Part 3: Monetary Policy: Recent Developments and Outlook

Monetary Policy Report submitted to the Congress on July 13, 2011, pursuant to section 2B of the Federal Reserve Act

Monetary Policy over the First Half of 2011

To promote the economic recovery and price stability, the Federal Open Market Committee (FOMC) maintained a target range for the federal funds rate of 0 to 1/4 percent throughout the first half of 2011 (figure 61).  In the statement accompanying each FOMC meeting over the period, the Committee noted that economic conditions were likely to warrant exceptionally low levels for the federal funds rate for an extended period.  At the end of June, the Federal Reserve concluded its purchases of longer-term Treasury securities under the $600 billion purchase program announced in November 2010; that program was undertaken to support the economic recovery and to help ensure that inflation, over time, returns to levels consistent with the FOMC's mandate of maximum employment and price stability.  In addition, throughout the first half of 2011, the Committee maintained its existing policy of reinvesting principal payments from its agency debt and agency mortgage-backed securities in longer-term Treasury securities.  In its June statement, the Committee noted that it would regularly review the size and composition of its securities holdings and was prepared to adjust those holdings, as appropriate, to foster maximum employment and price stability.

The information reviewed at the January 25–26 FOMC meeting indicated that the economic recovery was gaining a firmer footing, though the expansion had not yet been sufficient to bring about a significant improvement in labor market conditions.  Consumer spending had risen strongly in late 2010, and the ongoing expansion in business outlays for equipment and software appeared to have been sustained in recent months.  Industrial production had increased solidly in November and December.  However, construction activity in both the residential and nonresidential sectors remained weak.  Modest gains in employment had continued, and the unemployment rate remained elevated.  Conditions in financial markets were viewed by FOMC participants as having improved somewhat further over the intermeeting period, as equity prices had risen and credit spreads on the debt of nonfinancial corporations had continued to narrow, while yields on longer-term nominal Treasury securities were little changed.¹⁵  Credit conditions were still tight for smaller, bank-dependent firms, although bank loan growth had picked up in some sectors.  Despite further increases in commodity prices, measures of underlying inflation remained subdued and longer-run inflation expectations were stable.

The information received over the intermeeting period had increased Committee members' confidence that the economic recovery would be sustained, and the downside risks to both economic growth and inflation were viewed as having diminished.  Nevertheless, members noted that the pace of the recovery was insufficient to bring about a significant improvement in labor market conditions and that measures of underlying inflation were trending down.  Moreover, the economic projections submitted for this meeting indicated that unemployment was expected to remain above, and inflation to remain somewhat below, levels consistent with the Committee's objectives for some time.  Accordingly, the Committee decided to maintain its existing policy of reinvesting principal payments from its securities holdings and reaffirmed its intention to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.  Members emphasized that the Committee would continue to regularly review the pace of its securities purchases and the overall size of the asset purchase program in light of incoming information and would adjust the program as needed to best foster maximum employment and price stability.  In addition, the Committee maintained the target range of 0 to 1/4 percent for the federal funds rate and reiterated its expectation that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for an extended period.

The data presented at the March 15 FOMC meeting indicated that the economic recovery continued to proceed at a moderate pace, with a gradual improvement in labor market conditions.  Looking through weather-related distortions in various indicators, measures of consumer spending, business investment, and employment continued to show expansion.  Housing, however, remained depressed, and credit conditions were still uneven.  Large firms with access to financial markets continued to find credit, including bank loans, available on relatively attractive terms; however, credit conditions reportedly remained tight for smaller, bank-dependent firms.  Sizable increases in prices of crude oil and other commodities pushed up headline inflation, but measures of underlying inflation were subdued, and longer-run inflation expectations remained stable.  A number of participants expected that slack in resource utilization would continue to restrain increases in labor costs and prices.  Nonetheless, participants observed that rapidly rising commodity prices posed upside risks to the stability of longer-term inflation expectations, and thus to the outlook for inflation, even as they posed downside risks to the outlook for growth in consumer spending and business investment.  In addition, participants noted that unfolding events in the Middle East and North Africa, along with the tragic developments in Japan, had further increased uncertainty about the economic outlook.

