Part 2: Monetary Policy
Monetary Policy Report submitted to the Congress on March 3, 2023, pursuant to section 2B of the Federal Reserve Act
The Federal Open Market Committee continued to increase the federal funds rate...
With inflation still well above the Federal Open Market Committee's (FOMC) 2 percent objective and with labor market conditions remaining tight, the Committee continued to swiftly raise the target range for the federal funds rate. Since June, the Committee raised the target range by 3 percentage points, from 1-1/2 to 1-3/4 percent to 4-1/2 to 4-3/4 percent (figure 47). In light of the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation, after having increased the federal funds rate by 75 basis points at its meetings in June, July, September, and November, the Committee slowed the pace of policy firming at its December and January meetings to 50 basis points and 25 basis points, respectively. The Committee indicated that it anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.
...and has continued the process of significantly reducing its holdings of Treasury and agency securities
The Committee has continued to implement its plan for significantly reducing the size of the Federal Reserve's balance sheet in a predictable manner.14 Beginning in June, principal payments from securities held in the System Open Market Account (SOMA) have been reinvested only to the extent that they exceeded monthly caps. For Treasury securities, the cap was initially set at $30 billion per month and, in September, was increased to $60 billion per month. For agency debt and agency mortgage-backed securities, the cap was initially set at $17.5 billion per month and, in September, was increased to $35 billion per month. As a result of these actions, holdings of Treasury and agency securities in the SOMA have declined by about $500 billion to around $8 trillion, or 31 percent of U.S. nominal gross domestic product, since the process to reduce securities holdings began (figure 48). Reserve balances have fallen by about $200 billion to around $3 trillion over that period. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets.")
The Committee has stated that it intends to maintain securities holdings in amounts needed to implement monetary policy efficiently and effectively in its ample-reserves regime. To ensure a smooth transition, the Committee intends to slow and then stop reductions in its securities holdings when reserve balances are somewhat above the level the Committee judges to be consistent with ample reserves. Once balance sheet runoff has ceased, reserve balances will likely continue to decline at a slower pace—reflecting growth in other Federal Reserve liabilities—until the Committee judges that reserve balances are at the level required for implementing policy efficiently and effectively in its ample-reserves regime.
The FOMC will continue to monitor the implications of incoming information for the economic outlook
The FOMC is strongly committed to returning inflation to its 2 percent objective. 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's assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments. The Committee has noted that it is also prepared to adjust any of the details of its approach to reducing the size of the balance sheet in light of economic and financial developments.
In addition to considering a wide range of economic and financial data, the Committee gathers information from business contacts and other informed parties around the country, as summarized in the Beige Book. To hear from a broad range of stakeholders in the U.S. economy about how monetary policy affects people's daily lives and livelihoods, the Federal Reserve has continued to gather insights through the Fed Listens initiative and the Federal Reserve System's community development outreach. Policymakers also routinely consult prescriptions for the policy interest rate provided by various monetary policy rules. These rule prescriptions can provide useful benchmarks for the FOMC.
Although simple rules cannot capture all of the complexities of monetary policy, and many practical considerations make it undesirable for the FOMC to adhere strictly to the prescriptions of any specific rule, some principles of good monetary policy can be illustrated by these policy rules (see the box "Monetary Policy Rules in the Current Environment").
Developments in the Federal Reserve's Balance Sheet and Money Markets
The Federal Open Market Committee (FOMC) began to significantly reduce the size of the Federal Reserve's balance sheet in June 2022. Since that time, total assets have decreased by $550 billion, leaving the total size of the balance sheet at about $8.4 trillion (figures A and B). This discussion reviews recent developments in the Federal Reserve's balance sheet and money market conditions.
