Board of Governors of the Federal Reserve System

Monetary Policy and Economic Developments

As required by section 2B of the Federal Reserve Act, the Federal Reserve Board submits written reports to the Congress that contain discussions of "the conduct of monetary policy and economic developments and prospects for the future." The Monetary Policy Report, submitted semiannually to the Senate Committee on Banking, Housing, and Urban Affairs and to the House Committee on Banking and Financial Services, is delivered concurrently with testimony from the Federal Reserve Board Chair.

The following discussion is a review of U.S. monetary policy and economic developments in 2016, excerpted from the Monetary Policy Report published in February 2017 and June 2016. Those complete reports are available on the Board's website at www.federalreserve.gov/monetarypolicy/files/20170214_mprfullreport.pdf (February 2017) and www.federalreserve.gov/monetarypolicy/files/20160621_mprfullreport.pdf (June 2016).

Monetary Policy Report of February 2017

Summary

Labor market conditions continued to strengthen over the second half of 2016. Payroll employment has continued to post solid gains, averaging 200,000 per month since last June, a touch higher than the pace in the first half of 2016, though down modestly from its 225,000-per-month pace in 2015. The unemployment rate has declined slightly since mid-2016; the 4.8 percent reading in January of this year was in line with the median of Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level. The labor force participation rate has edged higher, on net, since midyear despite a structural trend that is moving down as a result of changing demographics of the population. In addition, wage growth seems to have picked up somewhat relative to its pace of a few years ago.

Consumer price inflation moved higher last year but remained below the FOMC's longer-run objective of 2 percent. The price index for personal consumption expenditures (PCE) increased 1.6 percent over the 12 months ending in December, 1 percentage point more than in 2015, importantly reflecting that energy prices have turned back up and declines in non-oil import prices have waned. The PCE price index excluding food and energy items, which provides a better indication than the headline index of where overall inflation will be in the future, rose 1.7 percent over the 12 months ending in December, about 1/4 percentage point more than its increase in 2015. Meanwhile, survey-based measures of longer-run inflation expectations have remained generally stable, though some are at relatively low levels; market-based measures of inflation compensation have moved up in recent months but also are at low levels.

Real gross domestic product is estimated to have increased at an annual rate of 2-3/4 percent in the second half of the year after rising only 1 percent in the first half. Consumer spending has been expanding at a moderate pace, supported by solid income gains and the ongoing effects of increases in wealth. The housing market has continued its gradual recovery, and fiscal policy at all levels of government has provided a modest boost to economic activity. Business investment had been weak for much of 2016 but posted larger gains toward the end of the year. Notwithstanding a transitory surge of exports in the third quarter, the underlying pace of exports has remained weak, a reflection of the appreciation of the dollar in recent years and the subdued pace of foreign economic growth.

Domestic financial conditions have generally been supportive of economic growth since mid-2016 and remain so despite increases in interest rates in recent months. Long-term Treasury yields and mortgage rates moved up from their low levels earlier last year but are still quite low by historical standards. Broad measures of stock prices rose, and the financial sector outperformed the broader equity market. Spreads of yields of both speculative- and investment-grade corporate bonds over yields of comparable-maturity Treasury securities declined from levels that were somewhat elevated relative to the past several years. Even with an ongoing easing in mortgage credit standards, mortgage credit is still relatively difficult to access for borrowers with low credit scores, undocumented income, or high debt-to-income ratios. 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. In foreign financial markets, meanwhile, equities, bond yields, and the exchange value of the U.S. dollar have all risen, and risk spreads have generally declined since June.

Financial vulnerabilities in the U.S. financial system overall have continued to be moderate since mid-2016. U.S. banks are well capitalized and have sizable liquidity buffers. Funding markets functioned smoothly as money market mutual fund reforms took effect in October. The ratio of household debt to income has changed little in recent quarters and is still far below the peak level it reached about a decade ago. Nonfinancial corporate business leverage has remained elevated by historical standards even though outstanding riskier corporate debt declined slightly last year. In addition, valuation pressures in some asset classes increased, particularly late last year. The Federal Reserve has continued to take steps to strengthen the financial system, including finalizing a rule that imposes total loss-absorbing capacity and long-term debt requirements on the largest internationally active bank holding companies as well as concluding an extensive review of its stress-testing and capital planning programs.