In the FOMC's discussion of monetary policy for the period ahead, the members agreed that no changes to the Committee's asset purchase program or to its target range for the federal funds rate were warranted.  The economic recovery appeared to be on a firmer footing, and overall conditions in the labor market were gradually improving.  Although the unemployment rate had declined in recent months, it remained elevated relative to levels that the Committee judged to be consistent, over the longer run, with its statutory mandate to foster maximum employment and price stability.  Similarly, measures of underlying inflation continued to be somewhat low relative to levels seen as consistent with the dual mandate over the longer run.  With longer-term inflation expectations remaining stable and measures of underlying inflation subdued, members anticipated that recent increases in the prices of energy and other commodities would result in only a transitory increase in headline inflation.  Given this economic outlook, the Committee agreed to maintain the existing policy of reinvesting principal payments from its securities holdings and reaffirmed its intention to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011 to promote a stronger pace of economic recovery and to help ensure that inflation, over time, was at levels consistent with the Committee's mandate.  Members emphasized that the Committee would continue to regularly review the pace of its securities purchases and the overall size of the asset purchase program in light of incoming information and would adjust the program as needed to best foster maximum employment and price stability.  The Committee maintained the target range for the federal funds rate at 0 to 1/4 percent and continued to anticipate that economic conditions were likely to warrant exceptionally low levels for the federal funds rate for an extended period.

The information reviewed at the April 26–27 FOMC meeting indicated that, on balance, economic activity was expanding at a moderate pace and that labor market conditions were continuing to improve gradually.  Headline consumer price inflation had been boosted by large increases in food and energy prices, but measures of underlying inflation were still subdued and longer-run inflation expectations remained stable.  Participants observed that while construction activity was still anemic, measures of consumer spending and business investment continued to expand, and overall labor market conditions were improving, albeit gradually.  Nevertheless, they agreed that the pace of economic growth in the first quarter had slowed unexpectedly.  Participants viewed this weakness as likely to be largely transitory, influenced by unusually severe weather, increases in energy and other commodity prices, and lower-than-expected defense spending; as a result, they saw economic growth picking up later in the year.  In addition, they noted that higher gasoline and food prices had weighed on consumer sentiment about near-term economic conditions but that underlying fundamentals pointed to continued moderate growth in spending.  Activity in the industrial sector had expanded further and manufacturers remained upbeat, although automakers were reporting some difficulties in obtaining parts normally produced in Japan, which could damp motor vehicle production in the second quarter.  Participants noted that financial conditions continued to improve.  Equity prices had risen significantly since the beginning of the year, buoyed by an improved outlook for earnings.  Although loan demand in general remained weak, banks reported an easing of their lending standards and terms on commercial and industrial loans.  Consumer credit conditions also eased somewhat, although the demand for consumer credit other than auto loans reportedly changed little. 

Meeting participants judged the information received over the intermeeting period as indicating that the economic recovery was proceeding at a moderate pace, although somewhat more slowly than had been anticipated earlier in the year.  Overall conditions in the labor market were gradually improving, but the unemployment rate remained elevated relative to levels that the Committee judged to be consistent, over the longer run, with its statutory mandate of maximum employment and price stability.  Significant increases in the prices of energy and other commodities had boosted overall inflation, but members expected this rise to be transitory.  Indicators of medium-term inflation remained subdued and somewhat below the levels seen as consistent with the dual mandate as indicated by the Committee's longer-run inflation projections.  Accordingly, the Committee agreed that no changes to its asset purchase program or to its target range for the federal funds rate were warranted at this meeting.  Specifically, the Committee agreed to maintain its policy of reinvesting principal payments from its securities holdings and affirmed that it would complete purchases of $600 billion of longer-term Treasury securities by the end of the second quarter.  The Committee also agreed to maintain the target range of the federal funds rate at 0 to 1/4 percent and anticipated that economic conditions would likely warrant exceptionally low levels for the federal funds rate for an extended period.  Members agreed that the Committee would regularly review the size and composition of its securities holdings in light of incoming information and that they were prepared to adjust those holdings as needed to best foster maximum employment and price stability.

The information received ahead of the June 21–22 FOMC meeting indicated that the pace of the economic recovery had slowed in recent months and that conditions in the labor market had softened.  Measures of inflation had picked up this year, reflecting in part higher prices for some commodities and imported goods.  Longer-run inflation expectations, however, remained stable.  In their discussion of the economic situation and outlook, meeting participants noted a number of transitory factors that were restraining growth, including the global supply chain disruptions in the wake of the earthquake in Japan, the unusually severe weather in some parts of the United States, a drop in defense spending, and the effect of increases in oil and other commodity prices on household purchasing power and spending.  Participants expected that the expansion would gain strength as the effects of these temporary factors waned.  Nonetheless, most participants judged that the pace of economic recovery was likely to be somewhat slower over coming quarters than they had projected in April, reflecting the persistent weakness in the housing market, the ongoing efforts by some households to reduce debt burdens, the recent sluggish growth of income and consumption, the fiscal contraction at all levels of government, and the effect of uncertainty regarding the economic outlook and future tax and regulatory policies on the willingness of firms to hire and invest.  Changes in financial conditions since the April meeting suggested that investors had become more concerned about risk.  Equity markets had seen a broad selloff, and risk spreads for many corporate borrowers had widened noticeably since April.  Nonetheless, large businesses continued to enjoy ready access to credit.

