Part 3: Monetary Policy: Recent Developments and Outlook

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

Monetary Policy over the Second Half of 2011 and Early 2012

To promote the Federal Open Market Committee's (FOMC) objectives of maximum employment and price stability, the Committee maintained a target range for the federal funds rate of 0 to 1/4 percent throughout the second half of 2011 and into 2012 (figure 64). With the incoming data suggesting a somewhat slower pace of economic recovery than the Committee had anticipated, and with inflation seen as settling at levels at or below those consistent with its statutory mandate, the Committee took steps during the second half of 2011 and in early 2012 to provide additional monetary accommodation in order to support a stronger economic recovery and to help ensure that inflation, over time, runs at levels consistent with its mandate. These steps included strengthening its forward rate guidance regarding the Committee's expectations for the period over which economic conditions will warrant exceptionally low levels for the federal funds rate, increasing the average maturity of the Federal Reserve's securities holdings through a program of purchases and sales, and reinvesting principal payments on agency securities in agency-guaranteed mortgage-backed securities (MBS) rather than Treasury securities.

On August 1, the Committee met by videoconference to discuss issues associated with contingencies in the event that the Treasury was temporarily unable to meet its obligations because the statutory federal debt limit was not raised or in the event of a downgrade of the U.S. sovereign credit rating. Participants generally anticipated that there would be no need to make changes to existing bank regulations, the operation of the discount window, or the conduct of open market operations.²⁰ With respect to potential policy actions, participants agreed that the appropriate response would depend importantly on the actual conditions in markets and should generally consist of standard operations.

The information reviewed at the regularly scheduled FOMC meeting on August 9 indicated that the pace of the economic recovery had remained slow in recent months and that labor market conditions continued to be weak. In addition, revised data for 2008 through 2010 from the Bureau of Economic Analysis indicated that the recent recession had been deeper than previously thought and that the level of real gross domestic product (GDP) had not yet regained its pre-recession peak by the second quarter of 2011. Moreover, downward revisions to first-quarter GDP growth and the slow growth reported for the second quarter indicated that the recovery had been quite sluggish in the first half of 2011. Private nonfarm payroll employment rose at a considerably slower pace in June and July than earlier in the year, and participants noted a deterioration in labor market conditions, slower household spending, a drop in consumer and business confidence, and continued weakness in the housing sector. Inflation, which had picked up earlier in the year as a result of higher prices for some commodities and imported goods as well as supply chain disruptions resulting from the natural disaster in Japan, moderated more recently as prices of energy and some commodities fell back from their earlier peaks. Longer-term inflation expectations remained stable. U.S. financial markets were strongly influenced by developments regarding the fiscal situations in the United States and in Europe and by generally weaker-than-expected readings on economic activity, as foreign economic growth appeared to have slowed significantly. Yields on nominal Treasury securities fell notably, on net, while yields on both investment- and speculative-grade corporate bonds fell a little less than those on comparable-maturity Treasury securities, leaving risk spreads wider. Broad U.S. stock price indexes declined significantly.

Most members agreed that the economic outlook had deteriorated by enough to warrant a Committee response at the August meeting. Those viewing a shift toward more accommodative policy as appropriate generally agreed that a strengthening of the Committee's forward guidance regarding the federal funds rate, by being more explicit about the period over which the Committee expected the federal funds rate to remain exceptionally low, would be a measured response to the deterioration in the outlook over the intermeeting period. The Committee agreed to keep the target range for the federal funds rate at 0 to 1/4 percent and to state that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. That anticipated path for the federal funds rate was viewed as appropriate in light of most members' outlook for the economy.

The data in hand at the September 20–21 FOMC meeting indicated that economic activity continued to expand at a slow pace and that labor market conditions remained weak. Consumer price inflation appeared to have moderated since earlier in the year as prices of energy and some commodities declined from their peaks, but it had not yet come down as much as participants had expected at previous meetings. Industrial production expanded in July and August, real business spending on equipment and software appeared to expand further, and real consumer spending posted a solid gain in July. However, private nonfarm employment rose only slightly in August, and the unemployment rate remained high. Consumer sentiment deteriorated significantly further in August and stayed downbeat in early September. Activity in the housing sector continued to be depressed by weak demand, uncertainty about future home prices, tight credit conditions for mortgages and construction loans, and a substantial inventory of foreclosed and distressed properties. Financial markets were volatile over the intermeeting period as investors responded to somewhat disappointing news, on balance, regarding economic activity in the United States and abroad. Weak economic data contributed to rising expectations among market participants of additional monetary accommodation; those expectations and increasing concerns about the financial situation in Europe led to an appreciable decline in intermediate- and longer-term nominal Treasury yields. Fluctuations in investors' level of concern about European fiscal and financial prospects also contributed to market volatility, particularly in equity markets, and spreads of yields on investment- and speculative-grade corporate bonds over those on comparable-maturity Treasury securities rose significantly over the intermeeting period, reaching levels last registered in late 2009.