A. Balance sheet comparison
Billions of dollars
| February 22, 2023 | June 15, 2022 | Change | |
|---|---|---|---|
| Assets | |||
| Total securities | |||
| Treasury securities | 5,364 | 5,763 | -399 |
| Agency debt and MBS | 2,623 | 2,730 | -107 |
| Net unamortized premiums | 308 | 336 | -28 |
| Repurchase agreements | 0 | 0 | 0 |
| Loans and lending facilities | |||
| PPPLF | 11 | 19 | -8 |
| Other loans and lending facilities | 34 | 38 | -4 |
| Central bank liquidity swaps | 0 | 0 | 0 |
| Other assets | 41 | 47 | -6 |
| Total assets | 8,382 | 8,932 | -550 |
| Liabilities | |||
| Federal Reserve notes | 2,252 | 2,227 | 25 |
| Reserves held by depository institutions | 2,984 | 3,190 | -206 |
| Reverse repurchase agreements | |||
| Foreign official and international accounts | 358 | 259 | 99 |
| Others | 2,114 | 2,163 | -49 |
| U.S. Treasury General Account | 451 | 770 | -319 |
| Other deposits | 193 | 258 | -65 |
| Other liabilities and capital | 32 | 66 | -34 |
| Total liabilities and capital | 8,382 | 8,932 | -550 |
Note: MBS is mortgage-backed securities. PPPLF is Paycheck Protection Program Liquidity Facility.
Source: Federal Reserve Board, Statistical Release H.4.1, "Factors Affecting Reserve Balances."
Reserve balances—the largest liability on the Federal Reserve's balance sheet—have declined by about $200 billion since June 2022 (figure C).1 The ongoing reduction in the Federal Reserve's securities holdings would reduce the level of reserve balances one-for-one, if all other balance sheet items stayed constant.
After fluctuating around $2.2 trillion over the second half of 2022, usage at the overnight reverse repurchase agreement (ON RRP) facility increased toward year-end and reached a record high of $2.55 trillion on December 30. Since early January, ON RRP take-up has declined to about $2.1 trillion at the time of this report. Low rates on private money market instruments—reflecting still abundant liquidity in the banking system and limited Treasury bill supply—have contributed to the overall high level of take-up. In addition, uncertainty about the economic outlook—and, as a result, about the magnitude and pace of policy rate increases—continued to contribute to a preference for short-duration assets, like those provided by the ON RRP facility.
The ON RRP facility is intended to help keep the effective federal funds rate from falling below the target range set by the FOMC, as institutions with access to the ON RRP should be unwilling to lend funds below the ON RRP's offering rate. The facility continued to serve this intended purpose, and the Federal Reserve's administered rates—interest on reserve balances and the ON RRP offering rate—were highly effective at maintaining the effective federal funds rate within the target range as the FOMC has tightened the stance of monetary policy since last March.
The Federal Reserve System had an estimated consolidated net income of about $58 billion over 2022. Given the significant increases in policy rates in response to sustained inflation pressures, the Federal Reserve's interest expenses have risen considerably, and, as a result, net income turned negative in September.2 Because the Federal Reserve no longer has positive net income to remit to the Treasury Department, as of February 2023, the Federal Reserve's balance sheet now reports a deferred asset of about $36 billion. The deferred asset is equal to the cumulative shortfall of net income and represents the amount of future net income that will need to be realized before remittances to the Treasury resume.3 Although remittances are suspended at the time of this report, over the past decade and a half, the Federal Reserve has remitted over $1 trillion to the Treasury. Net income is expected to again turn positive as interest expenses fall, and remittances will resume once the temporary deferred asset falls to zero.4 Negative net income and the associated deferred asset do not affect the Federal Reserve's conduct of monetary policy or its ability to meet its financial obligations.