In December, the FOMC raised the target for the federal funds rate to a range of 1/2 to 3/4 percent after maintaining it at 1/4 to 1/2 percent for a year. The decision to increase the federal funds rate reflected realized and expected labor market conditions and inflation. With the stance of monetary policy remaining accommodative, the Committee has anticipated some further strengthening in labor market conditions and a return of inflation to the Committee's 2 percent objective.

The Committee has 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. The Committee has expected that economic conditions will evolve in a manner that will warrant only gradual 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 December meeting of the FOMC, most 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 the February 2017 Monetary Policy Reporton pages 33-45; it is also included in section 9 of this annual report.)

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

Part 1: Recent Economic and Financial Developments

Labor market conditions continued to improve during the second half of last year and early this year. Payroll employment has increased 200,000 per month, on average, since June, and the unemployment rate has declined slightly further, reaching 4.8 percent in January, in line with the median of Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level. The labor force participation rate has edged higher, on net, which is all the more notable given a demographically induced downward trend.

The 12-month change in the price index for overall personal consumption expenditures (PCE) was 1.6 percent in December--still below the Committee's 2 percent objective but up noticeably from 2015, when the increase in top-line prices was held down by declines in energy prices. The 12-month change in the index excluding food and energy prices (the core PCE price index) was 1.7 percent last year. Measures of longer-term inflation expectations have been generally stable, though some survey-based measures remain lower than a few years ago; market-based measures of inflation compensation moved higher in recent months but also remain below their levels from a few years ago.

Real gross domestic product (GDP) is estimated to have increased at an annual rate of 2-3/4 percent over the second half of 2016 after increasing just 1 percent in the first half. The economic expansion continues to be supported by accommodative financial conditions--including the still-low cost of borrowing for many households and businesses--and gains in household net wealth, which has been boosted further by a rise in the stock market in recent months and by increases in households' real income spurred by continuing job gains. However, net exports were a moderate drag on GDP growth in the second half, as imports picked up and the rise in the exchange value of the dollar in recent years remained a drag on export demand.

Domestic Developments

The labor market has continued to tighten gradually…

Labor market conditions strengthened over the second half of 2016 and early this year. Payroll employment has continued to post solid gains, averaging 200,000 per month since last June (figure 1). This rate of job gains is a bit higher than that seen during the first half of 2016, though it is a little slower than the 225,000 monthly pace in 2015. The unemployment rate has declined slightly further, on net, since the middle of last year. After dipping as low as 4.6 percent in November, the unemployment rate stood at 4.8 percent in January, in line with the median of FOMC participants' estimates of its longer-run normal level.

The labor force participation rate, at 62.9 percent, is up slightly since June 2016. Changing demographics and other longer-run structural changes in the labor market likely have continued to put downward pressure on the participation rate. A flat or increasing trajectory of the participation rate should therefore be viewed as a cyclical improvement relative to that downward trend. Reflecting the slightly higher participation rate and the small drop in the unemployment rate, the employment-to-population ratio has moved up about 1/4 percentage point since mid-2016. (For additional historical context on the economic recovery, see the box "The Recovery from the Great Recession and Remaining Challenges" on pages 6-8 of the February 2017 Monetary Policy Report.)

… and is close to full employment

Other indicators are also consistent with a healthy labor market. Layoffs as a share of private employment, as measured in the Job Openings and Labor Turnover Survey (JOLTS), remained at a low level through December, and recent readings on initial claims for unemployment insurance, a more timely measure, point to a very low pace of involuntary separations. The JOLTS quits rate has generally continued to trend up and is now close to pre-crisis levels, indicating that workers feel increasingly confident about their employment opportunities. In addition, the rate of job openings as a share of private employment has remained near record-high levels. The share of workers who are employed part time but would like to work full time--which is part of the U-6 measure of underutilization from the Bureau of Labor Statistics (BLS)--is still somewhat elevated, however, even though it has declined further; as a result, the gap between U-6 and the headline unemployment rate is somewhat wider than it was in the years before the Great Recession (figure 2).

The jobless rate for African Americans also continued to edge lower in the second half of 2016, while the rate for Hispanics remained flat; as with the overall unemployment rate, these rates are near levels seen leading into the recession. Despite these gains, the average unemployment rates for these groups of Americans have remained high relative to the aggregate, and those gaps have not narrowed over the past decade.

