Board of Governors of the Federal Reserve System

Summary

Monetary Policy Report submitted to the Congress on February 7, 2020, pursuant to section 2B of the Federal Reserve Act

The U.S. economy continued to grow moderately last year and the labor market strengthened further. With these gains, the current expansion entered its 11th year, becoming the longest on record. However, inflation was below the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent. In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the FOMC lowered the target range for the federal funds rate at its July, September, and October meetings, bringing it to the current range of 1-1/2 to 1-3/4 percent. In the Committee's subsequent meetings, it judged that the prevailing stance of monetary policy was appropriate to support sustained expansion of economic activity, strong labor market conditions, and inflation returning to the Committee's symmetric 2 percent objective.

Economic and Financial Developments

The labor market. The labor market continued to strengthen last year. Payroll employment growth remained solid in the second half of 2019, and while the pace of job gains during the year as a whole was somewhat slower than in 2018, it was faster than what is needed to provide jobs for new entrants to the labor force. The unemployment rate moved down from 3.9 percent at the end of 2018 to 3.5 percent in December, and the labor force participation rate increased. Meanwhile, wage gains remained moderate although above the pace of gains seen earlier in the expansion.

Inflation. After having been close to the FOMC's objective of 2 percent in 2018, consumer price inflation, as measured by the price index for personal consumption expenditures, moved back below 2 percent last year, where it has been during most of the current expansion. The 12-month change was 1.6 percent in December 2019, as was the 12-month measure that excludes consumer food and energy prices (so-called core inflation), which historically has been a better indicator of where inflation will be in the future than the overall figure. The downshift relative to 2018 partly results from particularly low readings in the monthly price data in the early part of last year that appear to reflect transitory influences. Survey-based measures of longer-run inflation expectations have been broadly stable since the middle of last year, and market-based measures of inflation compensation are little changed on net.

Economic growth. Real gross domestic product (GDP) is reported to have increased at a moderate rate in the second half of 2019, although growth was somewhat slower than in the first half of the year and in 2018. Consumer spending rose at a moderate pace, on average, and residential investment turned up after having declined in 2018 and the first half of 2019. In contrast, business fixed investment declined in the second half of last year, reflecting a number of factors that likely include trade policy uncertainty and weak global growth. Downside risks to the U.S. outlook seem to have receded in the latter part of the year, as the conflicts over trade policy diminished somewhat, economic growth abroad showed signs of stabilizing, and financial conditions eased. More recently, possible spillovers from the effects of the coronavirus in China have presented a new risk to the outlook.

Financial conditions. Domestic financial conditions for businesses and households remained supportive of spending and economic activity. After showing some volatility over the summer, nominal Treasury yields declined and equity prices increased notably, on balance, supported by accommodative monetary policy actions and easing of investors' concerns regarding trade policy prospects and the global economic outlook. Spreads of yields on corporate bonds over those on comparable-maturity Treasury securities continued to narrow, and mortgage rates remained low. Moreover, loans remained widely available for most businesses and households, and credit provided by commercial banks continued to expand at a moderate pace.

Financial stability. The U.S. financial system is substantially more resilient than it was before the financial crisis. Leverage in the financial sector appears low relative to historical norms. Total household debt has grown at a slower pace than economic activity over the past decade, in part reflecting that mortgage credit has remained tight for borrowers with low credit scores, undocumented income, or high debt-to-income ratios. In contrast, the levels of business debt continue to be elevated compared with the levels of either business assets or GDP, with the riskiest firms accounting for most of the increase in debt in recent years. While overall liquidity and maturity mismatches and funding risks in the financial system remain low, the volatility in repurchase agreement (repo) markets in mid-September 2019 highlighted the possibility for frictions in repo markets to spill over to other markets. Finally, asset valuations are elevated and have risen since July 2019, as investor risk appetite appears to have increased. (See the box "Developments Related to Financial Stability" in Part 1.)

International developments. After weakening in 2018, foreign economic growth slowed further in 2019, held down by a slump in global manufacturing, elevated trade tensions, and political and social unrest in several countries. Growth in Asian economies slowed markedly, especially in Hong Kong and India, and many Latin American economies continued to underperform. The pace of economic activity weakened in several advanced foreign economies as well. However, recent indicators provide tentative signs of stabilization. The global slowdown in manufacturing and trade appears to be nearing an end, and consumer spending and services activity around the world continue to hold up. Moreover, in some economically important regions, such as China and the euro area, data through early this year suggested that growth was steadying. The recent emergence of the coronavirus, however, could lead to disruptions in China that spill over to the rest of the global economy. Amid weak economic activity and dormant inflation pressures, foreign central banks generally adopted a more accommodative policy stance.

