Part 2: Monetary Policy

Monetary Policy Report submitted to the Congress on July 17, 2013, pursuant to section 2B of the Federal Reserve Act

With unemployment still well above normal levels and inflation below its longer-run objective, the Federal Open Market Committee (FOMC) has continued its highly accommodative monetary policy this year by maintaining its forward guidance with regard to the target for the federal funds rate and continuing its program of large-scale asset purchases.

To foster the attainment of maximum employment and price stability, the FOMC kept in place its forward guidance on the path of the federal funds rate . . .

With unemployment still elevated and declining only gradually, and inflation having moved further below the Committee's 2 percent longer-run objective, the FOMC has maintained its highly accommodative monetary policy stance this year. Because the target range for the federal funds rate remains at its effective lower bound, the Committee has been relying mainly on its forward guidance about the future path of the federal funds rate and on its program of large-scale asset purchases to make progress toward its mandated objectives.

With regard to the federal funds rate, the Committee has continued to indicate its expectation that the current exceptionally low target range of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored (figure 46). In determining how long to maintain its target range for the federal funds rate, the Committee has stated that it would also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The FOMC also has reiterated that a highly accommodative stance of monetary policy would remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. Moreover, the Committee has indicated that when it decides to begin to remove policy accommodation, it would take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

. . . and maintained its policy of large-scale asset purchases . . .

To sustain downward pressure on longer-term interest rates, support mortgage markets, and help make broader financial conditions more accommodative, the FOMC has continued its large-scale asset purchases; the Committee also has maintained its practices of reinvesting principal payments it receives on agency debt and agency-guaranteed mortgage-backed securities (MBS) in new agency MBS and of rolling over maturing Treasury securities at auction. Over the first half of this year, purchases of longer-term securities totaled $510 billion, with the Committee purchasing additional agency MBS at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee reconfirmed at each meeting during the first half of 2013 that it would continue purchasing Treasury and agency MBS until the outlook for the labor market has improved substantially in a context of price stability.

In determining the size, pace, and composition of its asset purchases, the Committee has taken account of the likely efficacy and costs of such purchases. As noted in the minutes of the March FOMC meeting, most participants saw asset purchases as having a meaningful effect in easing financial conditions--for example, keeping longer-term interest rates, including mortgage rates, lower than they would be otherwise--and so supporting economic growth.⁸ FOMC participants generally judged that these benefits outweighed the likely costs and risks of additional purchases. However, the Committee has continued to monitor those costs and risks, including possible effects on financial stability, security market functioning, the smooth withdrawal of monetary accommodation when it eventually becomes appropriate, and the Federal Reserve's net income.⁹

. . . while providing additional information about potential adjustments to its asset purchases

During the first half of 2013, the FOMC took various steps to provide greater clarity regarding its thinking about possible adjustments in the pace of asset purchases and the eventual cessation of those purchases. In its statement after the March meeting, the Committee added that the size, pace, and composition of its asset purchases would reflect the extent of progress toward its economic objectives, in addition to the likely efficacy and costs of such purchases.¹⁰ And in May, to highlight its willingness to adjust the flow of purchases in light of incoming information, the Committee noted that it was prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changed.¹¹

At the June FOMC meeting, Committee participants generally thought it would be helpful to provide greater clarity about the Committee's approach to decisions about its asset purchase program and thereby reduce investors' uncertainty about how it might react to future economic developments. In choosing to provide this clarification, the Committee made no changes to its approach to monetary policy. Against this backdrop, Chairman Bernanke, at his postmeeting press conference, described a possible path for asset purchases that the Committee would anticipate implementing if economic conditions evolved in a manner broadly consistent with the outcomes the Committee saw as most likely.¹² The Chairman noted that such economic outcomes involved continued gains in labor markets, supported by moderate growth that picks up over the next several quarters, and inflation moving back toward its 2 percent objective over time. If the economy were to evolve broadly in line with the Committee's expectations, the FOMC would moderate the pace of purchases later this year and continue to reduce the pace of purchases in measured steps until purchases ended around the middle of next year, at which time the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains and inflation moving back toward the FOMC's 2 percent target.

In emphasizing that the Committee's policy was in no way predetermined, the Chairman noted that if economic conditions improved faster than expected, the pace of asset purchases could be reduced somewhat more quickly. Conversely, if the outlook for the economy or the labor market became less favorable, inflation did not move over time toward the Committee's 2 percent longer-term objective, or financial conditions were judged to be inconsistent with further progress in the labor markets, reductions in the pace of purchases could be delayed or the pace increased for a time. The Chairman also drew a strong distinction between the asset purchase program and the forward guidance regarding the target for the federal funds rate, noting that the Committee anticipates that there will be a considerable period between the end of asset purchases and the time when it becomes appropriate to increase the target for the federal funds rate.

