred as both labor force participation and the employment-to-population ratio fell back somewhat from their levels in March. On net, the participation rate in May was little changed from a year earlier (a position that should nonetheless be viewed as a strengthening relative to a trend that is probably declining because of demographic changes, especially the aging of the baby-boom generation).

Despite these disappointing data, other labor market indicators are consistent with a job market that has continued to strengthen. In particular, initial claims for unemployment insurance, now available through early June, remain very low--and therefore at odds with the weaker tenor of the recent payroll figures. In addition, according to the Job Openings and Labor Turnover Survey, the rate of job openings as a share of private employment remains at a very high level; the quits rate has continued to trend up and is now fairly high, the latter measure indicating that workers feel increasingly confident about their employment opportunities.

...and a few signs of labor underutilization remain

Although the May level of the unemployment rate is near the midpoint of the FOMC participants' estimates of its longer-run rate, a few indicators suggest that some slack in labor resource utilization remains. Most notably, the share of workers who are employed part time but would like to work full time is still elevated; accordingly, the more comprehensive U-6 measure of labor underutilization, which includes these underemployed individuals, has remained well above its pre-recession level (figure 3). Meanwhile, jobless rates for African Americans and Hispanics are high relative to the aggregate, though these rates have also improved during the economic recovery (figure 4). (For additional discussion, see the box "Have the Gains of the Economic Expansion Been Widely Shared?")

Have the Gains of the Economic Expansion Been Widely Shared?

The financial crisis resulted in massive job losses and falling income for American households. However, not all households suffered to the same extent during the downturn, nor have they benefited to the same extent during the subsequent recovery. This discussion reviews the labor market situation and household incomes for Americans of different races and ethnicities during the Great Recession and the ensuing economic expansion.1

A figure in the main text shows that unemployment rates for blacks and Hispanics rose more during the recession, and have declined more during the expansion, than for the nation as a whole (text figure 4).2 Rates for these groups remain higher than for whites; the differentials among these rates are now roughly the same as prior to the recession. A similar result is true for employment-to-population ratios of prime-age individuals (ages 25 to 54).3 Prime-age employment rates are lower for blacks and fell more sharply during the financial crisis, dropping nearly 8 percentage points between mid-2008 and the end of 2011, compared with declines of between 4 and 5 percentage points for whites, Asians, and Hispanics (Figure A). Since 2011, however, blacks have experienced the largest rebound in employment. Thus far in 2016, blacks continue to have the lowest prime-age employment rates among these four groups, and the racial differences in employment-to-population ratios are very similar to pre-recession levels.

Among the working population, blacks and Hispanics suffered the greatest losses in full-time employment share during the recession, and, even as overall employment has recovered, the full-time share remains significantly depressed for these workers (figure B). By early 2016, white and Asian prime-age workers had nearly returned to their pre-recession rates of full-time work, but the share of full-time employment among black and Hispanic workers remains several percentage points lower than their previous high levels. Prior to the Great Recession, black workers were the most likely to report usually working 35 hours per week or more, closely followed by Hispanics. By 2016, Hispanic workers had slightly lower rates of full-time employment than whites, and the full-time share of black workers was slightly lower than that of Asians.

In the period of sustained high unemployment following the financial crisis, household incomes for all groups of Americans fell sharply and did not begin to recover until 2012. The decline in median household income was particularly large for black households--16 percent, compared with approximately 8 percent for white, Hispanic, and Asian households (figure C).4

By 2014 (latest data available), median household incomes of Asian, white, and Hispanic households had improved and were at least 94 percent of pre-recession levels, but median income for black households remained only 88 percent of the 2007 level. Racial and ethnic differences in income were sizable before the financial crisis and have only grown larger since then, with the median black household income at $40,000 in 2014, compared with $67,000 for white and $85,000 for Asian households (figure D).

Losses in wage income account for the bulk of the decline in income for households during the downturn. Between 2007 and 2011, mean wage income for households in the middle quintile of the income distribution fell just over $5,000 for white households, $4,000 for Hispanic households, $8,000 for black households, and $7,000 for Asian households (figure E).5 Wages and salaries are the single largest source of income and have provided most of the increase in total income since 2011. Mean wage income for 2014 had returned to pre-recession levels for Asian households and had made up some of the lost ground among white and Hispanic households. Wage income for black households, however, remained substantially below levels experienced prior to the financial crisis.

Transfer income rose substantially during the recession because of federal economic stimulus programs and automatic stabilizers, but the increases only offset a modest portion of the overall decline in income.6 Transfer income has receded very slowly since 2011, with mean transfers in 2014 remaining above pre-recession levels for all racial and ethnic groups.


