Board of Governors of the Federal Reserve System

Part 1: Recent Economic and Financial Developments

Monetary Policy Report submitted to the Congress on July 5, 2024, pursuant to section 2B of the Federal Reserve Act

Domestic Developments

Inflation eased notably last year and has shown modest further progress in recent months

Inflation stepped down markedly last year and has shown modest further progress so far this year. Inflation remains elevated, though, and is still above the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent. The price index for personal consumption expenditures (PCE) rose 2.6 percent over the 12 months ending in May, down from the 4.0 percent pace a year ago but little changed since the end of last year (figure 1). After having slowed markedly in the second half of 2023, monthly core PCE price inflation—which excludes food and energy prices and is generally considered a better guide to the direction of future inflation—firmed in the first quarter of this year and then eased somewhat in April and May. As a result, the 12-month change in core PCE prices declined from the 4.7 percent pace in May of last year to 2.9 percent in December and moved down further this year, to 2.6 percent in May (figure 2). A similar message is evident from the trimmed mean measure of PCE prices constructed by the Federal Reserve Bank of Dallas, which provides an alternative approach to reducing the influence of idiosyncratic price movements. The index increased 2.8 percent over the 12 months ending in May, a pace that is somewhat slower than at the end of last year (as shown in figure 1).

Consumer energy prices have increased, while food price inflation has flattened out

PCE energy prices increased 4.8 percent in the 12 months ending in May after having declined 12.3 percent over the preceding 12 months (figure 3, left panel). Oil prices increased, on net, in the first half of this year (figure 4). Prices rose amid concerns about escalation of the conflict in the Middle East, additional costs of rerouting some oil shipping away from the Red Sea, and ongoing production cuts by OPEC (Organization of the Petroleum Exporting Countries) and its allies. Continuing geopolitical tensions, including tensions emanating from the conflicts in the Middle East and Ukraine, pose an upside risk to energy prices.

Prices of agricultural commodities and livestock edged up, on net, over the first half of this year after having come down markedly in 2022 and 2023 from the highs reached at the start of Russia's war on Ukraine in early 2022 (figure 5). As a result of these movements, the 12-month change in PCE food prices slowed substantially from its peak of 12.2 percent in August 2022 to just 1.2 percent in May (as shown in figure 3, left panel).

Prices of both energy and food products are of particular importance for lower-income households, for which such necessities account for a large share of expenditures. Reflecting the sharp increases seen in 2021 and 2022, these price indexes are 25 percent and 32 percent higher than in 2019, for food and energy, respectively.

Core goods prices increased modestly this year after having declined sharply in the second half of 2023

In assessing the outlook for inflation, it is helpful to consider three separate components of core prices: core goods, housing services, and core nonhousing services. After posting notable declines in the second half of last year, core goods prices increased modestly, on net, over the first months of this year. This development likely reflects, in part, movements in nonfuel import prices, which turned up in recent months after having declined, on net, over 2023 (figure 6). Smoothing through these monthly movements, prices for core goods over the 12 months ending in May moved down 1.1 percent, similar to their pre-pandemic rate of decline, after having increased 2.5 percent over the previous 12-month period (figure 3, right panel). The progress on inflation for core goods reflects improvements in supply–demand imbalances. Indeed, the supply chain issues and other capacity constraints that had earlier boosted inflation so much continued to ease, though at a more gradual pace this year than over the past two years, and supply–demand conditions in goods markets appear to be relatively balanced. For example, the shares of respondents to the Quarterly Survey of Plant Capacity Utilization citing insufficient supply of labor or materials as reasons for producing below capacity, which had increased considerably during the pandemic, have continued to fall and are now near pre-pandemic levels (figure 7).

Housing services price inflation continued to slow gradually but remains elevated...

The 12-month change in housing services prices moved down from more than 8 percent in May 2023 to 5.5 percent in May of this year but is still well above its pre-pandemic level (as shown in figure 3, right panel). Market rent inflation, which measures increases in rents for new housing leases to new tenants, has fallen markedly since late 2022 to near pre-pandemic rates, and this slowdown points to continued easing of housing services inflation over the year ahead. (The box "Housing Services Inflation and Market Rent Measures" provides further details.)

