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 2017, excerpted from the Monetary Policy Report published in February 2018 and July 2017. Those complete reports
are available on the Board's website at www.federalreserve.gov/monetarypolicy/files/20180223_mprfullreport.pdf (February 2018) and www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf (July 2017).

Monetary Policy Report February 2018

Summary

Economic activity increased at a solid pace over the second half of 2017, and the labor market continued to strengthen. Measured on a 12-month basis, inflation has remained below the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent. The FOMC raised the target range for the federal funds rate twice in the first half of 2017, resulting in a range of 1 to 1-1/4 percent by the end of its June meeting. With the federal funds rate rising toward more normal levels, at its September meeting, the FOMC decided to initiate a program of gradually and predictably reducing the size of its balance sheet. At its meeting in December, the Committee judged that current and prospective economic conditions called for a further increase in the target range for the federal funds rate, to 1-1/4 to 1-1/2 percent.

Economic and Financial Developments

The labor market. The labor market has continued to strengthen since the middle of last year. Payroll employment has posted solid gains, averaging 182,000 per month in the seven months starting in July 2017, about the same as the average pace in the first half of 2017. Although net job creation last year was slightly slower than in 2016, it has remained considerably faster than what is needed, on average, to absorb new entrants into the labor force. The unemployment rate declined from 4.3 percent in June to 4.1 percent in January--somewhat below the median of FOMC participants' estimates of its longer-run normal level. Other measures of labor utilization also suggest that the labor market has tightened since last summer. Nonetheless, wage growth has been moderate, likely held down in part by the weak pace of productivity growth in recent years.

Inflation. Consumer price inflation has remained below the FOMC's longer-run objective of 2 percent. The price index for personal consumption expenditures increased 1.7 percent over the 12 months ending in December 2017, about the same as in 2016. The 12-month measure of inflation that excludes food and energy items (so-called core inflation), which historically has been a better indicator of where overall inflation will be in the future than the headline figure, was 1.5 percent in December--0.4 percentage point lower than it had been one year earlier. However, monthly readings on core inflation were somewhat higher during the last few months of 2017 than earlier in the year. Measures of longer-run inflation expectations have, on balance, been generally stable, although some measures remain low by historical standards.

Economic growth. Real gross domestic product (GDP) is reported to have increased at an annual rate of nearly 3 percent in the second half of 2017 after rising slightly more than 2 percent in the first half. Consumer spending expanded at a solid rate in the second half, supported by job gains, rising household wealth, and favorable consumer sentiment. Business investment growth was robust, and indicators of business sentiment have been strong. The housing market has continued to improve slowly. Foreign activity remained solid and the dollar depreciated further in the second half, but net exports subtracted from real U.S. GDP growth as imports of consumer and capital goods surged late in the year.

Financial conditions. Financial conditions for businesses and households have eased on balance since the middle of 2017 amid an improving global growth outlook. Notwithstanding financial market developments in recent weeks, broad measures of equity prices are higher, and spreads of yields on corporate bonds over those of comparable-maturity Treasury securities have narrowed. Most types of consumer loans remained widely available, though credit was still difficult to access in credit card and mortgage markets for borrowers with low credit scores or harder-to-document incomes. Longer-term nominal Treasury yields and mortgage rates have moved up on net. The dollar depreciated, on average, against the currencies of our trading partners. In foreign financial markets, equity prices generally increased in the second half of 2017, and most of those indexes remain higher, on net, despite recent declines. Most longer-term yields rose noticeably.

Financial stability. Vulnerabilities in the U.S. financial system are judged to be moderate on balance. Valuation pressures continue to be elevated across a range of asset classes even after taking into account the current level of Treasury yields and the expectation that the reduction in corporate tax rates should generate an increase in after-tax earnings. Leverage in the nonfinancial business sector has remained high, and net issuance of risky debt has climbed in recent months. In contrast, leverage in the household sector has remained at a relatively low level, and household debt in recent years has expanded only about in line with nominal income. Moreover, U.S. banks are well capitalized and have significant liquidity buffers.

Monetary Policy

Interest rate policy. The FOMC continued to gradually increase the target range for the federal funds rate. After having raised it twice in the first half of 2017, the Committee raised the target range for the federal funds rate again in December, bringing it to the current range of 1-1/4 to 1-1/2 percent. The decision to increase the target range for the federal funds rate reflected the solid performance of the economy. Even with this rate increase, the stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

The FOMC expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12-month basis is expected to move up this year and to stabilize around the Committee's 2 percent objective over the next few years. The federal funds rate is likely to 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 FOMC meeting, the median of participants' assessments for the appropriate level of the federal funds rate through the end of 2019 remains below the median projection for its longer-run level. (The December SEP is included as Part 3 of the February 2018 Monetary Policy Report on pages 39-54; it is also included in section 9 of this annual report.) However, as the Committee has continued to emphasize, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data. In particular, with inflation having persistently run below the 2 percent longer-run objective, the Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.

Balance sheet policy. In the second half of 2017, the Committee initiated the balance sheet normalization program that is described in the Addendum to the Policy Normalization Principles and Plans the Committee issued in June.¹ Specifically, since October, the Federal Reserve has been gradually reducing its holdings of Treasury and agency securities by decreasing the reinvestment of principal payments it receives from these securities.

Special Topics

How tight is the labor market? Although there is no way to know with precision, the labor market appears to be near or a little beyond full employment at present. The unemployment rate is somewhat below most estimates of its longer-run normal rate, and the labor force participation rate is relatively close to many estimates of its trend. Although employers report having more difficulties finding qualified workers, hiring continues apace, and serious labor shortages would likely have brought about larger wage increases than have been evident to date. (See the box "How Tight Is the Labor Market?" on pages 8-9 of the February 2018 Monetary Policy Report.)

Low global inflation. Inflation has generally come in below central banks' targets in the advanced economies for several years now. Resource slack and commodity prices--as well as, for the United States, movements in the U.S. dollar--appear to explain inflation's behavior fairly well. But our understanding is imperfect, and other, possibly more persistent, factors may be at work. Resource slack at home and abroad might be greater than it appears to be, or inflation expectations could be lower than suggested by the available indicators. Moreover, some observers have pointed to increased competition from online retailers or international developments--such as global economic slack or the integration of emerging economies into the world economy--as contributing to lower inflation. Policymakers remain attentive to the possibility of such forces leading to continued low inflation; they also are watchful regarding the opposite risk of inflation moving undesirably high. (See the box "Low Inflation in the Advanced Economies" on pages 14-15 of the February 2018 Monetary Policy Report.)

Monetary policy rules. Monetary policymakers consider a wide range of information on current economic conditions and the outlook before deciding on a policy stance they deem most likely to foster the FOMC's statutory mandate of maximum employment and stable prices. They also routinely consult monetary policy rules that connect prescriptions for the policy interest rate with variables associated with the dual mandate. The use of such rules requires careful judgments about the choice and measurement of the inputs into these rules as well as the implications of the many considerations these rules do not take into account. (See the box "Monetary Policy Rules and Their Role in the Federal Reserve's Policy Process" on pages 35-38 of the February 2018 Monetary Policy Report.)

Part 1: Recent Economic and Financial Developments

Domestic Developments

The labor market strengthened further during the second half of 2017 and early this year

Payroll employment has continued to post solid gains, averaging 182,000 per month in the seven months starting in July 2017, about the same pace as in the first half of 2017.² Although net job creation last year was slightly slower than in 2016, it has remained considerably faster than what is needed, on average, to absorb new entrants to the labor force and is therefore consistent with the view that the labor market has strengthened further (figure 1). The strength of the labor market is also evident in the decline in the unemployment rate to 4.1 percent in January, 1/4 percentage point below its level in June 2017 and about 1/2 percentage point below the median of Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level (figure 2).

Other indicators also suggest that labor market conditions have continued to tighten. The labor force participation rate (LFPR)--that is, the share of adults either working or actively looking for work--was 62.7 percent in January. The LFPR is little changed, on net, since early 2014. However, the average age of the population is continuing to increase. In particular, the members of the baby-boom cohort increasingly are moving into their retirement years, a time when labor force participation typically is low. That development implies that a sustained period in which the demand for and supply of labor were in balance would be associated with a downward trend in the overall participation rate. Accordingly, the flat profile of the LFPR during the past few years is consistent with an overall picture of improving labor market conditions. In line with this perspective, the LFPR for individuals aged 25 to 54--which is much less sensitive to population aging--has been rising since 2015. The employment-to-population ratio for individuals 16 and older--that is, the share of people who are working--was 60.1 percent in January and has been increasing since 2011; this gain primarily reflects the decline in the unemployment rate. (The box "How Tight Is the Labor Market?" on pages 8-9 of the February 2018 Monetary Policy Report describes the available measures of labor market slack in more detail.)

Other indicators are also consistent with continuing strong labor demand. The number of people filing initial claims for unemployment insurance has remained near its lowest level in decades.³ As reported in the Job Openings and Labor Turnover Survey, the rate of job openings remained elevated in the second half of 2017, while the rate of layoffs remained low. In addition, the rate of quits stayed high, an indication that workers are able to obtain a new job when they seek one.