Labor compensation growth is picking up…

The improving labor market appears to be contributing to somewhat larger gains in labor compensation. Major BLS measures of hourly compensation posted larger increases last year. Of these, the measures that include the costs of benefits have posted smaller gains than wage-only measures because of a slowdown in the growth of employer health-care costs. A compensation measure computed by the Federal Reserve Bank of Atlanta, which tracks only the wages of workers who were employed at two points in time spaced 12 months apart, shows even more pickup than these BLS measures.

… amid persistently slow productivity growth

As in the previous several years, gains in labor compensation last year occurred against a backdrop of persistently slow productivity growth. Since 2008, labor productivity gains have averaged around 1 percent per year, well below the pace that prevailed from the mid-1990s to 2007 and somewhat below the 1974-95 average of 1-1/2 percent per year. Since 2011, output per hour has averaged only a little more than 1/2 percent per year. The relatively slow pace of productivity growth in recent years is in part a consequence of the slower pace of capital accumulation; diminishing gains in technological innovations and downward trends in business formation also may have played a role.

Price inflation has picked up over the past year…

In recent years inflation has been persistently low, in part because the drop in oil prices and the rise in the exchange value of the dollar since mid-2014 have led to sharp declines in energy prices and relatively weak non-energy import prices. The effects of these earlier developments have been waning, however, and overall inflation has been moving up toward the FOMC's 2 percent target; the 12-month change in overall PCE prices reached 1.6 percent in December, compared with only 0.6 percent over 2015. The PCE price index excluding food and energy items, which provides a better indication than the headline figure of where overall inflation will be in the future, rose 1.7 percent over the 12 months ending in December, somewhat greater than the 1.4 percent increase in the prior year, as prices for a wide range of core goods and services accelerated. Nonetheless, the rate of inflation for both total and core PCE prices remains below the Committee's target (figure 3).

… as oil and other commodity prices moved up moderately

The similar readings for headline and core PCE inflation last year partly reflect an upturn in crude oil in 2016 following the sharp decline in the prior two years. Since July, oil prices traded mostly in the $45 to $50 per barrel range until the November OPEC agreement regarding production cuts in 2017 (figure 4). In the wake of that agreement, prices moved up to about $55, roughly $15 per barrel higher since late 2015. Retail gasoline prices also rose after the November OPEC agreement, but that increase has partially reversed in recent weeks.

After falling during 2014 and 2015, non-oil import prices stabilized in late 2016, supported by the rise in nonfuel commodity prices as well as by an uptick in foreign inflation. In particular, prices of metals have increased in the past few months, boosted by production cuts combined with improved prospects for demand both in the United States and abroad. However, factors holding non-oil import prices down include dollar appreciation in the second half of 2016 and lower prices of agricultural goods last fall, as U.S. harvests hit record-high levels for many crops.

Survey measures of longer-term inflation expectations have been generally stable…

Wage- and price-setting decisions are likely influenced by expectations for inflation. Surveys of professional forecasters outside the Federal Reserve System indicate that their longer-term inflation expectations have remained stable and consistent with the FOMC's 2 percent objective for PCE inflation. In contrast, the median inflation expectation over the next 5 to 10 years as reported by the University of Michigan Surveys of Consumers has generally trended downward over the past few years, though it is little changed from a year ago; this measure was at 2.5 percent in early February (figure 5). It is unclear how best to interpret that downtrend; this measure of inflation expectations has been above actual inflation for much of the past 20 years.

… and market-based measures of inflation compensation have moved up notably in recent months but also remain relatively low

TIPS-based inflation compensation (5 to 10 years forward), after declining to very low levels through the middle of 2016, has risen to nearly 2 percent and is about 20 basis points higher than it was at the end of 2015. However, this level is still below the 2-1/2 to 3 percent range that persisted for most of the 10 years prior to 2014.

Real GDP growth picked up in the second half of 2016

Real GDP is reported to have increased at an annual rate of 2-3/4 percent in the second half of 2016 after increasing just 1 percent in the first half (figure 6). Much of the step-up reflects the stabilization of inventory investment, which held down GDP growth considerably in the first half of last year, as well as a pickup in government purchases of goods and services. Private domestic final purchases--that is, final purchases by U.S. households and businesses--grew more steadily than GDP last year and posted a fairly solid gain in the second half. PCE growth was bolstered by rising incomes and wealth, while private fixed investment was weak despite the low costs of borrowing for many households and businesses. Although the FOMC has increased the federal funds rate twice as this expansion has progressed--once in December 2015 and again in December 2016--in 1/4 percentage point steps, overall financial conditions have been sufficiently accommodative to support somewhat-faster-than-trend growth in real activity.