1. The employment-to-population ratio and full-time share of employed individuals are calculated using data from the monthly Current Population Survey (CPS). Median household income and the income composition are calculated using data from the March CPS Annual Social and Economic Supplement (ASEC). Monthly data are available through April 2016, while the most recent ASEC data (March 2015 CPS) are for 2014. Return to text

2. The Hispanic ethnicity and race categories are not mutually exclusive. Some individuals are, for example, both Hispanic and white, and they are represented in both lines in the figures in the box. Return to text

3. The unemployment rate shows the number of unemployed individuals actively looking for work as a share of the total labor force. The employment-to-population ratio ignores the distinction between those actively seeking work or not and simply measures the number of employed individuals as a share of the total population. We use the prime-age population because we want to focus on the labor market recovery and do not want income to include Social Security and other sources of retirement income that are largely independent of economic conditions. Return to text

4. Percentages are based on an analysis of income data from the March CPS ASEC. Household race was determined by answers to the Hispanic ethnicity question and the first racial category selected by household heads between the ages of 25 and 54. Income of all household members is included. Any household head identifying as Hispanic is coded as Hispanic, regardless of race. Incomes for a very small group of households (less than 2 percent in 2014) that are identified as some other race group are not shown here, as the estimates are somewhat volatile and not very precise. Return to text

5. To show changes in the composition of income for "typical" households, we switch here to using mean income of households in the middle quintile of the distribution. Return to text

6. Transfer income includes Social Security income, welfare, Supplemental Security Income, unemployment benefits, and educational assistance. Other income includes business income; farm income; income from interest, dividends, rent, alimony, and contributions; retirement income; trusts; workers' compensation; veterans', survivors', and disability benefits; educational assistance from nongovernment sources; assistance from friends and family; and other sources. Return to text

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Compensation growth has shown tentative signs of a pickup...

By most measures, the growth of labor compensation has remained modest, though recently there have been some signs of faster increases. The employment cost index (ECI) for private-industry workers, which includes the cost of employer-provided benefits as well as wages, registered a rise of only 1-3/4 percent over the 12 months ending in March (figure 5). However, two other prominent measures of labor compensation--average hourly earnings for all private-sector employees and business-sector compensation per hour--recorded larger increases than the ECI over the past year, and the increases in both series were above their corresponding averages over the preceding several years. In addition, according to the Federal Reserve Bank of Atlanta's Wage Growth Tracker, the median of 12-month changes in individuals' hourly wages (from the monthly survey of households) has been gradually trending higher, reaching 3-1/2 percent in May.

...amid persistently weak productivity growth

The relatively slow gains in labor compensation in recent years have occurred against a backdrop of persistently weak productivity growth. Since 2008, labor productivity gains have averaged around 1 percent per year, far below the pace that prevailed before the recession (figure 6). Indeed, in the past five years, productivity growth has averaged only 1/2 percent per year. The relatively slow pace of productivity growth is at least in part a consequence of the sustained weakness in capital investment over the recession and early recovery period. Productivity gains may improve in the future as investment in productivity-enhancing capital equipment and in research and development strengthens.

Falling energy prices have held down consumer price inflation

Overall consumer price inflation has moved up from the lows recorded last year, but it remains well below the FOMC's longer-run objective of 2 percent. In April, the 12-month change in the price index for personal consumption expenditures (PCE) was around 1 percent, higher than the 1/4 percent rate recorded in April 2015 (figure 7). The pickup over this period was largely due to a slower rate of decline in both energy prices and non-energy import prices.

Low oil prices have reduced global investment in the oil sector and have led to some cutbacks in production, particularly in the United States. These declines, firming global demand, and some temporary supply disruptions--including in Canada due to wildfires--have recently pushed crude oil prices higher after they reached a 12-year low in mid-January (figure 8). Nonetheless, at a bit below $50 per barrel, the spot price of Brent crude oil remains less than half its mid-2014 peak. Moreover, the continued low level of oil futures prices suggests that market participants expect only a modest increase in oil prices over the next couple of years, given the historically high global inventories of crude oil. The large cumulative drop in crude oil prices had mostly passed through to lower retail prices for gasoline and other energy products by early this year; despite some increases thereafter, prices at the pump remain at levels substantially below those of last summer.

Similar to the price of crude oil, prices of metals and agricultural goods have moved higher since early this year. The rise in the prices of agricultural goods followed several quarters of declines that have held down retail food prices for consumers so far this year. The rise in many nonfuel commodities prices, together with a weaker dollar, helped push non-oil import prices higher in May--the first increase since 2014 (figure 9).

Outside of the energy and food categories, inflation has picked up a little bit

Inflation for items other than food and energy (so-called core inflation) has picked up a little. Core PCE prices rose about 1-1/2 percent over the 12 months ending in April, up about 1/4 percentage point from its year-earlier pace.2 The increase in the trimmed mean PCE price index, an alternative indicator of underlying inflation, has also picked up a bit over the past year; as is typically the case, this measure has run somewhat above core inflation over this period. Because the slack in labor and product markets appears to have been mostly taken up, and given the recent upward movements in oil prices and non-oil import prices--after months of declines--the downward pressure on inflation from these factors is likely waning.