Unemployment rates have declined across demographic groups, but unemployment remains high for some groups

Unemployment rates have trended downward across racial and ethnic groups. The decline in the unemployment rate for blacks or African Americans over the past few years has been particularly notable. This broad pattern is typical: The unemployment rates for blacks and Hispanics tend to rise considerably more than the rates for whites and Asians during recessions, and then they decline more rapidly during expansions. Yet even with the recent narrowing, the disparities in unemployment rates across demographic groups remain substantial and largely the same as before the recession. The unemployment rate for whites has averaged 3.7 percent since the middle of 2017 and the rate for Asians has been about 3.3 percent, while the unemployment rates for Hispanics or Latinos (5.0 percent) and blacks (7.3 percent) have been substantially higher. In addition, the labor force participation rates for blacks, Hispanics, and Asians have generally been lower than those for whites of the same age group. As the labor market has strengthened over the past few years, the participation rates for prime-age individuals in each of these groups have risen.

Growth of labor compensation has been moderate...

Despite the strong labor market, the available indicators generally suggest that the growth of hourly compensation has been moderate. Growth of compensation per hour in the business sector--a broad-based measure of wages, salaries, and benefits that is quite volatile--was 2-1/4 percent over the four quarters ending in 2017:Q4, well above the low reading in 2016 but about in line with the average annual increase from 2010 to 2015.⁴ The employment cost index--which also measures both wages and the cost to employers of providing benefits--was up about 2-1/2 percent in the fourth quarter of 2017 relative to its year-ago level, roughly 1/2 percentage point faster than its gain a year earlier. Among measures that do not take account of benefits, average hourly earnings rose slightly less than 3 percent through January of this year, a gain that was somewhat faster than the average increase in the preceding few years. Similarly, the measure of wage growth computed by the Federal Reserve Bank of Atlanta that tracks median 12-month wage growth of individuals reporting to the Current Population Survey showed an increase of about 3 percent in January, similar to its readings from the past three years and above the average increase in the preceding few years.⁵

. . . and likely was restrained by slow growth of labor productivity

These moderate rates of compensation gain likely reflect the offsetting influences of a tightening labor market and persistently weak productivity growth. Since 2008, labor productivity has increased only a little more than 1 percent per year, on average, well below the average pace from 1996 through 2007 and also below the gains in the 1974-95 period. Considerable debate remains about the reasons for the general slowdown in productivity growth and whether it will persist. The slowdown may be partly attributable to the sharp pullback in capital investment during the most recent recession and the relatively long period of modest growth in investment that followed, but a reduced pace of capital deepening can explain only a portion of the step-down. Beyond that, some economists think that more recent technological advances, such as information technology, have been less revolutionary than earlier general-purpose technologies, such as electricity and internal combustion. Others have pointed to a slowdown in the speed at which capital and labor are reallocated toward their most productive uses, which is reflected in fewer business start-ups and a reduced pace of hiring and investment by the most innovative firms. Still others argue that there have been important innovations in many fields in recent years, from energy to medicine, often underpinned by ongoing advances in information technology, which augurs well for productivity growth going forward. However, those economists note that such productivity gains may appear only slowly as new firms emerge to exploit the new technologies and as incumbent firms invest in new vintages of capital and restructure their businesses.

Price inflation remains below 2 percent, but the monthly readings picked up toward the end of 2017

Consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures (PCE), remained below the FOMC's longer-run objective of 2 percent during most of 2017. The PCE price index increased 1.7 percent over the 12 months ending in December 2017, about the same as in 2016 (figure 3). Core inflation, which typically provides a better indication than the headline measure of where overall inflation will be in the future, was 1.5 percent over the 12 months ending in December 2017--0.4 percentage point lower than it had been one year earlier.

Both measures of inflation reflected some weak readings in the spring and summer of 2017. A portion of those weak readings seemed attributable to idiosyncratic events, such as a steep 1-month decline in the price index for wireless telephone services. However, the monthly readings on core inflation were somewhat higher during the last few months of 2017, in contrast to the more typical pattern that has prevailed in recent years in which readings around the end of the year have tended to be slightly below average. Moreover, the 12-month change in the trimmed mean PCE price index--an alternative indicator of underlying inflation produced by the Federal Reserve Bank of Dallas that may be less sensitive to idiosyncratic price movements--was 1.7 percent in December 2017 and has slowed by less than core PCE price inflation over the past 12 months.⁶ (For more discussion of inflation both in the United States and abroad, see the box "Low Inflation in the Advanced Economies" on pages 14-15 of the February 2018 Monetary Policy Report.)

Oil and metals prices increased notably

Headline inflation was a little higher than core inflation last year, which reflected a rise in consumer energy prices. The price of crude oil rose from $48 per barrel at the end of June to a peak of about $70 per barrel early in the year and, even after recent declines, remains more than 30 percent above its mid-2017 level (figure 4). The upswing in oil prices appears to have been driven primarily by strengthening global demand as well as OPEC's decision to further extend its November 2016 production cuts through the end of 2018. The higher oil prices fed through to moderate increases in the cost of gasoline and heating oil.

Inflation momentum was also supported by nonfuel import prices, which rose throughout 2017 in part because of dollar depreciation. That development marked a turn from the past several years, during which nonfuel import prices declined or held flat. In addition to the decline in the dollar, nonfuel import prices were driven higher by a substantial increase in the price of industrial metals. Despite recent volatility, metals prices remain higher, on net, boosted primarily by improved prospects for global demand and also by government policies that restrained production in China.

In contrast, headline inflation has been held down by consumer food prices, which increased only about 1/2 percent in 2017 after having declined in 2016. Food prices have been restrained by softness in the prices of farm commodities, which in turn has reflected robust supply in the United States and abroad. Although the harvests for many crops in the United States declined in 2017, they were larger than had been expected earlier in the year.

Survey-based measures of inflation expectations have been generally stable...

Expectations of inflation likely influence actual inflation by affecting wage- and price-setting decisions. Survey-based measures of inflation expectations at medium- and longer-term horizons have remained generally stable. In the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia, the median expectation for the annual rate of increase in the PCE price index over the next 10 years has been around 2 percent for the past several years (figure 5). In the University of Michigan Surveys of Consumers, the median value for inflation expectations over the next 5 to 10 years--which had drifted downward starting in 2014--has held about flat since the end of 2016 at a level that is a few tenths lower than had prevailed through 2014.

. . . and market-based measures of inflation compensation have increased in recent months but remain relatively low

Inflation expectations can also be gauged by market-based measures of inflation compensation, though the inference is not straightforward because market-based measures can be importantly affected by changes in premiums that provide compensation for bearing inflation and liquidity risks. Measures of longer-term inflation compensation--derived either from differences between yields on nominal Treasury securities and those on comparable Treasury Inflation-Protected Securities (TIPS) or from inflation swaps--have increased since June, returning to levels seen in early 2017, but nevertheless remain relatively low.⁷ The TIPS-based measure of 5-to-10-year-forward inflation compensation and the analogous measure of inflation swaps are now slightly lower than 2-1/4 percent and 2-1/2 percent, respectively, with both measures below the ranges that persisted for most of the 10 years before the start of the notable declines in mid-2014.

Real gross domestic product growth picked up in the second half of 2017

Real gross domestic product (GDP) is reported to have risen at an annual rate of nearly 3 percent in the second half of 2017 after increasing slightly more than 2 percent in the first half of 2017 (figure 6). Much of that faster growth reflects the stabilization of inventory investment, which had slowed considerably in the first half of last year. Private domestic final purchases--that is, final purchases by U.S. households and businesses, which tend to provide a better indication of future GDP growth than most other components of overall spending--rose at a solid annual rate of about 3-1/2 percent in the second half of the year, similar to the first-half pace.

The economic expansion continues to be supported by steady job gains, rising household wealth, favorable consumer sentiment, strong economic growth abroad, and accommodative financial conditions, including the still low cost of borrowing and easy access to credit for many households and businesses. In addition to these factors, very upbeat business sentiment appears to have supported solid growth over the past year.

Ongoing improvement in the labor market and gains in wealth continue to support consumer spending...

Supported by ongoing improvement in the labor market, real consumer spending rose at a solid annual rate of 3 percent in the second half of 2017, a somewhat faster pace than in the first half. Real disposable personal income--that is, income after taxes and adjusted for price changes--increased at a modest average rate of 1 percent in 2016 and 2017, as real wages changed little over this period (figure 7). With spending growth estimated to have outpaced income growth, the personal saving rate has declined considerably since the end of 2015.

Consumer spending has also been supported by further increases in household net wealth. Broad measures of U.S. equity prices rose robustly last year, though markets have been volatile in recent weeks; house prices have also continued to climb, strengthening the wealth of homeowners. As a result of the increases in home and equity prices, aggregate household net worth rose appreciably in 2017. In fact, at the end of the third quarter of 2017, household net worth was 6.7 times the value of disposable income, the highest-ever reading for that ratio, which dates back to 1947.

. . . borrowing conditions for consumers remain generally favorable...

Consumer credit expanded in 2017 at about the same pace as in 2016. Financing conditions for most types of consumer loans are generally favorable. However, banks have continued to tighten standards on credit card and auto loans for borrowers with low credit scores, possibly in response to some upward drift in delinquency rates for those borrowers. Mortgage credit has remained readily available for households with solid credit profiles, but it was still difficult to access for households with low credit scores or harder-to-document incomes.