Gains in income and wealth have continued to support consumer spending…

Real consumer spending rose at an annual rate of 2-3/4 percent in the second half of 2016, a solid pace similar to the one seen in the first half. Consumption has been supported by the ongoing improvement in the labor market and the associated increases in real disposable personal income (DPI)--that is, income after taxes and adjusted for price changes. Real DPI increased 2-1/4 percent in 2016 following a gain of 3 percent in 2015, when purchasing power was boosted by falling energy prices (figure 7).

Consumer spending has also been supported by further increases in household net worth. Broad measures of U.S. equity prices rose solidly over the past year, and house prices continued to move up. (In nominal terms, national house prices are approaching their peaks of the mid-2000s, though relative to rents or income, house price valuations are much lower than a decade ago. Buoyed by these cumulative increases in home and equity prices, aggregate household net worth has risen appreciably from its level during the recession, and the ratio of household net worth to income remains well above its historical average. The benefits of homeownership have not been distributed evenly; see the box "Homeownership by Race and Ethnicity" on pages 14-15 of the February 2017 Monetary Policy Report.

… as does credit availability

Consumer credit has continued to expand somewhat faster than income amid stable delinquencies on consumer debt. Auto and student loans remain widely available even to borrowers with lower credit scores, and outstanding balances on these types of loans continued to expand at a robust pace. Credit card balances continued to grow and were 6 percent higher than one year earlier in December. That said, credit card standards have remained tight for nonprime borrowers. As a result, delinquencies on credit cards are still near low historical levels.

Consumer confidence is strong

Household spending has also been supported by favorable consumer sentiment. In 2015 and through most of 2016, readings from the overall index of consumer sentiment from the Michigan survey were solid, likely reflecting rising incomes and job gains. Sentiment has improved further in the past couple of months. The share of households expecting real income gains over the next year or two is now close to its pre-recession level despite having lagged improvements in the headline sentiment measure earlier in the recovery.

Housing construction has been sluggish despite rising home demand

Residential investment spending appears to have only edged higher in 2016 following a larger gain in the previous year. Single-family housing starts registered a moderate increase in 2016, while multifamily housing starts flattened out on balance (figure 8). The pace of construction activity in 2016 remained sluggish despite solid gains in house prices and ongoing improvements in demand for both new and existing homes. As a result, the months' supply of inventories of homes for sale dropped to low levels, and the aggregate vacancy rate moved to its lowest level since 2005. Reportedly, tight supplies of skilled labor and developed lots have been restraining home construction.

Homebuying and residential construction have been supported by low interest rates and ongoing easing of credit standards for mortgages. Banks indicated in the October 2016 Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) that they eased standards on several categories of residential home purchase loans.¹ Even so, mortgage credit is still relatively difficult to access for borrowers with low credit scores, harder-to-document income, or high debt-to-income ratios. Although mortgage rates moved up from their all-time low levels over the second half of last year, they remain quite low by historical standards, and, consequently, housing affordability remains favorable.

Business investment may be turning up after a period of surprising weakness

Real outlays for business investment--that is, private nonresidential fixed investment--were generally weak in 2016 but posted larger gains toward the end of the year (figure 9). Last year's weakness occurred despite moderate increases in aggregate demand and generally favorable financing conditions, and it was widespread across categories of equipment investment. Investment in equipment and intangibles moved down over most of the year, likely reflecting the effects of the combination of low oil prices, weak export demand, and a muted longer-run demand outlook among businesses. Although such declines are unusual outside of a recession, spending on these items did turn up in the fourth quarter. Investment in drilling and mining structures, which had been falling sharply since the drop in oil prices in 2014, fell further through most of 2016 but seems to be bottoming out. Outside of the energy sector, investment in nonresidential structures increased moderately in 2016. Finally, after having been subdued for much of 2016, a widespread set of business sentiment indicators improved notably near the end of last year.