...while core nonhousing services price inflation flattened out so far this year

Finally, price inflation for core nonhousing services—a broad group that includes services such as travel and dining, financial services, and car repair—slowed last year but flattened out, on net, in the first five months of this year. Core nonhousing services prices rose 3.4 percent in the 12 months ending in May, down from 4.7 percent a year ago but little changed since the end of last year (as shown in figure 3, right panel). The lack of further progress this year is due in large part to price increases in volatile categories—for example, portfolio management services, which can be influenced by idiosyncratic factors, such as swings in the stock market, more than supply and demand conditions. Because labor is a significant input to these service sectors, the ongoing deceleration in labor costs—supported by softening labor demand and improvements in labor supply—suggests that disinflation will eventually resume for this category.

Measures of longer-term inflation expectations have been stable; shorter-term expectations have been volatile but are generally lower than a year earlier

The generally held view among economists and policymakers is that inflation expectations influence actual inflation by affecting wage- and price-setting decisions. Survey-based measures of expected inflation over a longer horizon have generally been moving sideways over the past year, within the range seen during the decade before the pandemic, and they appear broadly consistent with the FOMC's longer-run 2 percent inflation objective. This development is seen for surveys of households, such as the University of Michigan Surveys of Consumers, and for surveys of professional forecasters (figure 8). For example, the median forecaster in the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, continued to expect PCE price inflation to average 2 percent over the five years beginning five years from now.

Inflation expectations over a shorter horizon—which tend to follow observed inflation more closely and tend to be more volatile—have moved down, on net, since the middle of 2022 to near the range seen during the decade before the pandemic. In recent months, the median value for inflation expectations over the next year as measured in the Michigan survey has been generally lower than readings from a year earlier. Similarly, expected inflation for the next year as measured in the Survey of Consumer Expectations, conducted by the Federal Reserve Bank of New York, has also declined, on average, from a year earlier.

Market-based measures of longer-term inflation compensation, which are based on financial instruments linked to inflation such as Treasury Inflation-Protected Securities, are also broadly in line with readings seen in the years before the pandemic and consistent with PCE inflation returning to 2 percent. These measures have been little changed, on net, since the beginning of the year (figure 9).

The labor market remains strong

Payroll employment gains have been strong, averaging 248,000 per month over the first five months of the year. Job gains slowed from the first half to the second half of last year but appear to have picked up, on net, so far this year (figure 10). Recent job gains have been broad based, with over 60 percent of industries expanding their employment, on net, over the three months ending in May. That said, gains have been particularly strong in health care and in state and local governments, where employment remains below the levels implied by pre-pandemic trends.²

The unemployment rate has edged up since the middle of 2023 but was still at a historically low level of 4.0 percent in May. Through May, the unemployment rate has remained at or below 4 percent for over two years (figure 11). Unemployment rates among most age, educational attainment, sex, and ethnic and racial groups remain near their respective historical lows (figure 12).

Labor demand has been gradually cooling...

Demand for labor remained strong in the first half of 2024 but has continued to cool gradually, on net, from its very elevated levels of early 2022. Job openings, as measured in the Job Openings and Labor Turnover Survey (JOLTS), have continued to fall from their all-time high recorded in March 2022 but are still slightly above pre-pandemic levels.³ An alternative measure of job vacancies using job postings data from the large online job board Indeed also shows that while vacancies have proceeded to move gradually lower through the first half of 2024, they have remained above pre-pandemic levels.⁴ Consistent with the decline in job vacancies, the National Federation of Independent Business (NFIB) survey indicated that on net, in May, fewer firms planned to add workers over the next three months than was the case at the end of 2023; firms' hiring plans reported in the NFIB survey have been trending down since the middle of 2021.

The cooling in labor demand has been mostly due to reductions in firm hiring, as indicators of layoffs, such as initial claims for unemployment insurance and the rate of layoffs and discharges in the JOLTS report, have remained at historically low levels.

...and labor supply has increased further...

Meanwhile, the supply of labor has continued to increase on net. While labor force participation has leveled off over the past year, the U.S. population increased strongly because of high levels of immigration.