Although household borrowing continued to increase last year, the household debt service burden--the ratio of required principal and interest payments on outstanding household debt to disposable income, measured for the household sector as a whole--remained low by historical standards.

. . . and consumer confidence is strong

Consumers have remained optimistic about their economic situation. As measured by the Michigan survey, consumer sentiment was solid throughout 2017, likely reflecting rising income, job gains, and low inflation. Furthermore, the share of households expecting real income to rise over the next year or two has continued to strengthen and now exceeds its pre-recession level.

Activity in the housing sector has improved modestly

Real residential investment spending increased around 2 percent in 2017, about the same modest gain that was seen in 2016. Housing activity was soft in the spring and summer, possibly reflecting the rise in mortgage interest rates early in the year, and then picked up toward the end of the year. For the year as a whole, sales of new and existing homes gained, and single-family housing starts increased (figure 8). In contrast, multifamily housing starts continued to edge down from the solid pace seen in 2016. Going forward, lean inventories are likely to support further gains in homebuilding activity, as the months' supply of homes for sale has remained near low levels.

Business investment has continued to
rebound...

Real outlays for business investment--that is, private nonresidential fixed investment--rose at an annual rate of about 6 percent in the second half of 2017, a bit below the gain in the first half but still notably faster than the unusually weak pace recorded in 2016 (figure 9). Business spending on equipment and intangibles (such as research and development) advanced at a solid pace in the second half of the year, and forward-looking indicators of business spending are generally favorable: Orders and shipments of capital goods have posted net gains in recent months, and indicators of business sentiment and activity remain very upbeat. That said, business outlays on structures turned down in the second half of 2017, as investment growth in drilling and mining structures retreated from a very rapid pace in the first half and investment in other nonresidential structures declined.

. . . while corporate financing conditions have remained accommodative

Aggregate flows of credit to large nonfinancial firms remained solid through the third quarter, supported in part by continued low interest rates. The gross issuance of corporate bonds stayed robust during the second half of 2017, and yields on both investment-grade and high-yield corporate bonds remained low by historical standards.

Despite solid growth in business investment, outstanding commercial and industrial (C&I) loans on banks' books continued to rise only modestly in the third quarter of 2017. Respondents to the Senior Loan Officer Opinion Survey on Bank Lending Practices, or SLOOS, reported that demand for C&I loans declined in the third quarter and was little changed in the fourth quarter even as lending standards and terms on such loans eased.⁸ Respondents attributed this decline in demand in part to firms drawing on internally generated funds or using alternative sources of financing. Financing conditions for small businesses appear to have remained favorable, and although credit growth has remained sluggish, survey data suggest this sluggishness is largely due to continued weak demand for credit by small businesses.

Net exports subtracted from GDP growth in the fourth quarter after providing a modest addition during the rest of the year

U.S. real exports expanded at a moderate pace in the second half of last year after having increased more rapidly in the first half, supported by solid foreign growth (figure 10). At the same time, real imports surged in the fourth quarter following a slight contraction in the third quarter. As a result, real net exports moved from modestly lifting U.S. real GDP growth during the first three quarters of 2017 to subtracting more than 1 percentage point in the fourth quarter. Although the nominal trade and current account deficits narrowed in the third quarter of 2017, the trade deficit widened in the fourth quarter.

Federal fiscal policy actions had a roughly neutral effect on economic growth in 2017...

Federal government purchases rose 1 percent in 2017, and policy actions had little effect on federal taxes or transfers (figure 11). Under currently enacted legislation, which includes the Tax Cuts and Jobs Act (TCJA) and the Bipartisan Budget Act, federal fiscal policy will likely provide a moderate boost to GDP growth this year.⁹

The federal unified deficit continued to widen in fiscal year 2017, reaching 3-1/2 percent of nominal GDP. Although expenditures as a share of GDP were relatively stable at a little under 21 percent, receipts moved lower in 2017 to roughly 17 percent of GDP. The ratio of federal debt held by the public to nominal GDP was 75-1/4 percent at the end of fiscal year 2017 and remains quite elevated relative to historical norms.

. . . and the fiscal position of most state and local governments is stable

The fiscal position of most state and local governments is stable, although there is a range of experiences across these governments. Many state governments are experiencing lackluster revenue growth, as income tax collections have only edged up, on average, in recent quarters. In contrast, house price gains have continued to push up property tax revenues at the local level. Employment in the state and local government sector only inched up in 2017, while outlays for construction by these governments continued to decline on net.

Financial Developments

The expected path of the federal funds rate has moved up

The path of the expected federal funds rate implied by market quotes on interest rate derivatives has moved up on net since the middle of last year amid an improving global growth outlook. Part of the upward shift occurred around FOMC communications in the fall that were interpreted as implying a somewhat quicker pace of policy rate increases than had been previously anticipated. The expected policy path also moved higher around the time when the U.S. tax legislation was finalized.

Survey-based measures of the expected path of the policy rate have been generally little changed on net, suggesting that part of the rise in the market-implied path reflected higher term premiums. In the Federal Reserve Bank of New York's Survey of Primary Dealers and Survey of Market Participants, which were conducted just before the January 2018 FOMC meeting, the median respondents expected three 25 basis point increases in the FOMC's target range for the federal funds rate as the most likely outcome for this year, unchanged from what they had expected in surveys conducted before the June FOMC meeting. Market-based measures of uncertainty about the policy rate approximately one to two years ahead have, on balance, edged up from their levels in the middle of 2017.

The nominal Treasury yield curve has shifted up

The nominal Treasury yield curve has shifted up on net since the middle of 2017, owing to greater optimism about the global growth outlook and investors' perceptions of higher odds for the removal of monetary policy accommodation (figure 12). Yields on shorter-term nominal Treasury securities increased relatively more than those on longer-term nominal Treasury securities, thus resulting in some flattening of the yield curve. According to market participants, among the factors contributing to this outcome has been the Treasury Department's stated intention to increase its reliance on issuance of short-dated securities, as discussed in the two most recent releases of the Treasury's quarterly financing statement.

Consistent with the changes in Treasury yields, yields on 30-year agency mortgage-backed securities (MBS)--an important determinant of mortgage interest rates--increased but remain quite low by historical standards.

Broad equity price indexes have increased further...

Broad U.S. equity indexes, despite some declines seen in recent weeks, have, on balance, increased further since June 2017, with most of the net gains occurring during the final quarter of last year (figure 13). Equity prices were reportedly supported in part by an increase in investors' confidence that changes to the federal tax law will boost corporate earnings. Stock prices generally increased across industries outside utilities and real estate, two sectors for which the increases in interest rates described earlier are likely to have weighed more heavily on stock prices; stock prices of banks rose more than the broader market. Implied volatility for the S&P 500 index, as calculated from options prices, increased notably in early February, ending the period close to the median of its historical distribution.

. . . while risk spreads on corporate bonds have continued to decrease

Spreads on both high-yield and investment-grade corporate bond yields over comparable-maturity Treasury yields have decreased further since the middle of last year, with spreads for high-yield bonds moving closer to the bottom of their historical ranges. The narrowing of the spreads since the middle of 2017 appears to reflect both an anticipation that the losses from defaults on these bonds will be smaller and a lower compensation being charged for bearing the risk of such losses. (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability" on pages 24-26 of the February 2018 Monetary Policy Report.)

Markets for Treasury securities, mortgage-backed securities, municipal bonds, and short-term funding have functioned well

Available indicators of Treasury market functioning have generally remained stable over the second half of 2017 and early 2018, with a variety of liquidity metrics--including bid-ask spreads, bid sizes, and estimates of transaction costs--mostly unchanged over the period. Liquidity conditions in the agency MBS market have also been generally stable. In recent months, the functioning of Treasury and agency MBS markets has not been notably affected by the implementation of the Federal Reserve's balance sheet normalization program and the resulting reduction in reinvestment of principal payments from the Federal Reserve's securities holdings. In early February, amid financial market volatility, liquidity conditions in the Treasury market deteriorated but have recovered somewhat since. Credit conditions in municipal bond markets have also remained generally stable since June 2017. Over that period, yield spreads on 20-year general obligation municipal bonds over comparable-maturity Treasury securities have narrowed on balance. Nevertheless, significant financial strains were still evident for some issuers. In particular, prices for Puerto Rico general obligation bonds fell notably after Hurricane Maria hit the island and its economic outlook deteriorated even further. However, these developments left little imprint in broader municipal bond markets. Conditions in domestic short-term funding markets have remained stable since the middle of last year.

Bank credit continued to expand and bank profitability remained stable

Aggregate credit provided by commercial banks continued to expand in the second half of 2017 at a pace similar to the one seen earlier in the year but more slowly than in 2016. Its pace was also slower than that of nominal GDP, thus leaving the ratio of total commercial bank credit to current-dollar GDP slightly lower than earlier in 2017 (figure 14). Measures of bank profitability were little changed at levels below their historical averages.

International Developments

Economic activity in most foreign economies continued at a healthy pace in the second half
of 2017

Foreign real GDP appears to have expanded notably in the second half of 2017, extending the period since mid-2016 when the pace of economic growth picked up broadly around the world.

