Part 1: Overview: Monetary Policy and the Economic Outlook

Monetary Policy Report submitted to the Congress on February 29, 2012, pursuant to section 2B of the Federal Reserve Act

Economic activity in the United States expanded at a moderate rate in the second half of 2011 following an anemic gain in the first half, and the moderate pace of expansion appears to have continued into the opening months of 2012. Activity was held down in the first half of 2011 by temporary factors, particularly supply chain disruptions stemming from the earthquake in Japan and the damping effect of higher energy prices on consumer spending. As the effects of these factors waned over the second half of the year, economic activity picked up. Conditions in the labor market have improved since last summer, with an increase in the pace of job gains and a noticeable reduction in the unemployment rate. Meanwhile, consumer price inflation has stepped down from the temporarily high levels observed over the first half of 2011, as commodity and import prices retreated and as longer-term inflation expectations remained stable. Looking ahead, growth is likely to be modest during the coming year, as several factors appear likely to continue to restrain activity, including restricted access to credit for many households and small businesses, the still-depressed housing market, tight fiscal policy at all levels of government, and some slowing in global economic growth.

In light of these conditions, the Federal Open Market Committee (FOMC) took a number of steps during the second half of 2011 and early 2012 to provide additional monetary policy accommodation and thereby support a stronger economic recovery in the context of price stability. These steps included modifying the forward rate guidance included in postmeeting statements, increasing the average maturity of the Federal Reserve's securities holdings, and shifting the reinvestment of principal payments on agency securities from Treasury securities to agency-guaranteed mortgage-backed securities (MBS).

Throughout the second half of 2011 and early 2012, participants in financial markets focused on the fiscal and banking crisis in Europe. Concerns regarding the potential for spillovers to the U.S. economy and financial markets weighed on investor sentiment, contributing to significant volatility in a wide range of asset prices and at times prompting sharp pullbacks from risk-taking. Strains eased somewhat in a number of financial markets in late 2011 and early this year as investors seemed to become more confident that European policymakers would take the steps necessary to address the crisis. The more positive market sentiment was bolstered by recent U.S. data releases, which pointed to greater strength, on balance, than investors had expected. Nonetheless, market participants reportedly remain cautious about risks in the financial system, and credit default swap spreads for U.S. financial institutions have widened, on net, since early last summer.

After rising at an annual rate of just 3/4 percent in the first half of 2011, real gross domestic product (GDP) is estimated to have increased at a 2-1/4 percent rate in the second half.¹ The growth rate of real consumer spending also firmed a bit in the second half of the year, although the fundamental determinants of household spending improved little: Real household income and wealth stagnated, and access to credit remained tight for many potential borrowers. Consumer sentiment has rebounded from the summer's depressed levels but remains low by historical standards. Meanwhile, real investment in equipment and software and exports posted solid gains over the second half of the year. In contrast, the housing market remains depressed, weighed down by the large inventory of vacant houses for sale, the substantial volume of distressed sales, and homebuyers' concerns about the strength of the recovery and the potential for further declines in house prices. In the government sector, real purchases of goods and services continued to decline over the second half of the year.

Labor market conditions have improved. The unemployment rate moved down from around 9 percent over the first eight months of 2011 to 8-1/4 percent in January 2012. However, even with this improvement, the jobless rate remains quite elevated. Furthermore, the share of the unemployed who have been jobless for more than six months, although down slightly from its peak, was still above 40 percent in January--roughly double the fraction that prevailed during the economic expansion of the previous decade. Meanwhile, private payroll employment gains averaged 165,000 jobs per month in the second half of 2011, a bit slower than the pace in the first half of the year, but gains in December and January were more robust, averaging almost 240,000 per month.

Consumer price inflation stepped down in the second half of 2011. After rising at an annual rate of 3-1/2 percent in the first half of the year, prices for personal consumption expenditures (PCE) rose just 1-1/2 percent in the second half. PCE prices excluding food and energy also decelerated, rising at an annual rate of roughly 1-1/2 percent in the second half of 2011, compared with about 2 percent in the first half. The decline in inflation was largely in response to decreases in global commodity prices following their surge early in 2011, as well as a restoration of supply chains for motor vehicle production that had been disrupted after the earthquake in Japan and some deceleration in the prices of imported goods other than raw commodities.

The European fiscal and banking crisis intensified in the second half of the year. During the summer, the governments of Italy and Spain came under significant financial pressure and borrowing costs increased for many euro-area governments and banks. In early August, the European Central Bank (ECB) responded by resuming purchases of marketable debt securities. Although yields on the government debt of Italy and Spain temporarily moved lower, market conditions deteriorated in the fall and funding pressures for some governments and banks increased further. Over the second half of the year, European leaders worked toward bolstering the financial backstop for euro-area governments, reinforcing the fiscal discipline of those governments, and strengthening the capital and liquidity positions of banks. Additionally, the ECB made a significant injection of euro liquidity via its first three-year refinancing operation, and central banks agreed to reduce the price of U.S. dollar liquidity based on swap lines with the Federal Reserve. Since December, following these actions, yields on the debt of vulnerable European governments declined to some extent and funding pressures on European banks eased.

