Board of Governors of the Federal Reserve System

Summary

Monetary Policy Report submitted to the Congress on July 13, 2018, pursuant to section 2B of the Federal Reserve Act

Economic activity increased at a solid pace over the first half of 2018, and the labor market has continued to strengthen. Inflation has moved up, and in May, the most recent period for which data are available, inflation measured on a 12-month basis was a little above the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent, boosted by a sizable increase in energy prices. In this economic environment, the Committee judged that current and prospective economic conditions called for a further gradual removal of monetary policy accommodation. In line with that judgment, the FOMC raised the target for the federal funds rate twice in the first half of 2018, bringing it to a range of 1-3/4 to 2 percent.

Economic and Financial Developments

The labor market. The labor market has continued to strengthen. Over the first six months of 2018, payrolls increased an average of 215,000 per month, which is somewhat above the average pace of 180,000 per month in 2017 and is considerably faster than what is needed, on average, to provide jobs for new entrants into the labor force. The unemployment rate edged down from 4.1 percent in December to 4.0 percent in June, which is about 1/2 percentage point below the median of FOMC participants' estimates of its longer-run normal level. Other measures of labor utilization were consistent with a tight labor market. However, hourly labor compensation growth has been moderate, likely held down in part by the weak pace of productivity growth in recent years.

Inflation. Consumer price inflation, as measured by the 12-month percentage change in the price index for personal consumption expenditures, moved up from a little below the FOMC's objective of 2 percent at the end of last year to 2.3 percent in May, boosted by a sizable increase in consumer energy prices. The 12-month measure of inflation that excludes food and energy items (so-called core inflation), which historically has been a better indicator of where overall inflation will be in the future than the total figure, was 2 percent in May. This reading was 1/2 percentage point above where it had been 12 months earlier, as the unusually low readings from last year were not repeated. Measures of longer-run inflation expectations have been generally stable.

Economic growth. Real gross domestic product (GDP) is reported to have increased at an annual rate of 2 percent in the first quarter of 2018, and recent indicators suggest that economic growth stepped up in the second quarter. Gains in consumer spending slowed early in the year, but they rebounded in the spring, supported by strong job gains, recent and past increases in household wealth, favorable consumer sentiment, and higher disposable income due in part to the implementation of the Tax Cuts and Jobs Act. Business investment growth has remained robust, and indexes of business sentiment have been strong. Foreign economic growth has remained solid, and net exports had a roughly neutral effect on real U.S. GDP growth in the first quarter. However, activity in the housing market has leveled off this year.

Financial conditions. Domestic financial conditions for businesses and households have generally continued to support economic growth. After rising steadily through 2017, broad measures of equity prices are modestly higher, on balance, from their levels at the end of last year amid some bouts of heightened volatility in financial markets. While long-term Treasury yields, mortgage rates, and yields on corporate bonds have risen so far this year, longer-term interest rates remain low by historical standards, and corporate bond issuance has continued at a moderate pace. Moreover, most types of consumer loans remained widely available for households with strong creditworthiness, and credit provided by commercial banks continued to expand. The foreign exchange value of the U.S. dollar has appreciated somewhat against the currencies of our trading partners this year, but it remains below its level at the start of 2017. Foreign financial conditions remain generally supportive of growth despite recent increases in financial stress in several emerging market economies.

Financial stability. The U.S. financial system remains substantially more resilient than during the decade before the financial crisis. Asset valuations continue to be elevated despite declines since the end of 2017 in the forward price-to-earnings ratio of equities and the prices of corporate bonds. In the private nonfinancial sector, borrowing among highly levered and lower-rated businesses remains elevated, although the ratio of household debt to disposable income continues to be moderate. Vulnerabilities stemming from leverage in the financial sector remain low, reflecting in part strong capital positions at banks, whereas some measures of hedge fund leverage have increased. Vulnerabilities associated with maturity and liquidity transformation among banks, insurance companies, money market mutual funds, and asset managers remain below levels that generally prevailed before 2008.