Growth in advanced foreign economies was solid, and unemployment fell to multidecade
lows...

In the advanced foreign economies (AFEs), the economic recovery has continued to firm. Real GDP in the euro area and the United Kingdom expanded at a solid pace in the second half of the year. Economic activity also continued to expand in Japan, though real GDP growth slowed sharply in the fourth quarter. In Canada, data through November indicate that economic growth moderated somewhat in the second half following a very rapid expansion earlier in the year. Unemployment declined further as well, reaching 40-year lows in Canada and the United Kingdom, while growth in labor compensation ticked up only modestly.

. . . but inflation remained subdued...

Consumer price inflation rose somewhat in most AFEs, boosted by the rise in commodity prices. However, headline and especially core inflation remained below the central banks' targets in the euro area and Japan. In contrast, U.K. inflation rose further above the Bank of England's (BOE) 2 percent target as the substantial sterling depreciation observed since the June 2016 Brexit referendum continued to provide some uplift to import prices. (For more discussion of inflation both in the United States and abroad, see the box "Low Inflation in the Advanced Economies" on pages 14-15 of the February 2018 Monetary Policy Report.)

. . . leading AFE central banks to maintain accommodative monetary policies

The Bank of Japan kept its policy rates at historically low levels, with the target for 10-year government bond yields around zero. In October, the European Central Bank extended its asset purchase program until September 2018, albeit at a reduced pace. The Bank of Canada and the BOE both raised their policy rates but also indicated that they intend to proceed gradually with further removal of policy accommodation.

In emerging Asia, growth remained solid...

Economic growth in China remained relatively strong in the second half of 2017 even as the authorities enacted policies to limit production in heavily polluting industries, tighten financial regulations, and curb house price growth. Most other emerging Asian economies registered very strong growth in the third quarter of 2017, fueled by solid external demand, but slowed in the fourth quarter.

. . . while the largest Latin American economies continued to struggle

In Mexico, real GDP declined in the third quarter as two major earthquakes and a hurricane significantly disrupted economic activity, but rebounded in the fourth quarter. Following a prolonged period of contraction, the Brazilian economy continues to recover, but only at a weak pace. Private investment has remained sluggish amid corporate deleveraging and continued uncertainty about government policies, although it turned positive in the third quarter for the first time in nearly four years.

Foreign equity prices rose further on net...

Solid macroeconomic data and robust corporate earnings helped broad AFE and emerging market economies (EMEs) equity indexes extend their 2016 gains through the start of this year. Declines since the end of January have erased some of these gains, and volatility in foreign stock markets increased. On balance, most AFE stock prices are higher, and EME equity markets significantly outperformed those of AFEs. Capital flows into emerging market mutual funds generally remained robust as higher commodity prices added to optimism about the economic outlook.

. . . and government bond yields increased

Longer-term government bond yields in most AFEs were noticeably higher than their mid-2017 levels, reflecting strengthening growth and mounting prospects for the normalization of monetary policies
(figure 15). In Canada, where the central bank has raised its policy interest rate 75 basis points since June, the rise in longer-term yields was particularly notable. On balance, spreads of dollar-denominated emerging market sovereign bonds over U.S. Treasury securities were stable around the levels observed in mid-2017.

The dollar depreciated on net

The broad dollar index--a measure of the trade-weighted value of the dollar against foreign currencies--fell roughly 5 percent in the first half of 2017. Notwithstanding some appreciation in early February, the currency has depreciated further since the end of June, partially reversing substantial appreciation realized over the period from 2014 to 2016 (figure 16). The weakness in the dollar mostly reflects a broad-based improvement in the outlook for foreign economic growth. Brexit-related headlines weighed on the British pound at times during the second half of 2017, but progress regarding the terms of the U.K. separation from the European Union boosted the currency later in the year. In contrast, the dollar appreciated against the Mexican peso, on net, amid uncertainty around North American Free Trade Agreement negotiations.

Part 2: Monetary Policy

The Federal Open Market Committee raised the federal funds rate target range in December

For more than two years, the Federal Open Market Committee (FOMC) has been gradually increasing its target range for the federal funds rate as the labor market strengthened and headwinds in the aftermath of the recession continued to abate. After having raised the target range for the federal funds rate twice in the first half of 2017, the Committee raised it again in December, bringing the target range to 1-1/4 to 1-1/2 percent (figure 17).¹⁰ As on previous occasions, the decision to increase the federal funds rate in December reflected realized and expected labor market conditions and inflation relative to the FOMC's objectives. Information available at that time indicated that economic activity had been rising at a solid rate and the labor market had continued to strengthen. In addition, although inflation had continued to run below the FOMC's 2 percent longer-run objective, the Committee expected that it would stabilize around that target over the medium term. At its most recent meeting, which concluded on January 31, the Committee kept the target range for the federal funds rate unchanged.¹¹

Monetary policy continues to support economic growth

Even with the gradual increases in the federal funds rate to date, the Committee judges that the stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation. The federal funds rate remains somewhat below most estimates of its neutral rate--that is, the level of the federal funds rate that is neither expansionary nor contractionary.

In evaluating the stance of monetary policy, policymakers routinely consult prescriptions from a variety of policy rules, which can serve as useful benchmarks. However, the use and interpretation of such prescriptions require careful judgments about the choice and measurement of the inputs to these rules as well as the implications of the many considerations these rules do not take into account. (See the box "Monetary Policy Rules and Their Role in the Federal Reserve's Policy Process" on pages 35-38 of the February 2018 Monetary Policy Report.)

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

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. 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. The FOMC has emphasized that it will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal, as inflation has been running persistently below the 2 percent longer-run objective.

The Committee expects that the ongoing strength in the economy will warrant further gradual increases in the federal funds rate, and that the federal funds rate will likely remain, for some time, below the levels that the Committee expects to prevail in the longer run. Consistent with this outlook, in the most recent Summary of Economic Projections, which was compiled at the time of the December FOMC meeting, the median of participants' assessments for the appropriate level of the midpoint of the target range for the federal funds rate at year-end rises gradually over the period from 2018 to 2020, remaining below the median projection for its longer-run level through the end of 2019.¹²

The size of the Federal Reserve's balance sheet has begun to decrease

The Committee had communicated for some time that it intended to reduce the size of the Federal Reserve's balance sheet once normalization of the level of the federal funds rate was well under way. At its meeting in September, the FOMC decided to initiate the balance sheet normalization program described in the June 2017 Addendum to the Policy Normalization Principles and Plans. This program is gradually and predictably reducing the Federal Reserve's securities holdings by decreasing the reinvestment of the principal payments it receives from securities held in the System Open Market Account (SOMA). Since October, such payments have been reinvested only to the extent that they exceeded gradually rising caps.

In the fourth quarter, the Open Market Desk at the Federal Reserve Bank of New York, as directed by the Committee, reinvested principal payments from the Federal Reserve's holdings of Treasury securities maturing during each calendar month in excess of $6 billion. The Desk also reinvested in agency mortgage-backed securities (MBS) the amount of principal payments from the Federal Reserve's holdings of agency debt and agency MBS received during each calendar month in excess of $4 billion. Since January, payments of principal from maturing Treasury securities and from the Federal Reserve's holdings of agency debt and agency MBS have been reinvested to the extent that they have exceeded $12 billion and $8 billion, respectively. The Committee has indicated that the cap for Treasury securities will continue to increase in steps of $6 billion at three-month intervals until it reaches $30 billion per month, and that the cap for agency debt and agency MBS will continue to increase in steps of $4 billion at three-month intervals until it reaches $20 billion per month. These caps will remain in place until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

The initiation of the balance sheet normalization program was widely anticipated and therefore did
not elicit a notable reaction in financial markets. Subsequently, the implementation of the program has proceeded smoothly without materially affecting Treasury and MBS markets. With the caps having been set thus far at relatively low levels, the reduction in SOMA securities has represented a small fraction of the SOMA securities holdings. Consequently, the Federal Reserve's total assets have declined somewhat to about $4.4 trillion, with holdings of Treasury securities at approximately $2.4 trillion and holdings of agency debt and agency MBS at approximately $1.8 trillion (figure 18).

Interest income on the SOMA portfolio has continued to support substantial remittances to the U.S. Treasury. Preliminary financial statement results indicate that the Federal Reserve remitted about $80.2 billion of its estimated 2017 net income to the Treasury.

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

In December 2017, the Federal Reserve raised the effective federal funds rate by increasing the interest rate paid on reserve balances along with the interest rate offered on overnight reverse repurchase agreements (ON RRPs). Specifically, the Federal Reserve increased the interest rate paid on required and excess reserve balances to 1-1/2 percent and the ON RRP offering rate to 1-1/4 percent. In addition, the Board of Governors approved an increase in the discount rate (the so-called primary credit rate) to 2 percent. Yields on a broad set of money market instruments moved higher in response to the FOMC's policy action in December. The effective federal funds rate rose in line with the increase in the FOMC's target range and generally traded near the middle of the new target range amid orderly trading conditions in money markets. Usage of the ON RRP facility has declined on net since the middle of 2017, reflecting relatively attractive yields on alternative investments.

Although the normalization of the monetary policy stance has proceeded smoothly, 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 2017; 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 Desk conducted several small-value exercises solely for the purpose of maintaining operational readiness.