Financing conditions for nonfinancial firms have generally remained favorable

Nonfinancial businesses have continued to raise funds through bond issuance and bank loans, albeit at a somewhat slower pace than in the first half of 2016. The pace of such borrowing was supported in part by continued low interest rates: Corporate bond yields for speculative-grade borrowers have declined since last June, and those for investment-grade borrowers have increased but a fair bit less than those on comparable-maturity Treasury securities. Banks indicated in the October 2016 and January 2017 SLOOS that they eased lending terms on commercial and industrial loans in the second half of the year, but that standards on such loans remained unchanged relative to earlier in 2016; banks continued to tighten standards on commercial real estate loans over the second half of last year.

Net exports held down second-half real GDP growth

The rise in the dollar since mid-2014 and subdued foreign economic growth have continued to weigh on U.S. exports (figure 10). Nevertheless, exports increased at a moderate pace in the second half of 2016, but with much of the increase a result of rising agricultural exports. In particular, soybean exports surged in the third quarter before falling back toward a more normal level in the fourth quarter. Consistent with the stronger exchange value of the dollar, imports jumped in the second half of the year after having been about flat in the first half, when investment demand for imported equipment was very weak. Overall, real net exports were a moderate drag on real GDP growth in the second half of 2016. Although the trade balance and current account deficit narrowed slightly in the second and third quarters of 2016, the trade balance widened in the fourth quarter, as imports significantly outpaced exports.

Federal fiscal policy was a roughly neutral influence on GDP growth in 2016…

After being a drag on aggregate demand during much of the expansion, discretionary changes in federal fiscal policy have had a more neutral influence over the past two years. During 2016, policy actions had little effect on taxes and transfers, and federal purchases of goods and services are little changed over this period (figure 11). The federal budget deficit increased in fiscal year 2016 to 3.2 percent of GDP from 2.4 percent in fiscal 2015. Revenues rose only 1 percent last year in nominal terms and fell as a share of GDP because of soft personal income tax revenues and a decline in corporate income tax collections. Outlays rose 5 percent, edging up as a share of GDP, owing to increases in mandatory spending and interest payments as well as a shift in the timing of some payments that ordinarily would have been made in fiscal 2017. The Congressional Budget Office forecasts the deficit to be about the same size (as a share of GDP) in fiscal 2017 and in the next couple of years before rising thereafter. Consequently, the ratio of debt held by the public to nominal GDP is projected to remain near its current level of 77 percent of GDP for the next couple of years and then begin to rise.

… and real purchases at the state and local level continue to increase, albeit at a tepid pace

The fiscal conditions of most state and local governments have continued to improve, though the pace of improvement has been slower in recent quarters than it had been previously. The ongoing improvement facilitated a step-up in the average pace of employment gain in the sector to the strongest rate since 2008. At the same time, however, real investment in structures by state and local governments has declined, on net, since the first quarter of 2016 after trending up during the prior two years. All told, total real state and local purchases rose anemically in 2016. On the other side of the ledger, revenue growth was subdued overall, with little growth in tax collections at the state level but moderate gains at the local level.

Financial Developments

The expected path for the federal funds rate over the next several years steepened

Against the backdrop of continued strengthening in the labor market and an increase in inflation over the course of 2016, the path of the federal funds rate implied by market quotes on interest rate derivatives has moved up, on net, since the middle of last year. Following the U.S. elections in November, the expected policy path in the United States steepened significantly, apparently reflecting investors' expectations of a more expansionary fiscal policy. Meanwhile, market-based measures of uncertainty about the policy rate approximately one to two years ahead also increased, on balance, suggesting that some of the firming in market rates may reflect a rise in term premiums.

Survey-based measures of the expected path of policy also moved up in recent months. In the Survey of Primary Dealers that was conducted by the Federal Reserve Bank of New York just prior to the January 2017 FOMC meeting, the median dealer expected two rate hikes in 2017 and three rate hikes in 2018 as the most likely outcome.²

U.S. nominal Treasury yields increased considerably

After dropping significantly during the first half of 2016 and reaching near-historical lows in the aftermath of the U.K. referendum on exit from the European Union, or Brexit, in June, yields on medium- and longer-term nominal Treasury securities rebounded strongly in the second half of last year, with a substantial rise following the U.S. elections (figure 12). Market participants have attributed the increase in yields following the elections primarily to expectations of a more expansionary fiscal policy. The boost in longer-term nominal yields in recent months reflects roughly equal increases in real yields and inflation compensation. Consistent with the changes in Treasury yields, yields on 30-year agency mortgage-backed securities (MBS)--an important determinant of mortgage interest rates--increased significantly over the second half of the year. However, Treasury and MBS yields remain quite low by historical standards.

