Part 3: Monetary Policy: Recent Developments and Outlook

Monetary Policy Report submitted to the Congress on July 17, 2012, pursuant to section 2B of the Federal Reserve Act

Monetary Policy over the First Half of 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 first half of 2012 (figure 64).¹¹ 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, over the long run, with its statutory mandate, the Committee took steps during the first half of 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 lengthening the horizon of the 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, continuing the Committee's maturity extension program (MEP) through the end of this year rather than completing the program in June as previously scheduled, retaining its existing policies regarding the reinvestment of principal payments on agency securities in agency-guaranteed mortgage-backed securities (MBS), and continuing to reinvest the proceeds of maturing Treasury securities.

The information reviewed at the January 24-25 meeting indicated that U.S. economic activity had expanded 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, 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, in part because of the European Central Bank's (ECB) three-year refinancing operation. 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 several 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 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 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.

The data in hand at the March 13 FOMC meeting indicated that U.S. economic activity had continued to expand moderately. Although the unemployment rate remained elevated, it had declined notably in recent months and payroll employment had increased. Household spending and business fixed investment had advanced. Signs of improvement or stabilization emerged in some local housing markets, but overall housing activity continued to be restrained by the substantial inventory of foreclosed and distressed properties, tight credit conditions for mortgage loans, and uncertainty about the economic outlook and future home prices. Inflation continued to be subdued, although prices of crude oil and gasoline had increased substantially. Longer-term inflation expectations had remained stable.

Many participants believed that policy actions in the euro area, notably the Greek debt swap and the ECB's longer-term refinancing operations, had helped ease strains in financial markets and reduced the downside risks to the U.S. and global economic outlook. Against that backdrop, equity prices had risen and conditions in credit markets improved, leading many meeting participants to see financial conditions as more supportive of economic growth than at the time of the January meeting.

Members viewed the information on U.S. economic activity as suggesting that the economy would continue to expand moderately. However, despite the easing of strains in global financial markets, members continued to perceive significant downside risks to economic activity. Members generally anticipated that the recent increase in oil and gasoline prices would push up inflation temporarily, but that inflation subsequently would run at or below the rate that the Committee judges most consistent with its mandate. As a result, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent, to reiterate its anticipation that economic conditions were likely to warrant exceptionally low levels for the federal funds rate at least through late 2014, to continue the program of extending the average maturity of the Federal Reserve's holdings of securities that it had adopted in September, and to maintain the existing policies regarding the reinvestment of principal payments from Federal Reserve holdings of securities. The Committee again 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.

By the time of the April 24-25 FOMC meeting, the data again indicated that economic activity was expanding moderately. Payroll employment had continued to move up, and the unemployment rate, while still elevated, had declined a little further. Household spending and business fixed investment had continued to expand. The housing sector showed signs of improvement but from a very low level of activity. Mainly reflecting the increase in the prices of crude oil and gasoline earlier this year, inflation had picked up somewhat; however, measures of long-run inflation expectations remained stable. Meeting participants judged that, in general, conditions in domestic credit markets had improved further, but noted that investors' concerns about the sovereign debt and banking situation in the euro area intensified during the intermeeting period. Many U.S. financial institutions had been taking steps to bolster their resilience, including expanding their capital levels and liquidity buffers and reducing their European exposures.

Members expected growth to be moderate over coming quarters and then to pick up over time. Strains in global financial markets stemming from the sovereign debt and banking situation in Europe as well as uncertainty about U.S. fiscal policy continued to pose significant downside risks to economic activity both here and abroad. Most members anticipated that the increase in inflation would prove temporary and that subsequently inflation would run at or below the rate that the Committee judges to be most consistent with its mandate. Against this backdrop, the Committee members reached the collective judgment that it would be appropriate to maintain the existing highly accommodative stance of monetary policy. In particular, the Committee 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 last September, and to retain the existing policies regarding the reinvestment of principal payments from Federal Reserve holdings of securities. The Committee left the forward guidance for the target federal funds rate unchanged at this meeting. Members emphasized that their forward guidance was conditional on expected economic developments, but they preferred adjusting the forward guidance only once they were more confident that the medium-term economic outlook or the risks to that outlook had changed significantly.

Data received over the period leading up to the June 19-20 FOMC meeting indicated that economic activity was expanding at a somewhat more modest pace than earlier in the year. Improvements in labor market conditions had slowed in recent months, and the unemployment rate seemed to have flattened out. Household spending appeared to be rising at a somewhat slower rate, and business investment had continued to advance. Despite some ongoing signs of improvement, the housing sector remained depressed. Consumer price inflation had declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations remained well anchored. Meeting participants observed that financial markets were volatile over the intermeeting period and that investor sentiment was strongly influenced by the developments in Europe and evidence of slowing economic growth at home and abroad.