Monetary Policy Report July 2017

Summary

Economic activity increased at a moderate pace over the first half of the year, and the jobs market continued to strengthen. Measured on a 12-month basis, inflation has softened some in the past few months. The Federal Open Market Committee (FOMC) judged that, on balance, current and prospective economic conditions called for a further gradual removal of policy accommodation. At its most recent meeting in June, the Committee boosted the target range for the federal funds rate to 1 to 1-1/4 percent. The Committee also issued additional information regarding its plans for reducing the size of its balance sheet in a gradual and predictable manner.

Economic and Financial Developments

Labor markets. The labor market has strengthened further so far this year. Over the first five months of 2017, payroll employment increased 162,000 per month, on average, somewhat slower than the average monthly increase for 2016 but still more than enough to absorb new entrants into the labor force. The unemployment rate fell from 4.7 percent in December to 4.3 percent in May--modestly below the median of FOMC participants' estimates of its longer-run normal level. Other measures of labor utilization are also consistent with a relatively tight labor market. However, despite the broad-based strength in measures of employment, wage growth has been only modest, possibly held down by the weak pace of productivity growth in recent years.

Inflation. Consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures, briefly reached the FOMC's 2 percent objective earlier this year, but it more recently has softened. The latest reading, for May, was 1.4 percent--still up from a year earlier when falling energy prices restrained overall consumer prices. The 12-month measure of inflation that excludes food and energy items (so-called core inflation), which historically has been a better indicator than the headline figure of where overall inflation will be in the future, was also 1.4 percent over the year ending in May; this reading was a bit lower than it had been one year earlier. Measures of longer-run inflation expectations have been relatively stable, on balance, though some measures remain low by historical standards.

Economic growth. Real gross domestic product (GDP) is reported to have risen at an annual rate of about 1-1/2 percent in the first quarter of 2017, but more recent data suggest growth stepped back up in the second quarter. Consumer spending was sluggish in the early part of the year but appears to have rebounded recently, supported by job gains, rising household wealth, and favorable consumer sentiment. Business investment has turned up this year after having been weak for much of 2016, and indicators of business sentiment have been strong. The housing market continues its gradual recovery. Economic growth has also been supported by recent strength in foreign activity.

Financial conditions. On balance, domestic financial conditions for businesses and households have continued to support economic growth. Long-term nominal Treasury yields and mortgage rates have decreased so far in 2017, although yields remain somewhat above levels that prevailed last summer. Broad measures of equity prices increased further during the first half of the year. Spreads of yields on corporate bonds over comparable-maturity Treasury securities decreased. Most types of consumer loans remained widely available, while mortgage credit stayed readily available for households with solid credit profiles but was still difficult to access for households with low credit scores or harder-to-document incomes. In foreign financial markets, equity prices increased and risk spreads decreased amid generally firming economic growth and robust corporate earnings. The broad U.S. dollar index depreciated modestly against foreign currencies.

Financial stability. Vulnerabilities in the U.S. financial system remained, on balance, moderate. Contributing to the financial system's improved resilience, U.S. banks have substantial amounts of capital and liquidity. Valuation pressures across a range of assets and several indicators of investor risk appetite have increased further since mid-February. However, these developments in asset markets have not been accompanied by increased leverage in the financial sector, according to available metrics, or increased borrowing in the nonfinancial sector. Household debt as a share of GDP continues to be subdued, and debt owed by nonfinancial businesses, although elevated, has been either flat or falling in the past two years. (See the box "Developments Related to Financial Stability" on pages 24 -25 of the July 2017 Monetary Policy Report.)

Monetary Policy

Interest rate policy. Over the first half of 2017, the FOMC continued to gradually reduce the amount of monetary policy accommodation. Specifically, the Committee decided to raise the target range for the federal funds rate in March and in June, bringing it to the current range of 1 to 1-1/4 percent. Even with these rate increases, the stance of monetary policy remains accommodative, supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

The FOMC continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term. The federal funds rate is likely to 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), compiled at the time of the June FOMC meeting, most participants projected that the appropriate level of the federal funds rate would be below its longer-run level through 2018. (The June SEP is presented in Part 3 on pages 41-57 of the July 2017 Monetary Policy Report; it is also included in section 9 of this report.) However, as the Committee has continued to emphasize, monetary policy is not on a preset course; the actual path of the federal funds rate will depend on the evolution of the economic outlook as informed by incoming data. In particular, the Committee is monitoring inflation developments closely.

Balance sheet policy. To help maintain accommodative financial conditions, the Committee has continued its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and rolling over maturing Treasury securities at auction. In June, the FOMC issued an Addendum to the Policy Normalization Principles and Plans that provides additional details regarding the approach the FOMC intends to follow to reduce the Federal Reserve's holdings of Treasury and agency securities in a gradual and predictable manner. The Committee currently expects to begin implementing the balance sheet normalization program this year provided that the economy evolves broadly as anticipated. (See the box "Addendum to the Policy Normalization Principles and Plans" on page 40 of the July 2017 Monetary Policy Report.)

Special Topics

Education and climbing the economic ladder. Education, particularly a college degree, is often seen as a path to improved economic opportunities. However, despite the fact that young blacks and Hispanics have increased their educational attainment over the past quarter-century, their representation in the top 25 percent of the income distribution for young people has not materially increased. In part, this outcome has occurred because educational attainment has increased for young non-Hispanic whites and Asians as well. While education continues to be an important determinant of whether one can climb the economic ladder, sizable differences in economic outcomes across race and ethnicity remain even after controlling for educational attainment. (See the box "Does Education Determine Who Climbs the Economic Ladder?" on pages 8-9 of the July 2017 Monetary Policy Report.)

The global productivity slowdown. Over the past decade, labor productivity growth both in the United States and in other advanced economies has slowed markedly. This slowdown may reflect a waning of the effects from advances in information technology in the 1990s and early 2000s. Productivity growth may also be low because of the severity of the Global Financial Crisis, in part because spending for research and development was muted. Some of the factors restraining productivity growth may eventually fade, but it is difficult to ascertain whether the recent subdued performance of productivity represents a new normal. (See the box "Productivity Developments in the Advanced Economies" on pages 12-13 of the July 2017 Monetary Policy Report.)

Liquidity in the corporate bond market. A series of changes, including regulatory reforms, since the Global Financial Crisis have likely altered financial institutions' incentives to provide liquidity. Many market participants are particularly concerned with liquidity in markets for corporate bonds. However, the available evidence suggests that financial markets have performed well in recent years, with minimal impairment in liquidity, either in the market for corporate bonds or in markets for other assets. (See the box "Recent Developments in Corporate Bond Market Liquidity" on pages 26-28 of the July 2017 Monetary Policy Report.)

Monetary policy rules. Monetary policymakers consider a wide range of information on current economic conditions and the outlook before deciding on a policy stance they deem most likely to foster the FOMC's statutory mandate of maximum employment and stable prices. They also routinely consult monetary policy rules that connect prescriptions for the policy interest rate with variables associated with the dual mandate. The use of such rules requires careful judgments about the choice and measurement of the inputs into these rules as well as the implications of the many considerations these rules do not take into account. (See the box "Monetary Policy Rules and Their Role in the Federal Reserve's Policy Process" on pages 36-39 of the July 2017 Monetary Policy Report.)

Part 1: Recent Economic and Financial Developments

Domestic Developments

The labor market tightened further during the first half of the year...

Labor market conditions continued to strengthen in the first five months of this year. On average, payrolls expanded 162,000 per month between January and May, a little slower than the average monthly employment gain in 2016 but still more than enough to absorb new entrants to the labor force and therefore consistent with a further tightening of the labor market. The unemployment rate has declined 0.4 percentage point since December 2016, and in May it stood at 4.3 percent, its lowest level since late 2000 and modestly below the median of Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level.

The labor force participation rate (LFPR)--that is, the share of adults either working or actively looking for work--was 62.7 percent in May and is little changed, on net, since early 2014. Along with other factors, the aging of the population implies a downward trend in participation, so the flattening out of the LFPR during the past few years is consistent with an overall picture of improving labor market conditions. The employment-to-population ratio--that is, the share of the population that is working--was 60 percent in May and has been increasing for the past couple of years, reflecting the combination of the declining unemployment rate and the flat LFPR.

The strengthening condition of the labor market is evident in other measures as well. The number of people filing initial claims for unemployment insurance has fallen to the lowest level in decades. In addition, as reported in the Job Openings and Labor Turnover Survey, the rate of job openings remained elevated in the first part of the year, while the rate of layoffs remained low; both are signs that firms' demand for labor is still solid. In addition, the rate of quits stayed high, an indication that workers are confident in their ability to obtain a new job. Another measure, the share of workers who are working part time but would prefer to be employed full time--which is part of the U-6 measure of underutilization from the Bureau of Labor Statistics--fell noticeably further in the first five months of 2017.

