Part 2: Monetary Policy

Monetary Policy Report submitted to the Congress on February 11, 2014, pursuant to section 2B of the Federal Reserve Act

In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Federal Open Market Committee (FOMC) decided to modestly reduce the pace of its asset purchases at its December 2013 and January 2014 meetings. Nonetheless, with unemployment still well above its longer-run normal level and inflation below the Committee's 2 percent objective, the stance of monetary policy remains highly accommodative, with the Federal Reserve continuing to increase the size of its balance sheet, albeit at a reduced pace, and having enhanced its forward guidance with regard to the future path of the federal funds rate.  

Through most of last year, the FOMC maintained the current pace of large-scale asset purchases while awaiting more evidence that progress toward its economic objectives would be sustained...

Since the onset of the financial crisis and ensuing deep recession, the unemployment rate has remained well above its normal levels and the inflation rate has tended to run at or below the FOMC's 2 percent objective despite the target range for the federal funds rate remaining at its effective lower bound. Accordingly, the strategy of the FOMC during the past several years has been to employ alternative methods of providing additional monetary accommodation and promoting the more rapid achievement of its mandated objectives of maximum employment and price stability. In particular, the FOMC has used large-scale asset purchases and forward guidance regarding the future path of the federal funds rate to put downward pressure on longer-term interest rates.

During most of the second half of 2013, with unemployment still elevated (though declining), and with inflation remaining noticeably below the Committee's 2 percent longer-run objective, the FOMC left in place the key parameters of its monetary policy stance while awaiting further evidence that progress toward its economic objectives would be sustained. Nonetheless, the Committee recognized the cumulative improvement in labor market conditions and therefore believed it important to begin the process of outlining the considerations that would ultimately govern the winding-down of the program of large-scale asset purchases. In his press conference following the June 2013 FOMC meeting, Chairman Bernanke indicated that, if the economy were to evolve broadly in line with the expectations that the Committee held at that time, the FOMC would moderate the pace of purchases later in 2013 and, if economic developments remained broadly consistent with the Committee's expectations, subsequently reduce them in further measured steps. However, the Chairman emphasized that the Committee's purchases were in no way predetermined, and that a decision about reducing the pace of purchases would depend on how economic conditions evolved.⁸

At each of its subsequent meetings prior to December 2013, the Committee judged that the outlook for the economy and the labor market had improved, on net, since the inception of the current asset purchase program, but that it was appropriate to await more evidence that the progress would be sustained before the Committee began adjusting the pace of its purchases. In addition, at the July meeting, the Committee recognized that inflation persistently below its 2 percent objective could pose risks to economic performance.⁹ At the September FOMC meeting, Committee members also expressed concern about near-term fiscal uncertainties and the rapid tightening of financial conditions observed over the summer, which, if sustained, could have slowed improvements in the economy and the labor market.¹⁰ The Committee therefore decided to await more evidence that progress toward its goals would be maintained before adjusting the pace of asset purchases and, in the meantime, continued adding to its holdings of agency mortgage-backed securities (MBS) and longer-term Treasury securities at a pace of $40 billion and $45 billion per month, respectively.

...before modestly reducing the pace of asset purchases in light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions

By the time of the December 2013 meeting, most Committee members viewed the cumulative improvement in labor market conditions as meaningful and likely to be sustained. Participants also anticipated that inflation would move back toward 2 percent over time as the economic recovery strengthened and longer-run inflation expectations remained steady. Therefore, most members agreed that the Committee could appropriately begin to slow the pace of its asset purchases. Nonetheless, some members expressed concern about the potential for an unintended tightening of financial conditions if a reduction in the pace of asset purchases was misinterpreted as signaling that the Committee was likely to withdraw policy accommodation more quickly than had been anticipated. Many members therefore judged that the Committee should proceed cautiously in taking its first action to reduce the pace of asset purchases and should indicate that further reductions would be undertaken in measured steps. Members also stressed the need to underscore that the pace of asset purchases was not on a preset course and would remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the efficacy and costs of purchases.

Consistent with this approach, the Committee announced at the December meeting that it would reduce the pace of its purchases of agency MBS from $40 billion to $35 billion per month and reduce the pace of its purchases of longer-term Treasury securities from $45 billion to $40 billion per month. The Committee continued to see improvements in economic conditions and the labor market outlook at the January meeting and further reduced the pace of its asset purchases to $30 billion per month for agency MBS and $35 billion per month for longer-term Treasury securities.

While deciding to modestly reduce its pace of purchases, the Committee emphasized that its holdings of longer-term securities were sizable and would still be increasing, which would promote a stronger economic recovery by maintaining downward pressure on longer-term interest rates, supporting mortgage markets, and helping to make broader financial conditions more accommodative. The Committee reiterated that it will continue its asset purchases and employ its other policy tools as appropriate until the outlook for the labor market has improved substantially in a context of price stability. The FOMC also maintained its practices of reinvesting principal payments it receives on agency debt and agency-guaranteed MBS in new agency MBS and of rolling over maturing Treasury securities at auction.

The Committee first kept in place and then reinforced its forward guidance on the path of the federal funds rate

With regard to the federal funds rate, the Committee continued to indicate through the second half of 2013 its expectation that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee stated that the current exceptionally low target range for the federal funds rate 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 41). The Committee emphasized that these criteria are thresholds, not triggers, meaning that crossing a threshold will not lead automatically to an increase in the federal funds rate but will indicate only that it is appropriate for the Committee to consider whether the broader economic outlook justifies such an increase.