The labor force participation rate (LFPR)—which measures the share of people either working or actively seeking work—increased solidly from the beginning of 2021 through the middle of 2023 but appears to have flattened out at a relatively high level since then. The LFPR was 62.5 percent in May, a touch below its average level over the past 12 months (figure 13). Notably, the post-pandemic recovery in the LFPR has differed widely across demographic groups, with the participation rate for women aged 25 to 54 reaching all-time highs in recent months and the participation rate for individuals older than 55 exhibiting no signs of recovery. (The box "Employment and Earnings across Demographic Groups" provides further details.)

Labor supply has also been boosted in recent years by relatively strong population growth due to a notable expansion in immigration. Though official estimates by the Census Bureau show a robust increase in population growth in 2022 and 2023, recent estimates by the Congressional Budget Office indicate that actual population growth may have been considerably higher. The most recent data suggest that immigration is somewhat slower than the strong rates seen late last year.⁵

...resulting in a normalization of labor market conditions

With cooling labor demand and rising labor supply, the labor market became gradually less tight over the first half of this year, although it nevertheless remains strong. The balance between demand and supply in the labor market appears similar to that during the period immediately before the pandemic.

A variety of labor market indicators support this assessment. The ratio of job openings to unemployment has fallen notably from its peak of about 2.0 in spring 2022 to 1.2 in May, the same as its average in 2019. Similarly, the gap between the number of total available jobs (measured by employed workers plus job openings) and the number of available workers (measured by the size of the labor force) has also moved down markedly from its peak of 6.1 million in spring 2022 to 1.4 million in May and is only a bit above its 2019 average of 1.2 million (figure 14). The unemployment rate has continued to edge up this year and reached 4.0 percent in May, modestly higher than in 2019. In addition, the percentage of workers quitting their jobs each month, an indicator of the availability of attractive job prospects, has continued to move down this year and, though still elevated, is now modestly below its pre-pandemic level. Similarly, the share of respondents to the Conference Board Consumer Confidence Survey reporting that jobs are plentiful has continued to move down and is somewhat lower than its level in 2019. Furthermore, the NFIB survey indicates that firms' perceptions of labor market tightness have come down from their recent peaks and returned to their pre-pandemic range. Finally, business contacts surveyed for the Federal Reserve's May 2024 Beige Book reported signs of a cooling labor market—including easing in hiring plans, better labor availability, and modest wage growth—and, similar to 2019, cited some difficulty finding workers in selected industries or areas.⁶

Wage growth remains elevated but has slowed

Consistent with the easing in labor market tightness, nominal wage growth continued to slow so far this year, though it remains above its pre-pandemic pace and likely too high, given productivity trends, to be consistent with 2 percent inflation over time (figure 15). Total hourly compensation, as measured by the employment cost index, increased 4.1 percent over the 12 months ending in March, a noticeable slowing from the peak increase of 5.5 percent in mid-2022. Other aggregate measures of labor compensation, such as average hourly earnings (a less comprehensive measure of compensation) and the Federal Reserve Bank of Atlanta's Wage Growth Tracker (which reports the median 12-month wage growth of individuals responding to the Current Population Survey), have also continued to slow from their recent peaks in 2022 but remain well above their pre-pandemic growth rates. Wage growth has not normalized to the same extent as the measures of labor market tightness cited earlier, suggesting that there is some persistence in the adjustment process to past shocks. With PCE prices having risen 2.6 percent over the 12 months through May, these nominal wage measures suggest that most workers saw increases in the purchasing power of their wages over the past year.

Labor productivity has increased at a moderate pace with significant volatility

The extent to which nominal wage gains raise firms' costs and act as a source of inflation pressure depends importantly on the pace of productivity growth. Labor productivity in the business sector—the ratio of output to hours worked—has been extremely volatile since the pandemic began. It increased sharply in 2020, moved roughly sideways in 2021, declined strongly in 2022, and then rebounded solidly in 2023 (figure 16). Averaging through these large swings, business-sector productivity has increased at a moderate annual average rate of 1-1/2 percent since the onset of the pandemic, in line with the average rate of growth observed during the previous business cycle (from the fourth quarter of 2007 to the fourth quarter of 2019).

The pace of future productivity growth is highly uncertain. It is possible that productivity growth could remain at around its current moderate pace. However, it is also possible that the rapid adoption of new technologies like artificial intelligence (AI) and robotics, as well as the high rate of new business formation brought about by the pandemic, could boost productivity growth above that pace in coming years.

