Board of Governors of the Federal Reserve System

Monetary Policy and Economic Developments

The Federal Reserve conducts the nation's monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. This section reviews U.S. monetary policy and economic developments in 2022, with excerpts and select figures from the Monetary Policy Report published in March 2023 and June 2022.¹ The report, submitted semiannually to the Congress, is delivered concurrently with testimony from the Federal Reserve Board Chair.²

March 2023 Summary

Although inflation has slowed since the middle of last year as supply bottlenecks eased and energy prices declined, it remains well above the Federal Open Market Committee's (FOMC) objective of 2 percent. The labor market remains extremely tight, with robust job gains, the unemployment rate at historically low levels, and nominal wage growth slowing but still elevated. Real gross domestic product (GDP) growth picked up in the second half of 2022, although the underlying momentum in the economy likely remains subdued. Bringing inflation back to 2 percent will likely require a period of below-trend growth and some softening of labor market conditions.

In response to high inflation, the FOMC continued to rapidly increase interest rates and reduce its securities holdings. The Committee has raised the target range for the federal funds rate a further 3 percentage points since June, bringing the range to 4-1/2 to 4-3/4 percent, and indicated that it anticipates that ongoing increases in the target range will be appropriate. The Federal Reserve has also reduced its holdings of Treasury securities and agency mortgage-backed securities by about $500 billion since June, further tightening financial conditions.

The Federal Reserve is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials. The Committee is strongly committed to returning inflation to its 2 percent objective.

Recent Economic and Financial Developments

Inflation. Consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures (PCE), was 5.4 percent in January, down from its peak of 7 percent last June but still well above the FOMC's 2 percent objective. Core PCE prices—which exclude volatile food and energy prices and are generally considered a better guide to the direction of future inflation—also slowed but still increased 4.7 percent over the 12 months ending in January (figure 2.1). As supply chain bottlenecks have eased, increases in core goods prices slowed considerably in the second half of last year. Within core services prices, housing services inflation has been high, but slowing increases in rents for new tenants in the second half of last year point to lower inflation for housing services in the year ahead. For other services, however, price inflation remains elevated, and prospects for slowing inflation may depend in part on an easing of tight labor market conditions. Measures of longer-term inflation expectations remain within the range of values seen in the decade before the pandemic and continue to be broadly consistent with the FOMC's longer-run objective of 2 percent, suggesting that high inflation is not becoming entrenched.

The labor market. The labor market has remained extremely tight, with job gains averaging 380,000 per month since the middle of last year and the unemployment rate remaining at historical lows (figure 2.2). Labor demand in many parts of the economy exceeds the supply of available workers, with the labor force participation rate essentially unchanged from one year ago (figure 2.3). Nominal wage gains slowed over the second half of 2022, but they remain above the pace consistent with 2 percent inflation over the longer term, given prevailing trends in productivity growth.

Economic activity. Real GDP is reported to have fallen in the first half of 2022 but to have then risen at roughly a 3 percent pace in the second half. Some of the swings in growth reflect fluctuations in volatile expenditure categories such as net exports and inventory investment. Private domestic final demand, which excludes these volatile components, rose at a subdued rate in both the first and second halves last year. Consumer spending has continued to rise at a solid pace, supported by the savings accumulated during the pandemic. However, manufacturing output declined in recent months, and the housing sector has continued to contract in response to elevated mortgage rates.

Financial conditions. Financial conditions have tightened further since June and are significantly tighter than a year ago. The FOMC has raised the target range for the federal funds rate a further 3 percentage points since June, and the market-implied expected path of the federal funds rate over the next year also shifted up notably. Yields on nominal Treasury securities across maturities have risen considerably further since June, while investment-grade corporate bond yields and mortgage rates have also increased but by less than Treasury rates. Equity prices were volatile but increased moderately on net. The rise in interest rates over the past year has weighed on financing activity. Issuance of leveraged loans and speculative-grade corporate bonds slowed substantially in the second half of the year, while investment-grade bond issuance declined modestly. Business loans at banks continued to grow in the second half of 2022 but decelerated in the fourth quarter. While business credit quality remains strong, some indicators of future business defaults are somewhat elevated. For households, mortgage originations continued to decline materially, although consumer loans (such as auto loans and credit cards) grew further. Delinquency rates for credit cards and auto loans rose last year.