In December, with the unemployment rate having moved closer to the 6-1/2 percent threshold, the FOMC decided to provide qualitative guidance to clarify its likely actions during the time after the unemployment threshold is crossed and, in particular, to emphasize its commitment to providing a high level of monetary accommodation for as long as needed to foster its objectives. Specifically, the Committee indicated that in determining how long to maintain a highly accommodative stance of monetary policy, it will consider not only the unemployment rate but also other indicators, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. Further, the Committee stated that, based on these factors, it continues to anticipate that it will likely be appropriate to maintain the current federal funds rate target well past the time that the unemployment rate declines to below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal. The Committee continued to indicate that when it decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

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 middle of last year (figure 42). The par value of the holdings of U.S. Treasury securities in the System Open Market Account (SOMA) increased $315 billion to $2.2 trillion, and the par value of its holdings of agency debt and MBS increased $308 billion, on net, to $1.5 trillion. ¹¹ As of the end of January 2014, the SOMA's holdings of Treasury and agency securities constituted 55 percent and 39 percent, respectively, of the $4 trillion in total Federal Reserve assets. As a result of these purchases, the size of the overall Federal Reserve balance sheet increased briskly over the second half of the year; on the liability side of the balance sheet, the rise resulted in a further increase in reserve balances.

Reflecting the continued improvement in offshore U.S. dollar funding markets, the outstanding amount of dollars provided through the temporary U.S. dollar liquidity swap arrangements with foreign central banks decreased $1 billion, bringing the level close to zero. To reduce uncertainties among market participants as to whether and when these arrangements would be renewed, at the October FOMC meeting the Committee agreed to convert the existing temporary central bank liquidity swap arrangements to standing arrangements with no preset expiration dates, with the intention to review participation in these arrangements annually. These modifications to the liquidity swap arrangements were introduced to help support financial stability and confidence in global funding markets.

Interest income on the SOMA portfolio continued to support a substantial volume of remittances to the U.S. Treasury Department. Preliminary estimates suggest that in 2013 the Federal Reserve provided more than $77 billion of such distributions to the Treasury. ¹²

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

As part of its ongoing program to ensure the readiness of tools to manage reserves, the Federal Reserve conducted a series of small-scale transactions with eligible counterparties. Since the end of June 2013, the Federal Reserve has conducted four operations for 28-day term deposits under the Term Deposit Facility. The offerings had a fixed-rate format, with individual operations totaling between about $12 billion and $13.5 billion in deposits. In addition, in August 2013, the Federal Reserve conducted six overnight reverse repurchase operations with auction sizes between $1 billion and $5 billion, using Treasury securities and agency MBS as collateral.

Moreover, in support of the Committee's longer-run plan for improvements in the implementation of monetary policy, at the July 2013 FOMC meeting, the Committee discussed the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement (ON RRP) facility as an additional tool for managing money market interest rates. At the September 2013 meeting, the Committee authorized the Open Market Desk to conduct a series of fixed-rate ON RRP operations involving U.S. government securities and securities that are direct obligations of, or fully guaranteed as to principal and interest by, any agency of the United States, for the purpose of assessing operational readiness. A number of meeting participants emphasized that their interest in these operations reflected an ongoing effort to improve the technical execution of policy and did not signal any change in the Committee's views about policy going forward.

From the operations' inception through early February, the fixed rate on the operations has been adjusted gradually within the authorized limits of 0 to 5 basis points set by the FOMC, and the daily counterparty allotment limit has been gradually raised from $500 million to $5 billion. All operations to date have proceeded smoothly. Participation in and usage of ON RRP operations has varied from day to day, in part reflecting changes in the spread between market rates on repurchase agreement transactions and the rate offered in the Federal Reserve's ON RRP operations, as well as quarter-end dynamics. In particular, take-up at these operations surged at year-end and only partly retraced over recent weeks, as rates in markets for Treasury repurchase agreements remained generally low against the backdrop of reduced supply of U.S. Treasury securities in collateral markets. The operations were reauthorized at the January FOMC meeting through January 30, 2015, to allow the Committee to obtain additional information about the potential usefulness of ON RRP operations to affect market interest rates when doing so becomes appropriate.

In addition, the Desk has been developing the capability to conduct agency MBS transactions over FedTrade, its proprietary trading platform. To test this capability, the Desk conducted an exercise consisting of a series of small-value purchase and sale operations of agency MBS via FedTrade, running from November 21, 2013, through January 14, 2014. The operations conducted as part of this exercise did not exceed $500 million in total and were not counted toward the monthly agency MBS purchases that the Desk was conducting at the direction of the FOMC.

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Footnotes

8. See Board of Governors of the Federal Reserve System (2013), "Transcript of Chairman Bernanke's Press Conference," June 19, www.federalreserve.gov/mediacenter/files/FOMCpresconf20130619.pdf. Return to text

9. See Board of Governors of the Federal Reserve System (2013), "Federal Reserve Issues FOMC Statement," press release, July 31, www.federalreserve.gov/newsevents/press/monetary/20130731a.htm. Return to text

10. See Board of Governors of the Federal Reserve System (2013), "Transcript of Chairman Bernanke's Press Conference," September 18, www.federalreserve.gov/mediacenter/files/FOMCpresconf20130918.pdf. Return to text

11. The difference between changes in the par value of SOMA holdings and the amount of purchases of securities since the middle of 2013 reflects, in part, lags in settlements. Return to text

12. See Board of Governors of the Federal Reserve System (2014), "Reserve Bank Income and Expense Data and Transfers to the Treasury for 2013," press release, January 10, www.federalreserve.gov/newsevents/press/other/20140110a.htm. Return to text