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 2018, excerpted from the Monetary Policy Report published in February 2019 and July 2018. Those complete reports
are available on the Board's website at https://www.federalreserve.gov/monetarypolicy/files/20190222_mprfullreport.pdf (February 2019) and https://www.federalreserve.gov/monetarypolicy/files/20180713_mprfullreport.pdf (July 2018).

Monetary Policy Report February 2019

Summary

Economic activity in the United States appears to have increased at a solid pace, on balance, over the second half of 2018, and the labor market strengthened further. Inflation has been near the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent, aside from the transitory effects of recent energy price movements. In this environment, the FOMC judged that, on balance, current and prospective economic conditions called for a further gradual removal of policy accommodation. In particular, the FOMC raised the target range for the federal funds rate twice in the second half of 2018, putting its level at 2-1/4 to 2-1/2 percent following the December meeting. In light of softer global economic and financial conditions late in the year and muted inflation pressures, the FOMC indicated at its January meeting that it will be patient as it determines what future adjustments to the federal funds rate may be appropriate to support the Committee's congressionally mandated objectives of maximum employment and price stability.

Economic and Financial Developments

The labor market. The labor market has continued to strengthen since the middle of last year. Payroll employment growth has remained strong, averaging 224,000 per month since June 2018. The unemployment rate has been about unchanged over this period, averaging a little under 4 percent—a low level by historical standards—while the labor force participation rate has moved up despite the ongoing downward influence from an aging population. Wage growth has also picked up recently.

Inflation. Consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures, moved down from a little above the FOMC's objective of 2 percent in the middle of last year to an estimated 1.7 percent in December, restrained by recent declines in consumer energy prices. 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 measure that includes those items, is estimated to have been 1.9 percent in December—up 1/4 percentage point from a year ago. Survey-based measures of longer-run inflation expectations have generally been stable, though market-based measures of inflation compensation have moved down some since the first half of 2018.

Economic growth. Available indicators suggest that real gross domestic product (GDP) increased at a solid rate, on balance, in the second half of last year and rose a little under 3 percent for the year as a whole—a noticeable pickup from the pace in recent years. Consumer spending expanded at a strong rate for most of the second half, supported by robust job gains, past increases in household wealth, and higher disposable income due in part to the Tax Cuts and Jobs Act, though spending appears to have weakened toward year-end. Business investment grew as well, though growth seems to have slowed somewhat from a sizable gain in the first half. However, housing market activity declined last year amid rising mortgage interest rates and higher material and labor costs. Indicators of both consumer and business sentiment remain at favorable levels, but some measures have softened since the fall, likely a reflection of financial market volatility and increased concerns about the global outlook.

Financial conditions. Domestic financial conditions for businesses and households have become less supportive of economic growth since July. Financial market participants' appetite for risk deteriorated markedly in the latter part of last year amid investor concerns about downside risks to the growth outlook and rising trade tensions between the United States and China. As a result, Treasury yields and risky asset prices declined substantially between early October and late December in the midst of heightened volatility, although those moves partially retraced early this year. On balance since July, the expected path of the federal funds rate over the next several years shifted down, long-term Treasury yields and mortgage rates moved lower, broad measures of U.S. equity prices increased somewhat, and spreads of yields on corporate bonds over those on comparable-maturity Treasury securities widened modestly. Credit to large nonfinancial firms remained solid in the second half of 2018; corporate bond issuance slowed considerably toward the end of the year but has rebounded since then. Despite increases in interest rates for consumer loans, consumer credit expanded at a solid pace, and financing conditions for consumers largely remain supportive of growth in household spending. The foreign exchange value of the U.S. dollar strengthened slightly against the currencies of the U.S. economy's trading partners.

Financial stability. The U.S. financial system remains substantially more resilient than in the decade preceding the financial crisis. Pressures associated with asset valuations eased compared with July 2018, particularly in the equity, corporate bond, and leveraged loan markets. Regulatory capital and liquidity ratios of key financial institutions, including large banks, are at historically high levels. Funding risks in the financial system are low relative to the period leading up to the crisis. Borrowing by households has risen roughly in line with household incomes and is concentrated among prime borrowers. While debt owed by businesses is high and credit standards—especially within segments of the loan market focused on lower-rated or unrated firms—deteriorated in the second half of 2018, issuance of these loans has slowed more recently.

International developments. Foreign economic growth stepped down significantly last year from the brisk pace in 2017. Aggregate growth in the advanced foreign economies slowed markedly, especially in the euro area, and several Latin American economies continued to underperform. The pace of economic activity in China slowed noticeably in the second half of 2018. Inflation pressures in major advanced foreign economies remain subdued, prompting central banks to maintain accommodative monetary policies.

Financial conditions abroad tightened in the second half of 2018, in part reflecting political uncertainty in Europe and Latin America, trade policy developments in the United States and its trading partners, as well as concerns about moderating global growth. Although financial conditions abroad improved in recent weeks, alongside those in the United States, on balance since July 2018, global equity prices were lower, sovereign yields in many economies declined, and sovereign credit spreads in the European periphery and the most vulnerable emerging market economies increased somewhat. Market-implied paths of policy rates in advanced foreign economies generally edged down.

Monetary Policy

Interest rate policy. As the labor market continued to strengthen and economic activity expanded at a strong rate, the FOMC increased the target range for the federal funds rate gradually over the second half of 2018. Specifically, the FOMC decided to raise the federal funds rate in September and in December, bringing it to the current range of 2-1/4 to 2-1/2 percent.

In December, against the backdrop of increased concerns about global growth, trade tensions, and volatility in financial markets, the Committee indicated it would monitor global economic and financial developments and assess their implications for the economic outlook. In January, the FOMC stated that it continued to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's 2 percent objective as the most likely outcomes. Nonetheless, in light of global economic and financial developments and muted inflation pressures, the Committee noted that it will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes. FOMC communications continued to emphasize that the Committee's approach to setting the stance of policy should be importantly guided by the implications of incoming data for the economic outlook. In particular, the timing and size of future adjustments to the target range for the federal funds rate will depend on the Committee's assessment of realized and expected economic conditions relative to its maximum-employment objective and its symmetric 2 percent inflation objective.

Balance sheet policy. The FOMC continued to implement the balance sheet normalization program that has been under way since October 2017. Specifically, the FOMC reduced its holdings of Treasury and agency securities in a gradual and predictable manner by reinvesting only principal payments it received from these securities that exceeded gradually rising caps. Consequently, the Federal Reserve's total assets declined by about $260 billion since the middle of last year, ending the period close to $4 trillion.

Together with the January postmeeting statement, the Committee released an updated Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization to provide additional information about its plans to implement monetary policy over the longer run. In particular, the FOMC stated that it intends to continue to implement monetary policy in a regime with an ample supply of reserves so that active management of reserves is not required. In addition, the Committee noted that it is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.

Special Topics

Labor markets in urban versus rural areas. The recovery in the U.S. labor market since the end of the recession has been uneven across the country, with rural areas showing markedly less improvement than cities and their surrounding metropolitan areas. In particular, the employment-to-population ratio and labor force participation rate in rural areas remain well below their pre-recession levels, while the recovery in urban areas has been more complete. Differences in the mix of industries in rural and urban areas—a larger share of manufacturing in rural areas and a greater concentration of fast-growing services industries in urban areas—have contributed to the stronger rebound in urban areas. (See the box "Employment Disparities between Rural and Urban Areas" on pages 10–12 of the February 2019 Monetary Policy Report.)

Monetary policy rules.In evaluating the stance of monetary policy, policymakers consider a wide range of information on the current economic conditions and the outlook. Policymakers also consult prescriptions for the policy interest rate derived from a variety of policy rules for guidance, without mechanically following the prescriptions of any specific rule. The FOMC's approach for conducting systematic monetary policy provides sufficient flexibility to address the intrinsic complexities and uncertainties in the economy while keeping monetary policy predictable and transparent. (See the box "Monetary Policy Rules and Systematic Monetary Policy" on pages 36–39 of the February 2019 Monetary Policy Report.)

Balance sheet normalization and monetary policy implementation.Since the financial crisis, the size of the Federal Reserve's balance sheet has been determined in large part by its decisions about asset purchases for economic stimulus, with growth in total assets primarily matched by higher reserve balances of depository institutions. However, liabilities other than reserves have grown significantly over the past decade. In the longer run, the size of the balance sheet will be importantly determined by the various factors affecting the demand for Federal Reserve liabilities. (See the box "The Role of Liabilities in Determining the Size of the Federal Reserve's Balance Sheet" on pages 41–43 of the February 2019 Monetary Policy Report.)

Federal Reserve transparency and accountability.For central banks, transparency provides an essential basis for accountability. Transparency also enhances the effectiveness of monetary policy and a central bank's efforts to promote financial stability. For these reasons, the Federal Reserve uses a wide variety of communications to explain its policymaking approach and decisions as clearly as possible. Through several new initiatives, including a review of its monetary policy framework that will include outreach to a broad range of stakeholders, the Federal Reserve seeks to enhance transparency and accountability regarding how it pursues its statutory responsibilities. (See the box "Federal Reserve Transparency: Rationale and New Initiatives" on pages 45–46 of the February 2019 Monetary Policy Report.)

Part 1: Recent Economic and Financial Developments

Domestic Developments

The labor market strengthened further during the second half of 2018 and early this year...

Payroll employment gains have remained strong, averaging 224,000 per month since June 2018
(figure 1). This pace is similar to the pace in the first half of last year, and it is faster than the average pace of job gains in 2016 and 2017.