Financial stability. Against the backdrop of a weaker economic outlook, higher interest rates, and elevated uncertainty since June, financial vulnerabilities remain moderate overall. Valuations in equity markets remained notable and ticked up, on net, as equity prices increased moderately even as earnings expectations declined late in the year. Real estate prices remain high relative to fundamentals, such as rents, despite a marked slowing in price increases. While market functioning remained orderly, market liquidity—the ability to trade assets without a large effect on market prices—remained low in several key asset markets, including in the Treasury market, when compared with levels before the COVID-19 pandemic. Nonfinancial business and household debt grew in line with GDP, leaving vulnerabilities associated with borrowing by businesses and households unchanged at moderate levels. Risk-based capital ratios at banks declined a touch last year but remain well above regulatory requirements. Funding risks at domestic banks and broker-dealers remain low, and the large banks at the core of the financial system continue to have ample liquidity. Prime and tax-exempt money market funds, as well as many bond and bank-loan mutual funds, continue to be susceptible to runs. (See the box "Developments Related to Financial Stability" on pages 28–29 of the March 2023 Monetary Policy Report.)

International developments. Foreign economic growth moderated in the second half of last year, weighed down by the economic fallout of Russia's war against Ukraine and a slowdown in China related to COVID-19. Despite some signs of easing in headline inflation abroad, core foreign inflation remains high and inflationary pressures are broad, in part reflecting tight labor markets and the pass-through of past energy price increases to other prices. In response to persistently high inflation, many major foreign central banks, along with the Fed, have tightened the stance of monetary policy significantly since June. More recently, many foreign central banks slowed the pace of their policy rate increases, signaled that such a slowing is coming, or paused policy rate hikes to take stock of the effects of policy tightening thus far on their economies.

Financial conditions abroad have tightened modestly, on net, since the middle of last year. Global sovereign bond yields rose from continued tightening of foreign monetary policy and spillovers from increases in U.S. yields. Equity prices abroad rose toward the end of the year amid surprising resilience of European economies and the removal of China's zero-COVID policy. Meanwhile, the trade-weighted exchange value of the U.S. dollar is a touch higher since mid-2022.

Monetary Policy

In response to high inflation, the Committee last year rapidly increased the target range for the federal funds rate and began reducing its securities holdings. Adjustments to both interest rates and the balance sheet are playing a role in firming the stance of monetary policy in support of the Committee's maximum-employment and price-stability goals.

Interest rate policy. The FOMC continued to swiftly increase the target range for the federal funds rate, bringing it to the current range of 4-1/2 to 4-3/4 percent (figure 2.4). In light of the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation, the Committee slowed the pace of policy tightening at the December and January meetings but indicated that it anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

Balance sheet policy. The Federal Reserve has continued the process of significantly reducing its holdings of Treasury and agency securities in a predictable manner.³ Beginning in June of last year, principal payments from securities held in the System Open Market Account have been reinvested only to the extent that they exceeded monthly caps.

Special Topics

Employment and earnings across groups. At the onset of the pandemic, employment fell by more for disadvantaged groups than the overall population, but tight labor market conditions over the past two years have largely reversed those movements. As the labor market tightened, employment grew faster for African Americans and Hispanics, and for less educated workers, than for other workers. Wages have grown more rapidly for these workers also, as extremely strong labor demand has outstripped available labor supply. However, while disparities in employment have largely returned to pre-pandemic levels, there remain significant disparities in absolute levels of employment across groups. (See the box "Developments in Employment and Earnings across Demographic Groups" on pages 10–11 of the March 2023 Monetary Policy Report.)