In the discussion of monetary policy, most members agreed that the outlook had deteriorated somewhat, and that there were significant downside risks to the economic outlook, including strains in global financial markets. As a result, the Committee decided that providing additional monetary accommodation would be appropriate to support a stronger recovery and to help ensure that inflation, over time, was at a level consistent with the Committee's dual mandate. Those viewing greater policy accommodation as appropriate at this meeting generally supported a maturity extension program that would combine asset purchases and sales to extend the average maturity of securities held in the System Open Market Account without generating a substantial expansion of the Federal Reserve's balance sheet or reserve balances. Specifically, those members supported a program under which the Committee would announce its intention to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. They expected this program to put downward pressure on longer-term interest rates and to help make broader financial conditions more accommodative. In addition, to help support conditions in mortgage markets, the Committee decided to reinvest principal received from its holdings of agency debt and agency MBS in agency MBS rather than continuing to reinvest those funds in longer-term Treasury securities as had been the Committee's practice since the August 2010 FOMC meeting. At the same time, the Committee decided to maintain its existing policy of rolling over maturing Treasury securities at auction. In its statement, the Committee noted that it would continue to regularly review the size and composition of its securities holdings and that it was prepared to adjust those holdings as appropriate. The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and to reaffirm its anticipation that economic conditions were likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

The information reviewed at the November 1–2 meeting indicated that the pace of economic activity strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that weighed on economic growth in the first half of the year. Global supply chain disruptions associated with the natural disaster in Japan had diminished, and the prices of energy and some commodities had come down from their recent peaks, easing strains on household budgets and likely contributing to a somewhat stronger pace of consumer spending in recent months. Real equipment and software investment expanded appreciably, and real personal consumption expenditures (PCE) rose moderately in the third quarter. However, real disposable income declined in the third quarter and consumer sentiment continued to be downbeat in October. In addition, labor market conditions remained weak as the pace of private-sector job gains in the third quarter as a whole was less than it was in the first half of the year. Overall consumer price inflation was more moderate than earlier in the year, as prices of energy and some commodities declined from their recent peaks, and measures of longer-run inflation expectations remained stable. Financial markets were quite volatile and investor sentiment was strongly influenced by prospects for Europe, as market participants remained highly attuned to developments regarding possible steps to contain the fiscal and banking problems there. Longer-term Treasury yields declined appreciably, on net, over the period, and yields on investment- and speculative-grade corporate bonds moved lower, leaving their spreads to Treasury securities slightly narrower. Although equity markets were volatile, broad U.S. equity price indexes ended the intermeeting period little changed.

Most FOMC members anticipated that the pace of economic growth would remain moderate over coming quarters, with unemployment declining only gradually and inflation settling at or below levels consistent with the dual mandate. Moreover, the recovery was still seen as subject to significant downside risks, including strains in global financial markets. Accordingly, in the discussion of monetary policy, all Committee members agreed to continue the program of extending the average maturity of the Federal Reserve's holdings of securities as announced in September. The Committee decided to maintain its existing policy of reinvesting principal payments from its holdings of agency debt and agency MBS in agency MBS and of rolling over maturing Treasury securities at auction. In addition, the Committee agreed to keep the target range for the federal funds rate at 0 to 1/4 percent and to reiterate its expectation that economic conditions were likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

Over subsequent weeks, financial markets appeared to become increasingly concerned that a timely resolution of the European sovereign debt situation might not occur despite the measures that authorities there announced in October; pressures on European sovereign debt markets increased, and conditions in European funding markets deteriorated appreciably. The greater financial stress appeared likely to damp economic activity in the euro area and potentially to pose a risk to the economic recovery in the United States.

On November 28, the Committee met by videoconference to discuss a proposal to amend and augment the Federal Reserve's temporary liquidity swap arrangements with foreign central banks in light of the increased strains in global financial markets. The proposal included a six-month extension of the sunset date and a 50 basis point reduction in the pricing on the existing dollar liquidity swap arrangements with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank (ECB), and the Swiss National Bank. In addition, the proposal included the establishment, as a contingency measure, of swap arrangements that would allow the Federal Reserve to provide liquidity to U.S. institutions in foreign currencies should the need arise. The proposal was aimed at helping to ease strains in financial markets and thereby to mitigate the effects of such strains on the supply of credit to U.S. households and businesses, thus supporting the economic recovery. Most participants agreed that the proposed changes to the swap arrangements would represent an important demonstration of the commitment of the Federal Reserve and the other central banks to work together to support the global financial system. At the conclusion of the discussion, almost all members agreed to support the changes to the existing swap line arrangements and the establishment of the new foreign currency swap agreements.