Growth in gross domestic product moderated in the first quarter, but private domestic demand remained solid

After expanding at a robust pace in the second half of last year despite restrictive financial conditions, real gross domestic product (GDP) decelerated to a moderate annual growth rate of 1.4 percent in the first quarter of this year (figure 17). The step-down was due in large part to sizable drags from net exports and inventory investment; these categories of expenditures tend to be volatile even in normal times and have been even more so since the pandemic. Growth in private domestic final purchases—that is, consumer spending, business fixed investment, and residential investment—also moderated in the first quarter but remained solid.⁷ Among these components of GDP, consumer spending rose strongly in the second half of last year and decelerated in the first quarter, as goods spending declined while services spending continued to rise solidly. Business fixed investment increased at a moderate pace in the first quarter as a result of strength in nontransportation equipment spending and intellectual property investment, while nonresidential structures slowed after surging in 2023. Residential investment grew rapidly in the first quarter, reflecting, for the most part, increases in existing home sales and construction of single-family homes.

After having returned to pre-pandemic levels in late 2021, manufacturing output has been little changed, on net, since then. While motor vehicle production has continued to rebound from earlier disruptions, factory production outside of motor vehicles has drifted down somewhat. The diffusion indexes of new orders from various national and regional surveys of manufacturers remained mostly soft in June, suggesting continued modest weakness in coming months.

Consumer spending growth has been resilient but eased this year

Consumer spending adjusted for inflation grew at a solid rate of 2.7 percent in 2023 but slowed in the first quarter to a moderate 1.5 percent pace (figure 18). The resilience in consumer spending last year in the face of high interest rates likely reflected strong job gains and rising real wages. Indeed, real disposable personal income increased at a robust 3.8 percent rate in 2023. In addition, last year's spending was bolstered by households drawing down their liquid assets, such as checking accounts, and relying more on credit.

More recently, the easing in consumer spending growth in the first quarter was accompanied by a softening in some household spending fundamentals along with somewhat restrictive financial conditions. Disposable personal income growth moderated in the first quarter after a robust pace last year. While household finances appear healthy in the aggregate, credit card and auto loan delinquencies continued to rise in the first quarter, suggesting that a growing share of households are experiencing some financial stress.

Despite the recent easing in consumer spending growth, households continue to spend more of their income than is typical. The saving rate—the difference between current income and spending, as a share of income—was 3.8 percent in the first quarter and has been well below its pre-pandemic average of over 6 percent for nine consecutive quarters (figure 19). This low saving rate likely reflects in large part the effects of high wealth and still-strong balance sheets of higher-income households.

Consumer spending since the pandemic has been more robust than measures of consumer sentiment would suggest. The indexes of consumer sentiment published by both the University of Michigan and the Conference Board remain well below their pre-pandemic levels. Although the Michigan survey index has improved markedly since spring 2022, it is further below its pre-pandemic level than the Conference Board index, which puts more weight on labor market conditions (figure 20).

Consumer financing conditions remain somewhat restrictive

Consumer financing conditions have been somewhat restrictive, reflecting high borrowing costs and tight bank lending standards. Interest rates for consumer credit products such as new credit cards and auto loans edged down in recent months but remained elevated. In the April Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), conducted by the Federal Reserve Board, banks reported continued tightening of lending standards for consumer loans in the first quarter, likely reflecting increases in delinquency rates. Indeed, credit card and auto loan delinquency rates—measured as the fraction of balances that are at least 30 days past due—have increased from their 2021 lows and are above the levels observed just before the pandemic.

Even so, financing has been generally available to support consumer spending. Consumer credit expanded moderately, on net, during the first four months of the year, driven by still-solid growth in credit card balances and modest growth in auto loans and student loans (figure 21).

Residential investment turned around and has increased since mid-2023

After rising sharply between early 2022 and late 2023, mortgage interest rates have fallen back some since last fall but, at around 7 percent, remain well above their pre-pandemic peak in 2018 (figure 22). Following the sharp rise in mortgage rates, residential investment declined steeply in 2022 and fell further in the first half of last year but has picked up since mid-2023. Solid income growth and the declines in interest rates late last year have provided support for residential investment demand so far this year. Indeed, residential investment rose sharply in the first quarter.