Broad equity price indexes increased notably…

U.S. equity markets were volatile around the Brexit vote in the United Kingdom but operated without disruptions. Broad equity price indexes have increased notably since late June, with a sizable portion of the gain occurring after the U.S. elections in November (figure 13). Reportedly, equity prices have been supported in part by the perception that corporate tax rates may be reduced. Stock prices of banks, which tend to benefit from a steepening in the yield curve, outperformed the broader market. Moreover, market participants pointed to expectations of changes in the regulatory environment as a factor contributing to the outperformance of bank stocks. By contrast, stock prices of firms that tend to benefit from lower interest rates, such as utilities, declined moderately on net. The implied volatility of the S&P 500 index--the VIX-- fell, ending the period close to the bottom of its historical range. (For a discussion of financial stability issues over this same period, see the box "Developments Related to Financial Stability" on pages 22-23 of the February 2017 Monetary Policy Report.)

… while risk spreads on corporate bonds narrowed

Bond spreads in the nonfinancial corporate sector declined significantly across the credit spectrum, suggesting increased investor confidence in the outlook for the corporate sector since the middle of last year. Declines in spreads were particularly large for firms in the energy sector, likely reflecting improved prospects for U.S. producers as they continue to increase efficiency and benefit from higher prices.

Treasury market functioning and liquidity conditions in the mortgage-backed securities market were generally stable

Indicators of Treasury market functioning remained broadly stable over the second half of 2016 and early 2017. A variety of liquidity metrics--including bid-asked spreads and bid sizes--have displayed minimal signs of liquidity pressures overall, with a modest reduction in liquidity following the U.S. elections. In addition, Treasury auctions generally continued to be well received by investors. Liquidity conditions in the agency MBS market were also generally stable.

The compliance deadline for money market mutual fund reform passed in mid-October with no market disruption

In the weeks leading up to the October 14, 2016, deadline for money market mutual funds (also referred to as money market funds, or MMFs) to comply with a variety of regulatory reforms, shifts in investments from prime to government MMFs were substantial. However, the transition was smooth and without any market disruptions. Overnight Eurodollar deposit volumes fell significantly and have remained low as prime funds pulled back from lending in this market. Meanwhile, the rise in total assets of government funds appeared to contribute to modestly higher levels of take-up at the overnight reverse repurchase agreement (ON RRP) facility through late 2016. Overnight money market rates were little affected, although the spread between the three-month LIBOR (London interbank offered rate) and the OIS (overnight index swap) rate has remained elevated, likely reflecting MMFs' reduced appetite for term lending.

Bank credit continued to expand, and bank profitability improved

Aggregate credit provided by commercial banks continued to grow at a solid pace in the second half of 2016 (figure 14). The expansion in bank credit was driven by strong growth in core loans coupled with an increase in banks' holdings of securities. Measures of bank profitability improved since the middle of last year but remained below their historical averages.

Municipal bond markets continued to function smoothly

Credit conditions in municipal bond markets have generally remained stable since late June. Over that period, the MCDX--an index of credit default swap spreads for a broad portfolio of municipal bonds--decreased moderately, while yield spreads on 20-year general obligation municipal bonds over comparable-maturity Treasury securities were little changed on balance. The Puerto Rico Oversight, Management, and Economic Stability Act was passed into law in late June, providing the commonwealth with a clearer path toward debt restructuring. Although Puerto Rico missed a small amount of debt payments on general obligation bonds in August, this default appeared to have had no significant effect on the broader municipal bond market.

International Developments

Foreign financial market conditions improved despite global political uncertainties

Financial market conditions in both the advanced foreign economies (AFEs) and the emerging market economies (EMEs) have generally improved since June. In the AFEs, increasing distance from the Brexit vote, better-than-expected economic data for Europe, and the continuation of accommodative monetary policies by advanced-economy central banks have contributed to improved risk sentiment. Advanced-economy bond yields reversed their downward trend seen in the first half of the year and increased notably following the U.S. elections, in part on expectations of a more expansionary U.S. fiscal policy (figure 15).

