Board of Governors of the Federal Reserve System

Summary

Monetary Policy Report submitted to the Congress on March 3, 2023, pursuant to section 2B of the Federal Reserve Act

Although inflation has slowed since the middle of last year as supply bottlenecks eased and energy prices declined, it remains well above the Federal Open Market Committee's (FOMC) objective of 2 percent. The labor market remains extremely tight, with robust job gains, the unemployment rate at historically low levels, and nominal wage growth slowing but still elevated. Real gross domestic product (GDP) growth picked up in the second half of 2022, although the underlying momentum in the economy likely remains subdued. Bringing inflation back to 2 percent will likely require a period of below-trend growth and some softening of labor market conditions.

In response to high inflation, the FOMC continued to rapidly increase interest rates and reduce its securities holdings. The Committee has raised the target range for the federal funds rate a further 3 percentage points since June, bringing the range to 4-1/2 to 4-3/4 percent, and indicated that it anticipates that ongoing increases in the target range will be appropriate. The Federal Reserve has also reduced its holdings of Treasury securities and agency mortgage-backed securities by about $500 billion since June, further tightening financial conditions.

The Federal Reserve is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials. The Committee is strongly committed to returning inflation to its 2 percent objective.

Recent Economic and Financial Developments

Inflation. Consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures (PCE), was 5.4 percent in January, down from its peak of 7 percent last June but still well above the FOMC's 2 percent objective. Core PCE prices—which exclude volatile food and energy prices and are generally considered a better guide to the direction of future inflation—also slowed but still increased 4.7 percent over the 12 months ending in January. As supply chain bottlenecks have eased, increases in core goods prices slowed considerably in the second half of last year. Within core services prices, housing services inflation has been high, but slowing increases in rents for new tenants in the second half of last year point to lower inflation for housing services in the year ahead. For other services, however, price inflation remains elevated, and prospects for slowing inflation may depend in part on an easing of tight labor market conditions. Measures of longer-term inflation expectations remain within the range of values seen in the decade before the pandemic and continue to be broadly consistent with the FOMC's longer-run objective of 2 percent, suggesting that high inflation is not becoming entrenched.

The labor market. The labor market has remained extremely tight, with job gains averaging 380,000 per month since the middle of last year and the unemployment rate remaining at historical lows. Labor demand in many parts of the economy exceeds the supply of available workers, with the labor force participation rate essentially unchanged from one year ago. Nominal wage gains slowed over the second half of 2022, but they remain above the pace consistent with 2 percent inflation over the longer term, given prevailing trends in productivity growth.

Economic activity. Real GDP is reported to have fallen in the first half of 2022 but to have then risen at roughly a 3 percent pace in the second half. Some of the swings in growth reflect fluctuations in volatile expenditure categories such as net exports and inventory investment. Private domestic final demand, which excludes these volatile components, rose at a subdued rate in both the first and second halves last year. Consumer spending has continued to rise at a solid pace, supported by the savings accumulated during the pandemic. However, manufacturing output declined in recent months, and the housing sector has continued to contract in response to elevated mortgage rates.

Financial conditions. Financial conditions have tightened further since June and are significantly tighter than a year ago. The FOMC has raised the target range for the federal funds rate a further 3 percentage points since June, and the market-implied expected path of the federal funds rate over the next year also shifted up notably. Yields on nominal Treasury securities across maturities have risen considerably further since June, while investment-grade corporate bond yields and mortgage rates have also increased but by less than Treasury rates. Equity prices were volatile but increased moderately on net. The rise in interest rates over the past year has weighed on financing activity. Issuance of leveraged loans and speculative-grade corporate bonds slowed substantially in the second half of the year, while investment-grade bond issuance declined modestly. Business loans at banks continued to grow in the second half of 2022 but decelerated in the fourth quarter. While business credit quality remains strong, some indicators of future business defaults are somewhat elevated. For households, mortgage originations continued to decline materially, although consumer loans (such as auto loans and credit cards) grew further. Delinquency rates for credit cards and auto loans rose last year.