The strong pace of job gains over this period has primarily been manifest in a rising labor force participation rate (LFPR)—the share of the population that is either working or actively looking for work—rather than a declining unemployment rate.¹ Since June 2018, the LFPR has moved up about 1/4 percentage point and was 63.2 percent in January—a bit higher than the narrow range it has maintained in recent years (figure 2). The improvement is especially notable because the aging of the population—and, in particular, the movement of members of the baby-boom cohort into their retirement years—has otherwise imparted a downward influence on the LFPR. Indeed, the LFPR for individuals between 25 and 54 years old—which is much less sensitive to population aging—has improved considerably more than the overall LFPR, including a 1/2 percentage point rise since June 2018.²

At the same time, the unemployment rate has remained little changed and has generally been running a little under 4 percent.³ Nevertheless, the unemployment rate remains at a historically low level and is 1/2 percentage point below the median of the Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level (figure 3).⁴ Combining the movements in both unemployment and labor force participation, the employment-to-population ratio for individuals 16 and over—the share of that segment of the population who are working—was 60.7 percent in January and has been gradually increasing since 2011.

Other indicators are also consistent with a strong labor market. As reported in the Job Openings and Labor Turnover Survey (JOLTS), the job openings rate has moved higher since the first half of 2018, and in December, it was at its highest level since the data began in 2000. The quits rate in the JOLTS is also near the top of its historical range, an indication that workers have become more confident that they can successfully switch jobs when they wish to. In addition, the JOLTS layoff rate has remained low, and the number of people filing initial claims for unemployment insurance benefits has also remained low. Survey evidence indicates that households perceive jobs as plentiful and that businesses see vacancies as hard to fill.

...and unemployment rates have fallen for all major demographic groups over the past several years

The flattening in unemployment since mid-2018 has been evident across racial and ethnic groups. Even so, over the past several years, the decline in the unemployment rates for blacks or African Americans and for Hispanics has been particularly notable, and the unemployment rates for these groups are near their lowest readings since these series began in the early 1970s. Differences in unemployment rates across ethnic and racial groups have narrowed in recent years, as they typically do during economic expansions, after having widened during the recession; on net, unemployment rates for African Americans and Hispanics remain substantially above those for whites and Asians, with differentials generally a bit below pre-recession levels.

The rise in LFPRs for prime-age individuals over the past few years has also been apparent in each of these racial and ethnic groups. Nonetheless, the LFPR for whites remains higher than that for other groups. Important differences in economic outcomes persist across other characteristics as well (see, for example, the box "Employment Disparities between Rural and Urban Areas" on pages 10–12 of the February 2019 Monetary Policy Report, which highlights that there has been less improvement since 2010 in the LFPR and employment-to-population ratio for prime-age individuals in rural areas compared with urban areas).

Increases in labor compensation have picked up recently but remain moderate by historical standards...

Most available indicators suggest that growth of hourly compensation has stepped up further since June 2018 after having firmed somewhat over the past few years; however, growth rates remain moderate compared with those that prevailed in the decade before the recession. Compensation per hour in the business sector—a broad-based measure of wages and benefits, but one that is quite volatile—rose 2-1/4 percent over the four quarters ending in 2018:Q3, about the same as the average annual increase over the past seven years or so. The employment cost index, a less volatile measure of both wages and the cost to employers of providing benefits, increased 3 percent over the same period, while average hourly earnings—which do not take account of benefits—increased 3.2 percent over the 12 months ending in January of this year; the annual increases in both of these measures were the strongest in nearly 10 years. 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 3.7 percent in January, near the upper end of its readings in the past three years and well above the average increase in the preceding few years.⁵

...and have likely been restrained by slow growth of labor productivity over much of the expansion

These moderate rates of compensation gains likely reflect the offsetting influences of a strong labor market and productivity growth that has been weak through much of the expansion. From 2008 to 2017, labor productivity increased a little more than 1 percent per year, on average, well below the average pace from 1996 to 2007 of nearly 3 percent and also below the average gain in the 1974–95 period. Although considerable debate remains about the reasons for the slowdown over this period, the weakness in productivity growth may be partly attributable to the sharp pullback in capital investment during the most recent recession and the relatively slow recovery that followed. More recently, however, labor productivity is estimated to have increased almost 2 percent at an annual rate in the first three quarters of 2018—still moderate relative to earlier periods, but its fastest three-quarter gain since 2010. While it is uncertain whether this faster rate of growth will persist, a sustained pickup in productivity growth, as well as additional labor market strengthening, would likely support stronger gains in labor compensation.

Price inflation is close to 2 percent

Consumer price inflation has fluctuated around the FOMC's objective of 2 percent, largely reflecting movements in energy prices. As measured by the 12-month change in the price index for personal consumption expenditures (PCE), inflation is estimated to have been 1.7 percent in December after being above 2 percent for much of 2018 (figure 4).⁶ Core PCE inflation—that is, inflation excluding consumer food and energy prices—is estimated to have been 1.9 percent in December. Because food and energy prices are often quite volatile, core inflation typically provides a better indication than the total measure of where overall inflation will be in the future. Total inflation was below core inflation for the year as a whole not only because of softness in energy prices, but also because food price inflation has remained relatively low.

Core inflation has moved up since 2017, when inflation was held down by some unusually large price declines in a few relatively small categories of spending, such as mobile phone services. The trimmed mean PCE price index, produced by the Federal Reserve Bank of Dallas, provides an alternative way to purge inflation of transitory influences, and it may be less sensitive than the core index to idiosyncratic price movements such as those noted earlier. The 12-month change in this measure did not decline as much as core PCE inflation in 2017, and it was 2.0 percent in November.⁷ Inflation likely has been increasingly supported by the strong labor market in an environment of stable inflation expectations; inflation last year was also boosted slightly by the tariffs that were imposed throughout 2018.

Oil prices have dropped markedly in recent months...

As noted, the slower pace of total inflation in late 2018 relative to core inflation largely reflected softening in consumer energy prices toward the end of the year. After peaking at about $86 per barrel in early October, the price of crude oil subsequently fell sharply and has averaged around $60 per barrel this year (figure 5). The recent decline in oil prices has led to moderate reductions in the cost of gasoline and heating oil. Supply factors, including surging oil production in Saudi Arabia, Russia, and the United States, appear to be most responsible for the recent price declines, but concerns about weaker global growth likely also played a role.

...while prices of imports other than energy have also declined

After climbing steadily since their early 2016 lows, nonfuel import prices peaked in May 2018 and declined for much of the rest of 2018 in response to dollar appreciation, lower foreign inflation, and declines in commodity prices. In particular, metal prices fell markedly in the second half of 2018, partly reflecting concerns about prospects for the global economy. Nonfuel import prices, before accounting for the effects of tariffs on the price of imported goods, had roughly a neutral influence on U.S. price inflation in 2018.

Survey-based measures of inflation expectations have been 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 over the second half of 2018. 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 very close to 2 percent for the past several years (figure 6). In the University of Michigan Surveys of Consumers, the median value for inflation expectations over the next 5 to 10 years has been around 2-1/2 percent since the end of 2016, though this level is about 1/4 percentage point lower than had prevailed through 2014. In contrast, in the Survey of Consumer Expectations, conducted by the Federal Reserve Bank of New York, the median of respondents' expected inflation rate three years hence—while relatively stable around 3 percent since early 2018—is nonetheless at the top of the range it has occupied over the past couple
of years.

...while market-based measures of inflation compensation have come down since the first half of 2018

Inflation expectations can also be gauged by market-based measures of inflation compensation. However, 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-maturity Treasury Inflation-Protected Securities (TIPS) or from inflation swaps—moved down in the fall and are below levels that prevailed earlier in 2018.⁸ The TIPS-based measure of 5-to-10-year-forward inflation compensation and the analogous measure from inflation swaps are now about 1-3/4 percent and 2-1/4 percent, respectively, with both measures below their respective ranges that persisted for most of the 10 years before the start of the notable declines in mid-2014.⁹

Real gross domestic product growth was solid, on balance, in the second half of 2018

Real gross domestic product (GDP) rose at an annual rate of 3-1/2 percent in the third quarter, and available indicators point to a moderate gain in the fourth quarter.¹⁰ For the year, GDP growth appears to have been a little less than 3 percent, up from the 2-1/2 percent pace in 2017 and the 2 percent pace in the preceding two years (figure 7). Last year's growth reflects, in part, solid growth in household and business spending, on balance, as well as an increase in government purchases of goods and services; by contrast, housing-sector activity turned down last year. Private domestic final purchases—that is, final purchases by households and businesses, which tend to provide a better indication of future GDP growth than most other components of overall spending—likely posted a strong gain for the year.

Some measures of consumer and business sentiment have recently softened—likely reflecting concerns about financial market volatility, the global economic outlook, trade policy tensions, and the government shutdown—and consumer spending appears to have weakened at the end of the year. Nevertheless, the economic expansion continues to be supported by steady job gains, past increases in household wealth, expansionary fiscal policy, and still-favorable domestic financial conditions, including moderate borrowing costs and easy access to credit for many households and businesses.

Ongoing improvements in the labor market continue to support household income and consumer spending...

Real consumer spending picked up after some transitory weakness in the first half of 2018, rising at a strong annual rate of 3-1/2 percent in the third quarter and increasing robustly through November (figure 8). However, despite anecdotal reports of favorable holiday sales, retail sales were reported to have declined sharply in December. Real disposable personal income—that is, income after taxes and adjusted for price changes—looks to have increased around 3 percent over the year, boosted by ongoing improvements in the labor market and the reduction in income taxes due to the implementation of the Tax Cuts and Jobs Act (TCJA). With consumer spending rising at about the same rate as gains in disposable income in 2018 through the third quarter (the latest data available), the personal saving rate was roughly unchanged, on net, over this period.