A number of sources of investor anxiety--including the European crisis, concerns about the sustainability of U.S. fiscal policy, and a slowdown in global growth--weighed on U.S. financial markets early in the second half of 2011. More recently, these concerns eased somewhat, reflecting actions taken by global central banks as well as U.S. data releases that pointed to greater strength, on balance, than market participants had anticipated. Broad equity prices fell notably in August but subsequently retraced, and they are now little changed, on net, since early July. Corporate bond spreads remain elevated. Partly as a result of the forward guidance and ongoing maturity extension program provided by the Federal Reserve, market participants expect the target federal funds rate to remain low for a longer period than they thought early last July, and Treasury yields have moved down significantly. Meanwhile, measures of inflation compensation over the next five years derived from yields on nominal and inflation-indexed Treasury securities are little changed, on balance, though the forward measure 5-to-10 years ahead remains below its level in the middle of last year.

Among nonfinancial corporations, larger and higher-credit-quality firms with access to capital markets took advantage of generally attractive financing conditions to raise funds in the second half of 2011. On the other hand, for smaller firms without access to credit markets and those with less-solid financial situations, borrowing conditions remained more challenging. Reflecting these developments, investment-grade nonfinancial corporations continued to issue debt at a robust pace while speculative-grade issuance declined, as investors' appetite for riskier assets diminished. Similar issuance patterns were evident in the market for syndicated loans, where investment-grade issuance continued to be strong while that of higher-yielding leveraged loans fell back. In addition, commercial and industrial (C&I) loans on banks' books expanded strongly, particularly for larger domestic banks that are most likely to lend to big firms. According to the January Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), domestic banks eased terms on C&I loans and experienced increased loan demand during the fourth quarter of the year, the latter development in part reflecting a shift in some borrowing away from European banks.² By contrast, although credit supply conditions for smaller firms appear to have eased somewhat in the last several months, they remained tighter relative to historical norms than for larger firms. Commercial mortgage debt continued to decline through the third quarter of 2011, albeit at a more moderate pace than in 2010.

Household debt appears to have declined at a slightly slower pace in the second half of 2011 than in the first half, with the continued contraction in mortgage debt partially offset by growth in consumer credit. Even though mortgage rates continued to be near historically low levels, the volume of new mortgage loans remained muted. The smaller quantity of new mortgage origination reflects potential buyers' lack of either the down payment or credit history required to qualify for these loans, and many appear reluctant to buy a house now because of concerns about their income prospects and employment status, as well as the risk of further declines in house prices. Delinquency rates on most categories of residential mortgages edged lower but stayed near recent highs, and the number of properties in the foreclosure process remained elevated. Issuance of consumer asset-backed securities in the second half of 2011 ran at about the same rate as it had over the previous 18 months. A modest net fraction of SLOOS respondents to both the October and January surveys indicated that they had eased their standards on all categories of consumer loans.

Measures of the profitability of the U.S. banking industry have edged up, on net, since mid-2011, as indicators of credit quality continued to show signs of improvement and banks trimmed noninterest expenses. Meanwhile, banks' regulatory capital ratios remained at historically high levels, as authorities continued to take steps to enhance their regulation of financial institutions. Nonetheless, conditions in unsecured interbank funding markets deteriorated. Strains were particularly evident for European financial institutions, with funding costs increasing and maturities shortening, on balance, as investors focused on counterparty credit risk amid growing anxiety about the ongoing crisis in Europe. Given solid deposit growth and modest expansion in bank credit across the industry, most domestic banks reportedly had limited need for unsecured funding.

Concerns about the condition of financial institutions gave rise to heightened investor anxiety regarding counterparty exposures during the second half of 2011. Responses to the December Senior Credit Officer Opinion Survey on Dealer Financing Terms, or SCOOS, indicated that dealers devoted increased time and attention to the management of concentrated credit exposures to other financial intermediaries over the previous three months, and 80 percent of dealers reported reducing credit limits for some specific counterparties.³ Respondents also reported a broad but moderate tightening of credit terms applicable to important classes of counterparties over the previous three months, importantly reflecting a worsening in general market liquidity and functioning as well as a reduced willingness to take on risk.

In order to support a stronger economic recovery and help ensure that inflation, over time, is at levels consistent with its dual mandate, the FOMC provided additional monetary policy accommodation during the second half of 2011 and early 2012. In August, the Committee modified its forward rate guidance, noting that economic conditions were likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. The FOMC decided at its September meeting to extend the average maturity of its Treasury holdings, and to reinvest principal payments from its holdings of agency debt and agency MBS in agency MBS rather than in Treasury securities.⁴ Finally, at the Committee's January 2012 meeting, the FOMC modified its forward guidance to indicate that it expected economic conditions to warrant exceptionally low levels for the federal funds rate at least through late 2014. The Committee noted that it would regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in the context of price stability.