Financial stability. Against the backdrop of a weaker economic outlook, higher interest rates, and elevated uncertainty since June, financial vulnerabilities remain moderate overall. Valuations in equity markets remained notable and ticked up, on net, as equity prices increased moderately even as earnings expectations declined late in the year. Real estate prices remain high relative to fundamentals, such as rents, despite a marked slowing in price increases. While market functioning remained orderly, market liquidity—the ability to trade assets without a large effect on market prices—remained low in several key asset markets, including in the Treasury market, when compared with levels before the COVID-19 pandemic. Nonfinancial business and household debt grew in line with GDP, leaving vulnerabilities associated with borrowing by businesses and households unchanged at moderate levels. Risk-based capital ratios at banks declined a touch last year but remain well above regulatory requirements. Funding risks at domestic banks and broker-dealers remain low, and the large banks at the core of the financial system continue to have ample liquidity. Prime and tax-exempt money market funds, as well as many bond and bank-loan mutual funds, continue to be susceptible to runs. (See the box "Developments Related to Financial Stability" in Part 1.)

International developments. Foreign economic growth moderated in the second half of last year, weighed down by the economic fallout of Russia's war against Ukraine and a slowdown in China related to COVID-19. Despite some signs of easing in headline inflation abroad, core foreign inflation remains high and inflationary pressures are broad, in part reflecting tight labor markets and the pass-through of past energy price increases to other prices. In response to persistently high inflation, many major foreign central banks, along with the Fed, have tightened the stance of monetary policy significantly since June. More recently, many foreign central banks slowed the pace of their policy rate increases, signaled that such a slowing is coming, or paused policy rate hikes to take stock of the effects of policy tightening thus far on their economies.

Financial conditions abroad have tightened modestly, on net, since the middle of last year. Global sovereign bond yields rose from continued tightening of foreign monetary policy and spillovers from increases in U.S. yields. Equity prices abroad rose toward the end of the year amid surprising resilience of European economies and the removal of China's zero-COVID policy. Meanwhile, the trade-weighted exchange value of the U.S. dollar is a touch higher since mid-2022.

Monetary Policy

In response to high inflation, the Committee last year rapidly increased the target range for the federal funds rate and began reducing its securities holdings. Adjustments to both interest rates and the balance sheet are playing a role in firming the stance of monetary policy in support of the Committee's maximum-employment and price-stability goals.

Interest rate policy. The FOMC continued to swiftly increase the target range for the federal funds rate, bringing it to the current range of 4-1/2 to 4-3/4 percent. In light of the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation, the Committee slowed the pace of policy tightening at the December and January meetings but 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.

Balance sheet policy. The Federal Reserve has continued the process of significantly reducing its holdings of Treasury and agency securities in a predictable manner.¹ Beginning in June of last year, principal payments from securities held in the System Open Market Account have been reinvested only to the extent that they exceeded monthly caps.

Special Topics

Employment and earnings across groups. At the onset of the pandemic, employment fell by more for disadvantaged groups than the overall population, but tight labor market conditions over the past two years have largely reversed those movements. As the labor market tightened, employment grew faster for African Americans and Hispanics, and for less educated workers, than for other workers. Wages have grown more rapidly for these workers also, as extremely strong labor demand has outstripped available labor supply. However, while disparities in employment have largely returned to pre-pandemic levels, there remain significant disparities in absolute levels of employment across groups. (See the box "Developments in Employment and Earnings across Demographic Groups" in Part 1.)

Weak labor supply. Even with labor demand remarkably strong, the labor force has been slow to recover from the pandemic, leaving a significant labor supply shortfall relative to the levels expected before the pandemic. More than half of that labor force shortfall reflects a lower labor force participation rate because of a wave of retirements beyond what would have been expected given demographic trends. The remaining shortfall is attributable to slower population growth, which in turn reflects both the higher mortality primarily due to COVID and lower rates of immigration in the first two years of the pandemic. (See the box "Why Has the Labor Force Recovery Been So Slow?" in Part 1.)

Monetary policy rules. Simple monetary policy rules, which prescribe a setting for the policy interest rate based on a small number of other economic variables, can provide useful guidance to policymakers. 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. As a result, simple monetary policy rules have prescribed levels for the federal funds rate that are well above those observed over the past decade. (See the box "Monetary Policy Rules in the Current Environment" in Part 2.)

Federal Reserve's balance sheet and money markets. The size of the Federal Reserve's balance sheet decreased as the Federal Reserve reduced its securities holdings. Reserve balances—the largest liability on the Federal Reserve's balance sheet—continued to fall. Take-up in the overnight reverse repurchase agreement (ON RRP) facility remained elevated, as low rates on repurchase agreements persisted amid still abundant liquidity and limited Treasury bill supply. The ON RRP facility continued to serve its intended purpose of helping to provide a floor under short-term interest rates and supporting effective implementation of monetary policy. Because of the significant increases in administered rates to address high inflation, the Federal Reserve's interest expenses rose considerably, and, as a result, net income turned negative. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets" in Part 2.)

Footnotes