Weak labor supply. Even with labor demand remarkably strong, the labor force has been slow to recover from the pandemic, leaving a significant labor supply shortfall relative to the levels expected before the pandemic. More than half of that labor force shortfall reflects a lower labor force participation rate because of a wave of retirements beyond what would have been expected given demographic trends. The remaining shortfall is attributable to slower population growth, which in turn reflects both the higher mortality primarily due to COVID and lower rates of immigration in the first two years of the pandemic. (See the box "Why Has the Labor Force Recovery Been So Slow?" on pages 13–16 of the March 2023 Monetary Policy Report.)

Monetary policy rules. Simple monetary policy rules, which prescribe a setting for the policy interest rate based on a small number of other economic variables, can provide useful guidance to policymakers. Since 2021, inflation has run well above the Committee's 2 percent longer-run objective, and labor market conditions have been very tight over the past year. As a result, simple monetary policy rules have prescribed levels for the federal funds rate that are well above those observed over the past decade. (See the box "Monetary Policy Rules in the Current Environment" on pages 42–44 of the March 2023 Monetary Policy Report.)

Federal Reserve's balance sheet and money markets. The size of the Federal Reserve's balance sheet decreased as the Federal Reserve reduced its securities holdings. Reserve balances—the largest liability on the Federal Reserve's balance sheet—continued to fall. Take-up in the overnight reverse repurchase agreement (ON RRP) facility remained elevated, as low rates on repurchase agreements persisted amid still abundant liquidity and limited Treasury bill supply. The ON RRP facility continued to serve its intended purpose of helping to provide a floor under short-term interest rates and supporting effective implementation of monetary policy. Because of the significant increases in administered rates to address high inflation, the Federal Reserve's interest expenses rose considerably, and, as a result, net income turned negative. (See the box "Developments in the Federal Reserve's Balance Sheet and Money Markets" on pages 40–41 of the March 2023 Monetary Policy Report.)

June 2022 Summary

In the first part of the year, inflation remained well above the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent, with some inflation measures rising to their highest levels in more than 40 years. These price pressures reflect supply and demand imbalances, higher energy and food prices, and broader price pressures, including those resulting from an extremely tight labor market. In the labor market, demand has remained strong, and supply has increased only modestly. As a result, the unemployment rate fell noticeably below the median of FOMC participants' estimates of its longer-run normal level, and nominal wages continued to rise rapidly. Although overall economic activity edged down in the first quarter, household spending and business fixed investment remained strong. The most recent indicators suggest that private fixed investment may be moderating, but consumer spending remains strong.

In response to sustained inflationary pressures and a strong labor market, the FOMC has been adjusting its policies and communications since last fall. At its March meeting, the FOMC raised the target range for the federal funds rate off the effective lower bound to 1/4 to 1/2 percent. The Committee continued to raise the target range in May and June, bringing it to 1-1/2 to 1-3/4 percent following the June meeting, and indicated that ongoing increases are likely to be appropriate. The Committee ceased net asset purchases in early March and began reducing its securities holdings in June.

The Committee is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials. The Committee's commitment to restoring price stability—which is necessary for sustaining a strong labor market—is unconditional.

Recent Economic and Financial Developments

Inflation. Consumer price inflation, as measured by the 12-month change in the price index for personal consumption expenditures, rose from 5.8 percent in December 2021 to 6.3 percent in April, its highest level since the early 1980s and well above the FOMC's objective of 2 percent. This increase was driven by an acceleration of retail food and energy prices, reflecting further increases in commodity prices due to Russia's invasion of Ukraine. The 12-month measure of inflation that excludes the volatile food and energy categories (so-called core inflation) rose initially and then fell back to 4.9 percent in April, unchanged from last December. Three-month measures of core inflation have softened since December but remain far above levels consistent with price stability. Measures of near-term inflation expectations continued to rise markedly, while longer-term expectations moved up by less.

The labor market. Demand for labor continued to outstrip available supply across many parts of the economy, and nominal wages continued to increase at a robust pace. While labor demand remained very strong, labor supply increased only modestly. As a result, the labor market tightened further between December and May, with job gains averaging 488,000 per month and the unemployment rate falling from 3.9 percent to 3.6 percent—just above the bottom of its range over the past 50 years.