Sales of existing homes have moved up a touch this year but remain at very low levels. Relatively high mortgage interest rates and house prices have reduced affordability and depressed homebuying sentiment. Moreover, though new listings of existing homes have increased modestly this year, the supply of existing homes for sale remains quite low, as many homeowners are reportedly "rate locked"—unwilling to move and take out a new mortgage while mortgage rates are relatively high. Many households purchased homes or refinanced when fixed mortgage rates were at historically low levels in 2020 and 2021, and, as a result, the majority of outstanding mortgages have interest rates below 4 percent (figure 23).

In contrast to existing home sales, sales of new homes declined when mortgage rates first increased, but they bounced back fairly quickly and have remained around their pre-pandemic levels. The new home market has likely been supported by demand from buyers who are unable to find homes in the existing home market and by homebuilder interest rate incentives (figure 24).

The relative strength in new home demand encouraged builders to increase housing construction last year, boosting starts and permits for single-family housing (figure 25). In recent months, though, single-family housing starts and permits have drifted back down, likely because of high builder inventories and some easing in new home demand. Reflecting these demand and supply factors, house price growth slowed rapidly in 2022 from a historically high pace and has remained moderate since then (figure 26).

The balance of demand and supply in the multifamily housing market is fundamentally different from that in the single-family housing market, as it is dominated by rental units. Sharp increases in rents in 2021 and 2022 encouraged a dramatic increase in multifamily starts in those years, creating large amounts of new supply. With many units still under construction and weak rental growth since 2022, multifamily starts have been declining since last year (as shown in figure 25).⁸

Capital spending increased at a moderate pace

Business investment spending rose moderately in 2023 and in the first quarter of this year, supported by strong sales growth and improvements in business sentiment and profit expectations—and despite high interest rates (figure 27). However, the sources of strength in business investment shifted recently. Investment in structures—which had surged in early 2023 because of a boom in manufacturing construction, especially for factories that produce semiconductors or electric vehicle batteries—decelerated in the second half of 2023 and has slowed further so far this year, although the level of structures investment remains much higher than in previous years. Starting late last year, growth in business investment in nontransportation equipment and intellectual property stepped up, supported by gains in high-technology equipment spending and software investment.

Business financing conditions are somewhat restrictive, but credit remains generally available

Although businesses face somewhat restrictive financing conditions, as interest rates are still elevated, credit remains generally available to most nonfinancial corporations. Banks continued to tighten lending standards for all business loan types over the first quarter of this year, and even though business loan growth at banks increased in the first five months of the year, it stayed tepid. In contrast, issuance of corporate bonds remained strong so far this year, although well below the levels that prevailed at the beginning of the tightening cycle.

For small businesses, which are more reliant on bank financing than large businesses, credit conditions remained tight but stable over the first half of this year. Surveys indicate that credit supply for small businesses tightened modestly, while interest rates on loans to small businesses were little changed, staying near the top of the range observed since 2008. In addition, while loan default rates have continued to increase, delinquency rates stabilized in the first part of the year at levels that slightly exceeded their pre-pandemic rates. Finally, loan originations have remained stable over the past year and above the range observed before the pandemic, suggesting that credit continues to be available for small businesses.

Net exports were a drag on GDP growth

On balance, net exports subtracted 0.7 percentage point from U.S. GDP growth in the first quarter of this year after having contributed about one-tenth to annualized GDP growth in the second half of last year. After moderate growth in the second half of last year, real imports of goods and services have stepped up further this year despite some deceleration in U.S. GDP growth. By contrast, real export growth has slowed significantly, as some categories with especially strong growth in the second half of last year declined this year, particularly industrial supplies and materials (figure 28). The current account deficit as a share of GDP widened slightly in the first quarter of 2024 and remains wider than before the pandemic.

Federal fiscal policy actions were roughly neutral for GDP growth last year and so far this year

Federal purchases grew modestly in 2023 and moved sideways in the first quarter of the year. The overall contribution of discretionary federal fiscal policy to real GDP growth appears to have been roughly neutral last year and in the first quarter of this year, as the unwinding of pandemic-related policies offset the boost to consumption and investment from policies enacted after the pandemic.