Some survey-based measures of expected inflation have drifted downward...

The FOMC devotes careful attention to indicators of long-run inflation expectations, as these expectations are believed to be an important factor underlying many wage- and price-setting decisions. The latest readings from surveys of longer-term inflation expectations have sent mixed signals (figure 10). In the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, the median second-quarter reading on expected annual PCE price inflation over the next 10 years was again 2 percent. The distribution of inflation expectations 5 to 10 years ahead derived from surveys of primary dealers has remained similarly stable. But in the University of Michigan Surveys of Consumers, the median reading on inflation expectations over the next 5 to 10 years has drifted down over the past two years and recorded a new low in early June. To the extent that this downward drift is a reaction to energy-driven declines in overall inflation, it could reverse over time as energy prices stop declining.

...and market-based measures of inflation compensation have remained low

Market-based measures of longer-term inflation compensation--derived either from differences between yields on nominal Treasury securities and Treasury Inflation-Protected Securities or from inflation swaps--have continued to decline and now stand at very low levels (figure 11). Deducing the sources of changes in inflation compensation is challenging because such movements reflect not only expected inflation, but also an inflation risk premium--the compensation that holders of nominal securities demand for bearing inflation risk--and other factors. Nevertheless, one cannot rule out a decline in inflation expectations among market participants since last summer.

Economic activity has been expanding at a moderate pace

Real GDP is currently reported to have increased at an annual rate of just 3/4 percent in the first quarter, but with several signs of faster growth in the current quarter, real GDP appears on track to record a moderate overall gain in the first half of this year (figure 12).3 Consumer spending is advancing further, and housing activity continues to strengthen gradually. Meanwhile, government expenditures have maintained momentum. Although inventory investment exerted a sizable drag on GDP growth in the latter half of last year, it has been less of an influence in the first half of this year.

Nevertheless, several of the headwinds that were apparent last year have continued to restrain growth in activity this year. In particular, a substantial appreciation of the dollar over the past couple of years, along with continued sluggish foreign growth, is weighing on the demand for U.S. exports. In addition, the sizable drop in oil prices since 2014--notwithstanding the substantial benefit to households--has led to marked cutbacks in production and investment in the energy sector of our economy. These negative factors have had particularly pronounced effects on activity in the industrial sector.

Gains in income and wealth continue to support consumer spending

Consumption growth was lackluster early in 2016, but data on retail sales and motor vehicle sales suggest that spending has picked up appreciably so far this quarter. Smoothing through the monthly fluctuations, consumer spending is reported to have increased at an annual rate of nearly 3 percent over the first four months of this year, only a little slower than the pace in 2015 (figure 13). The improvement in the labor market has continued to support income growth, and low energy prices are boosting households' purchasing power. As a result, real disposable personal income--that is, income after taxes and adjusted for inflation--was reported to have advanced at an annual rate of about 3-1/4 percent over the first four months of this year, just a touch below the pace in 2015.

Ongoing gains in household net worth likely have also supported growth in consumer spending. House prices, which are of particular importance for the balance sheet positions of a broad set of households, have continued to move higher, with the CoreLogic national index showing a rise of about 6 percent over the 12 months ending in April (figure 14). Elsewhere, although equity prices have only increased slightly, on net, so far this year, the prior gains of the past few years have helped improve households' financial positions. In the first quarter of this year, the ratio of aggregate household net worth to disposable income, which had previously returned to its pre-recession highs, ticked down slightly but remained far above its long-run historical average (figure 15).

Consumers are upbeat about their economic prospects...

The solid pace of income growth over the past year has helped households retain fairly upbeat perceptions about their economic prospects. The Michigan survey's composite index of consumer sentiment--which incorporates households' views about their own financial situations as well as economic conditions more broadly--has improved again recently following a moderate deterioration earlier in the year, and the latest readings were near the upper end of the range of values recorded during the previous economic expansion (figure 16). After having lagged behind improvements in headline sentiment earlier in the recovery, the survey measures of households' expectations for real income changes over the next year or two have also improved noticeably and now stand close to their pre-recession levels.

...and household credit availability is generally favorable

Consumer credit has continued to expand this year amid stable credit performance (figure 17). Auto and student loans remain widely available, even to borrowers with lower credit scores, and outstanding balances of these types of loans expanded at a robust pace. Credit card borrowing has also accelerated a bit, on balance, and the outstanding balance in April was 5-1/2 percent above its level a year earlier. Although there have been some tentative signs of easing overall, credit card standards have remained tight for nonprime borrowers.