...although wealth gains have moderated and consumer confidence has recently softened

While increases in household wealth have likely continued to support consumer spending, gains in net worth slowed last year. House prices continued to move up in 2018, boosting the wealth of homeowners, but the pace of growth moderated. U.S. equity prices are, on net, similar to their levels at the end of 2017. Still, the level of equity and housing wealth relative to income remains very high by historical standards.¹¹

Consumer sentiment as measured by the Michigan survey flattened out at a high level through much of 2018, and the sentiment measure from the Conference Board survey climbed through most of the year, with both measures posting their highest annual averages since 2000. However, consumer sentiment has turned down since around year-end, on net, with the declines primarily reflecting consumers' expectations for future conditions rather than their assessment of current conditions. Consumer attitudes about car buying have also weakened. Nevertheless, these indicators of consumers' outlook remain at generally favorable levels, likely reflecting rising income, job gains, and low inflation.

Borrowing conditions for consumers remain generally favorable despite interest rates being near the high end of their post-recession range

Despite increases in interest rates for consumer loans and some reported further tightening in credit card lending standards, financing conditions for consumers largely remain supportive of growth in household spending, and consumer credit growth in 2018 expanded further at a solid pace. Mortgage credit has continued to be readily available for households with solid credit profiles. For borrowers with low credit scores, mortgage underwriting standards have eased somewhat since the first half of 2018 but remain noticeably tighter than before the recession. Financing conditions in the student loan market remain stable, with over 90 percent of such credit being extended by the federal government. Delinquencies on such loans, though staying elevated, continued to improve gradually on net.

Business investment growth has moderated after strong gains early in 2018...

Investment spending by businesses rose rapidly in the first half of last year, and the available data are consistent with growth having slowed in the second half (figure 9). The apparent slowdown reflects, in part, more moderate growth in investment in equipment and intangibles as well as a likely decline in investment in nonresidential structures after strong gains earlier in the year. Forward-looking indicators of business spending—such as business sentiment, capital spending plans, and profit expectations from industry analysts—have softened recently but remain positive overall. And while new orders of capital goods flattened out toward the end of last year, the backlog of unfilled orders for this equipment has continued to rise.

...as corporate financing conditions tightened somewhat but remained accommodative overall

Spreads of yields on nonfinancial corporate bonds over those on comparable-maturity Treasury securities widened modestly, on balance, since the middle of 2018 as investors' risk appetite appeared to recede some. Nonetheless, a net decrease in Treasury yields over the past several months has left interest rates on corporate bonds still low by historical standards, and financing conditions appear to have remained accommodative overall. Aggregate net flows of credit to large nonfinancial firms remained solid in the third quarter. The gross issuance of corporate bonds and new issuance of leveraged loans both fell considerably toward the end of the year but have since rebounded, mirroring movements in financial market volatility.

Respondents to the January Senior Loan Officer Opinion Survey on Bank Lending Practices, or SLOOS, reported that lending standards for commercial and industrial (C&I) loans remained basically unchanged in the fourth quarter after having reported easing standards over the past several quarters. However, banks reported tightening lending standards on all categories of commercial real estate (CRE) loans in the fourth quarter on net.

Meanwhile, financing conditions for small businesses have remained generally accommodative. Lending volumes to small businesses rebounded a bit in recent months, and indicators of recent loan performance stayed strong.

Activity in the housing sector has been declining

Residential investment declined in 2018, as housing starts held about flat and sales of existing homes moved lower (figure 10). The drop in residential investment reflects rising mortgage rates—which remain higher than in 2017 despite coming down some recently—as well as higher material and labor building costs, which have likely restrained new home construction. Consumers' perceptions of homebuying conditions deteriorated sharply over 2018, consistent with the decline in the affordability of housing associated with both higher mortgage rates and still-rising house prices.

Net exports likely subtracted from GDP growth in 2018

After a strong performance in the first half of last year supported by robust exports of agricultural products, real exports declined in the third quarter, and available indicators suggest only a partial rebound in the fourth quarter. At the same time, growth in real imports seems to have picked up in the second half of 2018. As a result, real net exports—which lifted U.S. real GDP growth during the first half of 2018—appear to have subtracted from growth in the second half. For the year as a whole, net exports likely subtracted a little from real GDP growth, similar to 2016 and 2017. The nominal trade deficit and the current account deficit in 2018 were little changed as a percent of GDP from 2017 (figure 11).

Federal fiscal policy actions boosted economic growth in 2018...

Fiscal policy at the federal level boosted GDP growth in 2018, both because of lower income and business taxes from the TCJA and because federal purchases appear to have risen significantly faster than in 2017 as a result of the Bipartisan Budget Act of 2018.¹² The partial government shutdown, which was in effect from December 22 through January 25, likely held down GDP growth in the first quarter of this year somewhat, largely because of the lost work of furloughed federal government workers and temporarily affected federal contractors.

The federal unified deficit widened in fiscal year 2018 to 3-3/4 percent of nominal GDP because receipts moved lower, to roughly 16-1/2 percent of GDP. Expenditures edged down, to 20-1/4 percent of GDP, but remain above the levels that prevailed in the decade before the start of the 2007–09 recession. The ratio of federal debt held by the public to nominal GDP equaled 78 percent at the end of fiscal 2018 and remains quite elevated relative to historical norms. The Congressional Budget Office projects that this ratio will rise over the next several years.

...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. After several years of slow growth, revenue gains of state governments strengthened notably as sales and income tax collections have picked up over the past few quarters. At the local level, property tax collections continue to rise at a solid clip, pushed higher by past house price gains. After declining a bit in 2017, real state and local government purchases grew moderately last year, driven largely by a boost in construction but also reflecting modest growth in employment at these governments.

Financial Developments

The expected path of the federal funds rate over the next several years has moved down

Despite the further strengthening in the labor market and continued expansion in the U.S. economy, market-based measures of the expected path for the federal funds rate over the next several years have declined, on net, since the middle of last year. Various factors contributed to this shift, including increased investor concerns about downside risks to the global economic outlook and rising trade tensions, as well as FOMC communications that were viewed as signaling patience and greater flexibility in the conduct of monetary policy in response to adverse macroeconomic or financial market developments.

Survey-based measures of the expected path of the policy rate through 2020 also shifted down, on net, relative to the levels observed in the first half of 2018. According to the results of the most recent Survey of Primary Dealers and Survey of Market Participants, both conducted by the Federal Reserve Bank of New York just before the January FOMC meeting, the median of respondents' modal projections for the path of the federal funds rate implies two additional 25 basis point rate increases in 2019. Relative to the December survey, these increases are expected to occur later in 2019. Looking further ahead, respondents to the January survey forecast no rate increases in 2020 and in 2021.¹³ Meanwhile, market-based measures of uncertainty about the policy rate approximately one to two years ahead were little changed, on balance, from their levels at the end of last June.

The nominal Treasury yield curve continued to flatten

The nominal Treasury yield curve flattened somewhat further since the first half of 2018, with the 2-year nominal Treasury yield little changed and the 5- and 10-year nominal Treasury yields declining about 25 basis points on net (figure 12). At the same time, yields on inflation-protected Treasury securities edged up, leaving market-based measures of inflation compensation moderately lower. In explaining movements in Treasury yields since mid-2018, market participants have pointed to developments related to the global economic outlook and trade tensions, FOMC communications, and fluctuations in oil prices. Option-implied volatility on swap rates—an indicator of uncertainty about Treasury yields—declined slightly on net.

Consistent with changes in yields on nominal Treasury securities, yields on 30-year agency mortgage-backed securities (MBS)—an important determinant of mortgage interest rates—decreased about 20 basis points, on balance, since the middle of last year and remain low by historical standards. Meanwhile, yields on both investment-grade and high-yield corporate debt declined a bit. As a result, the spreads on corporate bond yields over comparable-maturity Treasury yields are modestly wider than at the end of June. The cumulative increases over the past year have left spreads for high-yield and investment-grade corporate bonds close to their historical medians, with both spreads notably above the very low levels that prevailed a year ago.

Broad equity price indexes increased somewhat

Broad U.S. stock market indexes increased somewhat since the middle of last year, on net, amid substantial volatility (figure 13). Concerns over the sustainability of corporate earnings growth, the global growth outlook, international trade tensions, and some Federal Reserve communications that were perceived as less accommodative than expected weighed on investor sentiment for a time. There were considerable differences in stock returns across sectors, reflecting their varying degrees of sensitivities to energy price declines, trade tensions, and rising interest rates. In particular, stock prices of companies in the utilities sector—which tend to benefit from falling interest rates—and in the health-care sector outperformed broader indexes. Conversely, stock prices in the energy sector substantially underperformed the broad indexes, as oil prices dropped sharply. Basic materials—a sector that was particularly sensitive to concerns about the global growth outlook and trade tensions—also underperformed. Bank stock prices declined slightly, on net, as the yield curve flattened and funding costs rose. Measures of implied and realized stock price volatility for the S&P 500 index—the VIX and the 20-day realized volatility—increased sharply in the fourth quarter of last year to near the high levels observed in early February 2018 amid sharp equity price declines. These volatility measures partially retraced following the turn of the year, with the VIX returning to near the 30th percentile of its historical distribution and with realized volatility ending the period close to the 70th percentile of its historical range (figure 14). (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability" on pages 26–28 of the February 2019 Monetary Policy Report.)

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

Available indicators of Treasury market functioning have generally remained stable since the first half of 2018, with a variety of liquidity metrics—including bid-ask spreads, bid sizes, and estimates of transaction costs—displaying few signs of liquidity pressures. Liquidity conditions in the agency MBS market were also generally stable. Overall, the functioning of Treasury and agency MBS markets has not been materially affected by the implementation of the Federal Reserve's balance sheet normalization program over the past year and a half. Credit conditions in municipal bond markets have remained stable since the middle of last year, though yield spreads on 20-year general obligation municipal bonds over comparable-maturity Treasury securities were modestly higher on net.