In their discussion of monetary policy for the period ahead, members agreed that the Committee should complete its $600 billion asset purchase program at the end of the month and that no changes to the target range of the federal funds rate were warranted.  The information received over the intermeeting period indicated that the economic recovery was continuing at a moderate pace, though somewhat more slowly than the Committee had expected, and that the labor market had been weaker than anticipated.  Inflation had increased in recent months as a result of higher prices for some commodities, as well as supply chain disruptions related to the tragic events in Japan.  Nonetheless, members saw the pace of the economic expansion as picking up over the coming quarters and the unemployment rate resuming its gradual decline toward levels consistent with the Committee's dual mandate.  Moreover, with longer-term inflation expectations stable, members expected that inflation would subside to levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate.  However, many members saw the outlook for both employment and inflation as unusually uncertain.  Against this backdrop, members agreed that it was appropriate to maintain the Committee's current policy stance and accumulate further information regarding the outlook for growth and inflation before deciding on the next policy step.  A few members noted that, depending on how economic conditions evolve, the Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run.  A few other members, however, viewed the increase in inflation risks as suggesting that economic conditions might evolve in a way that would warrant the Committee taking steps to begin removing policy accommodation sooner than currently anticipated.

Also at its June meeting, in light of ongoing strains in some foreign financial markets, the Committee approved an extension through August 1, 2012, of its temporary U.S. dollar liquidity swap arrangements with the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank.  The authorization of the swap arrangements had been set to expire on August 1, 2011.

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Tools and Strategies for the Withdrawal of Monetary Policy Accommodation

Although the FOMC continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period, the Federal Reserve will eventually need to remove policy accommodation to maintain a stance of policy that is consistent with its statutory mandate to foster maximum employment and stable prices.  The FOMC has several tools for smoothly and effectively exiting at the appropriate time from the current accommodative policy stance.  One tool is the ability to pay interest on reserve balances; the Federal Reserve will be able to put significant upward pressure on short-term market interest rates by increasing the rate paid on excess reserves.  Two other tools--executing triparty reverse repurchase agreements (RRPs) with primary dealers and other counterparties and issuing term deposits to depository institutions through the Term Deposit Facility (TDF)--will be capable of temporarily reducing the quantity of reserves held by the banking system and thereby tightening the relationship between the interest rate paid on reserves and short-term market interest rates.¹⁶  Finally, the Federal Reserve could pare the size of its balance sheet over time by ceasing to reinvest principal payments from its securities holdings or by selling its securities holdings.

During the first half of 2011, the Federal Reserve continued to refine and test its temporary reserve draining tools.  The Federal Reserve Bank of New York (FRBNY) took further steps to expand the range of counterparties for RRPs to include entities other than primary dealers in order to enhance the capacity of such operations.  The FRBNY completed its third wave of counterparty expansions aimed at domestic money market funds in May, bringing the total number of RRP counterparties, including the primary dealers, to 110.   In May, the FRBNY also set forth criteria for the acceptance of government-sponsored enterprises as eligible counterparties for the next counterparty expansion wave.  During the first half of the year, the FRBNY conducted a series of small-scale triparty RRP transactions with its primary dealer and money market fund RRP counterparties.  The Federal Reserve also conducted three 28-day, $5 billion auctions of term deposits.  As a matter of prudent planning, these operations are intended to ensure the operational readiness of the TDF and RRP programs and to increase the familiarity of the participants with the auction procedures.

At its April and June meetings, the Committee discussed strategies for normalizing both the stance and conduct of monetary policy.  Participants noted that their discussions of this topic were undertaken as part of prudent planning and did not imply that a move toward such normalization would necessarily begin sometime soon.  Almost all participants agreed with the following principles to guide the exit process:

