Board of Governors of the Federal Reserve System

Summary

Monetary Policy Report submitted to the Congress on February 25, 2022, pursuant to section 2B of the Federal Reserve Act

U.S. economic activity posted further impressive gains in the second half of last year, but inflation rose to its highest level since the early 1980s. The labor market tightened substantially further amid high demand for workers and constrained supply, with the unemployment rate reaching the median of Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level and nominal wages rising at their fastest pace in decades. With demand strong, and amid ongoing supply chain bottlenecks and constrained labor supply, inflation increased appreciably last year, running well above the FOMC's longer-run objective of 2 percent and broadening out to a wider range of items. As 2022 began, the rapid spread of the Omicron variant appeared to be causing a slowdown in some sectors of the economy, but with Omicron cases having declined sharply since mid-January, the slowdown is expected to be brief.

Over the second half of last year, the FOMC held its policy rate near zero to support the continued economic recovery. The Committee began phasing out net asset purchases in November and accelerated the pace of the phaseout in December; net asset purchases will end in early March. With inflation well above the FOMC's longer-run objective and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.

Recent Economic and Financial Developments

Economic activity and the labor market. In the second half of 2021, gross domestic product (GDP) growth slowed somewhat from its brisk first-half pace but nevertheless rose at a solid annualized rate of 4.6 percent. Average monthly job gains remained robust at 575,000 in the second half. The unemployment rate has plummeted almost 2 percentage points since June and, at 4 percent in January, has reached the median of FOMC participants' estimates of its longer-run normal level. Moreover, unemployment declines have been widespread across demographic groups. That said, labor force participation only crept up last year and remains constrained. The tight labor supply, in conjunction with a continued surge in labor demand, has resulted in strong nominal wage growth, especially for low-wage workers. Supply bottlenecks also continued to significantly limit activity throughout the second half, while the Delta and Omicron waves led to notable, but apparently temporary, slowdowns in activity.

Inflation. The personal consumption expenditures (PCE) price index rose 5.8 percent over the 12 months ending in December, and the index that excludes food and energy items (so-called core inflation) was up 4.9 percent—the highest readings for both measures in roughly 40 years. Upward pressure on inflation from prices of goods experiencing both supply chain bottlenecks and strong demand, such as motor vehicles and furniture, has persisted, and elevated inflation has broadened out to a wider range of items. Services inflation has also stepped up further, reflecting strong wage growth in some service sectors and a significant increase in housing rents. While measures of near-term inflation expectations moved substantially higher over the course of last year, measures of longer-term inflation expectations have moved up only modestly; they remain in the range observed over the decade before the pandemic and thus appear broadly consistent with the FOMC's longer-run inflation objective of 2 percent.

Financial conditions. Yields on nominal Treasury securities across maturities increased notably since mid-2021, with much of the increase having occurred in the past couple of months, as the expected timing for the beginning of the removal of monetary policy accommodation has moved forward significantly. Equity prices decreased slightly, on net, and corporate bond yields rose but remain low, with stable corporate credit quality. Financing conditions for consumer credit continue to be largely accommodative except for borrowers with low credit scores. Mortgage rates for households remain low despite recent increases. Bank lending standards have eased across most loan categories, and bank credit has expanded. All told, financing conditions have been accommodative for businesses and households.

Financial stability. While some financial vulnerabilities remain elevated, the large banks at the core of the financial system continue to be resilient. Measures of valuation pressures on risky assets remain high compared with historical values. Nonfinancial-sector leverage has broadly declined, and credit growth in the household sector has been driven almost exclusively by residential mortgages and auto loans to prime-rated borrowers. Vulnerabilities from financial-sector leverage are within their historical range, with relatively lower leverage at banks partially offset by higher leverage at life insurers and hedge funds. Funding markets remain stable. Domestic banks continue to maintain significant levels of high-quality liquid assets, while assets under management at prime and tax-exempt money market funds have declined further since mid-2021. The Federal Reserve continues to evaluate the potential systemic risks posed by hedge funds and digital assets and is closely monitoring the transition away from LIBOR. (See the box "Developments Related to Financial Stability" in Part 1.)

International developments. Foreign GDP has continued to recover briskly, on balance, despite successive waves of the pandemic, which have been mirrored in slowdowns and rebounds in economic activity. This recovery has been supported by vaccination rates that have steadily increased in both advanced foreign economies and emerging market economies (EMEs). Inflation rose notably in many economies in the second half of last year, importantly boosted by higher energy and other commodity prices as well as supply chain constraints. Several emerging market foreign central banks and a few advanced-economy foreign central banks have raised policy rates, though foreign monetary and fiscal policies have generally continued to be accommodative.