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

Conditions in domestic short-term funding markets have also remained generally stable since the beginning of the summer. Increases in the FOMC's target range were transmitted effectively through money markets, with yields on a broad set of money market instruments moving higher in response to the FOMC's policy actions in September and December. The effective federal funds rate moved to parity with the interest rate paid on reserves and was closely tracked by the overnight Eurodollar rate. Other short-term interest rates, including those on commercial paper and negotiable certificates of deposits, also moved up in light of increases in the policy rate.

Bank credit continued to expand, and bank profitability improved

Aggregate credit provided by commercial banks expanded through the second half of 2018 at a stronger pace than the one observed in the first half of last year, as the strength in C&I loan growth more than offset the moderation in the growth in CRE loans and loans to households. In the fourth quarter of last year, the pace of bank credit expansion was about in line with that of nominal GDP, leaving the ratio of total commercial bank credit to current-dollar GDP little changed relative to last June
(figure 15). Overall, measures of bank profitability improved further in the third quarter despite a flattening yield curve, but they remain below their pre-crisis levels.

International Developments

Economic activity in most foreign economies weakened in the second half of 2018

After expanding briskly in 2017, foreign GDP growth moderated in 2018. While part of this slowdown is likely due to temporary factors, it also appears to reflect weaker underlying momentum against the backdrop of somewhat tighter financial conditions, increased policy uncertainty, and ongoing debt deleveraging.

The growth slowdown was particularly pronounced in advanced foreign economies

Real GDP growth in several advanced foreign economies (AFEs) slowed markedly in the second half of the year. This slowdown was concentrated in the manufacturing sector against the backdrop of softening global trade flows. In Japan, real GDP contracted in the second half of 2018, as economic activity, which was disrupted by a series of natural disasters in the third quarter, rebounded only partly in the fourth quarter. Growth in the euro area slowed in the second half of the year: Transportation bottlenecks and complications in meeting tighter emissions standards for new motor vehicles weighed on German economic activity, while output contracted in Italy. Although some of these headwinds appear to be fading, recent indicators—especially for the manufacturing sector—point to only a limited recovery of activity in the euro area at the start of 2019.

Inflation pressures remain contained in advanced foreign economies...

In recent months, headline inflation has fallen below central bank targets in many major AFEs, reflecting large declines in energy prices. In the euro area and Japan, low headline inflation rates also reflect subdued core inflation. In Canada and the United Kingdom, instead, core inflation rates have been close to 2 percent.

...prompting central banks to withdraw accommodation only gradually

With underlying inflation still subdued, the Bank of Japan and the European Central Bank (ECB) kept their short-term policy rates at negative levels. Although the ECB concluded its asset purchase program in December, it signaled an only very gradual removal of policy accommodation going forward. The Bank of England (BOE) and the Bank of Canada, which both began raising interest rates in 2017, increased their policy rates further in the second half of 2018 but to levels that are still low by historical standards. The BOE noted that elevated uncertainty around the United Kingdom's exit from the European Union (EU) weighed on the country's economic outlook.

Political uncertainty and slower economic growth weighed on AFE asset prices

Moderation in global growth, protracted budget negotiations between the Italian government and the EU, and developments related to the United Kingdom's withdrawal from the EU weighed on AFE asset prices in the second half of 2018. Broad stock price indexes in the AFEs fell, interest rates on sovereign bonds in several countries in the European periphery remained elevated, and European bank shares underperformed, although these moves have partially retraced in recent weeks. Market-implied paths of policy in major AFEs and long-term sovereign bond yields declined somewhat, as economic data disappointed.

Growth slowed in many emerging market economies

Chinese GDP growth slowed in the second half of 2018 as an earlier tightening of credit policy, aimed at restraining the buildup of debt, caused infrastructure investment to fall sharply and squeezed household spending. However, increased concerns about a sharper-than-expected slowdown in growth, as well as prospective effects of trade policies, prompted Chinese authorities to ease monetary and fiscal policy somewhat. Elsewhere in emerging Asia, growth remained well below its 2017 pace amid headwinds from moderating global growth. Tighter financial conditions also weighed on growth in other EMEs—notably, Argentina and Turkey.

Economic activity strengthened somewhat in Mexico and Brazil, but uncertainty about policy developments remains elevated

In Mexico, economic activity increased at a more rapid rate in the third quarter after modest advances earlier in the year. However, growth weakened again in the fourth quarter, as perceptions that the newly elected government would pursue less market-friendly policies led to a sharp tightening in financial conditions. Amid a sharp peso depreciation and above-target inflation, the Bank of Mexico raised its policy rate to 8.25 percent in December. Brazilian real GDP growth rebounded in the third quarter after being held down by a nationwide trucker's strike in May, and financial markets have rallied on expectations that Brazil's new government will pursue economic policies that support growth. However, investors continued to focus on whether the new administration would pass significant fiscal reforms.

Financial conditions in many emerging market economies were volatile but are, on net, little changed since July

Financial conditions in the EMEs generally tightened in the second half of 2018, as investor concerns about vulnerabilities in several EMEs intensified against the backdrop of higher policy uncertainty, slowing global growth, and rising U.S. interest rates. Trade policy tensions between the United States and China weighed on asset prices, especially in China and other Asian economies. Broad measures of EME sovereign bond spreads over U.S. Treasury yields rose, and benchmark EME equity indexes declined. However, financial conditions improved significantly in recent months, supported in part by more positive policy developments—including the U.S.-Mexico-Canada Agreement and progress on U.S.–China trade negotiations—and FOMC communications indicating a more gradual normalization of U.S. interest rates. EME mutual fund inflows resumed in recent months after experiencing outflows in the middle of 2018. While movements in asset prices and capital flows have been sizable for a number of economies, broad indicators of financial stress in EMEs are below those seen during other periods of stress in recent years.

The dollar appreciated slightly

The foreign exchange value of the U.S. dollar is bit a higher than in July (figure 16). Concerns about the global outlook, uncertainty about trade policy, and monetary policy normalization in the United States contributed to the appreciation of the dollar. The Chinese renminbi depreciated against the dollar slightly, on net, amid ongoing trade negotiations and increased concerns about growth prospects in China. The Mexican peso has been volatile amid ongoing political developments and trade negotiations but has, on net, declined only modestly against the dollar. Sharp declines in oil prices also weighed on the currencies of some energy-exporting economies.

Part 2: Monetary Policy

The Federal Open Market Committee continued to gradually increase the federal funds rate in the second half of last year

From late 2015 through the first half of last year, the Federal Open Market Committee (FOMC) gradually increased its target range for the federal funds rate as the economy continued to make progress toward the Committee's congressionally mandated objectives of maximum employment and price stability. In the second half of 2018, the FOMC continued this gradual process of monetary policy normalization, raising the federal funds rate at its September and December meetings, bringing the target range to 2-1/4 to 2-1/2 percent (figure 17).¹⁴ The FOMC's decisions to increase the federal funds rate reflected the solid performance of the U.S. economy, the continued strengthening of the labor market, and the fact that inflation had moved near the Committee's 2 percent longer-run objective.

Looking ahead, the FOMC will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate

With the gradual reductions in the amount of policy accommodation to date, the federal funds rate is now at the lower end of the range of estimates of its longer-run neutral level—that is, the level of the federal funds rate that is neither expansionary nor contractionary.

Developments at the time of the December FOMC meeting, including volatility in financial markets and increased concerns about global growth, made the appropriate extent and timing of future rate increases more uncertain than earlier. Against that backdrop, the Committee indicated it would monitor global economic and financial developments and assess their implications for the economic outlook. In the Summary of Economic Projections (SEP) from the December meeting—the most recent SEP available—participants generally revised down their individual assessments of the appropriate path for monetary policy relative to their assessments at the time of the September meeting.¹⁵

In January, the Committee stated that it continued to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective as the most likely outcomes. Nonetheless, in light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the federal funds rate may be appropriate to support these outcomes.

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 the actual path of monetary policy will depend on the evolution of the economic outlook as informed by incoming data. Specifically, in deciding on the timing and size of future adjustments to the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

In addition to evaluating a wide range of economic and financial data and information gathered from business contacts and other informed parties around the country, policymakers routinely consult prescriptions for the policy interest rate from a variety of rules, which can serve as useful guidance to the FOMC. However, many practical considerations make it undesirable for the FOMC to mechanically follow the prescriptions of any specific rule. Consequently, the FOMC's framework for conducting systematic monetary policy respects key principles of good monetary policy and, at the same time, provides flexibility to address many of the limitations of these policy rules (see the box "Monetary Policy Rules and Systematic Monetary Policy" on pages 36–39 of the February 2019 Monetary Policy Report).

The FOMC has continued to implement its program to gradually reduce the Federal Reserve's balance sheet

The Committee has continued to implement the balance sheet normalization program that has been under way since October 2017.¹⁶ Under this program, the FOMC has been reducing its holdings of Treasury and agency securities in a gradual and predictable manner by decreasing its reinvestment of the principal payments it received from these securities. Specifically, such payments have been reinvested only to the extent that they exceeded gradually rising caps.

In the third quarter of 2018, the Federal Reserve reinvested principal payments from its holdings of Treasury securities maturing during each calendar month in excess of $24 billion. It also reinvested in agency mortgage-backed securities (MBS) the amount of principal payments from its holdings of agency debt and agency MBS received during each calendar month in excess of $16 billion. In the fourth quarter, the FOMC increased the caps for Treasury securities and for agency securities to their respective maximums of $30 billion and $20 billion. Of note, reinvestments of agency debt and agency MBS ceased in October as principal payments fell below the maximum redemption caps.

The Federal Reserve's total assets have continued to decline from about $4.3 trillion last July to about $4.0 trillion at present, with holdings of Treasury securities at approximately $2.2 trillion and holdings of agency debt and agency MBS at approximately $1.6 trillion (figure 18).