Low interest rates and rising incomes have enabled many households to lower their debt payment burdens. The household debt service ratio--that is, the ratio of required principal and interest payments on outstanding household debt to disposable personal income--has remained at a very low level by historical standards (figure 18). Interest rates on 30-year fixed-rate mortgages are down about 1/2 percentage point from the level at the December liftoff date, and rates on auto loans, on net, have been little changed since then. Going forward, the effect of any policy rate tightening on mortgage rates and, in turn, on households' debt burdens will likely show through only gradually, as the current stock of household debt is disproportionately held in loan products with fixed interest rates.

Residential construction activity has improved at a gradual pace

The recovery in residential construction activity has maintained a moderate pace. Single-family starts continued to edge up slowly over the past year, while multifamily starts receded a little from their elevated levels in the middle of 2015 (figures 19). Looking further back, the rise in multifamily starts over the past five years has been substantial and has far exceeded the percent gain in single-family housing starts. The relative strength in multifamily construction partly reflects a shift in demand away from owner-occupied housing toward rental housing since the recession. Elsewhere, outlays for improvements to existing homes increased more than 10 percent over the past year, and commissions and fees paid on the sale of residential real estate rose moderately, in line with the uptrend in sales of existing homes and contracts for new homes (figure 20). In all, residential investment rose almost 10 percent in 2015 and appears on track to maintain a similar pace in the first half of this year.

Low interest rates and an ongoing easing in mortgage credit standards have continued to support the expansions in housing demand and construction activity. In the April Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), banks reported having eased lending standards and experienced stronger demand for most types of residential real estate loans in the first quarter.4 Even so, for individuals with relatively low credit scores, mortgages remain difficult to obtain. With mortgage interest rates having again moved down close to their all-time lows, housing affordability has remained favorable despite the moderate growth in house prices over the past year (figure 21).

Business fixed investment has declined...

A worrisome development in recent quarters has been the weakening in business fixed investment (private nonresidential fixed investment). Over the past year, real outlays in the nonresidential structures category--which constitutes roughly one-fourth of total business fixed investment--have fallen sharply, as investment in oil wells and other drilling and mining structures has followed the steep drop in oil prices (figure 22). The decline in the number of drilling rigs in operation has been so pronounced that investment in drilling and mining structures has shrunk to less than one-third its peak in 2014, and the ongoing contraction has subtracted nearly 1/2 percentage point from real GDP growth over the past four quarters. Outside of the energy sector, business outlays for structures recorded relatively modest increases following the sizable gains observed in the first half of 2015. Meanwhile, business spending on equipment and intellectual property products moved down in the fourth quarter of last year and the first quarter of 2016, and the available indicators, such as orders and shipments of capital goods and surveys of business conditions, point to continued softness in the current quarter.

Although investment spending continues to be supported by low interest rates and generally accommodative financial conditions, spending is likely being restrained by a slowing in actual and expected business output growth. Weak foreign demand and the stronger dollar are already having an adverse effect on domestic businesses, and analysts' forecasts for year-ahead corporate earnings have been revised down considerably, even outside of the energy sector. Meanwhile, as reported by the Bureau of Economic Analysis, corporate profits recorded only a slight increase in the first quarter after falling sharply at the end of last year, although here, too, the weakness was heavily concentrated in the energy sector.

...while corporate financing conditions have remained generally accommodative

Corporate financing conditions remained generally accommodative in the first half of this year, although ongoing oil market developments and episodes of global financial stress led to sporadic periods of heightened perceptions of risk. In particular, corporate bond markets showed strains early in the year, especially for those firms most affected by the low energy prices. In recent months, however, pressures in bond markets have eased somewhat, and corporate bond yields overall have returned to historically low levels (figure 23). In the April SLOOS, banks indicated that they had tightened their standards on commercial and industrial (C&I) loans to large and middle-market firms in the first quarter, but even so, such financing remained broadly available. For the first quarter as a whole, corporate bond issuance and the growth of C&I loans on banks' balance sheets were quite strong (figure 24). Firms' equity issuance was also generally solid, though initial public offerings have been weak. Meanwhile, the growth of small business loans was subdued.

Financing conditions in the commercial real estate (CRE) sector have remained accommodative overall, but here, too, there have been some signs of tightening. Growth of CRE loans at banks remained strong during the first half of the year. However, banks indicated that they had further tightened their lending standards on CRE loans in the first quarter of 2016, according to the April SLOOS. In addition, spreads on interest rates for CRE loans relative to 10-year swap rates and to yields on commercial mortgage-backed securities rose sharply further early this year, and although they have retreated significantly since then, these measures remain well above their historical average levels.

Exports and imports have both been weak this year

Based on recently released trade prices and the nominal census trade data, it appears that real exports were roughly flat in the first quarter of 2016, held back by slow foreign growth and the considerable appreciation of the dollar over the past two years. Despite the appreciation of the dollar, real imports looked to have declined in the first quarter, with weakness in both capital- and consumer-goods categories. Overall, the net export contribution to GDP growth was about neutral. While the nominal trade deficit narrowed a little in the first quarter, the current account deficit widened a touch to 2.7 percent of nominal GDP (figure 25). The April trade data suggest that net exports will be a small drag on GDP growth in the current quarter, as the trade deficit increased, with imports rebounding from a very weak March level.