• The Committee will determine the timing and pace of policy normalization to promote its statutory mandate of maximum employment and price stability.
• To begin the process of policy normalization, the Committee will likely first cease reinvesting some or all payments of principal on the securities holdings in the System Open Market Account (SOMA).
• At the same time or sometime thereafter, the Committee will modify its forward guidance on the path of the federal funds rate and will initiate temporary reserve-draining operations aimed at supporting the implementation of increases in the federal funds rate when appropriate.
• When economic conditions warrant, the Committee's next step in the process of policy normalization will be to begin raising its target for the federal funds rate, and from that point on, changing the level or range of the federal funds rate target will be the primary means of adjusting the stance of monetary policy.  During the normalization process, adjustments to the interest rate on excess reserves and to the level of reserves in the banking system will be used to bring the funds rate toward its target.
• Sales of agency securities from the SOMA portfolio will likely commence sometime after the first increase in the target for the federal funds rate.  The timing and pace of sales will be communicated to the public in advance; that pace is anticipated to be relatively gradual and steady, but it could be adjusted up or down in response to material changes in the economic outlook or financial conditions.
• Once sales begin, the pace of sales is expected to be aimed at eliminating the SOMA's holdings of agency securities over a period of three to five years, thereby minimizing the extent to which the SOMA portfolio might affect the allocation of credit across sectors of the economy.  Sales at this pace would be expected to normalize the size of the SOMA securities portfolio over a period of two to three years.  In particular, the size of the securities portfolio and the associated quantity of bank reserves are expected to be reduced to the smallest levels that would be consistent with the efficient implementation of monetary policy.
• The Committee is prepared to make adjustments to its exit strategy if necessary in light of economic and financial developments.

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FOMC Communications

Transparency is an essential principle of modern central banking because it appropriately contributes to the accountability of central banks to the government and to the public and because it can enhance the effectiveness of central banks in achieving their macroeconomic objectives.  To this end, the Federal Reserve provides a considerable amount of information concerning the conduct of monetary policy.  Immediately following each meeting of the FOMC, the Committee releases a statement that lays out the rationale for its policy decision, and detailed minutes of each FOMC meeting are made public three weeks following the meeting.  Lightly edited transcripts of FOMC meetings are released to the public with a five-year lag.¹⁷

In recent years, the Federal Reserve has taken additional steps to enhance its communications regarding monetary policy decisions and deliberations.  In November 2010, the FOMC directed a subcommittee, headed by Governor Yellen, to conduct a review of the Committee's communications guidelines with the aim of ensuring that the public is well informed about monetary policy issues while preserving the necessary confidentiality of policy discussions until their scheduled release.  In a discussion on external communications at the January 25–26 FOMC meeting, participants noted the importance of fair and equal access by the public to information about future policy decisions.  Several participants indicated that increased clarity of communications was a key objective, and some referred to the central role of communications in the monetary policy transmission process.  Discussion focused on how to encourage dialogue with the public in an appropriate and transparent manner, and the subcommittee on communications was to consider providing further guidance in this area.

At the March 15 FOMC meeting, the Committee endorsed the communications subcommittee's recommendation that the Chairman conduct regular press conferences after the four FOMC meetings each year for which participants provide numerical projections of several key economic variables.  While those projections are already made public with the minutes of the relevant FOMC meetings, press conferences were viewed as being helpful in explaining how the Committee's monetary policy strategy is informed by participants' projections of the rates of output growth, unemployment, and inflation likely to prevail during each of the next few years, and by their assessments of the values of those variables that would prove most consistent, over the longer run, with the Committee's mandate to promote both maximum employment and stable prices.  It was agreed that the Chairman would begin holding press conferences effective with the April 26–27, 2011, FOMC meeting; the second press briefing was held on June 22 in conjunction with the forecasts that policymakers submitted at that FOMC meeting.

At its June 21–22 meeting, the Committee followed up on the discussions from its January meeting about policies to support effective communication with the public regarding the outlook for the economy and monetary policy.  The Committee unanimously approved a set of principles, proposed by the subcommittee on communications, for Committee participants and for the Federal Reserve System staff to follow in their communications with the public in order to reinforce the public's confidence in the transparency and integrity of the monetary policy process.¹⁸

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Footnotes

15. Members of the FOMC in 2011 consist of the members of the Board of Governors of the Federal Reserve System plus the presidents of the Federal Reserve Banks of Chicago, Dallas, Minneapolis, New York, and Philadelphia.  Participants at FOMC meetings consist of the members of the Board of Governors of the Federal Reserve System and all Reserve Bank presidents. Return to text

16. In a triparty repurchase agreement, both parties to the agreement must have cash and collateral accounts at the same triparty agent, which is by definition also a clearing bank.  The triparty agent will ensure that collateral pledged is sufficient and meets eligibility requirements, and all parties agree to use collateral prices supplied by the triparty agent. Return to text

17. FOMC statements, minutes, and transcripts, as well as other related information, are available on the Federal Reserve Board's website at www.federalreserve.gov/monetarypolicy/fomc.htm. Return to text

18. The FOMC policies on external communications of Committee participants and of the Federal Reserve System staff are available on the Federal Reserve Board's website at www.federalreserve.gov/monetarypolicy/files/FOMC_ExtCommunicationParticipants.pdf and www.federalreserve.gov/monetarypolicy/files/FOMC_ExtCommunicationStaff.pdf, respectively. Return to text

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