As of the December 13 FOMC meeting, the data indicated that U.S. economic activity had expanded moderately despite some apparent slowing in the growth of foreign economies and strains in global financial markets. Conditions in the labor market seemed to have improved somewhat, as the unemployment rate dropped in November and private nonfarm employment continued to increase moderately. In October, industrial production rose, and overall real PCE grew modestly following significant gains in the previous month. However, revised estimates indicated that households' real disposable income declined in the second and third quarters, the net wealth of households decreased, and consumer sentiment was still at a subdued level in early December. Activity in the housing market remained depressed by the substantial inventory of foreclosed and distressed properties and by weak demand that reflected tight credit conditions for mortgage loans and uncertainty about future home prices. Overall consumer price inflation continued to be more modest than earlier in the year, and measures of long-run inflation expectations had been stable. The risks associated with the fiscal and financial difficulties in Europe remained the focus of attention in financial markets over the intermeeting period and contributed to heightened volatility in a wide range of asset markets. However, stock prices and longer-term interest rates had changed little, on balance, since the November meeting.

Members viewed the information on U.S. economic activity received over the intermeeting period as suggesting that the economy would continue to expand moderately. Strains in global financial markets continued to pose significant downside risks to economic activity. Members also anticipated that inflation would settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate. In the discussion of monetary policy for the period immediately ahead, Committee members generally agreed that their overall assessments of the economic outlook had not changed greatly since their previous meeting. As a result, the Committee decided to continue the program of extending the average maturity of the Federal Reserve's holdings of securities as announced in September, to retain the existing policies regarding the reinvestment of principal payments from Federal Reserve holdings of securities, and to keep the target range for the federal funds rate at 0 to 1/4 percent. While several members noted that the reference to mid-2013 in the forward rate guidance might need to be adjusted before long, and a number of them looked forward to considering possible enhancements to the Committee's communications, the Committee agreed to reiterate its anticipation that economic conditions were likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

The information reviewed at the January 24–25 meeting indicated that U.S. economic activity continued to expand moderately, while global growth appeared to be slowing. Labor market indicators pointed to some further improvement in labor market conditions, but progress was gradual and the unemployment rate remained elevated. Household spending had continued to advance at a moderate pace despite diminished growth in real disposable income, but growth in business fixed investment had slowed. The housing sector remained depressed. Inflation had been subdued in recent months, there was little evidence of wage or cost pressures, and longer-term inflation expectations had remained stable. Meeting participants observed that financial conditions had improved and financial market stresses had eased somewhat during the intermeeting period: Equity prices were higher, volatility had declined, and bank lending conditions appeared to be improving. Participants noted that the ECB's three-year refinancing operation had apparently resulted in improved conditions in European sovereign debt markets. Nonetheless, participants expected that global financial markets would remain focused on the evolving situation in Europe and they anticipated that further policy efforts would be required to fully address the fiscal and financial problems there.

With the economy facing continuing headwinds and growth slowing in a number of U.S. export markets, members generally expected a modest pace of economic growth over coming quarters, with the unemployment rate declining only gradually. At the same time, members thought that inflation would run at levels at or below those consistent with the Committee's dual mandate. Against this backdrop, members agreed that it would be appropriate to maintain the existing highly accommodative stance of monetary policy. They agreed to keep the target range for the federal funds rate at 0 to 1/4 percent, to continue the program of extending the average maturity of the Federal Reserve's holdings of securities as announced in September, and to retain the existing policies regarding the reinvestment of principal payments from Federal Reserve holdings of securities. In light of the economic outlook, most members also agreed to indicate that the Committee expects to maintain a highly accommodative stance for monetary policy and anticipates that economic conditions are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014, longer than had been indicated in recent FOMC statements. The Committee also stated that it is prepared to adjust the size and composition of its securities holdings as appropriate to promote a stronger economic recovery in a context of price stability.

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FOMC Communications

Transparency is an essential principle of modern central banking because it appropriately contributes to the accountability of central banks to the government and to the public and because it can enhance the effectiveness of central banks in achieving their macroeconomic objectives. To this end, the Federal Reserve provides to the public a considerable amount of information concerning the conduct of monetary policy. Immediately following each meeting of the FOMC, the Committee releases a statement that lays out the rationale for its policy decision, and detailed minutes of each FOMC meeting are made public three weeks following the meeting. Lightly edited transcripts of FOMC meetings are released to the public with a five-year lag.²¹ Moreover, since last April, the Chairman has held press conferences after regularly scheduled two-day FOMC meetings. At the press conferences, the Chairman presents the current economic projections of FOMC participants and provides additional context for its policy decisions.