. . . though unemployment rates remain elevated for some demographic groups

Although the aggregate unemployment rate was at a 16-year low in May, there are substantial disparities across demographic groups. Notably, the unemployment rate for whites averaged 4 percent during the first five months of the year, and the rate for Asians was about 3-1/2 percent. However, the unemployment rates for Hispanics (5.4 percent) and African Americans (7.8 percent) were substantially higher. The differences in the unemployment rates across racial and ethnic groups are long-standing, and they also vary over the business cycle. Indeed, the unemployment rates for blacks and Hispanics both rose considerably more than the rates for whites and Asians during the Great Recession, and their subsequent declines have been more rapid. On balance, however, the differences in unemployment rates across the groups have not narrowed relative to the pre-recession period. (For additional discussion on differences in economic outcomes by race and ethnicity, see the box "Does Education Determine Who Climbs the Economic Ladder?" on pages 8-9 of the July 2017 Monetary Policy Report.)

Growth of labor compensation has been modest...

Indicators of hourly compensation suggest that wage growth has remained modest. Growth of compensation per hour in the business sector--a broad-based measure of wages, salaries, and benefits--has slowed in recent quarters and was 2-1/4 percent over the four quarters ending in 2017:Q1.¹³ This measure can be quite volatile even at annual frequencies (and a smoothed version is shown in figure 5 for that reason). The employment cost index--which also measures both wages and the cost to employers of providing benefits--also was up 2-1/4 percent in the first quarter relative to its year-ago level, about 1/2 percentage point faster than its gain of a year earlier. Among measures limited to wages, average hourly earnings growth--at 2-1/2 percent through May--was little changed from a year ago, and a compensation measure computed by the Federal Reserve Bank of Atlanta that tracks median 12-month wage growth of individuals reporting to the Current Population Survey was about 3-1/2 percent in May, also similar to its reading from a year earlier.

. . . and likely restrained by slow growth of labor productivity

These modest rates of compensation gain likely reflect the offsetting influences of a tightening labor market and persistently weak productivity growth. Since 2008, labor productivity has increased only about 1 percent per year, on average, well below the average pace from 1996 through 2007 and also below the gains in the 1974-95 period. For most of the period since 2011, labor productivity growth has been particularly weak, although it has turned up in recent quarters. The longer-term softness in productivity growth may be partly attributable to the sharp pullback in capital investment during the most recent recession and the relatively modest rebound that followed. But there may be other explanations, too, and considerable debate remains about the reasons for the general slowdown in productivity growth. (For a more comprehensive discussion of productivity, see the box "Productivity Developments in the Advanced Economies" on pages 12 -13 of the July 2017 Monetary Policy Report.)

Price inflation moved up but softened in the spring and remains below 2 percent

In the early months of 2017, consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures (PCE), continued its climb from the very low levels that prevailed in 2015 and early 2016 when it was held down by falling oil and import prices. Indeed, consumer price inflation briefly reached the FOMC's 2 percent objective earlier this year before falling back to 1.4 percent in May. Core inflation, which typically provides a better indication than the headline measure of where overall inflation will be in the future, also was 1.4 percent over the 12 months ending in May, a slightly slower rate than a year earlier. As is the case with headline inflation, the 12-month measure of core inflation had been higher earlier this year, reaching 1.8 percent. Both measures of inflation have recently been held down by steep and likely idiosyncratic price declines for a few specific categories, including wireless telephone services and prescription drugs, which do not appear to be related to the overall trends in consumer prices. The 12-month change in the trimmed mean PCE price index--an alternative indicator of underlying inflation produced by the Federal Reserve Bank of Dallas--slowed by less than overall or core PCE price inflation over the past several months.

Oil prices declined somewhat but remain well above their early 2016 lows...

After rebounding from their early 2016 lows, oil prices leveled off early this year. Since then they have declined somewhat, despite OPEC's decision in late May to renew its November 2016 agreement to reduce its oil production, thereby extending the November production cuts through early 2018. Reflecting lower crude oil prices as well as smaller retail margins, seasonally adjusted retail gasoline prices have also declined since the beginning of the year. Nevertheless, prices of both crude oil and retail gasoline remain above their early 2016 lows, and futures prices suggest that market participants expect oil prices to rise gradually in coming years.

. . . while prices of imports other than energy have been bolstered by higher commodity prices

Throughout 2015, nonfuel import prices declined because of appreciation of the dollar and declines in nonfuel commodity prices. Nonfuel import prices stabilized last year and have risen since then, as the dollar stopped appreciating and supply disruptions boosted world prices of some nonfuel commodities, especially industrial supplies and metals. In recent months, depreciation of the dollar has further pushed up non-oil import prices, which are now slightly higher than in mid-2016.

Survey-based measures of inflation expectations are little changed this year...

Expectations of inflation likely influence actual inflation by affecting wage- and price-setting decisions. Survey-based measures of inflation expectations at medium- and longer-term horizons have remained relatively stable so far in 2017. In the second-quarter Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia, the median expectation for the annual rate of increase in the PCE price index over the next 10 years was 2.1 percent, the same as in the first quarter and little changed from the readings during 2016. In the University of Michigan Surveys of Consumers, the median value for inflation expectations over the next 5 to 10 years--which has been drifting downward for the past few years--has held about flat at a low level since late
last year.

. . . while market-based measures of inflation compensation fell back somewhat

Inflation expectations can also be gauged by market-based measures of inflation compensation, though the inference is not straightforward because inflation compensation can be importantly affected by changes in premiums associated with risk and liquidity. Measures of longer-term inflation compensation--derived either from differences between yields on nominal Treasury securities and those on comparable Treasury Inflation-Protected Securities (TIPS) or from inflation swaps--have fallen back somewhat this year after having moved up in late 2016.¹⁴ The TIPS-based measure of 5-to-10-year-forward inflation compensation is now 1-3/4 percent, and the analogous measure of inflation swaps is now about 2 percent. Both measures are well below the 2-1/2 to 3 percent range that persisted for most of the 10 years before 2014.

Real gross domestic product growth slowed in the first quarter, but spending by households and businesses appears to have picked up in recent months

After having moved up at an annual rate of 2-3/4 percent in the second half of 2016, real gross domestic product (GDP) is reported to have increased about 1-1/2 percent in the first quarter of this year.¹⁵ The step-down in first-quarter growth was largely attributable to soft inventory investment and a lull in the growth of consumer spending; in contrast, net exports increased a bit, residential investment grew robustly, and spending by businesses surged. Indeed, business investment was strong enough that overall private domestic final purchases--that is, final purchases by U.S. households and businesses, which tend to carry more signal for future GDP growth than most other components of overall spending--moved up at an annual rate of about 3 percent in the first quarter. For more recent months, indicators of spending by consumers and businesses have been strong and suggest that growth of economic activity rebounded in the second quarter; thus, overall activity appears to have expanded moderately, on average, over the first half of the year.

The economic expansion continues to be supported by accommodative financial conditions, including the low cost of borrowing and easy access to credit for many households and businesses, continuing job gains, rising household wealth, and favorable consumer and business sentiment.

Gains in income and wealth continue to support consumer spending...

After increasing strongly in the second half of 2016, consumer spending in the first quarter of this year was tepid. Unseasonably warm weather depressed spending on energy services, and purchases of motor vehicles slowed from an unusually high pace late last year. However, household spending seems to have picked up in more recent months, as purchases of energy services returned to seasonal norms and retail sales firmed. All told, consumer spending increased at an annual rate of 2 percent over the first five months of this year, only a bit slower than in the past couple of years.

Beyond spending, other indicators of consumers' economic well-being have been strong in the aggregate. The ongoing improvement in the labor market has supported further gains in real disposable personal income (DPI), a measure of income after accounting for taxes and adjusting for inflation. Real DPI increased at a solid annual rate of 3 percent over the first five months of this year.

Gains in the stock market and in house prices over the first half of the year have boosted household net wealth. Broad measures of U.S. equity prices have continued to increase in recent months after moving up considerably late last year and in the first quarter. House prices have also continued to climb, adding to the balance sheet strength of homeowners. Indeed, nominal house price indexes are close to their peaks of the mid-2000s. However, while the ratio of house prices to rents has edged higher, it remains well below its previous peak. As a result of the increases in home and equity prices, aggregate household net worth has risen appreciably. In fact, at the end of the first quarter of 2017, household net worth was more than six times the value of disposable income, the highest-ever reading for that ratio.

Consumer spending has also been supported by low burdens from debt service payments. The household debt service burden--the ratio of required principal and interest payments on outstanding household debt to disposable income, measured for the household sector as a whole--has remained at a very low level by historical standards. As interest rates rise, the debt burden will move up only gradually, as most household debt is in fixed-interest products.

. . . as does credit availability

Consumer credit has continued to expand this year but more moderately than in 2016. Financing conditions are generally favorable, with auto and student loans remaining widely available and outstanding balances continuing to expand at a robust, albeit somewhat reduced, pace. Even though delinquency rates on most types of consumer debt have remained low by historical standards, credit card and auto loan delinquencies among subprime borrowers have drifted up some. Possibly in response to this deteriorating credit performance, banks have tightened standards for credit cards and auto lending. Mortgage credit has remained readily available for households with solid credit profiles, but it was still difficult to access for households with low credit scores or harder-to-document incomes.

Consumer confidence is strong

Consumers have remained optimistic about their financial situation. As measured by the Michigan survey, consumer sentiment was solid through most of 2016, likely reflecting rising income and job
gains. Sentiment moved up appreciably after the presidential election last November and has remained at a high level so far this year. Furthermore, the
share of households expecting real income to rise over the next year or two has gone up markedly in the past few months and is now in line with its pre-recession level.