1. Reserve balances consist of deposits held at Federal Reserve Banks by depository institutions, such as commercial banks, savings banks, credit unions, thrift institutions, and U.S. branches and agencies of foreign banks. Reserve balances allow depository institutions to facilitate daily payment flows, both in ordinary times and in stress scenarios, without borrowing funds or selling assets. Return to text
2. The ongoing monetary tightening also reduces the market value of the Federal Reserve's securities holdings by putting upward pressure on longer-term market interest rates. The System Open Market Account (SOMA) portfolio was in an estimated unrealized loss position of about $1.1 trillion as of September 2022. Under the current May 2022 Plans for Reducing the Size of the Federal Reserve's Balance Sheet, unrealized gains or losses will not flow through to the Federal Reserve's net income, as SOMA securities will be held until maturity. An individual security's market value converges to its face value as it approaches maturity, and, so long as the security is held until that time, any gains or losses due to interest rate fluctuations remain unrealized. Further information on the topics of the Federal Reserve's income and the SOMA portfolio's unrealized position is available in two FEDS Notes articles. For a discussion of concepts related to net income and the SOMA portfolio's unrealized position, see Alyssa Anderson, Dave Na, Bernd Schlusche, and Zeynep Senyuz (2022), "An Analysis of the Interest Rate Risk of the Federal Reserve's Balance Sheet, Part 1: Background and Historical Perspective," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, July 15), https://doi.org/10.17016/2380-7172.3173; and for illustrative projections of the Federal Reserve's balance sheet and income under a wide range of potential interest rate paths, see Alyssa Anderson, Philippa Marks, Dave Na, Bernd Schlusche, and Zeynep Senyuz (2022), "An Analysis of the Interest Rate Risk of the Federal Reserve's Balance Sheet, Part 2: Projections under Alternative Interest Rate Paths," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, July 15), https://doi.org/10.17016/2380-7172.3174. Return to text
3. Because of variation in the timing and magnitude of payments for expenditures, interest income, and interest expense, individual Reserve Banks may have positive earnings while Systemwide net income is negative. As net income is remitted on a weekly basis at the Reserve Bank level, individual Reserve Banks may occasionally remit small amounts of positive earnings to the Treasury while the Systemwide deferred asset grows. Return to text
4. As a result of the ongoing reduction in the size of the Federal Reserve's balance sheet, it is expected that interest expenses will fall over time as they are tied to a smaller total amount of liabilities. Return to text
Monetary Policy Rules in the Current Environment
Simple interest rate rules relate a policy interest rate, such as the federal funds rate, to a small number of other economic variables—typically including the current deviation of inflation from its target value and a measure of resource slack in the economy. Policymakers consult policy rate prescriptions derived from a variety of policy rules as part of their monetary policy deliberations without mechanically following the prescriptions of any particular rule.
Since 2021, inflation has run well above the Committee's 2 percent longer-run objective, and labor market conditions have been very tight over the past year. Reflecting these developments, the simple monetary policy rules considered in this discussion have called for levels of the federal funds rate well above those observed over the past decade. Also because of the persistently high levels of inflation, the Federal Open Market Committee (FOMC) has expeditiously raised the target range for the federal funds rate and has reduced its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a historically rapid pace.
Selected Policy Rules: Descriptions
In many economic models, desirable economic outcomes can be achieved if monetary policy responds in a predictable way to changes in economic conditions. In recognition of this idea, economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule, the "balanced approach" rule, the "adjusted Taylor (1993)" rule, and the "first difference" rule.1 Figure A shows these rules, along with a "balanced-approach (shortfalls)" rule, which represents one simple way to illustrate the Committee's focus on shortfalls from maximum employment.2 All of these simple rules shown embody key design principles of good monetary policy, including that the policy rate should be adjusted forcefully enough over time to ensure a return of inflation to the central bank's longer-run objective and to anchor longer-term inflation expectations at levels consistent with that objective.
All five rules feature the difference between inflation and the FOMC's longer-run objective of 2 percent. The five rules use the unemployment rate gap, measured as the difference between an estimate of the rate of unemployment in the longer run ($$ u_t^{LR}$$) and the current unemployment rate; the first-difference rule includes the change in the unemployment rate gap rather than its level.3 All but the first-difference rule include an estimate of the neutral real interest rate in the longer run ($$ r_t^{LR}$$).4
Unlike the other simple rules featured here, the adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below the effective lower bound. To make up for the cumulative shortfall in policy accommodation following a recession during which the federal funds rate is constrained by its effective lower bound, the adjusted Taylor (1993) rule prescribes delaying the return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule until after the economy begins to recover.