The budget deficit and federal debt remain elevated

After surging to about 15 percent of GDP in fiscal year 2020, the budget deficit declined through fiscal 2022 as the imprint of the pandemic faded (figure 29). The budget deficit moved up to 6.3 percent of GDP in fiscal 2023 as net interest outlays increased, while tax receipts declined from their elevated level in 2022. Debt service costs have moved up sharply in recent years—as a result of higher interest rates and a higher level of debt—and are at their highest level in over two decades. The primary deficit—the difference between noninterest outlays and receipts—has moved down, on net, since fiscal 2020 and moved sideways in 2022 to 2023, as the effects of a decline in noninterest outlays as a share of GDP were offset by a decline in receipts as a share of GDP.

As a result of the unprecedented fiscal support enacted early in the pandemic, federal debt held by the public jumped roughly 20 percentage points to close to 100 percent of GDP in 2020—the highest debt-to-GDP ratio since 1947 (figure 30). The debt-to-GDP ratio has moved roughly sideways since then, as upward pressure from large primary deficits has been offset by strong nominal GDP growth.

Most state and local government budget positions remained strong...

Federal policymakers provided a historically high level of fiscal support to state and local governments during the pandemic; this aid, together with robust state tax collections in 2021 and 2022, left the sector in a strong budget position overall (figure 31). Although state tax revenues weakened in 2023 and early this year—mainly reflecting a normalization of receipts from elevated levels in 2022, as well as the effects of recently enacted tax cuts in some states—taxes as a percentage of GDP remained near recent historical norms. Moreover, states' total balances—that is, including rainy day fund balances and previous-year surplus funds—continued to be near all-time highs. Nevertheless, budget situations varied widely across states, with some states—particularly those that depend heavily on capital gains tax collections—facing tighter budget conditions. At the local level, overall property tax receipts rose briskly in 2023 and continued to increase at an elevated rate in the first quarter.

...contributing to brisk growth in employment and construction spending

Employment in state and local governments rose strongly in 2023 and early this year and has now recovered from the drop during the pandemic, though it is still below the level implied by the pre-pandemic trend (figure 32). This surge in state and local employment reflects the waning of pandemic-related headwinds such as a big increase in retirements early in the pandemic and slower wage growth relative to that in the private sector. Similarly, real construction outlays grew at a historically high rate last year, reflecting easing bottlenecks and support from federal grants, and are now somewhat above their pre-pandemic levels.

Financial Developments

The expected level of the federal funds rate over the next few years is higher since the beginning of the year

Over the late winter and early spring, the market-implied federal funds rate path moved up, boosted by above-expectations inflation data that prompted market participants to reassess the monetary policy restraint required to return inflation to 2 percent. The rise in the path was partially reversed since late April amid mixed but generally softer-than-expected data on real activity and inflation. Since the beginning of the year, on net, the market-implied federal funds rate path rose substantially (figure 33). Financial market prices currently suggest that investors expect the federal funds rate to decline to about 4.9 percent and 4.0 percent by year-ends 2024 and 2025, respectively. Roughly consistent with market-implied measures, respondents to the Blue Chip Financial Forecasts survey have significantly revised upward their expectations for the path of the federal funds rate, with the average respondent in the July survey expecting the federal funds rate to decline to 5.0 percent in the fourth quarter of 2024—0.6 percentage point higher than anticipated at the end of last year.

Yields on U.S. nominal Treasury securities are higher on net

Consistent with the upward revision in the market-implied federal funds rate path, yields on shorter-term Treasury securities rose notably between mid-February and late April before retracing some of the increase afterward. Yields on longer-term nominal Treasury securities moved similarly with yields on shorter-term nominal Treasury securities. On balance, nominal Treasury yields are moderately higher than at the beginning of the year across the maturity spectrum (figure 34). An increase in real yields—as measured by yields on Treasury Inflation-Protected Securities—accounted for a large portion of the rise in nominal Treasury yields, especially at longer maturities.