Economic activity. Real gross domestic product (GDP) is reported to have surged at a 6.9 percent annual rate in the fourth quarter of 2021 and then to have declined at a 1.5 percent annual rate in the first quarter. The large swings in growth rates reflected fluctuations in the volatile expenditure categories of net exports and inventory investment. Abstracting from these volatile components, growth in private domestic final demand (consumer spending plus residential and business fixed investment—a measure that tends to be more stable and better reflects the strength of overall economic activity) was strong in the first quarter, supported by some unwinding of supply bottlenecks and a further reopening of the economy. The most recent indicators suggest that private fixed investment may be moderating, but consumer spending remains strong. As a result, real GDP appears on track to rise moderately in the second quarter.

Financial conditions. Financial conditions have tightened significantly this year. The expected path of the federal funds rate over the next few years shifted up substantially, and yields on nominal Treasury securities across maturities have risen considerably since late February amid sustained inflationary pressures and associated expectations for further monetary policy tightening. Equity prices were volatile and declined sharply, on net, while corporate bond yields increased substantially and spreads increased notably, partly reflecting some concerns about the future corporate credit outlook. Mortgage rates also rose sharply. In turn, tighter financial conditions may have begun to weigh on some financing activity. On the business side, nonfinancial corporate bond issuance was solid in the first quarter but slowed somewhat in April and May, with speculative-grade bond issuance being particularly weak. That said, the growth of bank loans to businesses picked up, and business credit quality has remained strong thus far. For households, mortgage originations declined materially. Nevertheless, mortgage credit remained broadly available for a wide range of potential borrowers. For other consumer loans (such as auto loans and credit cards), credit standards eased somewhat further or changed little, and credit outstanding grew briskly.

Financial stability. Despite experiencing a series of adverse shocks—higher-than-expected inflation, the ongoing supply disruptions related to COVID-19, and Russia's invasion of Ukraine—the financial system has been resilient, though portions of the commodities markets temporarily experienced elevated levels of stress. The drop in equity prices and rising bond spreads suggest that valuation pressures in corporate securities markets have eased some from their previously elevated levels, but real estate prices have risen further this year. While business and household debt has been growing solidly, the ratio of credit to GDP has decreased to near pre-pandemic levels and most indicators of credit quality remained robust, suggesting that vulnerabilities from nonfinancial leverage are moderate. Large bank capital ratios dipped in the first quarter, but overall leverage in the financial sector appears moderate and little changed this year. Recent strains experienced in markets for stablecoins—digital assets that aim to maintain a stable value relative to a national currency or other reference assets—and other digital assets have highlighted the structural fragilities in that rapidly growing sector. A few signs of funding pressures emerged amid the geopolitical tensions, particularly in commodities markets. However, broad funding markets proved resilient, and with direct exposures of U.S. financial institutions to Russia and Ukraine being small, financial spillovers have been limited to date.

International developments. Economic activity has continued to recover in many foreign economies, albeit with new significant headwinds from Russia's invasion of Ukraine and COVID lockdowns in China. These headwinds have, on net, pushed commodity prices higher, worsened supply disruptions, and lowered household and business confidence, thus damping the rebound in foreign economic activity. As in the United States, consumer price inflation abroad is high and has continued to rise in many economies, boosted by higher energy, food, and other commodity prices as well by supply chain constraints. In response, many foreign central banks have raised policy rates, and some have started to reduce the size of their balance sheets.

Foreign financial conditions have tightened notably since the beginning of the year, in part reflecting the tightening in foreign monetary policy and concerns about persistently high inflation. Sovereign bond yields in many advanced foreign economies rose. Foreign risky asset prices declined, also driven by downside risks to the growth outlook amid the lockdowns in China and Russia's invasion of Ukraine. The trade-weighted value of the dollar appreciated notably.