Financial conditions abroad eased in the second half of last year, supported by accommodative actions by central banks and, later in the period, positive political developments, including progress on the U.S.–China trade negotiations and diminished risks of a disorderly Brexit. On balance, since July global equity prices moved higher, sovereign bond spreads in the European periphery narrowed, and measures of sovereign spreads in emerging market economies decreased somewhat. In many advanced foreign economies, long-term interest rates remained well below the levels seen at the end of 2018.

Monetary Policy

Interest rate policy. In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the FOMC lowered the target range for the federal funds rate over the second half of 2019. Specifically, at its July, September, and October meetings, the FOMC lowered the target range a cumulative 75 basis points, bringing it to the current range of 1-1/2 to 1-3/4 percent. In its subsequent meetings, the Committee judged that the prevailing stance of monetary policy was appropriate to support sustained expansion of economic activity, strong labor market conditions, and inflation returning to the Committee's symmetric 2 percent objective. The Committee noted that it will continue to monitor the implications of incoming information for the economic outlook as it assesses the appropriate path of the target range for the federal funds rate.

Balance sheet policy. At its July meeting, the FOMC decided to conclude the reduction of its aggregate securities holdings in the System Open Market Account, or SOMA, in August. Ending the runoff earlier than initially planned was seen as having only very small effects on the balance sheet, with negligible implications for the economic outlook; it was also seen as helpful in simplifying communications regarding the use of the Committee's policy tools at a time when the Committee was lowering the target range for the federal funds rate. As discussed further in the next paragraph, since October 2019, the size of the balance sheet has been expanding to provide an ample level of reserves to ensure that the federal funds rate trades within the FOMC's target range.

Monetary policy implementation. Domestic short-term funding markets were volatile in mid-September—amid large flows related to corporate tax payments and settlement of Treasury securities—and experienced a significant tightening of conditions. Since then, the Federal Reserve has been conducting open market operations—repo operations and Treasury bill purchases—in order to maintain ample reserve balances over time. While the balance sheet has expanded in light of the open market operations to maintain ample reserves, these operations are purely technical measures to support the effective implementation of the FOMC's monetary policy, are not intended to change the stance of monetary policy, and reflect the Committee's intention to implement monetary policy in a regime with an ample supply of reserves. The Committee will continue to monitor money market developments as it assesses the level of reserves most consistent with efficient and effective policy implementation and stands ready to adjust the details of its technical operations as necessary to foster efficient and effective implementation of monetary policy. (See the box "Money Market Developments and Monetary Policy Implementation" in Part 2.)

Special Topics

Manufacturing and U.S. business cycles. After increasing solidly in 2017 and 2018, manufacturing output turned down last year. This decline raised fears among some observers that the weakness could spread and potentially lead to an economy-wide recession. In general, a decline in manufacturing similar to that in 2019 would not be large enough to initiate a major downturn for the economy. Furthermore, after accounting for changing trends in growth of manufacturing output, mild slowdowns have often occurred during expansionary phases of business cycles. In contrast, a more pronounced contraction in manufacturing has historically been associated with an economy-wide recession. (See the box "Manufacturing and U.S. Business Cycles" in Part 1.)

Monetary policy rules. Prescriptions for the policy interest rate from monetary policy rules often depend on judgments and assumptions about economic variables that are inherently uncertain and may change over time. Notably, many policy rules depend on estimates of resource slack and of the longer-run neutral real interest rate, both of which are not directly observable and are estimated with a high degree of uncertainty. As a result, the amount of policy accommodation that these rules prescribe—and whether that amount is appropriate in light of underlying economic conditions—is also uncertain. Such a situation cautions against mechanically following the prescriptions of any specific rule. (See the box "Monetary Policy Rules and Uncertainty in Monetary Policy Settings" in Part 2.)

Framework review and Fed Listens events. In 2019, the Federal Reserve System began a broad review of the monetary policy strategy, tools, and communication practices it uses to pursue its statutory dual-mandate goals of maximum employment and price stability. The Federal Reserve sees this review as particularly important at this time because the U.S. economy appears to have changed in ways that matter for monetary policy. For example, the neutral level of the policy interest rate appears to have fallen in the United States and abroad, increasing the risk that the effective lower bound on interest rates will constrain central banks from reducing their policy interest rates enough to effectively support economic activity during downturns. The review is considering what monetary policy strategy will best enable the Federal Reserve to meet its dual mandate in the future, whether the existing monetary policy tools are sufficient to achieve and maintain the dual mandate, and how communication about monetary policy can be improved.

A key component of the review has been a series of public Fed Listens events engaging with a broad range of stakeholders in the U.S. economy about how the Federal Reserve can best meet its statutory goals. During 14 Fed Listens events in 2019, policymakers heard from individuals and groups around the country on issues related to the labor market, inflation, interest rates, and the transmission of monetary policy. (See the box "Federal Reserve Review of Monetary Policy Strategy, Tools, and Communication Practices" in Part 2.)