Equity prices in the AFEs have generally risen since June, with financial stocks outperforming broader stock indexes as third-quarter earnings largely beat expectations, several major risk events passed, and the steepening of yield curves was expected to boost profits going forward. Despite some widening of euro-area corporate spreads in the last months of 2016, corporate credit conditions in the advanced foreign economies have remained accommodative, with the continuation of corporate asset purchase programs by several AFE central banks and with low corporate spreads.

In EMEs, equities have risen significantly and sovereign yield spreads have narrowed since June, supported in part by higher commodity prices. Financial conditions did tighten briefly following the U.S. elections, with increased capital outflows and wider sovereign spreads, on concerns that higher global interest rates, as well as the possibility of more protectionist trade policies, would weigh on EME growth. However, the favorable risk sentiment seen in the summer and early fall of 2016 resumed by the end of the year for most EMEs.

After depreciating slightly in the first half of last year, the dollar strengthened in the second half

The dollar has strengthened since June, with the broad dollar index--a measure of the trade-weighted value of the dollar against foreign currencies--rising about 4 percent on balance (figure 16). Much of this strengthening of the U.S. dollar reflects the combined influences of the large depreciation of the Mexican peso, expectations of fiscal and trade policy changes after the U.S. elections, and market expectations of tighter Federal Reserve monetary policy. The Chinese renminbi also weakened notably against the dollar, on net, as capital outflows from China picked up; Chinese authorities tightened capital controls in response.

In general, AFE economic growth was moderate and inflation remained subdued

In Canada, economic growth picked up sharply in the third quarter, following a contraction in the previous quarter, as oil extraction recovered from the disruptions caused by wildfires in May. In contrast, economic growth in Japan in the second and third quarters slowed after a strong first quarter, returning to a more typical moderate pace. Euro-area growth firmed in the second half, and, in the United Kingdom, economic activity was resilient in the aftermath of the Brexit referendum in June. Available indicators suggest that growth in most AFEs was moderate near the end of 2016 and early this year.

Headline inflation in most AFEs increased over the second half of 2016, in part driven by higher oil prices. In the United Kingdom, the substantial sterling depreciation after the Brexit referendum also exerted upward pressure on consumer prices. Even so, core inflation readings in AFEs remained generally subdued, and headline inflation stayed below central bank targets in Canada, the euro area, Japan, and the United Kingdom.

AFE central banks maintained highly accommodative monetary policies

In August, the Bank of England cut its policy rate 25 basis points, announced additional purchases of government and corporate bonds, and introduced a term funding scheme. In September, the Bank of Japan committed to expanding the monetary base until inflation exceeds 2 percent in a stable manner and adopted a new policy framework aimed at controlling the yield curve by targeting short- and long-term interest rates. In December, the European Central Bank announced an extension of the intended duration of its asset purchases through at least December 2017, albeit with a slight reduction in those purchases beginning in April 2017.

In EMEs, Asian growth was solid…

Chinese economic activity remained robust in the second half of 2016, as earlier policy easing supported stable manufacturing growth and a strong property market. However, the property market cooled somewhat toward the end of the year following the introduction of new macroprudential measures aimed at curbing rapidly rising house prices. Elsewhere in emerging Asia, growth held steady in the third quarter but stepped down in some countries in the fourth, even though exports and manufacturing improved. And in India, a surprise mandatory exchange of large-denomination bank notes--a move aimed at battling tax evasion and corruption--has disrupted activity.

… but many Latin American economies continued to struggle

In Mexico, after considerable weakness in the first half of 2016, growth surged in the third quarter, supported in part by a recovery in exports to the United States. However, activity weakened again in the fourth quarter, as consumer and business confidence dropped. Furthermore, inflation in Mexico jumped over the second half of the year, pressured in part by the peso's sizable depreciation, prompting the Bank of Mexico to hike its policy rate sharply. Brazil's recession deepened in the third quarter, reflecting in part tight macroeconomic policies, although the central bank began to ease monetary policy as inflation dropped in response to the weak economy. Elsewhere in the region, activity in the third quarter was mixed; Chile's economy rebounded, but Argentina's GDP contracted and the crisis in Venezuela deepened.

