Summary

Labor market conditions continued to improve during the second half of 2015 and into early 2016. Payroll employment has increased at a solid average pace of 225,000 per month since June. The unemployment rate, which had reached a high of 10 percent in late 2009, declined from 5.3 percent last June to 4.9 percent in January. Although the unemployment rate now equals the median of Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level, other considerations suggest that some further improvement in labor market conditions is needed to achieve the Committee's maximum employment mandate. The labor force participation rate remains somewhat below most assessments of its trend, and an unusually large number of people continue to work part time when they would prefer full-time employment.

Inflation remains below the FOMC's longer-run goal of 2 percent: The price index for personal consumption expenditures (PCE) rose only 1/2 percent over the 12 months ending in December. The PCE price index excluding food and energy items, which often provides a better indication of future inflation, also remained subdued, rising 1-1/2 percent over that period. Inflation has been held down substantially by the drop in energy prices; declines in the prices of non-oil imported goods have contributed as well. Meanwhile, survey-based measures of longer-run inflation expectations have drifted down a little since the middle of last year and generally stand near the lower ends of their historical ranges; market-based measures of inflation compensation have fallen and are at low levels.

Real gross domestic product (GDP) is reported to have increased at an annual rate of about 1-1/4 percent over the second half of the year, slower than the first-half pace. The expansion in economic activity reflected continued increases in private domestic final demand, supported by ongoing job gains and accommodative monetary policy. Government purchases rose modestly. By contrast, the rise in the foreign exchange value of the dollar over the past year and a half and the sluggish pace of economic activity abroad have continued to weigh on exports. In addition, the pace of inventory accumulation slowed markedly from its elevated first-half pace, thereby reducing overall GDP growth in the second half of 2015.

Domestic financial conditions have become somewhat less supportive of economic growth since mid-2015. Recent months have been marked by bouts of turbulence in financial markets that largely reflected concerns about the global economic outlook and developments in oil markets. Broad measures of U.S. equity prices have declined, on net, roughly returning these indexes to levels that prevailed during the first half of 2014. And the dollar has strengthened further, on balance, since the summer of 2015. Corporate risk spreads have widened, particularly for lower-rated issuers. Nonetheless, interest rates for investment-grade issuers are generally still low, reflecting declines in yields on longer-term Treasury securities. Moreover, although debt issuance by lower-rated firms has slowed, credit flows to nonfinancial businesses have remained solid since the middle of last year, supported by continued strong bond issuance of higher-rated firms and by bank lending. Household access to credit was mixed, with mortgages and credit cards still difficult to access for some borrowers while student and auto loans remained broadly available, even to borrowers with lower credit scores. Overall, debt growth in the household sector has remained modest and continues to be concentrated among borrowers with strong credit histories.

The U.S. financial system overall has been resilient to the stresses that have emerged since mid-2015, and financial vulnerabilities remain moderate. Regulatory capital ratios and holdings of liquid assets at large banking firms are at historically high levels. Usage of short-term wholesale funding in the financial system is relatively low, and the use of leverage to finance securities purchases has declined somewhat. The ratio of aggregate private nonfinancial credit to GDP is below most estimates of its long-run trend, although leverage of speculative-grade nonfinancial corporations has risen further since the middle of last year and is relatively high. Risk premiums for many asset classes have increased. For instance, the rise in spreads on corporate debt has been larger than would be expected given the evolution of expected defaults. The direct exposures of the largest U.S. banking firms to the oil sector and to emerging market economies are limited. If conditions in those sectors worsen, however, wider stresses could emerge and be transmitted to the United States through indirect global financial linkages.

In December, after holding the federal funds rate near zero for seven years, the FOMC raised the target range for that rate to 1/4 to 1/2 percent. The decision to increase the federal funds rate reflected the Committee's assessment that there had been considerable improvement in the labor market last year and that the Committee was reasonably confident that inflation would move back to 2 percent over the medium term; thus, the criteria set out by the Committee in March 2015 had been met.

The Committee anticipates that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate. This expectation is consistent with the view that the neutral nominal federal funds rate--defined as the value of the federal funds rate that would be neither expansionary nor contractionary if the economy was operating at its productive potential--is currently low by historical standards and is likely to rise only gradually over time, as headwinds to economic growth dissipate slowly and as inflation rises toward the Committee's goal of 2 percent. Consistent with this outlook, in the most recent Summary of Economic Projections (SEP), which was compiled at the time of the December FOMC meeting, FOMC participants projected that the appropriate level of the federal funds rate would be below its longer-run level through 2018. (The December SEP is included as Part 3 of this report.)

With respect to its securities holdings, the Committee will continue to reinvest principal payments from its securities portfolio, and it expects to maintain this reinvestment policy until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

The Committee has emphasized that the actual path of monetary policy will depend on how incoming data affect the economic outlook. In determining the timing and size of future adjustments to the target range of the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. Stronger growth or a more rapid increase in inflation than the Committee currently anticipates would likely call for faster increases in the federal funds rate; conversely, if conditions prove weaker, a lower path of the federal funds rate would likely be appropriate.

To move the federal funds rate into the new target range announced in December, the Federal Reserve raised the rate of interest paid on required and excess reserve balances and also employed an overnight reverse repurchase agreement facility. The effective federal funds rate was moved successfully into the increased target range. The FOMC remains confident that it has the tools it needs to adjust short-term interest rates as appropriate.

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