As the Federal Reserve has continued to gradually reduce its securities holdings, the level of reserve balances in the banking system has declined. In particular, the level of reserve balances has decreased by about $350 billion since the middle of last year, and by about $1.2 trillion since its peak in 2014.¹⁷ At the January meeting, the Committee released an updated Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization to provide additional information regarding its plans to implement monetary policy over the longer run.¹⁸ In this statement, the Committee indicated that it intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve's administered rates, and in which active management of the supply of reserves is not required. This operating procedure is often called a "floor system." The FOMC judges that this approach provides good control of short-term money market rates in a variety of market conditions and effective transmission of those rates to broader financial conditions. In addition, the FOMC stated that it is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.

Although reserve balances play a central role in the ongoing balance sheet normalization process, in the longer run, the size of the balance sheet will also be importantly determined by trend growth in nonreserve liabilities. The box "The Role of Liabilities in Determining the Size of the Federal Reserve's Balance Sheet" on pages 41–43 of the February 2019 Monetary Policy Report discusses various factors that influence the size of reserve and nonreserve liabilities.

Meanwhile, interest income on the Federal Reserve's securities holdings has continued to support substantial remittances to the U.S. Treasury. Preliminary financial statement results indicate that the Federal Reserve remitted about $65 billion in 2018.

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

As with the previous federal funds rate increases since late 2015, the Federal Reserve successfully raised the effective federal funds rate in September and December by increasing the interest rate paid on reserve balances and the interest rate offered on overnight reverse repurchase agreements (ON RRPs). Specifically, the Federal Reserve raised the interest rate paid on required and excess reserve balances to 2.20 percent in September and to 2.40 percent in December. In addition, the Federal Reserve increased the ON RRP offering rate to 2.00 percent in September and to 2.25 percent in December. The Federal Reserve also approved a 1/4 percentage point increase in the discount rate (the primary credit rate) in both September and December. Yields on a broad set of money market instruments moved higher, roughly in line with the federal funds rate, in response to the FOMC's policy decisions in September and December. Usage of the ON RRP facility has remained low, excluding quarter-ends.

The effective federal funds rate moved to parity with the interest rate paid on reserve balances in the months before the December meeting. At its December meeting, the Committee made a second small technical adjustment by setting the interest on excess reserves rate 10 basis points below the top of the target range for the federal funds rate; this adjustment was intended to foster trading in the federal funds market at rates well within the FOMC's target range.

The Federal Reserve will conduct a review of its strategic framework for monetary policy in 2019

With labor market conditions close to maximum employment and inflation near the Committee's 2 percent objective, the FOMC judges it is an opportune time for the Federal Reserve to conduct a review of its strategic framework for monetary policy—including the policy strategy, tools, and communication practices. The goal of this assessment is to identify possible ways to improve the Committee's current policy framework in order to ensure that the Federal Reserve is best positioned going forward to achieve its statutory mandate of maximum employment and price stability.

Specific to the communications practices, the Federal Reserve judges that transparency is essential to accountability and the effectiveness of policy, and therefore the Federal Reserve seeks to explain its policymaking approach and decisions to the Congress and the public as clearly as possible. The box "Federal Reserve Transparency: Rationale and New Initiatives" on pages 45–46 of the February 2019 Monetary Policy Reportdiscusses the steps and new initiatives the Federal Reserve has taken to improve transparency.

Monetary Policy Report July 2018

Summary

Economic activity increased at a solid pace over the first half of 2018, and the labor market has continued to strengthen. Inflation has moved up, and in May, the most recent period for which data are available, inflation measured on a 12-month basis was a little above the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent, boosted by a sizable increase in energy prices. In this economic environment, the Committee judged that current and prospective economic conditions called for a further gradual removal of monetary policy accommodation. In line with that judgment, the FOMC raised the target for the federal funds rate twice in the first half of 2018, bringing it to a range of 1-3/4 to 2 percent.

Economic and Financial Developments

The labor market. The labor market has continued to strengthen. Over the first six months of 2018, payrolls increased an average of 215,000 per month, which is somewhat above the average pace of 180,000 per month in 2017 and is considerably faster than what is needed, on average, to provide jobs for new entrants into the labor force. The unemployment rate edged down from 4.1 percent in December to 4.0 percent in June, which is about 1/2 percentage point below the median of FOMC participants' estimates of its longer-run normal level. Other measures of labor utilization were consistent with a tight labor market. However, hourly labor compensation growth has been moderate, likely held down in part by the weak pace of productivity growth in recent years.

Inflation. Consumer price inflation, as measured by the 12-month percentage change in the price index for personal consumption expenditures, moved up from a little below the FOMC's objective of 2 percent at the end of last year to 2.3 percent in May, boosted by a sizable increase in consumer energy prices. 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 total figure, was 2 percent in May. This reading was 1/2 percentage point above where it had been 12 months earlier, as the unusually low readings from last year were not repeated. Measures of longer-run inflation expectations have been generally stable.

Economic growth. Real gross domestic product (GDP) is reported to have increased at an annual rate of 2 percent in the first quarter of 2018, and recent indicators suggest that economic growth stepped up in the second quarter. Gains in consumer spending slowed early in the year, but they rebounded in the spring, supported by strong job gains, recent and past increases in household wealth, favorable consumer sentiment, and higher disposable income due in part to the implementation of the Tax Cuts and Jobs Act. Business investment growth has remained robust, and indexes of business sentiment have been strong. Foreign economic growth has remained solid, and net exports had a roughly neutral effect on real U.S. GDP growth in the first quarter. However, activity in the housing market has leveled off this year.

Financial conditions. Domestic financial conditions for businesses and households have generally continued to support economic growth. After rising steadily through 2017, broad measures of equity prices are modestly higher, on balance, from their levels at the end of last year amid some bouts of heightened volatility in financial markets. While long-term Treasury yields, mortgage rates, and yields on corporate bonds have risen so far this year, longer-term interest rates remain low by historical standards, and corporate bond issuance has continued at a moderate pace. Moreover, most types of consumer loans remained widely available for households with strong creditworthiness, and credit provided by commercial banks continued to expand. The foreign exchange value of the U.S. dollar has appreciated somewhat against the currencies of our trading partners this year, but it remains below its level at the start of 2017. Foreign financial conditions remain generally supportive of growth despite recent increases in financial stress in several emerging market economies.

Financial stability. The U.S. financial system remains substantially more resilient than during the decade before the financial crisis. Asset valuations continue to be elevated despite declines since the end of 2017 in the forward price-to-earnings ratio of equities and the prices of corporate bonds. In the private nonfinancial sector, borrowing among highly levered and lower-rated businesses remains elevated, although the ratio of household debt to disposable income continues to be moderate. Vulnerabilities stemming from leverage in the financial sector remain low, reflecting in part strong capital positions at banks, whereas some measures of hedge fund leverage have increased. Vulnerabilities associated with maturity and liquidity transformation among banks, insurance companies, money market mutual funds, and asset managers remain below levels that generally prevailed before 2008.

Monetary Policy

Interest rate policy. Over the first half of 2018, the FOMC has continued to gradually increase the target range for the federal funds rate. Specifically, the Committee decided to raise the target range for the federal funds rate at its meetings in March and June, bringing it to the current range of 1-3/4 to 2 percent. The decisions to increase the target range for the federal funds rate reflected the economy's continued progress toward the Committee's objectives of maximum employment and price stability. Even with these policy rate increases, 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 further gradual increases in the target range for the federal funds rate will be consistent with a sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective over the medium term. Consistent with this outlook, in the most recent Summary of Economic Projections (SEP), which was compiled at the time of the June FOMC meeting, the median of participants' assessments for the appropriate level for the federal funds rate rises gradually over the period from 2018 to 2020 and stands somewhat above the median projection for its longer-run level by the end of 2019 and through 2020. (The June SEP is presented in Part 3of the July 2018 Monetary Policy Report.) However, as the Committee has continued to emphasize, the timing and size of future adjustments to the target range for the federal funds rate will depend on the Committee's assessment of realized and expected economic conditions relative to its maximum-employment objective and its symmetric 2 percent inflation objective.

Balance sheet policy. The FOMC has continued to implement the balance sheet normalization program described in the Addendum to the Policy Normalization Principles and Plans that the Committee issued about a year ago. Specifically, the FOMC has been reducing its holdings of Treasury and agency securities by decreasing, in a gradual and predictable manner, the reinvestment of principal payments it receives from these securities.

Special Topics

Prime-age labor force participation. Labor force participation rates (LFPRs) for men and women between 25 and 54 years old—that is, the share of these individuals either working or actively seeking work—trended lower between 2000 and 2013. Those trends likely reflect numerous factors, including a long-run decline in the demand for workers with lower levels of education and an increase in the share of the population with some form of disability. By contrast, the prime-age LFPR has increased notably since 2013, and the share of nonparticipants who report wanting a job remains above pre-recession levels. Thus, some continuation of the recent increase in the prime-age LFPR may be possible if labor demand remains strong. (See the box "The Labor Force Participation Rate for Prime-Age Individuals" on pages 8–10 of the July 2018 Monetary Policy Report.)

Oil prices. Oil prices have climbed rapidly over the past year, reflecting both supply and demand factors. Although higher oil prices are likely to restrain household consumption in the United States, much of the negative effect on GDP from lower consumer spending is likely to be offset by increased production and investment in the growing U.S. oil sector. Consequently, higher oil prices now imply much less of a net overall drag on the economy than they did in the past, although they will continue to have important distributional effects. The negative effect of upward moves in oil prices should get smaller still as U.S. oil production grows and net oil imports decline further. (See the box "The Recent Rise in Oil Prices" on pages 16–17 of the July 2018 Monetary Policy Report.)