Activity in the housing sector has improved modestly

Several indicators of housing activity have continued to strengthen gradually this year. Sales of existing homes have gained, on net, while house prices have continued to rise and mortgage rates have remained low, even though they are up from last year. In addition, single-family housing starts registered a slight increase, on average, in the first five months of the year, although multifamily housing starts have slipped. Despite the modest increase in construction activity, the months' supply of homes for sale has remained near the low levels seen in 2016, and the aggregate vacancy rate has fallen back to levels observed in the mid-2000s. Lean inventories are likely to support further gains in homebuilding activity going forward.

Business investment has turned up after a period of weakness...

Led by a surge in spending on drilling and mining structures, real outlays for business investment--that is, private nonresidential fixed investment--rose robustly at the beginning of the year after having been about flat for 2016 as a whole. The sharp gains in drilling and mining in the first quarter mark a turnaround for the sector; energy-sector investment had declined noticeably following the drop in oil prices that began in mid-2014 and ran through early 2016. More recently, rapid increases in the number of drilling rigs in operation suggest that investment in this area remained strong in the second quarter of this year.

Moreover, business spending on equipment and intangibles (such as research and development) advanced solidly at the beginning of the year after having been roughly flat in 2016. Furthermore, indicators of business spending are generally upbeat: Orders and shipments of capital goods have posted net gains in recent months, and indexes of business sentiment and activity remain elevated after having improved significantly late last year.

. . . while corporate financing conditions have remained accommodative

Aggregate flows of credit to large nonfinancial firms have remained solid, supported in part by continued low interest rates. The gross issuance of corporate bonds was robust during the first half of 2017, and yields on both speculative- and investment-grade corporate bonds remained low by historical standards. Gross equity issuance by nonfinancial firms stayed solid, on average, as seasoned equity offerings continued at a robust pace and the pace of initial public offerings picked up from the low levels seen in 2016.

Despite the pickup in business investment, demand for business loans was subdued early this year, and outstanding commercial and industrial (C&I) loans on banks' books contracted in the first quarter. In the April Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), banks reported a broad-based decline in demand for C&I loans during the first quarter of 2017 even as lending standards on such loans were reported to be basically unchanged.¹⁶ Banks also reported weaker demand for commercial real estate loans as well as a continued tightening of standards on such loans. However, lending to large nonfinancial firms appeared to be strengthening somewhat during the second quarter. Meanwhile, measures of small business credit demand remained weak amid stable supply.

U.S. exports grew at a faster pace

In the first quarter of 2017, U.S. real exports increased briskly and broadly following moderate growth in the second half of last year that was driven by a surge in agricultural exports. At the same time, real import growth declined somewhat from its strong pace in the second half of last year. As a result, real net exports contributed slightly to U.S. real GDP growth in the first quarter. Available trade data through May suggest that the growth of real exports slowed to a modest pace in the second quarter. Nevertheless, the average pace of export growth appears to have stepped up in the first half of 2017 compared with last year, partly reflecting stronger growth abroad and a diminishing drag from earlier dollar appreciation. All told, the available data for the first half of this year suggest that net exports added a touch to U.S. real GDP growth and that the nominal trade deficit widened slightly relative to GDP.

Federal fiscal policy had a roughly neutral effect on economic growth...

Federal purchases moved sideways in 2016, and policy actions had little effect on federal taxes or transfers. Under currently enacted legislation, federal fiscal policy will likely again have a roughly neutral influence on the growth in real GDP this year.

After narrowing significantly for several years, the federal unified deficit has widened from about 2-1/2 percent of GDP in fiscal year 2015 to 3-1/4 percent currently. Although expenditures as a share of GDP have been relatively stable over this period at a little under 21 percent, receipts moved lower in 2016 and have edged down further so far this year to roughly 17-1/2 percent of GDP. The ratio of federal debt held by the public to nominal GDP is quite elevated relative to historical norms. Nevertheless, the deficit remains small enough to roughly stabilize this ratio in the neighborhood of 75 percent.

. . . and the fiscal position of most state and local governments is stable

The fiscal position of most state and local governments is stable, although there is a range of experiences across these governments. Many state governments are experiencing lackluster revenue growth, as income tax collections have been only edging up, on average, in recent quarters. In contrast, house price gains have continued to push up property tax revenues at the local level. Employment growth in the state and local government sector has been anemic so far this year following a pace of hiring in 2016 that was the strongest since 2008. Outlays for construction by these governments have been declining.

Financial Developments

The expected path for the federal funds rate flattened

The path for the expected federal funds rate implied by market quotes on interest rate derivatives has flattened, on net, since the end of December, moving higher for 2017 but slightly lower further out. The expected policy path moved up at the beginning of the year, reportedly reflecting investor perceptions that expansionary fiscal policy would likely be forthcoming over the near term, but subsequently fell amid some waning of these expectations as well as FOMC communications that were interpreted as signaling a somewhat slower pace of policy rate increases than had been anticipated.

Survey-based measures of the expected path of policy also moved up for 2017. Most of the respondents to the Federal Reserve Bank of New York's Survey of Primary Dealers and Survey of Market Participants--which were conducted just before the June FOMC meeting--projected an additional 25 basis point increase in the FOMC's target range for the federal funds rate, relative to what they projected in surveys conducted before the December FOMC meeting, as the most likely outcome for this year. Expectations for the number of rate hikes in 2018 were about unchanged. Market-based measures of uncertainty about the policy rate approximately one to two years ahead decreased slightly, on balance, from their year-end levels.

Longer-term nominal Treasury yields remain low

After rising significantly during the second half of 2016, yields on medium- and longer-term nominal Treasury securities have decreased 5 to 25 basis points, on net, so far in 2017. The decrease in longer-term nominal yields since the beginning of the year largely reflects declines in inflation compensation due in part to soft incoming data on inflation, with real yields little changed on net. Consistent with the changes in Treasury yields, yields on 30-year agency mortgage-backed securities (MBS)--an important determinant of mortgage interest rates--decreased slightly over the first half of the year. Treasury and MBS yields picked up somewhat in late June, driven in part by increases in government yields overseas. However, yields remain quite low by historical standards.

Broad equity price indexes increased further...

Broad U.S. equity indexes continued to increase during the period. Equity prices were reportedly supported by lower interest rates and increased optimism that corporate earnings will continue to strengthen this year. Stock prices of companies in the technology sector increased notably on net. After rising significantly toward the end of last year, stock prices of banks performed about in line with the broader market during the first half of 2017. The implied volatility of the S&P 500 index one month ahead--the VIX--decreased, on net, ending the period close to the bottom of its historical range. (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability" on pages 24-25 of the July 2017 Monetary Policy Report.)

. . . and risk spreads on corporate bonds decreased

Bond spreads for investment- and speculative-grade firms decreased, and spreads for speculative-grade firms now stand near the bottom of their historical ranges.

Treasury and mortgage securities markets have functioned well

Available indicators of Treasury market functioning remained stable over the first half of 2017. A variety of liquidity metrics--including bid-ask spreads, bid sizes, and estimates of transaction costs--either improved or remained unchanged over the period, displaying no notable signs of liquidity pressures. The agency MBS market also continued to function well. (For a detailed discussion of corporate bond market functioning, see the box "Recent Developments in Corporate Bond Market Liquidity" on pages 26-28 of the July 2017 Monetary Policy Report.)

Money market rates have moved up in line with increases in the FOMC's target range

Conditions in domestic short-term funding markets have remained stable so far in 2017. Yields on a broad set of money market instruments moved higher in response to the FOMC's policy actions in March and June. The effective federal funds rate generally traded near the middle of the target range and was closely tracked by the overnight Eurodollar rate. The spread between the three-month LIBOR (London interbank offered rate) and the OIS (overnight index swap) rate has returned to historical norms over the first half of 2017, declining from the elevated levels that prevailed at the end of last year around the implementation of the Securities and Exchange Commission money market fund reform.

Bank credit continued to expand, though at a slower pace than in 2016, and bank profitability improved

Aggregate credit provided by commercial banks continued to increase through the first quarter of 2017, though at a slower pace than in 2016, leaving the ratio of total commercial bank credit to nominal GDP slightly lower. The expansion of core loans slowed during 2017, consistent with banks' reports in the April SLOOS of weakened demand for most loan categories and tighter lending standards for commercial real estate loans. However, the growth of core loans appeared to be picking up somewhat during the second quarter. Measures of bank profitability have continued to improve so far this year but remained below their historical averages.

Credit conditions in municipal bond markets have generally been stable

Credit conditions in municipal bond markets have generally remained stable since year-end. Over that period, yield spreads on 20-year general obligation municipal bonds over comparable-maturity Treasury securities were little changed on balance. Puerto Rico filed to enter a court-supervised process to restructure its debt after it failed to reach an agreement with bondholders, and several credit rating agencies downgraded the bond ratings of the state of Illinois. However, these events have had no noticeable effect on broader municipal bond markets.