In addition to these policy actions, the Federal Reserve took further steps to improve communications regarding its monetary policy decisions and deliberations. At the Committee's January 2012 meeting, the FOMC released a statement of its longer-run goals and policy strategy in an effort to enhance the transparency, accountability, and effectiveness of monetary policy and to facilitate well-informed decisionmaking by households and businesses. The statement emphasizes the Federal Reserve's firm commitment to pursue its congressional mandate to promote maximum employment, stable prices, and moderate long-term interest rates. To clarify how it seeks to achieve these objectives, the FOMC stated that inflation at the rate of 2 percent, as measured by the annual change in the PCE price index, is most consistent over the longer run with the Federal Reserve's statutory mandate. While noting that the Committee's assessments of the maximum level of employment are necessarily uncertain and subject to revision, the statement indicated that the central tendency of FOMC participants' current estimates of the longer-run normal rate of unemployment is between 5.2 and 6.0 percent. It stressed that the Federal Reserve's statutory objectives are generally complementary, but when they are not, the Committee will follow a balanced approach in its efforts to return both inflation and employment to levels consistent with its mandate.

In addition, the January Summary of Economic Projections (SEP) provided information for the first time about FOMC participants' individual assessments of the appropriate timing of the first increase in the target federal funds rate given their view of the economic situation and outlook, as well as participants' assessments of the appropriate level of the target federal funds rate in the fourth quarter of each year through 2014 and over the longer run. The SEP also included qualitative information regarding individual participants' expectations for the Federal Reserve's balance sheet under appropriate monetary policy.

The economic projections in the January SEP (presented in Part 4 of this report) indicated that FOMC participants (the members of the Board of Governors and the presidents of the 12 Federal Reserve Banks) generally anticipated aggregate output to increase at a somewhat faster pace in 2012 than in 2011. Although the participants marked down their GDP growth projections slightly compared with those prepared in November, they stated that the economic information received since that time showed continued gradual improvement in the pace of economic activity during the second half of 2011, as the influence of the temporary factors that damped activity in the first half of the year subsided. However, a number of additional factors, including ongoing weakness in the housing sector, modest growth in real disposable income, and the restraining effects of fiscal consolidation, suggested that the pace of the recovery would be modest in coming quarters. Participants also read the information on economic activity abroad, particularly in Europe, as pointing to weaker demand for U.S. exports. As these factors wane, FOMC participants anticipated that the pace of the economic expansion will gradually strengthen over the 2013–14 period, pushing the rate of increase in real GDP above their estimates of the longer-run rate of output growth. With real GDP expected to increase at a modest rate in 2012, the unemployment rate was projected to decline only a little this year. Participants expected further gradual improvement in labor market conditions over 2013 and 2014 as the pace of output growth picks up. They also noted that inflation expectations had remained stable over the past year despite fluctuations in headline inflation. Most participants anticipated that both headline and core inflation would remain subdued over the 2012–14 period at rates at or below the FOMC's longer-run objective of 2 percent.

With the unemployment rate projected to remain elevated over the projection period and inflation expected to be subdued, most participants expected that the federal funds rate would remain extraordinarily low for some time. Six participants anticipated that, under appropriate monetary policy, the first increase in the target federal funds rate would occur after 2014, and five expected policy firming to commence during 2014. The remaining six participants judged that raising the federal funds rate sooner would be required to forestall inflationary pressures or avoid distortions in the financial system. All of the individual assessments of the appropriate target federal funds rate over the next few years were below the participants' estimates of the longer-run level of the federal funds rate. Eleven of the 17 participants placed the target federal funds rate at 1 percent or lower at the end of 2014, while 5 saw the appropriate rate as 2 percent or higher.

A sizable majority of participants continued to judge the level of uncertainty associated with their projections for real activity and the unemployment rate as exceeding the average of the past 20 years. Many also attached a greater-than-normal level of uncertainty to their forecasts for inflation. As in November, many participants saw downside risks attending their forecasts of real GDP growth and upside risks to their forecasts of the unemployment rate; most participants viewed the risks to their inflation projections as broadly balanced. Participants also reported their assessments of the values to which key macroeconomic variables would be expected to converge over the longer term under appropriate monetary policy and in the absence of further shocks to the economy. The central tendencies of these longer-run projections were 2.3 to 2.6 percent for real GDP growth and 5.2 to 6.0 percent for the unemployment rate. In light of the 2 percent inflation that is the objective included in the statement of longer-run goals and policy strategy adopted at the January meeting, the range and central tendency of participants' projections of longer-run inflation were all equal to 2 percent.

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Footnotes

1. The numbers in this report are based on the Bureau of Economic Analysis's (BEA) advance estimate of fourth-quarter GDP, which was released on January 27, 2012. The BEA will release a revised estimate on February 29, 2012. Return to text

2. The SLOOS is available on the Federal Reserve Board's website at www.federalreserve.gov/boarddocs/SnLoanSurvey. Return to text

3. The SCOOS is available on the Federal Reserve Board's website at www.federalreserve.gov/econresdata/releases/scoos.htm. Return to text

4. Between the August 2010 and September 2011 FOMC meetings, principal payments from securities held on the Federal Reserve balance sheet had been reinvested in longer-term Treasury securities. Return to text