The Committee's large-scale asset purchases led to a significant increase in the size of the Federal Reserve's balance sheet

As a result of the Committee's large-scale asset purchase program, Federal Reserve assets have increased significantly since the end of last year (figure 47). The par value of the System Open Market Account's (SOMA) holdings of U.S. Treasury securities increased about $300 billion to $2 trillion, and the par value of its holdings of agency debt and MBS increased about $270 billion, on net, to $1.3 trillion.¹³ These asset purchases accounted for nearly all of the increase in total assets of the Federal Reserve and were accompanied by a significant rise in reserve balances over the period. As of July 10, the SOMA's holdings of Treasury and agency securities constituted 56 percent and 36 percent, respectively, of the $3.5 trillion in total Federal Reserve assets. By contrast, balances of facilities established during the financial crisis declined further from already low levels.¹⁴

Interest income on the SOMA portfolio continued to support a substantial sum of remittances to the Treasury Department. In the first quarter, the Federal Reserve provided more than $15 billion of such distributions to the Treasury.¹⁵ The Federal Reserve has also released detailed transactions data on open market operations and discount window operations with a two-year lag in compliance with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

The Committee also reviewed the principles for policy normalization

During its May and June meetings, the FOMC reviewed the Federal Reserve's principles for the eventual normalization of the stance of monetary policy, which initially were published in the minutes of the Committee's June 2011 meeting.¹⁶ The Committee's discussion included various aspects of those principles--the size and composition of the SOMA portfolio in the longer run, the use of a range of reserve-draining tools, the approach to sales of securities, the eventual framework for policy implementation, and the relationship between the principles and the economic thresholds in the Committee's forward guidance on the federal funds rate. Meeting participants, in general, continued to view the broad principles set out in 2011 as still applicable. Nonetheless, they agreed that many of the details of the eventual normalization process would likely differ from those specified two years ago, that the appropriate details would depend in part on economic and financial developments between now and the time when it becomes appropriate to begin normalizing monetary policy, and that the Committee would need to provide additional information about its intentions as that time approaches. Participants continued to think that the Federal Reserve should, in the long run, hold predominantly Treasury securities. Most, however, now anticipated that the Committee would not sell agency MBS as part of the normalization process, although some indicated that limited sales might be warranted in the longer run to reduce or eliminate residual holdings.

The Federal Reserve continued to test tools that could potentially be used to manage reserves

As part of the Federal Reserve's ongoing program to ensure the readiness of tools to manage reserves, the Federal Reserve conducted a series of small-scale transactions with eligible counterparties. During the first half of 2013, the Federal Reserve conducted four repurchase agreement (repo) operations and three reverse repurchase agreement (reverse repo) operations. Operation sizes ranged between $0.2 and $2.8 billion using all eligible collateral types. While the repo transactions were conducted only with primary dealers, two of the reverse repo operations were open to the expanded set of eligible counterparties, which include not only primary dealers, but also banks, government-sponsored enterprises, and money market funds.¹⁷ In addition, the Federal Reserve Board conducted three operations for 28-day term deposits under the Term Deposit Facility (TDF). These operations included two competitive single-price TDF auctions totaling $3 billion in deposits and an offering with a fixed-rate, full-allotment format, which totaled $10 billion in deposits.

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Footnotes

8. See Board of Governors of the Federal Reserve System (2013), "Minutes of the Federal Open Market Committee, March 19-20, 2013," press release, April 10, www.federalreserve.gov/newsevents/press/monetary/20130410a.htm. Return to text

9. For further discussion of these issues, see the box "Efficacy and Costs of Large-Scale Asset Purchases" in Board of Governors of the Federal Reserve System (2013), Monetary Policy Report (Washington: Board of Governors, February), www.federalreserve.gov/monetarypolicy/mpr_20130226_part2.htm. Return to text

10. See Board of Governors of the Federal Reserve System (2013), "Federal Reserve Issues FOMC Statement," press release, March 20, www.federalreserve.gov/newsevents/press/monetary/20130320a.htm. Return to text

11. See Board of Governors of the Federal Reserve System (2013), "Federal Reserve Issues FOMC Statement," press release, May 1, www.federalreserve.gov/newsevents/press/monetary/20130501a.htm. Return to text

12. See Ben S. Bernanke (2013), "Transcript of Chairman Bernanke's Press Conference," June 19, www.federalreserve.gov/mediacenter/files/FOMCpresconf20130619.pdf. Return to text

13. The difference between changes in the par value of SOMA holdings and the amount of purchases of securities since the end of 2012 reflects, in part, lags in settlements. Return to text

14. The outstanding amount of dollars provided through the temporary U.S. dollar liquidity swap arrangements with foreign central banks decreased $7 billion to about $1 billion because of the improvement in offshore U.S. dollar funding markets. During the financial crisis, the Federal Reserve created several special lending facilities to support financial institutions and markets and strengthen economic activity. These facilities were closed by 2010; however, some loans made under the Term Asset-Backed Securities Loan Facility, which is closed to new lending, remain outstanding and will mature over the next two years. Other programs supported certain specific institutions in order to avert disorderly failures that could have resulted in severe dislocations and strains for the financial system as a whole and harmed the U.S. economy. While the loans made by the Federal Reserve under these programs have been repaid, the Federal Reserve will continue to receive cash flows generated from assets remaining in the portfolios established in connection with such support, principally the portfolio of Maiden Lane LLC. Return to text

15. The Quarterly Report on Federal Reserve Balance Sheet Developments for the first quarter is available on the Federal Reserve Board's website at www.federalreserve.gov/monetarypolicy/quarterly-balance-sheet-developments-report.htm. Return to text

16. See Board of Governors of the Federal Reserve System (2011), "Minutes of the Federal Open Market Committee, June 21-22, 2011," press release, July 12, www.federalreserve.gov/newsevents/press/monetary/20110712a.htm. Return to text

17. To prepare for the potential need to conduct large-scale reverse repo transactions, the Federal Reserve Bank of New York is developing arrangements with an expanded set of counterparties with which it can conduct these transactions. These counterparties are in addition to the existing set of primary dealer counterparties with whom the Federal Reserve can already conduct reverse repos. The list of the expanded set of counterparties is available on the Federal Reserve Bank of New York's website at www.newyorkfed.org/markets/expanded_counterparties.html . Return to text

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