Part 2: Monetary Policy

In December, the Federal Open Market Committee (FOMC) raised the target for the federal funds rate by 1/4 percentage point to a range of 1/2 to 3/4 percent. The FOMC's decision reflected realized and expected labor market conditions and inflation. Moreover, the decision to raise the target range was consistent with the Committee's expectation that, with gradual adjustments in the stance of monetary policy, economic activity would expand at a moderate pace, labor market conditions would strengthen somewhat further, and inflation would rise to the FOMC's 2 percent objective over the medium term. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data. In addition, the Committee anticipates reinvesting principal payments of its securities holdings until normalization of the level of the federal funds rate is well under way.

The FOMC raised the federal funds rate target range in December

About a year ago, in December 2015, the FOMC raised the target range for the federal funds rate after holding the range at near zero since late 2008 to support economic activity and stem disinflationary pressures in the wake of the Great Recession. At that time, the Committee judged that it had seen sufficient improvement in the labor market and was reasonably confident that inflation would move back to its 2 percent objective, which would warrant an initial increase in the federal funds rate. Through most of 2016, the Committee maintained the target range of 1/4 to 1/2 percent, pending further evidence of continued progress toward its objectives. In December, in view of realized and expected labor market conditions and inflation, the FOMC raised the target range for the federal funds rate another 1/4 percentage point, to a range of 1/2 to 3/4 percent (figure 17).³ The Committee kept that same target range at its most recent meeting, which concluded on February 1.

Monetary policy continues to support the economic expansion

The Committee has continued to see the federal funds rate as likely to remain, for some time, below the levels that are expected to prevail in the longer run. With gradual adjustments in the stance of monetary policy, the FOMC expects that economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will rise to 2 percent over the medium term.

Consistent with this outlook, in the most recent Summary of Economic Projections (included as Part 3 of the February 2017 Monetary Policy Reporton pages 33-45; also included in section 9 of this annual report), which was compiled at the time of the December 2016 meeting, most participants projected that the appropriate level of the federal funds rate would be below its longer-run level through 2018.

Future changes in the federal funds rate will depend on the economic outlook as informed by incoming data

Although the Committee has expected that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate, the Committee has continued to emphasize that the actual path of monetary policy will depend on the evolution of the economic outlook. In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment 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. In light of the current shortfall of inflation from 2 percent, the Committee has indicated that it will carefully monitor actual and expected progress toward its inflation goal.

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

To help maintain accommodative financial conditions, the Committee has continued its existing policy of rolling over maturing Treasury securities at auction and reinvesting principal payments on all agency debt and agency mortgage-backed securities in agency mortgage-backed securities. The Federal Reserve's total assets have held steady at around $4.5 trillion, with holdings of U.S. Treasury securities at $2.5 trillion and holdings of agency debt and agency mortgage-backed securities at approximately $1.8 trillion (figure 18). The Committee has for some time stated that it anticipates maintaining this policy until normalization of the level of the federal funds rate is well under way.

Interest income on the System Open Market Account, or SOMA, portfolio has continued to support substantial remittances to the U.S. Treasury. Preliminary results indicate that the Reserve Banks provided for payments of $92 billion of their estimated 2016 net income to the Treasury. The Federal Reserve's remittances to the Treasury have averaged about $80 billion a year since 2008, compared with about $25 billion a year over the decade prior to 2008.⁴

The Federal Reserve's implementation of monetary policy has continued smoothly

As in December 2015, the Federal Reserve successfully raised the effective federal funds rate in December 2016 using the interest rate paid on reserve balances, together with an overnight reverse repurchase agreement (ON RRP) facility.⁵ Specifically, the Federal Reserve raised the interest rate paid on required and excess reserve balances to 3/4 percent and the ON RRP offering rate to 1/2 percent. In addition, the Board of Governors approved an increase in the discount rate (the primary credit rate) to 1.25 percent. The effective federal funds rate rose into the new range amid orderly trading conditions in money markets. Increases in interest rates in other money markets were similar to the rise in the federal funds rate following the December meeting.

The total take-up at the ON RRP facility increased modestly in the second half of 2016 as a result of higher demand by government money market mutual funds in the wake of money fund reform that took effect in mid-October.

Although the implementation of monetary policy has been smooth, the Federal Reserve has continued to test the operational readiness of other policy tools as part of prudent planning. Two operations of the Term Deposit Facility were conducted in the second half of 2016; seven-day deposits were offered at both operations with a floating rate of 1 basis point over the interest rate on excess reserves. In addition, the Open Market Desk conducted several small-value exercises solely for the purpose of maintaining operational readiness.