Monetary Policy

Interest rate policy. Over the first half of 2018, the FOMC has continued to gradually increase the target range for the federal funds rate. Specifically, the Committee decided to raise the target range for the federal funds rate at its meetings in March and June, bringing it to the current range of 1 3/4 to 2 percent. The decisions to increase the target range for the federal funds rate reflected the economy's continued progress toward the Committee's objectives of maximum employment and price stability. Even with these policy rate increases, the stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

The FOMC expects that further gradual increases in the target range for the federal funds rate will be consistent with a sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective over the medium term. Consistent with this outlook, in the most recent Summary of Economic Projections (SEP), which was compiled at the time of the June FOMC meeting, the median of participants' assessments for the appropriate level for the federal funds rate rises gradually over the period from 2018 to 2020 and stands somewhat above the median projection for its longer-run level by the end of 2019 and through 2020. (The June SEP is presented in Part 3 of this report.) However, as the Committee has continued to emphasize, the timing and size of future adjustments to the target range for the federal funds rate will depend on the Committee's assessment of realized and expected economic conditions relative to its maximum-employment objective and its symmetric 2 percent inflation objective.

Balance sheet policy. The FOMC has continued to implement the balance sheet normalization program described in the Addendum to the Policy Normalization Principles and Plans that the Committee issued about a year ago. Specifically, the FOMC has been reducing its holdings of Treasury and agency securities by decreasing, in a gradual and predictable manner, the reinvestment of principal payments it receives from these securities.

Special Topics

Prime-age labor force participation. Labor force participation rates (LFPRs) for men and women between 25 and 54 years old--that is, the share of these individuals either working or actively seeking work--trended lower between 2000 and 2013. Those trends likely reflect numerous factors, including a long-run decline in the demand for workers with lower levels of education and an increase in the share of the population with some form of disability. By contrast, the prime-age LFPR has increased notably since 2013, and the share of nonparticipants who report wanting a job remains above pre-recession levels. Thus, some continuation of the recent increase in the prime-age LFPR may be possible if labor demand remains strong. (See the box "The Labor Force Participation Rate for Prime-Age Individuals" in Part 1.)

Oil prices. Oil prices have climbed rapidly over the past year, reflecting both supply and demand factors. Although higher oil prices are likely to restrain household consumption in the United States, much of the negative effect on GDP from lower consumer spending is likely to be offset by increased production and investment in the growing U.S. oil sector. Consequently, higher oil prices now imply much less of a net overall drag on the economy than they did in the past, although they will continue to have important distributional effects. The negative effect of upward moves in oil prices should get smaller still as U.S. oil production grows and net oil imports decline further. (See the box "The Recent Rise in Oil Prices" in Part 1.)

Monetary policy rules. Monetary policymakers consider a wide range of information on current economic conditions and the outlook when deciding on a policy stance they deem most likely to foster the FOMC's statutory mandate of maximum employment and stable prices. They also routinely consult monetary policy rules that connect prescriptions for the policy interest rate with variables associated with the dual mandate. The use of such rules requires, among other considerations, careful judgments about the choice and measurement of the inputs into the rules such as estimates of the neutral interest rate, which are highly uncertain. (See the box "Complexities of Monetary Policy Rules" in Part 2.)

Interest on reserves. The payment of interest on reserves--balances held by banks in their accounts at the Federal Reserve--is an essential tool for implementing monetary policy because it helps anchor the federal funds rate within the FOMC's target range. This tool has permitted the FOMC to achieve a gradual increase in the federal funds rate in combination with a gradual reduction in the Fed's securities holdings and in the supply of reserve balances. The FOMC judged that removing monetary policy accommodation through first raising the federal funds rate and then beginning to shrink the balance sheet would best contribute to achieving and maintaining maximum employment and price stability without causing dislocations in financial markets or institutions that could put the economic expansion at risk. (See the box "Interest on Reserves and Its Importance for Monetary Policy" in Part 2.)