The Committee continued to consider additional improvements in its communications approach in the second half of 2011 and the first part of 2012. In a discussion on external communications at the September 20–21 FOMC meeting, most participants indicated that they favored taking steps to increase further the transparency of monetary policy, including providing more information about the Committee's longer-run policy objectives and the factors that influence the Committee's policy decisions. Participants generally agreed that a clear statement of the Committee's longer-run policy objectives could be helpful; some noted that it would also be useful to clarify the linkage between these longer-run objectives and the Committee's approach to setting the stance of monetary policy in the short and medium runs. Participants generally saw the Committee's postmeeting statements as not well suited to communicate fully the Committee's thinking about its objectives and its policy framework, and they agreed that the Committee would need to use other means to communicate that information or to supplement information in the statement. A number of participants suggested that the Committee's periodic Summary of Economic Projections (SEP) could be used to provide more information about their views on the longer-run objectives and the likely evolution of monetary policy.

At the November 1–2 FOMC meeting, participants discussed alternative monetary policy strategies and potential approaches for enhancing the clarity of their public communications, though no decision was made at that meeting to change the Committee's policy strategy or communications. It was noted that many central banks around the world pursue an explicit inflation objective, maintain the flexibility to stabilize economic activity, and seek to communicate their forecasts and policy plans as clearly as possible. Many participants pointed to the merits of specifying an explicit longer-run inflation goal, but it was noted that such a step could be misperceived as placing greater weight on price stability than on maximum employment; consequently, some suggested that a numerical inflation goal would need to be set forth within a context that clearly underscored the Committee's commitment to fostering both parts of its dual mandate. Most of participants agreed that it could be beneficial to formulate and publish a statement that would elucidate the Committee's policy approach, and participants generally expressed interest in providing additional information to the public about the likely future path of the target federal funds rate. The Chairman asked the subcommittee on communications, headed by Governor Yellen, to give consideration to a possible statement of the Committee's longer-run goals and policy strategy, and he also encouraged the subcommittee to explore potential approaches for incorporating information about participants' assessments of appropriate monetary policy into the SEP.²²

At the December 13 FOMC meeting, participants further considered ways in which the Committee might enhance the clarity and transparency of its public communications. The subcommittee on communications recommended an approach for incorporating information about participants' projections of appropriate future monetary policy into the SEP, which the FOMC releases four times each year. In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP. Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions. At the conclusion of the discussion, participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January.

Following up on the Committee's discussion of policy frameworks at its November meeting, the subcommittee on communications presented a draft statement of the Committee's longer-run goals and policy strategy. Participants generally agreed that issuing such a statement could be helpful in enhancing the transparency and accountability of monetary policy and in facilitating well-informed decisionmaking by households and businesses, and thus in enhancing the Committee's ability to promote the goals specified in its statutory mandate in the face of significant economic disturbances. However, a couple of participants expressed the concern that a statement that was sufficiently nuanced to capture the diversity of views on the Committee might not, in fact, enhance public understanding of the Committee's actions and intentions. Participants commented on the draft statement, and the Chairman encouraged the subcommittee to make adjustments to the draft and to present a revised version for the Committee's further consideration in January.

At the January 24–25 meeting, the subcommittee on communications presented a revised draft of a statement of principles regarding the FOMC's longer-run goals and monetary policy strategy. Almost all participants supported adopting and releasing the revised statement (see the box "FOMC Statement Regarding Longer-Run Goals and Monetary Policy Strategy"). It was noted that the proposed statement did not represent a change in the Committee's policy approach. Instead, the statement was intended to help enhance the transparency, accountability, and effectiveness of monetary policy.

In addition, in light of the decision made at the December meeting, the Committee provided in the January SEP information about each participant's assessments of appropriate monetary policy. Specifically, the SEP included information about participants' estimates of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also reported participants' current projections of the likely timing of the appropriate first increase in the target rate given their projections of future economic conditions. The accompanying narrative described the key factors underlying those assessments and provided some qualitative information regarding participants' expectations for the Federal Reserve's balance sheet. A number of participants suggested further possible enhancements to the SEP; the Chairman asked the subcommittee to explore such enhancements over coming months.

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Footnotes

20. Members of the FOMC consist of the members of the Board of Governors of the Federal Reserve System plus the president of the Federal Reserve Bank of New York and 4 of the remaining 11 Reserve Bank presidents, who serve one-year terms on a rotating basis. Participants at FOMC meetings consist of the members of the Board of Governors of the Federal Reserve System and all 12 Reserve Bank presidents. Return to text

21. FOMC statements, minutes, and transcripts, as well as other related information, are available on the Federal Reserve Board's website at www.federalreserve.gov/monetarypolicy/fomc.htm. Return to text

22. The subcommittee on communications is chaired by Governor Yellen and includes Governor Raskin and Presidents Evans and Plosser. Return to text

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