Yields on other long-term debt fluctuated with Treasury yields

Yields on corporate bonds generally followed the movements in longer-term Treasury yields and increased since the beginning of the year for both the investment- and speculative-grade segments of the market (figure 35). Both yield spreads on investment- and speculative-grade corporate bonds over comparable-maturity Treasury securities remain near the low end of their respective historical distributions as corporate bond investors appeared to be pricing in a generally optimistic outlook. Yields on municipal bonds remain at elevated levels relative to rates prevailing before the recent tightening cycle, having increased moderately since January. Meanwhile, spreads of municipal bond yields to yields on comparable-maturity Treasury securities were relatively little changed, on net, and are at compressed levels relative to their historical distribution. Yields on agency mortgage-backed securities (MBS)—an important influence on home mortgage interest rates—increased since the start of the year (figure 36). Agency MBS spreads to Treasury securities remain elevated relative to pre-pandemic levels, due in part to elevated interest rate volatility, which increases the risk of holding MBS.

Broad equity price indexes increased

Broad equity price indexes rose substantially since the start of the year, on net, led by large technology firms (figure 37). While equity prices remained sensitive to inflation news, equity investors appeared to be generally sanguine about the prospect of inflation coming down without a sharp downturn in activity. First-quarter corporate earnings releases, which were generally solid, also supported equity valuations. Meanwhile, equity prices for small-cap firms were little changed. Equity prices for large banks increased, on net, while equity prices for regional banks declined, reflecting lingering concerns about the health of these banks related in part to the quality of their commercial real estate loans. One-month option-implied volatility on the S&P 500 index—the VIX—fluctuated somewhat, reaching its peak so far this year in early April amid increased inflation concerns and geopolitical tensions, but quickly retraced and ended the period little changed (figure 38). Currently, the VIX stands close to its typical historical level that was observed before the pandemic. (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability.")

Major asset markets functioned in an orderly manner, despite some indicators pointing to low liquidity

Functioning of the Treasury securities market has continued to be orderly. While a number of measures of Treasury market liquidity remain low by historical standards, some of these measures—such as on-the-run securities market depth, a measure of the availability of securities to transact at the best quoted prices—improved modestly since January. Liquidity in the equity market remained low compared with pre-pandemic levels, and liquidity conditions deteriorated slightly since the beginning of the year. The depth of the S&P 500 futures market decreased a bit, and the price impact increased slightly. Corporate and municipal bond markets continued to function well, and trading conditions remained stable; transaction costs in these markets continued to be fairly low by historical standards.

Short-term funding market conditions remained stable

Conditions in overnight money markets remained stable, with spreads of money market rates to the Federal Reserve's administered rates roughly unchanged outside of month-end dates. Since the beginning of the year, the effective federal funds rate has stayed 7 basis points below the interest rate on reserve balances, and other unsecured overnight rates have been around similar levels with limited volatility. The Secured Overnight Financing Rate has remained 1 or 2 basis points above the offering rate on the overnight reverse repurchase agreement (ON RRP) facility, except for short-lived upward pressure around month-ends. Take-up at the ON RRP facility declined in the first quarter, reflecting an increase in the net supply of Treasury bills and the associated upward pressure on bill yields relative to the offered rate on ON RRP investments as well as relatively more attractive rates on other short-term investments such as private repurchase agreements. However, the pace of decline in take-up slowed somewhat in the second quarter, primarily because of a decline in net bill supply. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets" in Part 2.)

Assets under management of prime and government money market funds (MMFs), the largest investors in the ON RRP facility, trended up as they continued to offer favorable yields relative to most bank deposits. Prime MMFs increased liquid asset holdings and decreased weighted average maturities to satisfy the Securities and Exchange Commission's reform requirements that became effective in April. Several institutional prime funds announced conversions to government funds, while a handful announced closures, citing the reform's liquidity fees starting in October as the main driver behind the decision. However, these announced conversions and closures are unlikely to materially affect the funds' usage of the ON RRP facility, because only minor additional portfolio changes will be required for conversions and because the decline in money fund assets due to funds closing is likely too small relative to total investments in the facility.

Bank credit continued to expand at a slow pace

Banks' total loan holdings grew at about a 2 percent annualized rate in the first five months of the year, modestly up from a 1.3 percent rate in the fourth quarter of 2023. The still-tepid loan growth likely reflects the effects of higher interest rates, tighter credit standards, and economic uncertainty (figure 39). Banks in the SLOOS reported generally tighter standards and weaker demand over the first quarter of 2024, extending trends for standards and demand that have been reported since the middle of 2022. Delinquency rates continued to climb to above their longer-run average for commercial real estate and consumer loans in the first quarter of 2024 but remained in ranges observed before the pandemic across most other credit segments. Bank profitability picked up in the first quarter—reversing the dip in the fourth quarter of 2023—mainly driven by recent rising noninterest income and reduced loan loss provisions. Bank profitability levels are still below those that prevailed before the pandemic, reflecting rising funding costs and subdued loan demand (figure 40).

