Part 2: Monetary Policy

Monetary Policy Report submitted to the Congress on July 15, 2015, pursuant to section 2B of the Federal Reserve Act

To support further progress toward maximum employment and price stability, the Federal Open Market Committee (FOMC) has kept the target federal funds rate at its effective lower bound and maintained the Federal Reserve's holdings of longer-term securities at sizable levels. At its two most recent meetings, the Committee indicated that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. The Federal Reserve has continued to plan for the eventual normalization of monetary policy, including by testing the operational readiness of the policy tools to be used.

 

To support further progress toward its statutory objectives, the FOMC has kept the target federal funds rate at its lower bound...

The FOMC has maintained the target range of 0 to 1/4 percent for the federal funds rate to support continued progress toward its statutory objectives of maximum employment and price stability (figure 40). The Committee has further reiterated that, in determining how long to maintain this target range, it will assess realized and expected progress toward its objectives. This assessment will continue to take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. Based on its assessment of those factors, the Committee maintained the judgment at its January meeting that it could be patient in beginning to normalize the stance of monetary policy, and it stated at its March meeting that a start of the normalization process remained unlikely at its April meeting.⁴ Chair Yellen indicated that, subsequent to the April meeting, the FOMC would determine the timing of the initial increase in the target federal funds rate on a meeting-by-meeting basis, depending on its assessment of incoming economic information and its implications for the economic outlook.⁵

Specifically, the FOMC anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. While the Committee has not decided on the timing of the initial increase in the target range for the federal funds rate, according to the June Summary of Economic Projections (SEP), 15 of the 17 policymakers anticipated that conditions may warrant a first increase in the federal funds rate target sometime this year. (The June SEP is included as Part 3 of this report.)

The Committee has reiterated 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. Even after the initial increase in the target federal funds rate, the Committee's policy is likely to remain highly accommodative in order to support continued progress toward its objectives of maximum employment and 2 percent inflation.

In addition, the Committee continues to anticipate that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. As pointed out by Chair Yellen in her recent press conferences, FOMC participants provide a number of explanations for this view, with many citing the residual effects of the financial crisis.⁶ These effects are expected to ease gradually, but they are seen as likely to continue to constrain spending and credit availability for some time.

...and stressed that its policy decisions will be data dependent

In her recent speeches and press conferences, Chair Yellen emphasized that, while the return of the federal funds rate to a more normal level is likely to be gradual, forecasts of the appropriate path of the federal funds rate are conditional on individual projections for economic output, inflation, and other factors, and the Committee's actual policy decisions over time will be data dependent. The FOMC does not intend to embark on any predetermined course of tightening following an initial decision to raise the federal funds rate target range. Accordingly, if the expansion proves to be more vigorous than currently anticipated and inflation moves higher than expected, then the appropriate path would likely follow a higher and steeper trajectory; conversely, if conditions were to prove weaker, then the appropriate trajectory would be lower and less steep.

The size of the Federal Reserve's balance sheet has remained stable

The Committee has maintained its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities (MBS) in agency MBS and of rolling over maturing Treasury securities at auction. This policy, by keeping the Federal Reserve's holdings of longer-term securities at sizable levels, is expected to help maintain accommodative financial conditions by putting downward pressure on longer-term interest rates and supporting mortgage markets. In turn, those effects are expected to contribute to progress toward both the maximum employment and price-stability objectives of the FOMC.

After the conclusion of the large-scale asset purchase program at the end of October 2014 and with the continuation of the Committee's reinvestment policy, the Federal Reserve's total assets have held steady at around $4.5 trillion (figure 41). Holdings of U.S. Treasury securities in the System Open Market Account (SOMA) have remained at $2.5 trillion, and holdings of agency debt and agency MBS at $1.8 trillion. Consequently, total liabilities on the Federal Reserve's balance sheet were largely unchanged.

Given the Federal Reserve's large securities holdings, interest income on the SOMA portfolio has continued to support substantial remittances to the U.S. Treasury Department. The Federal Reserve provided $96.9 billion of such distributions to the Treasury in 2014 and $21.7 billion during the first quarter of 2015.⁷ Remittances total over $500 billion on a cumulative basis since 2008.

The FOMC continued to plan for the eventual normalization of monetary policy...