The drag from federal fiscal policy has ended...

Fiscal policy at the federal level had a roughly neutral influence on GDP growth in 2015, as the substantial contractionary effects of earlier fiscal consolidation have abated. Policy actions had little effect on taxes, while transfers and federal purchases of goods and services merely edged up (figure 26). Going forward, if the increased spending authority enacted in last year's budget agreement is fully utilized, federal fiscal policy would likely be mildly supportive of GDP growth over 2016 and 2017.

After narrowing significantly over the past several years, the federal unified budget deficit has recently widened slightly. At 18 percent of GDP, receipts have remained high relative to the recession and early recovery period (figure 27). At 21 percent, expenditures as a share of GDP are above the levels that prevailed before the start of the most recent recession. Although the ratio of federal debt held by the public to nominal GDP is already quite elevated, the deficit currently remains small enough to roughly stabilize this ratio at around 75 percent (figure 28).

...and state and local government expenditures are rising

The expansion of economic activity and further gains in house prices continue to support a gradual improvement in the fiscal position of most state and local governments. Consistent with their improving finances, states and localities significantly expanded real construction spending in 2015 and in the early part of this year. By contrast, employment growth in the state and local sector was muted last year, but the pace has stepped up somewhat so far in 2016 (figure 29).

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Financial Developments

Financial conditions tightened early in the year but then eased

Early in 2016, domestic financial conditions tightened, as uncertainty about the outlook for the Chinese economy, lower oil prices, and weak data on economic activity in several economies contributed to concerns about the prospects for global economic growth and to a pullback from risky assets. At that time, Treasury yields declined across maturities, equity prices fell steeply, equity price volatility rose, and risk spreads on corporate bonds widened notably. In addition, investors came to expect a more gradual increase in the target range for the federal funds rate than they had previously anticipated. However, investors' concerns appeared to diminish beginning in mid-February, and since then, amid mixed U.S. economic data, domestic financial conditions have generally eased on balance: Stock prices rose notably, equity price volatility declined, and credit spreads on corporate bonds narrowed. (For a discussion of financial stability developments over this same period, see the box "Developments Related to Financial Stability.")

Developments Related to Financial Stability

Financial vulnerabilities in the United States overall remain at a moderate level. This assessment is supported by the resilience demonstrated by domestic financial firms and markets during the period of heightened financial volatility near the start of the year. Capital and liquidity ratios at large banks have stayed at high levels relative to historical standards, and debt growth in the household sector has been modest. However, leverage of nonfinancial corporations continues to be elevated by historical standards, leaving lower-rated firms potentially vulnerable to adverse developments. Stresses on energy firms remain high given the low level of oil prices. Valuation pressures have increased somewhat in equity markets as expected profits have been marked down. Commercial real estate (CRE) prices are near or above their previous peaks. Even given moderate financial vulnerabilities, a number of possible external shocks, including if the United Kingdom chooses to leave the European Union in a pending referendum, could pose risks to financial stability.

Stronger capital positions at domestic banking organizations have substantially contributed to the improved resilience of the U.S. financial system (Figure A). The results of the stress tests mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the accompanying Comprehensive Capital Analysis and Review are scheduled to be released June 23 and June 29, 2016, respectively.1 In addition, large domestic banks have continued to hold high levels of liquid assets and have shifted the composition of their liabilities toward more-stable funding sources. However, measures of profitability, such as return on assets and return on equity, declined noticeably in the first quarter as many banking firms increased provisions for loan losses. The pickup in provisions to date primarily reflects rising delinquencies for loans to energy-related firms. Energy exposures for most banks appear manageable, but some small domestic banks still have significant exposure to the oil sector, and others could be affected by spillovers from the energy sector to other business lines. A few large domestic banks have material ties to global banks that appear to be more susceptible to low oil prices due to their significant exposures to oil-producing emerging market economies.

Capital positions also have remained relatively elevated at insurance companies and broker-dealers. In addition, net secured borrowing by dealers--primarily used to finance their own portfolios of securities--has stayed near its lowest levels since 2001. Margin credit extended by dealers--which funds clients' positions in traded stocks--has fluctuated within the upper part of its historical range, but margin calls reportedly were met without disruption or a marked increase in disputes during the heightened market volatility at the start of the year.