International Developments

Foreign economic growth rose after a soft patch in the second half of 2023

After a soft patch in the second half of 2023, foreign activity appears to have improved in both advanced foreign economies (AFEs) and emerging market economies (EMEs). In AFEs, growth rates returned to moderate levels despite the effects of restrictive monetary policy as lower inflation improved real household incomes. In Europe, energy-intensive sectors continue to struggle amid ongoing structural adjustment to past increases in energy prices following Russia's 2022 invasion of Ukraine.

In EMEs, economic growth was supported by a rebound in exports. In addition, industrial production in emerging Asia was supported by rising global demand for high-tech products, driven in part by the AI and electric vehicle sectors. China was a significant contributor to the pickup in foreign aggregate growth, boosted by both strong exports and fiscal policy support, even though household spending expanded only moderately. Notably, activity in China's property sector remained extremely weak and house prices fell sharply, prompting the authorities to introduce new policy support measures.

Inflation abroad continued to ease but remains above central bank targets in most regions

Foreign headline inflation has continued to stabilize overall since the middle of last year, primarily reflecting disinflation in AFE food and energy prices (figures 41 and 42). That said, the pace of disinflation has proved to be slower than expected and uneven across countries and economic sectors. As in the U.S., the deceleration in goods prices abroad has generally outpaced that in services prices. Inflation remains above target in Europe but has been near zero in China. In many economies, the main risks to continued disinflation include both domestic factors, such as sustained wage pressures, and external geopolitical factors, such as Russia's war against Ukraine and developments in the Middle East, which pose risks for supply chain disruptions, increased trade costs, and higher energy prices.

Foreign central banks cut policy rates but remain cautious

Many foreign central banks have noted progress in lowering inflation and easing resource tightness and have indicated that they expect further progress. Some have begun to cut their policy rates while continuing to stress a data-dependent approach.

In EMEs, several central banks began easing monetary policy late in 2023. AFE central banks began to cut rates in the second quarter. The Swiss National Bank, Sweden's Riksbank, the Bank of Canada, and the European Central Bank all cut their policy rates amid easing inflation. Policy rate paths implied by financial market pricing indicate that markets expect other AFE central banks to begin reducing interest rates later this year. Still, most foreign central bank communications have also emphasized upside risks to inflation from persistent core services inflation, currency depreciation, and geopolitical tensions. Japan has been a notable exception: Amid persistently high Japanese inflation, the Bank of Japan (BOJ) ended its negative interest rate policy and yield curve control in March.

Equity prices rose even as sovereign bond yields in advanced foreign economies increased

Foreign equity indexes rose significantly across AFEs and EMEs, consistent with above-expectations economic data and strong corporate earnings in many economies (figure 43). Nevertheless, investors withdrew from EME-focused investment funds as higher advanced-economy yields weighed on their demand for EME assets. In addition, some recent elections abroad contributed to notable movements in equities and other asset prices.

AFE sovereign bond yields increased significantly in early 2024 and are up notably since the start of the year in Germany, Japan, and the U.K. (figure 44). These increases were driven by stronger-than-expected global activity data and spillovers from higher U.S. yields. Relative to late 2023, market-implied paths for policy rates now indicate a later start to easing and fewer rate cuts by many central banks. In Japan, yields were further supported by three BOJ tightening actions: raising policy rates from negative 0.1 percent to a band of 0 to 0.1 percent, discontinuing the yield curve control framework, and issuing guidance pointing to a potential reduction in sovereign bond purchases.

The exchange value of the dollar rose notably

Since year-end 2023, the broad dollar index—a measure of the exchange value of the dollar against a trade-weighted basket of foreign currencies—increased significantly, on net, reflecting dollar appreciation against both AFE and EME currencies (figure 45). The increase in the dollar index was consistent with a widening of interest rate differentials between the U.S. and the rest of the world.

Footnotes