Board of Governors of the Federal Reserve System

Summary

Monetary Policy Report submitted to the Congress on June 16, 2023, pursuant to section 2B of the Federal Reserve Act

Although inflation has moderated somewhat since the middle of last year, it remains well above the Federal Open Market Committee's (FOMC) objective of 2 percent. The labor market continues to be very tight, with robust job gains and the unemployment rate near historically low levels, though nominal wage growth has shown some signs of easing and job vacancies have declined. Real gross domestic product (GDP) growth was modest in the first quarter, despite a pickup in consumer spending. 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 increase interest rates and reduce its securities holdings. The FOMC has raised the target range for the federal funds rate a further 75 basis points since the start of the year, bringing the range to 5 to 5-1/4 percent. In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the FOMC indicated that it will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments. The Federal Reserve also continued to reduce its holdings of Treasury and agency mortgage-backed securities; these holdings have declined by about $420 billion since January, 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 FOMC 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 4.4 percent in April, down from its peak of 7.0 percent last June but still well above the FOMC's 2 percent objective. Core PCE price inflation—which excludes volatile food and energy prices and is generally considered a better guide to the direction of future inflation—is also off its peak but was still 4.7 percent over the 12 months ending in April. As supply chain bottlenecks have eased and demand has stabilized, increases in core goods prices slowed considerably over the past year. Within core services prices, housing services inflation has been high, but the monthly changes have started to ease in recent months, consistent with the slower increases in rents for new tenants that have been observed since the second half of last year. For other core services, price inflation remains elevated and has not shown signs of easing, and prospects for slowing inflation may depend in part on a further easing of tight labor market conditions. Measures of longer-term inflation expectations are 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 very tight, with job gains averaging 314,000 per month during the first five months of the year and the unemployment rate remaining near historical lows. Labor demand has eased in many sectors of the economy but continues to exceed the supply of available workers, with job vacancies still elevated. Labor supply has improved, with a pickup in immigration and an improvement in the labor force participation rate, particularly among prime-age workers. Nominal wage gains continued to slow in the first half of 2023, but they remain above the pace consistent with 2 percent inflation over the longer term, given prevailing trends in productivity growth.

Economic activity. After the strong rebound in 2021 from the pandemic-induced recession, economic activity lost momentum last year, and growth in the first quarter of this year was modest as financial conditions continued to tighten. Real consumer spending grew at a solid pace in the first quarter but appears to be moderating as consumer financing conditions have tightened and consumer confidence has remained low. Real business fixed investment growth continued to slow in the first quarter, likely reflecting tighter financial conditions and weaker output growth, while manufacturing output has been roughly unchanged so far this year after having declined in the fourth quarter. Activity in the housing sector continued to contract in response to elevated mortgage rates, but several indicators appear to have bottomed out.

Financial conditions. Financial conditions have tightened further since January. The FOMC has raised the target range for the federal funds rate a further 75 basis points since January, and the market-implied expected path of the federal funds rate over the next year shifted up. Though yields on longer-term nominal Treasury securities were little changed, on net, over this period, the relatively high level of interest rates has weighed on financing activity. Business loans at banks grew since the start of 2023, but the pace of growth continued to slow as banks tightened standards and average borrowing costs rose. Investment-grade corporate bond issuance rebounded to a brisk pace in May, following a slowdown in March and April. Speculative-grade issuance rebounded as well but was still subdued by historical standards. While business credit quality remains strong, some indicators of future business defaults are somewhat elevated. For households, mortgage originations remained weak, although consumer loans (such as auto loans and credit cards) grew further. After having risen last year, delinquency rates leveled off in the first quarter for auto loans and continued to increase for credit card loans.