Foreign financial conditions have tightened modestly but are generally contained. In advanced foreign economies, sovereign yields have increased since the first half of last year on firming expectations for higher policy rates. The change in financial conditions in EMEs has been relatively muted in the face of the shift in monetary policy in some advanced economies. The trade-weighted value of the dollar appreciated modestly, on net, over the past six months. Recent geopolitical tensions related to the Russia–Ukraine situation are a source of uncertainty in global financial and commodity markets.

Monetary Policy

Interest rate policy. The FOMC has continued to keep the target range for the federal funds rate at 0 to 1/4 percent since the previous Monetary Policy Report. With inflation well above the Committee's 2 percent longer-run goal and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.

Balance sheet policy. From June 2020 until November 2021, the Federal Reserve expanded its holdings of Treasury securities by $80 billion per month and its holdings of agency mortgage-backed securities by $40 billion per month. In December 2020, the Committee indicated that it would continue to increase its holdings of securities at least at this pace until the economy had made substantial further progress toward its maximum-employment and price-stability goals. Last November, the Committee judged that this criterion had been achieved and began to reduce the monthly pace of its net asset purchases. In December, in light of inflation developments and further improvements in the labor market, the Committee announced it would double the pace of reductions in its monthly net asset purchases. At its January meeting, the FOMC decided to continue to reduce its net asset purchases at this accelerated pace, which will bring them to an end in early March, and issued a statement of principles for its planned approach for significantly reducing the size of the Federal Reserve's balance sheet.¹ A number of participants at the meeting commented that conditions would likely warrant beginning to reduce the size of the balance sheet sometime later this year.²

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee is firmly committed to its price-stability and maximum-employment goals and is prepared to use its tools to prevent higher inflation from becoming entrenched while promoting a sustainable expansion and strong labor market.

Special Topics

Low labor supply. Labor supply has been slow to rebound even as labor demand has been remarkably strong. The labor force participation rate remains well below estimates of its longer-run trend, principally reflecting a wave of retirements among older individuals and increases in the number of people out of the labor force and engaged in caregiving responsibilities. The ongoing pandemic has also affected labor supply through fear of the virus or the need to quarantine. Moreover, savings buffers accumulated during the pandemic may have enabled some people to remain out of the labor force. (See the box "The Limited Recovery of Labor Supply" in Part 1.)

Wage and employment growth across jobs and workers. Wage and employment gains were widespread across jobs and industries last year, with the lowest-wage jobs experiencing the largest gains in both median wages and employment. Wage growth in the leisure and hospitality industry accelerated sharply, which, together with a lagging employment rebound and high job openings, suggests a lack of available workers in the industry. Median wages also increased across racial and ethnic groups, leaving differences in wage levels across groups little changed relative to 2019. (See the box "Differences in Wage and Employment Growth across Jobs and Workers" in Part 1.)

Broadening of inflation. Higher PCE price inflation broadened out over the course of 2021, with the share of products experiencing notable price increases moving appreciably higher. The broadening was evident in both goods and services, though most of last year's very high inflation readings were concentrated in goods, a reflection of the strong demand and supply bottlenecks that have particularly affected these items. (See the box "How Widespread Has the Rise in Inflation Been?" in Part 1.)

Supply bottlenecks. Supply chain bottlenecks have plagued the economy for much of the past year. Against a backdrop of robust demand for goods, global distribution networks have been strained, and domestic manufacturers have had trouble finding the materials and labor needed to fill orders for their products. U.S. ports have been congested amid record volumes of shipping, and delivery times for materials have remained elevated. Supply shortages of semiconductors have been particularly acute and have weighed heavily on motor vehicle production and sales. While there are some signs of improvement, general supply chain bottlenecks are not expected to resolve for some time. (See the box "Supply Chain Bottlenecks in U.S. Manufacturing and Trade" in Part 1.)

Developments in the Federal Reserve's balance sheet. The size of the Federal Reserve's balance sheet continued to grow, albeit at a slower rate given the reduced monthly pace of net asset purchases since November. However, reserve balances—the largest liability on the Federal Reserve's balance sheet—were little changed, on net, reflecting growth in nonreserve liabilities such as currency and overnight reverse repurchase agreements (ON RRP). The elevated level of reserves continued to put broad downward pressure on short-term interest rates, while the decline in Treasury bill supply over 2021 has contributed to a shortage of short-term investments. Amid these developments, the ON RRP facility continued to serve its intended purpose of helping to provide a floor under short-term interest rates and support effective implementation of monetary policy. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets" in Part 2.)

Footnotes