Summary

Labor market conditions clearly continued to strengthen during the early months of this year: Payrolls expanded at a solid pace of almost 200,000 per month in the first quarter, and while the unemployment rate flattened out at close to 5 percent, the labor force participation rate moved up strongly. More recently, the signals regarding labor market improvement have become more mixed: Payroll gains are reported to have slowed to an average of 80,000 per month in April and May (or about 100,000 after adjustment for the effects of a strike). The unemployment rate dropped in May to 4.7 percent, its lowest level since late 2007; however, the labor force participation rate fell back again and was little changed from its year-ago level. All told, the latest readings suggest that labor markets are tighter than they were at the end of last year but that the pace of improvement has slowed. Whether those signs of slowing will be confirmed by subsequent data, and how persistent any such slowing will be, remains to be seen.

Consumer price inflation has continued to be held down by lower prices for energy and imports, and the price index for personal consumption expenditures (PCE) increased only about 1 percent over the 12 months ending in April. Changes in the PCE price index excluding food and energy items, which provide a better indication than the headline figure of where overall inflation will be in the future, also remained modest; this index, which rose 1-1/2 percent over the 12 months ending in April, was partly restrained by lower prices for non-oil imported goods. However, both the headline and core inflation measures have picked up somewhat from a year earlier. Meanwhile, some survey-based measures of longer-run inflation expectations have remained relatively stable, while others have moved down; market-based measures of inflation compensation also are at low levels.

Although real gross domestic product is reported to have increased at a sluggish rate in the first quarter of 2016, the available data for the second quarter point to a noticeable step-up in the pace of growth. On average, consumer spending so far this year appears to be expanding at a moderate pace, supported by solid income gains and the ongoing effects of the increases in wealth and the declines in oil prices of the past two years. The housing market continues its gradual recovery, and fiscal policy at all levels of government is now modestly boosting economic activity after exerting a considerable drag in recent years. One area of concern, however, is the softening in business fixed investment in recent quarters even beyond those sectors most directly affected by the plunge in energy prices. In addition, the weakness of exports--following the significant appreciation of the dollar over the past two years and the subdued pace of foreign economic growth--continues to hold back overall output growth.

On balance, household and business credit conditions in the United States have remained accommodative so far this year. Following a period of heightened global financial market volatility earlier this year in which risk spreads for U.S. corporate bonds rose, financial conditions have eased somewhat in recent months, and corporate bond yields have returned to historically low levels. Mortgage rates once again have approached their all-time lows, and mortgage credit appears widely available to borrowers with solid credit profiles, though less so to would-be borrowers with imperfect credit histories. Student and auto loans are broadly available, including to borrowers with nonprime credit scores, and the availability of credit card loans for such borrowers appears to have expanded somewhat over the past several quarters. Broad measures of U.S. equity prices have increased slightly, on net, since the beginning of the year. Meanwhile, foreign financial markets appear to have stabilized following the period of volatility earlier this year, with foreign equity prices higher and risk spreads lower. That said, the potential remains for spillovers to the U.S. economy from shocks to foreign economic activity and financial markets, including possible reverberations from the U.K. referendum this week on membership in the European Union.

Turning to the stability of the U.S. financial system, financial vulnerabilities have remained at a moderate level this year. Domestic financial institutions and markets functioned well during the period of heightened volatility early in the year. Large banking firms have kept their capital and liquidity ratios at high levels relative to historical standards, capital at other financial firms also appears to be elevated, and financial firms' use of short-term wholesale funding remains subdued. Debt growth in the household sector has been modest. However, leverage of nonfinancial corporations is elevated by historical standards, and lower-rated firms are potentially vulnerable to adverse developments. In particular, the performance of firms in the energy sector has been especially weak due to the prolonged period of low oil prices. In equity markets, valuation pressures have increased somewhat as expectations for corporate earnings have been revised downward; valuation pressures have remained notable in the commercial real estate sector, to which some small banks have substantial exposures.

After having raised the target range for the federal funds rate to between 1/4 and 1/2 percent last December, the Committee maintained that target range over the first half of the year. The Committee's decisions to leave the stance of policy unchanged were supported by its assessments earlier in the year that global economic and financial developments posed risks to the economic outlook and that growth in economic activity appeared to have slowed. In June, the Committee noted that recent information indicated that the pace of improvement in the labor market had slowed, while growth in economic activity appeared to have picked up. In addition, the Committee's policy stance so far this year reflected its expectation that inflation would remain low in the near term, in part due to earlier declines in energy prices and in the prices of non-energy imports. The Committee stated that its accommodative stance of policy is intended to support further improvements in labor market conditions and a return to 2 percent inflation.

The Committee continued to emphasize that, in determining the timing and size of future adjustments to the target range for the federal funds rate, it will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. These judgments will 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. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual future increases in the federal funds rate, and that the federal funds rate will likely remain, for some time, below levels that are expected to prevail in the longer run. Consistent with this outlook, in the most recent Summary of Economic Projections (SEP), which was compiled at the time of the June meeting of the Federal Open Market Committee (FOMC), FOMC participants projected that the appropriate level of the federal funds rate would be below its longer-run level through 2018. (The June SEP is discussed in more detail in Part 3 of this report.)

The Federal Reserve continued to use interest paid on reserve balances and employ an overnight reverse repurchase agreement facility to manage the federal funds rate, and these tools were effective in keeping the federal funds rate within its target range. The Federal Reserve also continued to test the operational readiness of other policy implementation tools.

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