The stock of private, short-term, money-like instruments, which form funding intermediation chains that are vulnerable to runs, has continued to trend down relative to gross domestic product (GDP) and total nonfinancial debt, suggesting vulnerabilities from maturity transformation have continued to fall. Assets in money market mutual funds (MMFs) have been relatively stable this year, though assets in institutional prime MMFs have been declining, primarily because Securities and Exchange Commission (SEC) reforms aimed at mitigating the funds' susceptibility to investor runs have induced conversions of prime funds into government-only funds. Nevertheless, some structural vulnerabilities are expected to persist in MMFs even after SEC reforms go fully into effect in October 2016. For open-end mutual funds, the Financial Stability Oversight Council highlighted potential risks to financial stability from liquidity transformation through funds that hold less liquid assets and could face elevated redemptions, and the council suggested possible actions to mitigate those risks.

Valuation pressures have generally stayed at a moderate level since January, though they rose for a few asset classes. Forward price-to-earnings ratios for equities have increased to a level well above their median of the past three decades. Although equity valuations do not appear to be rich relative to Treasury yields, equity prices are vulnerable to rises in term premiums to more normal levels, especially if a reversion was not motivated by positive news about economic growth. In contrast, valuation pressures in corporate bond markets--which manifest in low yields and credit spreads--were about unchanged. Credit spreads for 10-year investment- and speculative-grade bonds changed little, on balance, and far-term forward spreads on speculative-grade corporate bonds have risen slightly, suggesting only a small decrease in investors' risk appetite. Although respondents to the Board's Senior Credit Officer Opinion Survey on Dealer Financing Terms reported some deterioration in market liquidity during the heightened financial volatility near the start of the year, standard measures of liquidity in corporate bond markets decreased only about in line with what might be expected given historical relationships between liquidity and volatility.

Valuations in the CRE sector appear increasingly vulnerable to negative shocks, as CRE prices have continued to outpace rental income and exceed, by some measures, their pre-crisis peaks. However, leverage in the sector does not appear excessive, and some evidence points to a recent reduction in risk appetite among CRE investors. Overall growth of CRE debt is moderate, and the ratio of debt backed by nonfarm nonresidential property to GDP is below an estimate of its long-run historical trend. In addition, according to the January and April results of the Board's Senior Loan Officer Opinion Survey on Bank Lending Practices, banks tightened lending standards in the fourth quarter of 2015 and first quarter of 2016.

The private nonfinancial-sector credit-to-GDP ratio has stayed near the levels that prevailed in the mid-2000s, though it is below conventional estimates of its long-term upward trend. In addition, debt growth in the household sector remained modest and mostly attributable to prime borrowers. In contrast, leverage for the nonfinancial corporate sector has stayed elevated and indicators of corporate credit quality, though still solid overall, continued to show signs of deterioration for lower-rated firms, especially in the energy sector. Even so, the risks posed by the elevated indebtedness of nonfinancial corporations may be attenuated by substantial cash holdings of investment-grade firms, relatively low interest expenses, and limited short-term debt.

The Federal Reserve Board has taken several further steps to improve the resilience of financial institutions and overall financial stability, including three proposals that apply only to large banking organizations and increase in stringency with the systemic footprint of the organization. First, the Board issued for public comment a proposed rule that would impose single-counterparty credit limits to help constrain interconnectedness within the financial system.2 Second, the Board and the other federal banking agencies issued for public comment a proposed rule that would require large U.S. banking organizations to maintain a minimum net stable funding ratio (NSFR).3 The proposal would require those institutions to maintain sufficient levels of stable funding relative to the liquidity of their assets, derivatives, and commitments over a one-year period, reducing liquidity risk in the banking system. The NSFR proposal would also serve as a complement to the liquidity coverage ratio rule. Third, the Board issued for public comment a proposed rule that would reduce the threat of disorderly liquidation of financial firms by requiring U.S. global systemically important banks (G-SIBs) and the U.S. operations of foreign G-SIBs to restrict the ability of counterparties to terminate qualified financial contracts early if the firm enters bankruptcy or a resolution process.4

In addition, the Board and the Federal Deposit Insurance Corporation announced their determinations and provided firm-specific feedback on the 2015 resolution plans of eight U.S. G-SIBs. 5 The two agencies ordered five of the firms to address identified deficiencies in their plans by October 1, 2016, or possibly be subjected to more stringent prudential requirements.


1. The exercise tests the ability of the 34 participating bank holding companies to maintain adequate capital ratios and continue to provide intermediary services in the face of a hypothetical severe recession. For descriptions of the scenarios, see Board of Governors of the Federal Reserve System (2016), 2016 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule (Washington: Board of Governors, January), Return to text

2. See Board of Governors of the Federal Reserve System (2016), "Federal Reserve Board Proposes Rule to Address Risk Associated with Excessive Credit Exposures of Large Banking Organizations to a Single Counterparty," press release, March 4, Return to text

3. See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (2016), "Agencies Propose Net Stable Funding Ratio Rule," joint press release, May 3, Return to text

4. See Board of Governors of the Federal Reserve System (2016), "Federal Reserve Board Proposes Rule to Support U.S. Financial Stability by Enhancing the Resolvability of Very Large and Complex Financial Firms," press release, May 3, Return to text

5. See Board of Governors of the Federal Reserve System and Federal Deposit Insurance Corporation (2016), "Agencies Announce Determinations and Provide Feedback on Resolution Plans of Eight Systemically Important, Domestic Banking Institutions," joint press release, April 13, Return to text

On balance to date this year, the expected path for the federal funds rate over the next several years declined...