International Developments

Foreign financial market conditions eased

Financial market conditions in both the advanced foreign economies (AFEs) and the emerging market economies (EMEs) have generally eased since January. Better-than-expected data releases, robust corporate earnings, and the passage of risk events--such as national elections in some European countries--boosted investor confidence. Broad equity indexes in advanced and emerging foreign economies rose further. In addition, spreads of emerging market sovereign bonds over U.S. Treasury securities narrowed, and capital flows into emerging market mutual funds picked up. Government bond yields in the AFEs generally remained very low, partly reflecting investor expectations that substantial monetary policy accommodation would be required for some time. In the United Kingdom, softer macroeconomic data and uncertainty about future policies and growth as the country begins the process of exiting the European Union also weighed on yields. However, AFE government bond yields picked up somewhat in late June, partly reflecting investors' focus on remarks by officials from some AFE central banks suggesting possible shifts toward less accommodative policy stances. In the euro area, bank supervisors intervened to prevent the disorderly failure of a few small to medium-sized lenders in Italy and Spain; business disruptions were minimal, and spillovers to other European banks were limited.

The dollar depreciated somewhat

Since the start of the year, the broad dollar index--a measure of the trade-weighted value of the dollar against foreign currencies--has depreciated about 5 percent, on balance, after rising more than 20 percent between mid-2014 and late 2016. The weakening since the start of the year partly reflected growing uncertainty about prospects for more expansionary U.S. fiscal policy as well as mounting confidence in the foreign economic outlook. The euro rose against the dollar following the French presidential election, and the Mexican peso appreciated substantially as the Mexican central bank tightened monetary policy and as investor concerns about the potential for substantial disruptions of U.S.-Mexico trade appeared to ease.

Economic activity in the AFEs grew at a solid pace

In the first quarter, real GDP grew at a solid pace in Canada, the euro area, and Japan, partly reflecting robust growth in fixed investment in all three economies. In contrast, economic growth slowed to a tepid pace in the United Kingdom, reflecting weaker consumption growth and a decline in exports. In most AFEs, economic survey indicators, such as purchasing manager surveys, generally remained consistent with continued economic growth at a solid pace during the second quarter.

Inflation leveled off in most AFEs...

In late 2016, consumer price inflation (measured as a 12-month percent change) rose substantially in most AFEs, partly reflecting increases in energy prices. Since then, inflation has leveled off in Japan and declined somewhat in the euro area as upward pressure from energy prices eased, core inflation stayed low, and wage growth was subdued even as unemployment rates declined further in both economies. In contrast, in the United Kingdom, headline inflation rose well above the Bank of England's (BOE) 2 percent target, largely reflecting upward pressure from the substantial sterling depreciation since the Brexit referendum in June 2016.

. . . and AFE central banks maintained highly accommodative monetary policies

AFE central banks kept their policy rates at historically low levels, and the Bank of Japan kept its target range for 10-year government bond yields near zero. The European Central Bank (ECB) maintained its asset purchase program, though it slightly reduced the pace of purchases, and the BOE completed the bond purchase program it announced last August. However, the Bank of Canada, BOE, and ECB have recently suggested that if growth continues to reduce resource slack, some policy accommodation could be withdrawn. The ECB remarked that the forces holding down inflation could be temporary. The BOE indicated that some monetary accommodation might need to be removed if the tradeoff between supporting employment and expediting the return of inflation to its target is reduced.

In EMEs, Asian growth was solid...

Chinese economic activity was robust in the first quarter of 2017 as a result of solid domestic and external demand. More recent indicators suggest that growth moderated in the second quarter as Chinese authorities tightened financial conditions and as export growth slowed. In some other emerging Asian economies, growth picked up in early 2017 as a result of stronger external demand and manufacturing activity. However, growth of the region's exports, especially to China, slowed so far in the second quarter.

. . . and many Latin American economies continue their tepid recovery

In Mexico, growth decelerated a touch in the first quarter of 2017, partly reflecting a slowdown in private consumption following sharp hikes in domestic fuel prices. These price hikes, together with the effects of earlier peso depreciation on import prices, contributed to a sharp rise in Mexican inflation, which prompted the Bank of Mexico to further tighten monetary policy. Following a prolonged period of contraction, the Brazilian economy posted solid growth in the first quarter of 2017, partly reflecting a surge in exports and a strong harvest. However, domestic demand has remained very weak amid high unemployment and heightened political tensions, and indicators of economic activity have stepped down recently. In Brazil and some other South American economies, declining inflation has led central banks to reduce their policy interest rates.

Part 2: Monetary Policy

The Federal Open Market Committee raised the federal funds rate target range in March and June

Over the past year and a half, the Federal Open Market Committee (FOMC) has been gradually increasing its target range for the federal funds rate as the economy continued to make progress toward the Committee's objectives of maximum employment and price stability. After having raised the target range for the federal funds rate last December, the Committee decided to raise the target range again in March and in June, bringing it to 1 to 1-1/4 percent.¹⁷ The FOMC's decisions reflected the progress the economy has made, and is expected to make, toward the Committee's objectives.

When the Committee met in March, it decided to raise the target range for the federal funds rate to
3/4 to 1 percent. Available information suggested that the labor market had continued to strengthen even as growth in economic activity slowed during the first quarter. Inflation measured on a 12-month basis had moved up appreciably and was close to the Committee's 2 percent longer-run objective. Core inflation, which excludes volatile energy and food prices, continued to run somewhat below 2 percent.

The data available at the time of the June FOMC meeting suggested a rebound in economic activity in the second quarter, leaving the projected average pace of growth over the first half of the year at a moderate level. The labor market had continued to strengthen, with the unemployment rate falling nearly 1/2 percentage point since the beginning of the year to 4.3 percent in May, a low level by historical standards and modestly below the median of FOMC participants' estimates of its longer-run normal level. Inflation measured on a 12-month basis had declined over the previous few months but was still up significantly since last summer. Like the headline inflation measure, core inflation was running somewhat below 2 percent. With employment expected to remain near its maximum sustainable level, the Committee continued to expect that inflation would move up and stabilize around 2 percent over the next couple of years, in line with the Committee's longer-run objective. In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target another 1/4 percentage point to a range of 1 to 1-1/4 percent.

Monetary policy continues to support economic growth

Even with the gradual reductions in the amount of policy accommodation to date, the Committee judges that the stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation. In particular, the federal funds rate appears to remain somewhat below its neutral level--that is, the level of the federal funds rate that is neither expansionary nor contractionary.

In evaluating the stance of monetary policy, policymakers routinely consult prescriptions from a variety of policy rules, which can serve as useful benchmarks. However, the use and interpretation of such prescriptions require careful judgments about the choice and measurement of the inputs to these rules as well as the implications of the many considerations these rules do not take into account. (See the box "Monetary Policy Rules and Their Role in the Federal Reserve's Policy Process" on pages 36-39 of the July 2017 Monetary Policy Report.)

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

The FOMC 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. 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. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.

The Committee currently expects that the ongoing strength in the economy will warrant gradual increases in the federal funds rate, and that the federal funds rate will likely remain, for some time, below the levels that the Committee expects to prevail in the longer run. Consistent with this outlook, in the most recent Summary of Economic Projections, which was compiled at the time of the June FOMC meeting, most FOMC participants projected that the appropriate level of the federal funds rate would be below its longer-run level through 2018.¹⁸

The size of the Federal Reserve's balance sheet has remained stable so far this year

To help maintain accommodative financial conditions, the Committee has continued its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and rolling over maturing Treasury securities at auction. Consequently, 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. Total liabilities on the Federal Reserve's balance sheet were also mostly unchanged over the first half of 2017.

The Committee intends to implement a balance sheet normalization program

In June, policymakers augmented the Committee's Policy Normalization Principles and Plans issued in September 2014 by providing additional details regarding the approach the FOMC intends to use to reduce the Federal Reserve's holdings of Treasury and agency securities once normalization of the federal funds rate is well under way.¹⁹ The Committee intends to gradually reduce the Federal Reserve's securities holdings by decreasing its reinvestment of the principal payments it receives from the securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps. Initially, these caps will be set at relatively low levels to limit the volume of securities that private investors will have to absorb. The Committee currently expects that, provided the economy evolves broadly as anticipated, it would likely begin to implement the program this year. In addition, the Committee affirmed that changing the target range for the federal funds rate remains its primary means of adjusting the stance of monetary policy. (See the box "Addendum to the Policy Normalization Principles and Plans" on page 40 of the July 2017 Monetary Policy Report.)

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

The Federal Reserve successfully raised the effective federal funds rate in March and June of 2017 by increasing the interest rate paid on reserve balances along with the interest rate offered on overnight reverse repurchase agreements (ON RRPs). Specifically, the Federal Reserve increased the interest rate paid on required and excess reserve balances to 1.00 percent in March and 1.25 percent in June while increasing the ON RRP offering rate to 0.75 percent in March and 1.00 percent in June. In addition, the Board of Governors approved 1/4 percentage point increases in the discount rate (the primary credit rate) in March and June. In both March and June, the effective federal funds rate rose near the middle of its new target range amid orderly trading conditions in money markets, closely tracked by most other overnight money market rates.

Usage of the ON RRP facility, which had increased late last year as a result of higher demand by government money market funds in the wake of last October's money fund reform, has declined some, on average, in recent months. However, usage has remained somewhat above its levels of one year ago.

Footnotes