Monetary policy rules. Monetary policymakers consider a wide range of information on current economic conditions and the outlook when 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, among other considerations, careful judgments about the choice and measurement of the inputs into the rules such as estimates of the neutral interest rate, which are highly uncertain. (See the box "Complexities of Monetary Policy Rules" on pages 37–41 of the July 2018 Monetary Policy Report.)

Interest on reserves. The payment of interest on reserves—balances held by banks in their accounts at the Federal Reserve—is an essential tool for implementing monetary policy because it helps anchor the federal funds rate within the FOMC's target range. This tool has permitted the FOMC to achieve a gradual increase in the federal funds rate in combination with a gradual reduction in the Fed's securities holdings and in the supply of reserve balances. The FOMC judged that removing monetary policy accommodation through first raising the federal funds rate and then beginning to shrink the balance sheet would best contribute to achieving and maintaining maximum employment and price stability without causing dislocations in financial markets or institutions that could put the economic expansion at risk. (See the box "Interest on Reserves and Its Importance for Monetary Policy"on pages 44–46 of the July 2018 Monetary Policy Report.)

Part 1: Recent Economic and Financial Developments

Domestic Developments

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

Labor market conditions have continued to strengthen so far in 2018. According to the Bureau of Labor Statistics (BLS), gains in total nonfarm payroll employment averaged 215,000 per month over the first half of the year. That pace is up from the average monthly pace of job gains in 2017 and is considerably faster than what is needed to provide jobs for new entrants into the labor force.¹⁹ Indeed, the unemployment rate edged down from 4.1 percent in December to 4.0 percent in June. This rate is below all Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level and is about 1/2 percentage point below the median of those estimates.²⁰ The unemployment rate in June is close to the lows last reached in 2000.

The labor force participation rate (LFPR), which is the share of individuals aged 16 and older who are either working or actively looking for work, was 62.9 percent in June and has changed little, on net, since late 2013. The aging of the population is an important contributor to a downward trend in the overall participation rate. In particular, members of the baby-boom cohort are increasingly moving into their retirement years, a time when labor force participation is typically low. Indeed, the share of the civilian population aged 65 and over in the United States climbed from 16 percent in 2000 to 19 percent in 2017 and is projected to rise to 24 percent by 2026. Given this trend, the flat trajectory of the LFPR during the past few years is consistent with strengthening labor market conditions. Similarly, the LFPR for individuals between 25 and 54 years old—which is much less sensitive to population aging—has been rising for the past several years. (The box "The Labor Force Participation Rate for Prime-Age Individuals" on pages 8–10 of the July 2018 Monetary Policy Reportexamines the prospects for further increases in participation for these individuals.) The employment-to-population ratio for individuals 16 and over—the share of the total population who are working—was 60.4 percent in June and has been gradually increasing since 2011, reflecting the combination of the declining unemployment rate and the flat LFPR.

Other indicators are also consistent with a strong labor market. As reported in the Job Openings and Labor Turnover Survey (JOLTS), the rate of job openings has remained quite elevated.²¹ The rate of quits has stayed high in the JOLTS, an indication that workers are able to successfully switch jobs when they wish to. In addition, the JOLTS layoff rate has been low, and the number of people filing initial claims for unemployment insurance benefits has remained near its lowest level in decades. Other survey evidence indicates that households perceive jobs as plentiful and that businesses see vacancies as hard to fill. Another indicator, 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 labor underutilization from the BLS—fell further in the first six months of the year and now stands close to its pre-recession level.

...and unemployment rates have fallen for all major demographic groups

The continued decline in the unemployment rate has been reflected in the experiences of multiple racial and ethnic groups. The unemployment rates for blacks or African Americans and Hispanics tend to rise considerably more than rates for whites and Asians during recessions but decline more rapidly during expansions. Indeed, the declines in the unemployment rates for blacks and Hispanics have been particularly striking, and the rates have recently been at or near their lowest readings since these series began in the early 1970s. Although differences in unemployment rates across ethnic and racial groups have narrowed in recent years, they remain substantial and similar to pre-recession levels. The rise in LFPRs for prime-age individuals over the past few years has also been evident in each of these racial and ethnic groups, with increases again particularly notable for African Americans. Even so, the LFPR for whites remains higher than that for the other groups.²²

Increases in labor compensation have been moderate...

Despite the strong labor market, the available indicators generally suggest that increases in hourly labor compensation have been moderate. Compensation per hour in the business sector—a broad-based measure of wages, salaries, and benefits that is quite volatile—rose 2-3/4 percent over the four quarters ending in 2018:Q1, slightly more than the average annual increase over the preceding seven or so years. The employment cost index—a less volatile measure of both wages and the cost to employers of providing benefits—likewise was 2-3/4 percent higher in the first quarter of 2018 relative to its year-earlier level; this increase was 1/2 percentage point faster than its gain a year earlier. Among measures that do not account for benefits, average hourly earnings rose 2-3/4 percent in June relative to 12 months earlier, a gain in line with the average increase in the preceding few years. According to the Federal Reserve Bank of Atlanta, the median 12-month wage growth of individuals reporting to the Current Population Survey increased about 3-1/4 percent in May, also similar to its readings from the past few years.²³

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

Those moderate rates of compensation gains likely reflect the offsetting influences of a strong 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 of 2.8 percent and also below the average gain in the 1974–95 period of 1.6 percent. The weakness in productivity growth may be partly attributable to the sharp pullback in capital investment during the most recent recession and the relatively slow recovery that followed. However, considerable debate remains about the reasons for the recent slowdown in productivity growth and whether it will persist.²⁴

Price inflation has picked up from the low readings in 2017

In 2017, inflation remained below the FOMC's longer-run objective of 2 percent. Partly because the softness in some price categories appeared idiosyncratic, Federal Reserve policymakers expected inflation to move higher in 2018.²⁵ This expectation appears to be on track so far. Consumer price inflation, as measured by the 12-month percentage change in the price index for personal consumption expenditures (PCE), moved up to 2.3 percent in May. Core PCE inflation, which excludes consumer food and energy prices that are often quite volatile and typically provides a better indication than the total measure of where overall inflation will be in the future, was 2 percent over the 12 months ending in May—0.5 percentage point higher than it had been one year earlier. The total measure exceeded core inflation because of a sizable increase in consumer energy prices. In contrast, food price inflation has continued to be low by historical standards—data through May show the PCE price index for food and beverages having increased less than 1/2 percent over the past year.

The higher readings in both total and core inflation relative to a year earlier reflect faster price increases for a wide range of goods and services this year and the dropping out of the 12-month calculation of the steep one-month decline in the price index for wireless telephone services in March last year. 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 than the core index to idiosyncratic price movements—slowed by less than core inflation over 2017 and has also increased a bit less this year. This index rose 1.8 percent over the 12 months ending in May, up a touch from the increase over the same period last year.²⁶

Oil prices have surged amid supply concerns...

As noted, the faster pace of total inflation this year relative to core inflation reflects a substantial rise in consumer energy prices. Retail gasoline prices this year were driven higher by a rise in oil prices. The spot price of Brent crude oil rose from about $65 per barrel in December to around $75 per barrel in early July. Although that increase took place against a backdrop of continued strength in global demand, supply concerns have become more prevalent in recent months. (For a discussion of the reasons behind the oil price increases along with a review of the effects of oil prices on U.S. economic growth, see the box "The Recent Rise in Oil Prices" on pages 16–17 of the July 2018 Monetary Policy Report.)

...while prices of imports other than energy have also increased

Nonfuel import prices rose sharply in early 2018, partly reflecting the pass-through of earlier increases in commodity prices. In particular, metals prices posted sizable gains late last year due to strong global demand but have retreated somewhat in recent weeks.

Survey-based measures of inflation expectations have been 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 so far this year. 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. In the University of Michigan Surveys of Consumers, the median value for inflation expectations over the next 5 to 10 years has been about 2-1/2 percent since the end of 2016, though this level is about 1/4 percentage point lower than had prevailed through 2014. In contrast, in the Survey of Consumer Expectations conducted by the Federal Reserve Bank of New York, the median of respondents' expected inflation rate three years hence has been moving up recently and is currently at the top of the range it has occupied over the past couple of years.

...while market-based measures of inflation compensation have largely moved sideways this year

Inflation expectations can also be gauged by market-based measures of inflation compensation. However, 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-maturity Treasury Inflation-Protected Securities (TIPS) or from inflation swaps—have moved sideways for the most part this year after having returned to levels seen in early 2017.²⁷ The TIPS-based measure of 5-to-10-year-forward inflation compensation and the analogous measure of inflation swaps are now about 2 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-2014.²⁸

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

After having expanded at an annual rate of 3 percent in the second half of 2017, real gross domestic product (GDP) is now reported to have increased 2 percent in the first quarter of this year. The step-down in growth during the first quarter was largely attributable to a sharp slowing in the growth of consumer spending that appears transitory, and gains in GDP appear to have rebounded in the second quarter. Meanwhile, business investment has remained strong, and net exports had little effect on output growth in the first quarter. On balance, over the first half of this year, overall economic activity appears to have expanded at a solid pace.

The economic expansion continues to be supported by favorable consumer and business sentiment, past increases in household wealth, solid economic growth abroad, and accommodative domestic financial conditions, including moderate borrowing costs and easy access to credit for many households and businesses.

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

Following exceptionally strong growth in the fourth quarter of 2017, consumer spending in the first quarter of this year was tepid, rising at an annual rate of 0.9 percent. The slowdown in growth was evident in outlays for motor vehicles and in retail sales more generally; moreover, unseasonably warm weather depressed spending on energy services. However, consumer spending picked up in more recent months as retail sales firmed, and PCE in April and May rose at an annual rate of 2-1/4 percent relative to the average over the first quarter.