FOMC meeting participants have continued their discussions about the eventual normalization of the stance and conduct of monetary policy.⁸ The participants emphasized that, during the early stages of policy normalization, it will be a priority to ensure appropriate control over the federal funds rate and other short-term interest rates. Consequently, the discussions involved various tools that could be used to control the level of short-term interest rates, even while the balance sheet of the Federal Reserve remains very large, as well as approaches to eventually normalizing the size and composition of the Federal Reserve's balance sheet.

As was the case before the crisis, the Committee intends to adjust the stance of monetary policy during normalization primarily through actions that influence the level of the federal funds rate and other short-term interest rates. The Committee indicated that, when economic conditions warrant the commencement of policy firming, the Federal Reserve intends to continue to target a range for the federal funds rate that is 25 basis points wide, set the interest rate it pays on excess reserves (the IOER rate) equal to the top of the target range for the federal funds rate, and set the offering rate associated with an overnight reverse repurchase agreement (ON RRP) facility equal to the bottom of the target range for the federal funds rate. The Committee will further allow aggregate capacity of the ON RRP facility to be temporarily elevated to support policy implementation and will use other tools, such as term operations, as necessary. The Committee expects that it will be appropriate to reduce the capacity of the facility fairly soon after it commences policy firming. Regarding the balance sheet, the Committee intends to reduce securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the SOMA. The Committee noted that economic and financial conditions could change, and that it was prepared to make adjustments to its normalization plans if warranted. (For more information, see the box "Policy Normalization Principles and Plans: Additional Details.")

...including by testing the policy tools to be used

The Federal Reserve continued to test the operational readiness of its policy tools, conducting daily ON RRP operations and a series of term RRP operations. At its March meeting, the Committee approved further tests of term RRP operations over quarter-ends through January 2016.⁹ In addition, the Federal Reserve conducted two further series of Term Deposit Facility (TDF) operations. In these TDF operations, the Federal Reserve eliminated the three-day lag between the execution of an operation and settlement that existed in previous tests. These operations showed that bank demand for term deposits continues to be strong even for incremental increases in yield.

To date, testing has progressed smoothly, and, in particular, short-term market rates have generally traded above the ON RRP rate, which suggests that the facility will be a useful supplementary tool for the FOMC in addition to the IOER rate to control the federal funds rate during the normalization process. Overall, testing operations reinforced the Federal Reserve's confidence in its view that it has the tools necessary to tighten policy at the appropriate time.

Footnotes

4. See Board of Governors of the Federal Reserve System (2015), "Federal Reserve Issues FOMC Statement," press release, January 28, www.federalreserve.gov/newsevents/press/monetary/20150128a.htm; and Board of Governors of the Federal Reserve System (2015), "Federal Reserve Issues FOMC Statement," press release, March 18, www.federalreserve.gov/newsevents/press/monetary/20150318a.htm. Return to text

5. See Board of Governors of the Federal Reserve System (2015), "Transcript of Chair Yellen's FOMC Press Conference," March 18, www.federalreserve.gov/mediacenter/files/FOMCpresconf20150318.pdf; and Board of Governors of the Federal Reserve System (2015), "Transcript of Chair Yellen's Press Conference," June 17, www.federalreserve.gov/mediacenter/files/FOMCpresconf20150617.pdf. Return to text

6. See Board of Governors, "Transcript of Chair Yellen's FOMC Press Conference," March 18, and Board of Governors, "Transcript of Chair Yellen's Press Conference," June 17, in note 5. Return to text

7. See Board of Governors of the Federal Reserve System (2015), "Federal Reserve System Publishes Annual Financial Statements," press release, March 20, www.federalreserve.gov/newsevents/press/other/20150320a.htm; and Board of Governors of the Federal Reserve System (2015), Quarterly Report on Federal Reserve Balance Sheet Developments (Washington: Board of Governors, May), www.federalreserve.gov/monetarypolicy/files/quarterly_balance_sheet_developments_report_201505.pdf. Return to text

8. See Board of Governors of the Federal Reserve System (2015), "Minutes of the Federal Open Market Committee, March 17-18, 2015," press release, April 8, www.federalreserve.gov/newsevents/press/monetary/20150408a.htm; and Board of Governors of the Federal Reserve System (2015), "Minutes of the Federal Open Market Committee, April 28-29, 2015," press release, May20, www.federalreserve.gov/newsevents/press/monetary/20150520a.htm. Return to text

9. See Board of Governors, "Minutes of the Federal Open Market Committee, March 17-18, 2015," in note 8. Return to text

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