In the discussion of monetary policy, most members agreed that the outlook had deteriorated somewhat relative to the time of the April meeting, and that significant downside risks were present, importantly including the financial stresses in the euro area and uncertainty about the degree of fiscal restraint in the United States, and its effects on economic activity over the medium term. As a result, the Committee decided that providing additional monetary policy accommodation would be appropriate to support a stronger economic recovery and to help ensure that inflation, over time, was at a level consistent with the Committee's dual mandate. Specifically, the Committee agreed to continue the MEP through the end of the year, instead of ending the program in June as had been planned. In doing so, the Federal Reserve will purchase Treasury securities with remaining maturities of 6 years to 30 years and sell or redeem an equal par value of Treasury securities with remaining maturities of approximately 3 years or less. This continuation of the MEP will proceed at about the same pace as had been executed through the first phase of the program, increasing the Federal Reserve's holdings of longer-term Treasury securities by about $267 billion while reducing its holdings of shorter-term Treasury securities by the same amount. For the duration of this program, the Committee directed the Open Market Desk to suspend its current policy of rolling over maturing Treasury securities into new issues at auction (and instead purchase only additional longer-term securities with the proceeds of maturing securities). The Committee expected the continuation of the MEP to put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. In addition, the Committee decided to continue reinvesting principal payments from its holdings of agency debt and agency MBS in agency MBS. 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 late 2014. In its statement, the Committee noted that it was prepared to take further action as appropriate to promote stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

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FOMC Communications

Transparency is an essential principle of modern central banking because it 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. Following each meeting of the FOMC, the Committee immediately releases a statement that lays out the rationale for its policy decision and issues detailed minutes of the meeting about three weeks later. Lightly edited transcripts of FOMC meetings are released to the public with a five-year lag.¹² Moreover, beginning in April 2011, the Chairman has held press conferences on an approximately quarterly basis. At the press conferences, the Chairman presents the current economic projections of FOMC participants and provides additional context for the Committee's policy decisions.

The Committee continued to consider further improvements in its communications approach in the first half of 2012. At the January 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.¹³ The statement did not represent a change in the Committee's policy approach, but rather was intended to help enhance the transparency, accountability, and effectiveness of monetary policy. 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 its longer-term objectives, the FOMC stated that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, 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, in light of a decision made at the December meeting, the Committee provided, starting in the January Summary of Economic Projections (SEP), information about each participant's assessment 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 federal funds rate given their assessments of the economic outlook. 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.

At the March meeting, participants discussed a range of additional steps that the Committee might take to help the public better understand the linkages between the evolving economic outlook and the Federal Reserve's monetary policy decisions, and thus the conditionality in the Committee's forward guidance. Participants discussed ways in which the Committee might include, in its postmeeting statements and other communications, additional qualitative or quantitative information that could convey a sense of how the Committee might adjust policy in response to changes in the economic outlook. However, participants also observed that the Committee had introduced several important enhancements to its policy communications over the past year or so; these included the Chairman's postmeeting press conference as well as changes to the FOMC statement and the SEP. Against this backdrop, some participants noted that additional experience with the changes implemented to date could be helpful in evaluating potential further enhancements.

At the April meeting, the Committee discussed the relationship between the postmeeting statement, which expresses the collective view of the Committee, and the policy projections of individual participants, which are included in the SEP. The Chairman asked the subcommittee on communications to consider possible enhancements and refinements to the SEP that might help clarify the link between economic developments and the Committee's view of the appropriate stance of monetary policy. Following up on this issue at the June meeting, participants discussed several possibilities for enhancing the clarity and transparency of the Committee's economic projections as well as the role they play in policy decisions and policy communications. Many participants indicated that if it were possible to construct a quantitative economic projection and associated path of appropriate policy that reflected the collective judgment of the Committee, such a projection could potentially be helpful in clarifying how the outlook and policy decisions are related. However, many participants noted that developing a quantitative forecast that reflects the Committee's collective judgment could be challenging, given the range of their views about the economy's structure and dynamics. Participants agreed to continue to explore ways to increase clarity and transparency in the Committee's policy communications, but many emphasized that further changes in those communications should be considered carefully.

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Footnotes

11. Members of the FOMC in 2012 consist of the members of the Board of Governors of the Federal Reserve System plus the presidents of the Federal Reserve Banks of Atlanta, Cleveland, New York, Richmond, and San Francisco. As of the June FOMC meeting, Governors Jerome H. Powell and Jeremy C. Stein joined the Board of Governors increasing the number of FOMC members to 12. Return to text

12. 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

13. The FOMC statement of longer-run goals and policy strategy is available on the Federal Reserve Board's website at www.federalreserve.gov/monetarypolicy/fomccalendars.htm. Return to text

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