Real disposable personal income (DPI), a measure of after-tax income adjusted for inflation, has increased at a solid annual rate of about 3 percent so far this year. Real DPI has been supported by the reduction in income taxes owing to the implementation of the Tax Cuts and Jobs Act (TCJA) as well as the continued strength in the labor market. With consumer spending rising just a little less than the gains in disposable income so far this year, the personal saving rate has edged up after having fallen for the past two years.

Ongoing gains in household net worth likely have also supported consumer spending. House prices, which are of particular importance for the balance sheet positions of a large set of households, have been increasing at an average annual pace of about 6 percent in recent years.²⁹ Although U.S. equity prices have posted modest gains, on net, so far this year, this flattening followed several years of sizable gains. Buoyed by the cumulative increases in home and equity prices, aggregate household net worth was 6.8 times household income in the first quarter, down just slightly from its ratio in the fourth quarter—the highest-ever reading for that ratio, which dates back to 1947.

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

Financing conditions for consumers are generally favorable and remain supportive of growth in household spending. However, banks have continued to tighten standards for credit cards and auto loans for borrowers with low credit scores, possibly in response to some upward moves in the delinquency rates of those borrowers. Mortgage credit has remained readily available for households with solid credit profiles. For borrowers with low credit scores, mortgage financing conditions have eased somewhat further but remain tight overall. In this environment, consumer credit continued to increase in the first few months of 2018, though the rate of increase moderated some from its robust pace in the previous year.

...while consumer confidence remains strong

Consumers have remained upbeat. So far this year, the Michigan survey index of consumer sentiment has been near its highest level since 2000, likely reflecting rising income, job gains, and low inflation. Indeed, households' expectations for real income changes over the next year or two now stand above levels preceding the previous recession.

Business investment has continued to rebound...

Investment spending by businesses has continued to increase so far this year, with notable gains for spending, both on equipment and intangibles and on nonresidential structures. Within structures, the rise in oil prices propelled another steep ramp-up in investment in drilling and mining structures—albeit not yet back to the levels recorded from 2012 to 2014—while investment in nonresidential structures outside of the energy sector picked up after declining in 2017. Forward-looking indicators of business investment spending remain favorable on balance. Business sentiment and the profit expectations of industry analysts have been positive overall, while new orders of capital goods have advanced on net this year.

...while corporate financing conditions have remained accommodative

Aggregate flows of credit to large nonfinancial firms remained strong in the first quarter, supported in part by relatively low interest rates and accommodative financing conditions. The gross issuance of corporate bonds stayed robust during the first half of 2018, while yields on both investment- and speculative-grade corporate bonds moved up notably but remained low by historical standards. Despite strong growth in business investment, outstanding commercial and industrial (C&I) loans on banks' books rose only modestly in the first quarter, although their pace of expansion in more recent months has strengthened on average. In April, respondents to the Senior Loan Officer Opinion Survey on Bank Lending Practices, or SLOOS, reported that demand for C&I loans weakened in the first quarter even as lending standards and terms on such loans eased.³⁰ Respondents attributed this decline in demand in part to firms drawing on internally generated funds or using alternative sources of financing. Meanwhile, growth in commercial real estate loans has moderated some but remains strong. In addition, financing conditions for small businesses appear to have remained generally accommodative, with lending standards little changed at most banks and with most firms reporting that they are able to obtain credit. Although small business credit growth has been subdued, survey data suggest this sluggishness is largely due to continued weak demand for credit by small businesses.

But activity in the housing sector has leveled off

Residential investment, which rose a modest 2-1/2 percent in 2017, appears to have largely moved sideways over the first five months of the year. The slowing in residential investment likely is partly a result of higher mortgage interest rates. Although these rates are still low by historical standards, they have moved up and are near their highest levels in seven years. In addition, higher lumber prices and tight supplies of skilled labor and developed lots reportedly have been restraining home construction. While starts of both single-family and multifamily housing units rose in the fourth quarter, single-family starts have been little changed, on net, since then, whereas multifamily starts continued to climb earlier this year before flattening out. Meanwhile, over the first five months of this year, new home sales have held at around the rate of late last year, but sales of existing homes have eased somewhat. Despite the continued increases in house prices, the pace of construction has not kept up with demand. As a result, the months' supply of inventories of homes for sale has remained at a relatively low level, and the aggregate vacancy rate stands at the lowest level since 2003.

Net exports had a neutral effect on GDP growth in the first quarter

After being a small drag on U.S. real GDP growth last year, net exports had a neutral effect on growth in the first quarter. Real U.S. exports increased about 3-1/2 percent at an annual rate, as exports of automobiles and consumer goods remained robust. Real import growth slowed sharply following a surge late last year. Nominal trade data through May suggest that export growth picked up in the second quarter, led by agricultural exports, while import growth was tepid. All told, the available data suggest that the nominal trade deficit likely narrowed relative to GDP in the second quarter.

Fiscal policy became more expansionary this year...

Federal fiscal policy will likely provide a moderate boost to GDP growth this year. The individual and corporate tax cuts in the TCJA should lead to increased private consumption and investment, while the Bipartisan Budget Act of 2018 (BBA) enables increased federal spending on goods and services. As the effects of the BBA had yet to show through, federal government purchases posted only a modest gain in the first quarter.

After narrowing significantly for several years, the federal unified deficit widened from about 2-1/2 percent of GDP in fiscal year 2015 to 3-1/2 percent in fiscal 2017, and it is on pace to move up further in fiscal 2018. Although expenditures as a share of GDP in 2017 were relatively stable at 21 percent, receipts moved lower to roughly 17 percent of GDP and have remained at about the same level so far this year. The ratio of federal debt held by the public to nominal GDP was 76-1/2 percent at the end of fiscal 2017 and is 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 remains stable, although there is a range of experiences across these governments and some states are still struggling. After several years of slow growth, revenue gains of state governments have strengthened notably as sales and income tax collections have picked up over the past few quarters. In addition, house price gains have continued to push up property tax revenues at the local level. But expenditures by state and local governments have been restrained. Employment growth in this sector has been moderate, while real outlays for construction by these governments have largely been moving sideways at a relatively low level.

Financial Developments

The expected path of the federal funds rate has moved up

Market-based measures of the path of the federal funds rate continue to suggest that market participants expect further gradual increases in the federal funds rate. Relative to the end of last year, the expected policy rate path has moved up, boosted in part by investors' perception of a strengthening in the domestic economic outlook. In particular, the policy path moved higher in response to incoming economic data so far this year, especially the employment reports, which were seen as supporting expectations for a solid pace of growth in domestic economic activity. In addition, investors reportedly interpreted FOMC communications in the first half of 2018 as signaling an upbeat economic outlook and as reinforcing expectations for further gradual removal of monetary policy accommodation.

Survey-based measures of the expected path of the policy rate over the next few years have also increased modestly since the end of last year. According to the results of the most recent Survey of Primary Dealers and Survey of Market Participants, both conducted by the Federal Reserve Bank of New York just before the June FOMC meeting, the median of respondents' projections for the path of the federal funds rate shifted up about 25 basis points for 2018 and beyond, compared with the median of assessments last December.³¹ Market-based measures of uncertainty about the policy rate approximately one to two years ahead increased slightly, on balance, from their levels at the end of last year.

The nominal Treasury yield curve has shifted up

The nominal Treasury yield curve has shifted up and flattened somewhat further during the first half of 2018 after flattening considerably in the second half of 2017. In particular, the yields on 2- and 10-year nominal Treasury securities increased about 70 basis points and 45 basis points, respectively, from their levels at the end of 2017. The increase in Treasury yields seems to largely reflect investors' greater optimism about the domestic growth outlook and firming expectations for further gradual removal of monetary policy accommodation. Expectations for increases in the supply of Treasury securities following the federal budget agreement in early February also appear to have contributed to the increase in Treasury yields, while increased concerns about trade policy both domestically and abroad, political developments in Europe, and the foreign economic outlook weighed on longer-dated Treasury yields. Yields on 30-year agency mortgage-backed securities (MBS)—an important determinant of mortgage interest rates—increased about 60 basis points over the first half of the year, a bit more than the rise in the 10-year nominal Treasury yield, but remain low by historical standards. Yields on corporate debt securities—both investment grade and high yield—rose more than Treasury yields, leaving the spreads on corporate bond yields over comparable-maturity Treasury yields notably wider than at the beginning of the year.

Broad equity indexes rose modestly amid some bouts of market volatility

After surging as much as 20 percent in 2017, broad stock market indexes rose modestly, on balance, so far this year amid some bouts of heightened volatility in financial markets. The boost to equity prices from first-quarter earnings reports that generally beat analysts' expectations was reportedly offset by increased uncertainty about trade policy, rising interest rates, and concerns about political developments abroad. While stock prices for companies in the technology and consumer discretionary sectors rose notably, those of companies in the industrial and financial sectors declined modestly. After spiking considerably in early February, the implied volatility for the S&P 500 index—the VIX—declined and ended the period slightly above the low levels that prevailed in 2017. (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability" on pages 26–28 of the July 2018 Monetary Policy Report.)

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

On balance, indicators of Treasury market functioning remained broadly stable over the first half of 2018. A variety of liquidity metrics—including bid-ask spreads, bid sizes, and estimates of transaction costs—have displayed minimal signs of liquidity pressures overall, with the exception of a brief period of reduced liquidity in early February amid elevated financial market volatility. Liquidity conditions in the agency MBS market were also generally stable. Overall, the functioning of Treasury and agency MBS markets has not been materially affected by the implementation of the Federal Reserve's balance sheet normalization program, including the accompanying reduction in reinvestment of principal payments from the Federal Reserve's securities holdings. Credit conditions in municipal bond markets have remained stable since the turn of the year. Over that period, yield spreads on 20-year general obligation municipal bonds over comparable-maturity Treasury securities edged up a bit.