Financial stability. Despite concerns about profitability at some banks, the banking system remains sound and resilient. Most measures of valuation pressures in corporate securities markets remained near the middle of their historical distributions. By contrast, valuation pressures in commercial and residential real estate markets continued to be elevated. Borrowing by households and businesses grew a bit more slowly than GDP, leaving vulnerabilities arising from household and business debt largely unchanged at moderate levels. In the banking sector, heavy reliance on uninsured deposits, declining fair values of long-duration fixed-rate assets associated with higher interest rates, and poor risk management led to the failure of three domestic banks. Broad bank equity prices fell sharply as market participants reassessed the strength of some banks with similar risk profiles to those that failed. However, the broader banking sector maintained substantial loss-absorbing capacity and ample liquidity. In the nonbank financial sector, leverage at hedge funds remained elevated, and structural vulnerabilities associated with funding risk persisted at some money market funds and certain mutual funds. (See the box "Developments Related to Financial Stability" in Part 1.)

International developments. Following a slowdown at the end of 2022, foreign activity rebounded early this year. This rebound was driven in part by strong growth in China, as the lifting of COVID-19 restrictions unleashed pent-up demand, though recent indicators suggest that momentum is slowing. Europe showed resilience to the energy price shock stemming from Russia's war against Ukraine. Foreign headline inflation continued to fall, driven by declines in retail energy prices. However, while energy inflation has moderated in many foreign economies, both food and core inflation remain elevated.

Since January, several major foreign central banks continued tightening their monetary policies, communicating concerns about elevated inflation and tight labor markets. That said, some central banks also emphasized the need to be cautious in their approach, given the lags of monetary policy and the uncertainty about the outlook for growth and inflation. The trade-weighted exchange value of the U.S. dollar is a touch lower.

Monetary Policy

In response to high inflation, the FOMC continued to increase the target range for the federal funds rate and reduce its securities holdings this year. Adjustments to both interest rates and the balance sheet are playing a role in firming the stance of monetary policy in support of the Federal Reserve's maximum-employment and price-stability goals.

Interest rate policy. The FOMC continued to increase the target range for the federal funds rate, bringing it to the current range of 5 to 5-1/4 percent. In light of the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation, the FOMC slowed the pace of policy tightening relative to last year. The FOMC will determine meeting by meeting the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, based on the totality of incoming data and their implications for the outlook for economic activity and inflation.

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 (SOMA) have been reinvested only to the extent that they exceeded monthly caps. The Federal Reserve has reduced its securities holdings by about $420 billion since January. This decrease in assets was partially offset by liquidity provisions to the banking system following the banking-sector stresses in March.

Special Topics

Employment and earnings across groups. Strong labor demand over the past two years has particularly benefited historically more disadvantaged workers. As a result, many of the disparities in employment and wages across racial, ethnic, sex, and education groups, which had been exacerbated by the pandemic, have narrowed—in some cases to historically narrow ranges. Despite this narrowing, there remain significant disparities in absolute levels of employment and wages across groups. (See the box "Developments in Employment and Earnings across Demographic Groups" in Part 1.)

Bank stress and lending. Bank lending conditions have tightened notably over the past year, and bank loan growth has slowed, following the tightening of monetary policy that started in early 2022. Banking-sector strains in March 2023 reportedly led to further tightening in lending conditions at some banks. Results from the April 2023 Senior Loan Officer Opinion Survey on Bank Lending Practices show that banks expect to further tighten their lending standards over the remainder of 2023, with some banks reporting concerns about their liquidity positions, deposit outflows, and funding costs. Economic research suggests that tighter credit conditions at banks can have adverse effects on economic activity, but different studies find effects that vary in scope, magnitude, and timing. In terms of scope, the effects are also likely to differ across borrowers, economic sectors, and geographic areas, and they may be larger for sectors that depend more heavily on bank credit, such as the commercial real estate and the small business sectors. (See the box "Recent Developments in Bank Lending Conditions" in Part 1.)

Federal Reserve's balance sheet and money markets. The Federal Reserve continued to reduce the size of its SOMA portfolio. However, in March, amid banking-sector developments, borrowing from the discount window increased, and the Federal Reserve implemented a new facility, the Bank Term Funding Program (BTFP), to make additional funding available to eligible depository institutions. As a result of Federal Reserve lending through the BTFP, the discount window, and other credit extensions, the Federal Reserve's total assets have increased since March. 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. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets" in Part 2.)

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 FOMC'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 called for elevated levels of the federal funds rate. (See the box "Monetary Policy Rules in the Current Environment" in Part 2.)

Footnotes