Monetary Policy

In response to significant ongoing inflation pressures and the tightening labor market, the Committee has been adjusting its policies and communications since last fall. The Committee wound down net purchases of securities and began reducing those securities holdings more rapidly than expected and also initiated a swift increase in interest rates. Adjustments to both interest rates and the balance sheet are playing a role in firming the stance of monetary policy in support of the Committee's maximum-employment and price-stability goals.

Interest rate policy. In March, after holding the federal funds rate near zero since the onset of the pandemic, the FOMC raised the target range for that rate to 1/4 to 1/2 percent. The Committee raised the target range again in May and June, bringing it to the current range of 1-1/2 to 1-3/4 percent, and conveyed its anticipation that ongoing increases in the target range will be appropriate.

Balance sheet policy. The Federal Reserve began reducing its monthly net asset purchases last November and accelerated the reductions in December, bringing net purchases to an end in early March. In January, the FOMC issued a set of principles regarding its planned approach for significantly reducing the size of the Federal Reserve's balance sheet. Consistent with those principles, the Committee announced in May its specific plans for significantly reducing its securities holdings and that these reductions would begin on June 1.⁴

The Committee acutely recognizes the significant hardship caused by elevated inflation, especially on those least able to meet the higher costs of essentials. The Committee is strongly committed to restoring price stability, which is necessary for sustaining a strong labor market.

Special Topics

Labor market disparities. The labor market recovery over the past year and a half has been robust and widespread as the labor market effects of the pandemic have eased, with particularly strong improvement among groups that had suffered the most. As a result, employment and earnings of nearly all major demographic groups are near or above their levels before the pandemic, and employment rates are again near multidecade highs. However, there remain notable differences in employment and earnings across groups that predate the pandemic.

Developments in global supply chains. Supply chain bottlenecks remain a major impediment for domestic and foreign firms. While U.S. manufacturers have been recording solid output growth for more than a year, order backlogs and delivery times remain high, and producer prices have risen rapidly. Further risks to global supply chains abound. In China, COVID-19 lockdowns drove the largest monthly declines in industrial production there since early 2020 while also disrupting internal and international freight transportation. In addition, the war in Ukraine continues to put upward pressure on energy and food prices and has raised the risk of disruption in the supply of inputs to some manufacturing industries.

Monetary policy rules. Simple monetary policy rules, which relate a policy interest rate to a small number of other economic variables, can provide useful guidance to policymakers. Many simple policy rules prescribed strongly negative values for the federal funds rate during the pandemic-driven recession. With inflation running well in excess of the Committee's 2 percent longer-run objective, a strong U.S. economy, and tight labor market conditions, the simple monetary policy rules considered here call for raising the target range for the federal funds rate significantly.

Global inflation. Inflation abroad rose rapidly over the past year, reflecting soaring food and commodity prices, pandemic-related supply disruptions, and demand imbalances between goods and services. The price pressures have been amplified by the war in Ukraine and COVID-19 lockdowns in China. Although the recent inflation surge was concentrated in volatile components, such as food and energy, price increases have broadened to core goods and services.

Global monetary policy. With inflation rising sharply across the globe, many central banks have tightened monetary policy. Policy tightening started last year as some emerging market central banks, particularly those in Latin America, were concerned that sharp increases in inflation could become entrenched in inflation expectations. Since fall 2021, many central banks in the advanced foreign economies have also started tightening monetary policy or are expected to do so soon, and several central banks that had expanded their balance sheets over the past two years are now allowing them to shrink.

Developments in the Federal Reserve's balance sheet. Following the conclusion of net asset purchases, the balance sheet remained stable at around $9 trillion. Alongside the removal of policy accommodation—through actual and expected increases in the policy rate—plans for shrinking the size of the balance sheet were announced in May and were initiated in June. Despite the size of the balance sheet remaining steady, reserve balances fell, in large part because of increasingly elevated take-up at the overnight reverse repurchase agreement (ON RRP) facility, which reached a record high of $2.2 trillion. In an environment of ample liquidity, limited Treasury bill supply, and low repurchase agreement rates, the ON RRP facility continued to serve its intended purpose of helping to provide a floor under short-term interest rates and to support effective implementation of monetary policy.

Footnotes