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

Conditions in domestic short-term funding markets have also remained generally stable so far in 2018. Yields on a broad set of money market instruments moved higher in response to the FOMC's policy actions in March and June. Some money market rates rose during the first quarter more than what would normally occur with monetary tightening. For example, the spreads of certificates of deposit and term London interbank offered rates relative to overnight index swap (OIS) rates increased notably, reportedly reflecting increased issuance of Treasury bills and perhaps also the anticipated tax-induced repatriation of foreign earnings by U.S. corporations. The upward pressure on short-term funding rates, beyond that driven by expected monetary policy, eased in recent months, leading to a narrowing of spreads of some money market rates to OIS rates. However, the spreads remain wider than at the beginning of the year.

Bank credit continued to expand and bank profitability improved

Aggregate credit provided by commercial banks continued to increase through the first quarter of 2018 at a pace similar to the one seen in 2017. Its pace was slower than that of nominal GDP, thus leaving the ratio of total commercial bank credit to current-dollar GDP slightly lower than in the previous year. Available data for the second quarter suggest that growth in banks' core loans continued to be moderate. Measures of bank profitability improved in the first quarter of 2018 after having experienced a temporary decline in the last quarter of 2017. Weaker fourth-quarter measures of bank profitability were partly driven by higher write-downs of deferred tax assets in response to the U.S. tax legislation.

International Developments

Political developments and signs of moderating growth weighed on advanced foreign economy asset prices

Since February, political developments in Europe and moderation in economic growth outside of the United States weighed on some risky asset prices in advanced foreign economies (AFEs). Interest rates on sovereign bonds in several countries in the European periphery rose notably relative to core countries, and European bank shares came under pressure, as investors focused on the formation of the Italian government. Nonetheless, peripheral bond spreads remained well below their levels at the height of the euro-area crisis, and the moves partly retraced as a government was put in place. Broad stock price indexes were little changed on net. In contrast to the United States, long-term sovereign yields and market-implied paths of policy rates in the core euro area as well as the United Kingdom declined somewhat, and rates were little changed in Japan.

Heightened investor focus on vulnerabilities in emerging market economies led asset prices to come under pressure

Investor concerns about financial vulnerabilities in several emerging market economies (EMEs) intensified this spring against the backdrop of rising U.S. interest rates. Broad measures of EME sovereign bond spreads over U.S. Treasury yields widened notably, and benchmark EME equity indexes declined, as investors scrutinized macroeconomic policy approaches in several countries. Turkey and Argentina, which faced persistently high inflation, expansionary fiscal policies, and large current account deficits, were among the worst performers. Trade policy developments between the United States and its trading partners also weighed on EME asset prices, especially on stock prices in China and some emerging Asian countries. EME mutual funds saw net outflows in May and June after generally solid inflows earlier in the year. While movements in asset prices and capital flows were notable for a number of economies, broad indicators of financial stress in EMEs remained low relative to levels seen during other periods of stress in recent years.

The dollar appreciated

After depreciating during 2017, the broad exchange value of the U.S. dollar has appreciated moderately in recent months. Factors contributing to the appreciation of the dollar likely include moderating growth in some foreign economies combined with continued output strength and ongoing policy tightening in the United States, downside risks stemming from political developments in Europe and several EMEs, and the recent developments in trade policy. Several currencies appeared particularly sensitive to trade policy developments, including the Canadian dollar and the Mexican peso, related to the North American Free Trade Agreement negotiations, as well as the Chinese renminbi, which fell notably against the dollar in June.

The pace of economic activity moderated in the AFEs

In the first quarter, real GDP growth decelerated in all major AFEs and turned negative in Japan, down from robust rates of activity in 2017. Part of this slowing is a result of temporary factors, though, including unusually cold weather in Japan and the United Kingdom, labor strikes in the euro area, and disruptions in oil production in Canada. In most AFEs, economic indicators for the second quarter, including purchasing manager surveys and exports, are generally consistent with solid economic growth.

Despite tight labor markets, inflation pressures remain subdued in most AFEs...

Sustained increases in oil prices provided upward pressure on consumer price inflation across all AFEs in the first half of the year. However, core inflation has generally remained muted in most AFEs, despite further improvement in labor market conditions. In Canada, in contrast, core inflation picked up amid solid wage growth, pushing the total inflation rate above the central bank target.

...prompting central banks to maintain highly accommodative monetary policies

With underlying inflation still subdued, the Bank of Japan and the European Central Bank (ECB) kept their policy rates at historically low levels, although the ECB indicated it would again reduce the pace of its asset purchases starting in October. The Bank of England and the Bank of Canada, which both began raising interest rates last year, signaled that further rate increases will be gradual, given a moderation in the pace of economic activity.

In emerging Asia, growth remained solid...

Economic growth in China remained solid in the first quarter of 2018, as a rebound in steel production and strong external demand bolstered a recovery in industrial activity and overall growth. Indicators of investment and retail sales have slowed in recent months, however, suggesting that the authorities' effort to rein in credit may have softened domestic demand. Most other emerging Asian economies registered strong growth in the first quarter of 2018, partly reflecting solid external demand.

... while growth in some Latin American economies was mixed

In Mexico, real GDP surged in the first quarter as economic activity rebounded from two major earthquakes and a hurricane last year. Following a brief recovery in the first half of 2017, Brazil's economy stalled in the fourth quarter and grew tepidly in the first quarter, and a truckers' strike paralyzed economic activity in late May.

Part 2: Monetary Policy

The Federal Open Market Committee continued to gradually increase the federal funds target range in the first half of the year...

Since December 2015, the Federal Open Market Committee (FOMC) has been gradually increasing its target range for the federal funds rate as the economy has continued to make progress toward the Committee's congressionally mandated objectives of maximum employment and price stability. In the first half of this year, the Committee continued this gradual process of scaling back monetary policy accommodation, increasing its target range for the federal funds rate 1/4 percentage point at its meetings in both March and June. With these increases, the federal funds rate is currently in the range of 1-3/4 to 2 percent.³² The Committee's decisions reflected the continued strengthening of the labor market and the accumulating evidence that, after many years of running below the Committee's 2 percent longer-run objective, inflation had moved close to 2 percent.

...but monetary policy continues to support economic growth

Even after the gradual increases in the federal funds rate over the first half of the year, 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. In particular, the federal funds rate remains somewhat below most FOMC participants' estimates of its longer-run value.

The Committee expects that a gradual approach to increasing the target range for the federal funds rate will be consistent with a sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective over the medium term. Consistent with this outlook, in the most recent Summary of Economic Projections (SEP), which was compiled at the time of the June FOMC meeting, the median of participants' assessments for the appropriate level of the target range for the federal funds rate at year-end rises gradually over the period from 2018 to 2020 and stands somewhat above the median projection for its longer-run level by the end of 2019 and through 2020.³³

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 maximum-employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

In 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, among other considerations, careful judgments about the choice and measurement of the inputs to these rules such as estimates of the neutral interest rate, which are highly uncertain (see the box "Complexities of Monetary Policy Rules" on pages 37–41 of the July 2018 Monetary Policy Report).

The FOMC has continued to implement its program to gradually reduce the Federal Reserve's balance sheet

The Committee has continued to implement the balance sheet normalization program described in the June 2017 Addendum to the Policy Normalization Principles and Plans.³⁴ 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. Since the initiation of the balance sheet normalization program in October of last year, such payments have been reinvested to the extent that they exceeded gradually rising caps.

In the first 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 $12 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 $8 billion. Over the second quarter, payments of principal from maturing Treasury securities and from the Federal Reserve's holdings of agency debt and agency MBS were reinvested to the extent that they exceeded $18 billion and $12 billion, respectively. At its meeting in June, the FOMC increased the cap for Treasury securities to $24 billion and the cap for agency debt and agency MBS to $16 billion, both effective in July. The Committee has indicated that the caps for Treasury securities and for agency securities will increase to $30 billion and $20 billion per month, respectively, in October. These terminal 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 implementation of the program has proceeded smoothly without causing disruptive price movements in Treasury and MBS markets. As the caps have increased gradually and predictably, the Federal Reserve's total assets have started to decrease, from about $4.4 trillion last October to about $4.3 trillion at present, with holdings of Treasury securities at approximately $2.4 trillion and holdings of agency and agency MBS at approximately $1.7 trillion.

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

To implement the FOMC's decisions to raise the target range for the federal funds rate in March and June of 2018, the Federal Reserve increased the rate of interest on excess reserves (IOER) along with the interest rate offered on overnight reverse repurchase agreements (ON RRPs). Specifically, the Federal Reserve increased the IOER rate to 1-3/4 percent and the ON RRP offering rate to 1-1/2 percent in March. In June, the Federal Reserve increased the IOER rate to 1.95 percent—5 basis points below the top of the target range—and the ON RRP offering rate to 1-3/4 percent. In addition, the Board of Governors approved a 1/4 percentage point increase in the discount rate (the primary credit rate) in both March and June. Yields on a broad set of money market instruments moved higher, roughly in line with the federal funds rate, in response to the FOMC's policy decisions in March and June. Usage of the ON RRP facility has declined, on net, since the turn of the year, reflecting relatively attractive yields on alternative investments.

The effective federal funds rate moved up toward the IOER rate in the months before the June FOMC meeting and, therefore, was trading near the top of the target range. At its June meeting, the Committee made a small technical adjustment in its approach to implementing monetary policy by setting the IOER rate modestly below the top of the target range for the federal funds rate. This adjustment resulted in the effective federal funds rate running closer to the middle of the target range since mid-June. In an environment of large reserve balances, the IOER rate has been an essential policy tool for keeping the federal funds rate within the target range set by the FOMC (see the box "Interest on Reserves and Its Importance for Monetary Policy" on pages 44–46 of the July 2018 Monetary Policy Report).

Footnotes