The path of the federal funds rate implied by market quotes on interest rate derivatives flattened, on net, since December. The turbulence in global financial markets early in the year, the FOMC's communications, and some indications of a slowing in the pace of improvement in the labor market of late contributed to market participants' expectation that U.S. monetary policy would be more accommodative than they had anticipated late last year.

Survey-based measures of the expected path of policy also moved down this year. Respondents to the Survey of Primary Dealers and to the Survey of Market Participants in June expected fewer 25 basis point increases in the FOMC's target range for the federal funds rate this year than they projected in December. Market-based measures of uncertainty about the policy rate approximately one to two years ahead declined, on balance, from their year-end levels.

...longer-term nominal Treasury yields decreased...

Yields on 5-, 10-, and 30-year nominal Treasury securities declined in the first half of the year on balance (figure 30). Treasury yields decreased most notably in the early part of the year amid an increase in safe-haven demands and a pullback from risky assets. Yields changed little since then, on net, as risk sentiment generally improved but concerns about longer-term economic growth remained. Consistent with the change in yields on Treasury securities, yields on 30-year agency mortgage-backed securities (MBS)--an important determinant of mortgage interest rates--decreased, on balance, in the first half of 2016 (figure 31).

...broad equity price indexes increased slightly, and those of companies linked to energy sectors rose substantially...

After incurring sharp declines early in the year, broad equity price indexes rebounded as risk sentiment improved, resulting in levels that were slightly higher, on net, than at year-end (figure 32). In addition, reflecting the rebound in oil prices since the turn of the year, stock prices of companies in the energy sector outperformed broad equity market indexes over the first half of 2016. Meanwhile, implied volatility of the S&P 500 index increased through mid-February and then declined, ending the period above its year-end level.

...while risk spreads on corporate bonds narrowed

Similar to the movements in equity markets, spreads on corporate bonds over comparable-maturity Treasury securities widened early in the year but later retraced those moves, leaving spreads generally little changed, on net, over the first half of the year. Spreads on the lowest-rated speculative-grade issues declined appreciably. Nonetheless, corporate bond spreads stayed notably above their historical median levels, consistent with some deterioration in credit quality in the corporate sector.

Bank credit continued to expand, but profitability declined

Aggregate credit provided by commercial banks increased at a solid pace through May (figure 33). The expansion in bank credit reflected strong loan growth coupled with a modest increase in banks' holdings of securities. The growth of loans on banks' books was generally consistent with banks' reports in the April SLOOS of stronger demand for most loan categories and easier lending standards for loans to households.

Measures of bank profitability remained below their historical averages and declined in the first quarter of 2016, pressured by higher provisioning for losses on loans to borrowers in the oil and gas sectors, reduced trading and investment banking revenues, and continued low net interest margins (figure 34). However, with the exception of C&I loans, loan delinquency and charge-off rates continued to decline across most major loan types and remained near or at their lowest levels since the financial crisis. Stock prices of large bank holding companies decreased over the first half of the year, while banks' credit default swap spreads increased and stayed above their average level over the past two years.

Measures of liquidity conditions and functioning in financing markets were generally stable

Available indicators of Treasury market functioning have remained broadly stable over the first half of 2016. A variety of liquidity metrics--including bid-asked spreads and bid sizes in secondary markets for Treasury securities--have displayed no notable signs of liquidity pressures over the same period. In addition, Treasury auctions generally continued to be well received by investors.

Liquidity conditions in the agency MBS market also appeared to be generally stable. Dollar-roll-implied financing rates for production coupon MBS--an indicator of the scarcity of agency MBS for settlement--suggested limited settlement pressures over the first half of 2016. In addition, measures of corporate bond market liquidity, such as gauges of the effect of trades on market prices, stayed at levels comparable with those seen prior to the financial crisis. However, accurately measuring liquidity in fixed-income markets can be challenging, and liquidity conditions may vary in certain segments of the market or during times of stress.

Short-term dollar funding markets also continued to function smoothly during the first half of 2016. There were generally no signs of stress in either secured or unsecured money markets, including at March quarter-end.

Municipal bond markets functioned smoothly despite recent developments on Puerto Rico's debt

Credit conditions in municipal bond markets continued to be stable even as the situation facing Puerto Rico and its creditors deteriorated further. Gross issuance of municipal bonds remained solid in the first quarter, and yield spreads on general obligation (GO) municipal bonds over comparable-maturity Treasury securities increased a bit on net. Puerto Rico's Government Development Bank missed a substantial debt payment due in early May, and investors remained focused on the next sizable payment of GO bonds due in July.