Policy Rules: Limitations
Simple policy rules are also subject to important limitations. One important limitation is that simple policy rules were designed and tested under very different economic conditions than those faced at present. In addition, the simple policy rules respond to only a small set of economic variables and thus necessarily abstract from many of the factors that the FOMC considers when it assesses the appropriate setting of the policy rate. Another important limitation is that most simple policy rules do not take into account the effective lower bound on interest rates, which limits the extent to which the policy rate can be lowered to support the economy. This constraint was particularly evident during the pandemic-driven recession, when the lower bound on the policy rate motivated the FOMC's other policy actions to support the economy. Relatedly, another limitation is that simple policy rules do not take into account the other tools of monetary policy, such as balance sheet policies. Finally, simple policy rules generally abstract from the risk-management considerations associated with uncertainty about economic relationships and the evolution of the economy.
Selected Policy Rules: Prescriptions
Figure B shows historical prescriptions for the federal funds rate under the five simple rules considered. For each quarterly period, the figure reports the policy rates prescribed by the rules, taking as given the prevailing economic conditions and survey-based estimates of $$ u_t^{LR}$$ and $$ r_t^{LR}$$ at the time. All of the rules considered called for a highly accommodative stance for monetary policy in response to the pandemic-driven recession, followed by values above the effective lower bound as inflation picked up and labor market conditions strengthened. For most of 2022, the prescriptions for the federal funds rate were between 4 and 8 percent; these values are well above the levels observed before the pandemic and reflect, in large part, elevated inflation readings. Throughout 2021 and 2022, the target range for the federal funds rate was below the prescriptions of most of the simple rules, though that gap has narrowed considerably as the FOMC has expeditiously tightened the stance of monetary policy and inflation has begun to moderate.
1. The Taylor (1993) rule was introduced in John B. Taylor (1993), "Discretion versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy, vol. 39 (December), pp. 195–214. The balanced-approach rule was analyzed in John B. Taylor (1999), "A Historical Analysis of Monetary Policy Rules," in John B. Taylor, ed., Monetary Policy Rules (Chicago: University of Chicago Press), pp. 319–41. The adjusted Taylor (1993) rule was studied in David Reifschneider and John C. Williams (2000), "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, vol. 32 (November), pp. 936–66. The first-difference rule is based on a rule suggested by Athanasios Orphanides (2003), "Historical Monetary Policy Analysis and the Taylor Rule," Journal of Monetary Economics, vol. 50 (July), pp. 983–1022. A review of policy rules is in John B. Taylor and John C. Williams (2011), "Simple and Robust Rules for Monetary Policy," in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol. 3B (Amsterdam: North-Holland), pp. 829–59. The same volume of the Handbook of Monetary Economics also discusses approaches other than policy rules for deriving policy rate prescriptions. Return to text
2. Since August 2020, the FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy has referred to "shortfalls of employment" from the Committee's assessment of its maximum level rather than the "deviations of employment" used in the previous statement. The balanced-approach (shortfalls) rule reflects this change by responding asymmetrically to unemployment rates above or below their estimated longer-run value: When unemployment is above that value, the policy rates are identical to those prescribed by the balanced-approach rule, whereas when unemployment is below that value, policy rates do not rise because of further declines in the unemployment rate. As a result, the prescription of the balanced-approach (shortfalls) rule in 2022:Q4 is more accommodative than that of the balanced-approach rule. Return to text
3. Implementations of simple rules often use the output gap as a measure of resource slack in the economy. The rules described in figure A instead use the unemployment rate gap because that gap better captures the FOMC's statutory goal to promote maximum employment. Movements in these alternative measures of resource utilization tend to be highly correlated. For more information, see the note below figure A. Return to text
4. The neutral real interest rate in the longer run ($$ r_t^{LR}$$) is the level of the real federal funds rate that is expected to be consistent, in the longer run, with maximum employment and stable inflation. Like $$ u_t^{LR}$$, $$ r_t^{LR}$$ is determined largely by nonmonetary factors. The first-difference rule shown in figure A does not require an estimate of $$ r_t^{LR}$$, a feature that is touted by proponents of such rules as providing an element of robustness. However, this rule has its own shortcomings. For example, research suggests that this sort of rule often results in greater volatility in employment and inflation relative to what would be obtained under the Taylor (1993) and balanced-approach rules. Return to text
Footnotes
14. See the May 4, 2022, press release regarding the Plans for Reducing the Size of the Federal Reserve's Balance Sheet, available on the Board's website at https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504b.htm. Return to text