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International Developments

Foreign financial market conditions improved after tightening early in the year

Foreign financial market conditions tightened early in the year, with bond spreads rising and equity markets falling in most countries as investor concerns about global economic growth increased, particularly with regard to China (figure 35). Since mid-February, in response to the release of some positive foreign data, reassuring moves by Chinese policymakers, and a market perception that U.S. monetary policy would be somewhat more accommodative than previously expected, financial conditions generally improved. A rebound in oil prices also seemed to reassure investors, possibly by diminishing financial stability concerns around oil-producing firms and oil-exporting economies. Bond yields, however, have generally moved lower since February, both because of low readings on inflation and in response to the U.S. employment report in June (figure 36).

The dollar depreciated early in the year but has risen, on balance, more recently

After increasing more than 20 percent from mid-2014 through its recent peak in January of this year, the broad dollar index--a measure of the trade-weighted value of the dollar against foreign currencies--has declined about 4 percent on balance (figure 37). The exchange value of the dollar fluctuated importantly over the first half of this year in response to shifting views about the path of U.S. monetary policy--falling early on, rising starting in May, and declining again more recently. On net, the dollar declined significantly against currencies of some commodity exporters, including Canada, as higher oil prices provided support for those currencies. In contrast, the British pound appreciated less against the dollar than other currencies, likely reflecting investor concerns about the upcoming referendum on whether the United Kingdom should leave the European Union. The Chinese renminbi was under considerable depreciation pressure late last year and very early in 2016 but stabilized as fears that Chinese policymakers would allow the renminbi to fall considerably further were allayed by reassuring statements of Chinese authorities, positive macroeconomic data, and decreased capital outflows (figure 38).

Economic growth remained modest in most advanced foreign economies

In the euro area, Canada, and Japan, economic growth picked up in the first quarter of 2016 (figure 39). The euro-area economy was supported by the European Central Bank's highly accommodative monetary policies, and the Canadian economy continued to recover from a brief recession in early 2015, with past depreciation of the Canadian dollar providing some support. However, GDP growth in the second quarter is likely to be hampered in Japan (as a result of an earthquake in April) and in Canada (on account of massive wildfires that have disrupted oil production). In addition, uncertainty related to the forthcoming U.K. referendum appears to have contributed to a step-down in U.K. growth this year.

Inflation also remained low...

In most advanced foreign economies (AFEs), core inflation remained subdued, reflecting continued economic slack in some countries and generally subdued wage growth. As a result, despite the recent rebound in oil prices and the inflationary effects of past sizable depreciations of some currencies, headline inflation remained well below central bank targets in Canada, the euro area, Japan, and the United Kingdom (figure 40).

...leading AFE central banks to maintain highly accommodative monetary policies

In late January of this year, the Bank of Japan adopted a negative policy rate, and in March, the European Central Bank reduced its deposit rate further into negative territory, increased the pace and scope of its asset purchases, and announced a new program of four-year loans--potentially at slightly negative rates--to euro-area banks. Meanwhile, the Bank of Canada, the Bank of England, and many other AFE central banks maintained their policy rates at historically low levels.

In emerging markets, economic growth picked up from late last year but remains subpar

The Chinese economy slowed in the first quarter (figure 41). However, recent indicators suggest that more accommodative fiscal and monetary policies are providing a lift to economic activity, particularly in the property market, where easier credit conditions have fueled a sharp turnaround. Elsewhere in emerging Asia, weak external demand from both the advanced economies and China weighed on growth in the first quarter, but exports and manufacturing have improved more recently.

Mexico's economy was a bright spot in Latin America in the first quarter, as GDP growth picked up despite lackluster exports to the United States; however, it appears economic activity decelerated in the second quarter. In Brazil, the recession continued in the first quarter, reflecting long-standing structural problems, low commodity prices, and a political crisis, subsequently resulting in a change in government. However, the contraction was smaller than in previous quarters, as commodity prices recovered somewhat and the sharp depreciation of the currency last year helped boost exports. Growth was mixed in the rest of South America, with Chilean GDP rebounding sharply while Venezuela's economy continued to experience a deep recession.


1. According to the Labor Department, payroll employment in May was reduced by about 35,000 because of workers on strike at Verizon. These employees have returned to work and are expected to be included in payroll figures for June. Return to text

2. Data from the consumer price index and the producer price index point to a similar reading for the 12-month change in core PCE prices in May. Return to text

3. While it appears likely that residual seasonality--a predictable seasonal pattern remaining in data that have already been seasonally adjusted--in some components of GDP held down measured GDP growth in the first quarter, this factor would imply an offsetting boost in measured GDP growth over the remainder of the year. Return to text

4. The SLOOS is available on the Board's website at Return to text

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Last update: June 21, 2016