Summary

Thus far this year, labor market conditions have improved further, while consumer price inflation has run below the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent. Gains in payroll employment since the start of the year have averaged about 200,000 jobs per month, and various measures of underutilization in labor markets have continued to trend down. Even so, the unemployment rate, at 7-1/2 percent in June, was still well above levels prevailing prior to the recent recession and well above the levels that FOMC participants think can be sustained in the longer term consistent with price stability.

Consumer price inflation has slowed this year. Over the first five months of the year, the price index for personal consumption expenditures increased at an annual rate of only 1/2 percent, while the index excluding food and energy prices rose at a rate of 1 percent, both down from increases of about 1-1/2 percent over 2012. This slowing appears to owe partly to transitory factors. Survey measures of longer-term inflation expectations have remained in the narrow ranges seen over the past several years, while market-based measures have declined so far this year, reversing their rise over the second half of 2012.

Meanwhile, real gross domestic product (GDP) continued to increase at a moderate pace in the first quarter of this year. Available indicators suggest that the growth of real GDP proceeded at a somewhat slower pace in the second quarter. Although federal fiscal policy is imposing a substantial drag on growth this year and export demand is still damped by subdued growth in foreign economies, some of the other headwinds that have weighed on the economic recovery have begun to dissipate. Against this backdrop, a sustained housing market recovery now appears to be under way, and consumption growth is estimated to have held up reasonably well despite the increase in taxes earlier this year.

Credit conditions generally have eased further, though they remain relatively tight for households with lower credit scores--and especially for such households seeking mortgage loans. However, beginning in May, longer-term interest rates rose significantly and asset price volatility increased as investors responded to somewhat better-than-expected economic data as well as Federal Reserve communications about monetary policy. Despite their recent moves, interest rates have generally remained low by historical standards, importantly due to the Federal Reserve's highly accommodative monetary policy stance.

With unemployment still well above normal levels and inflation quite low, and with the economic recovery anticipated to pick up only gradually, the FOMC has continued its highly accommodative monetary policy this year in order to support progress toward maximum employment and price stability.

The FOMC kept its target range for the federal funds rate at 0 to 1/4 percent and anticipated that this exceptionally low range would be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee also stated that when it decides to begin to remove policy accommodation, it would take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

The FOMC also has continued its asset purchase program, purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee has reiterated that the purchase program will continue until the outlook for the labor market has improved substantially in a context of price stability. In addition, the FOMC has indicated that the size, pace, and composition of purchases will be adjusted in light of the Committee's assessment of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives. The Committee has noted that it is prepared to increase or reduce the pace of purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

At the June FOMC meeting, Committee participants generally thought it would be helpful to provide greater clarity about the Committee's approach to decisions about its asset purchase program and thereby reduce investors' uncertainty about how the Committee might react to future economic developments. In choosing to provide this clarification, the Committee made no changes to its approach to monetary policy. Against this backdrop, Chairman Bernanke, at his postmeeting press conference, described a possible path for asset purchases that the Committee would anticipate implementing if economic conditions evolved in a manner broadly consistent with the outcomes the Committee saw as most likely. The Chairman noted that such economic outcomes involved continued gains in labor markets, supported by moderate growth that picks up over the next several quarters, and inflation moving back toward its 2 percent objective over time. If the economy were to evolve broadly in line with the Committee's expectations, the FOMC would moderate the pace of purchases later this year and continue to reduce the pace of purchases in measured steps until purchases ended around the middle of next year, at which time the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains and inflation moving back toward the FOMC's 2 percent target. In emphasizing that the Committee's policy was in no way predetermined, the Chairman noted that the pace of asset purchases could increase or decrease depending on the evolution of the outlook and its implications for further progress in the labor market. The Chairman also drew a strong distinction between the asset purchase program and the forward guidance regarding the target for the federal funds rate, noting that the Committee anticipates that there will be a considerable period between the end of asset purchases and the time when it becomes appropriate to increase the target for the federal funds rate.

In conjunction with the most recent FOMC meeting in June, Committee participants submitted individual economic projections under each participant's judgment of appropriate monetary policy. According to the Summary of Economic Projections (SEP), Committee participants saw the downside risks to the outlook for the economy and the labor market as having diminished since the fall. (The June SEP is included as Part 3 of the July 2013 Monetary Policy Report; it is also included in section 8 of this annual report. Committee participants also projected that, with appropriate monetary policy accommodation, economic growth would pick up, the unemployment rate would gradually decline, and inflation would move up over the medium term from recent very low readings and subsequently move back toward the FOMC's 2 percent longer-run objective. Committee participants saw increases in the target for the federal funds rate as being quite far in the future, with most expecting the first increase to occur in 2015 or 2016.

Part 1: Recent Economic and Financial Developments

Real economic activity continued to increase at a moderate pace in the first quarter of 2013, though available indicators suggest that the pace of economic growth was somewhat slower in the second quarter. Federal fiscal policy is imposing a substantial drag on economic growth this year, and subdued growth in foreign economies continues to weigh on export demand. However, some other headwinds have diminished, and interest rates, despite recent increases, have generally remained low by historical standards, importantly due to the ongoing monetary accommodation provided by the Federal Open Market Committee (FOMC). A sustained housing market recovery appears to be under way, and, despite the increase in taxes earlier this year, consumption growth is estimated to have held up reasonably well, supported by higher equity and home prices, more-upbeat consumer sentiment, and the improving jobs situation. Payroll employment has continued to rise at a moderate pace, and various measures of underutilization in labor markets have improved further. But, at 7-1/2 percent in June, the unemployment rate was still well above levels prevailing prior to the recent recession. Meanwhile, consumer price inflation has slowed further this year, in part because of falling energy and import prices and other factors that are expected to prove transitory, and it remains below the FOMC's longer-run objective of 2 percent. Survey measures of longer-term inflation expectations have remained in the fairly narrow ranges seen over the past several years.

Domestic Developments

Economic growth continued at a moderate pace early this year

Output appears to have risen further in the first half of 2013 despite the substantial drag on economic growth from federal fiscal policy this year and the restraint on export demand from subdued foreign growth. Real gross domestic product (GDP) increased at an estimated annual rate of 1-3/4 percent in the first quarter of the year, the same as the average pace in 2012, though available indicators point at present to a somewhat smaller gain in the second quarter. Economic activity so far this year has been supported by the continued expansion in demand by U.S. households and businesses, including what appears to be a sustained recovery in the housing market. Private demand has been bolstered by the historically low interest rates and rising prices of houses and other assets, partly associated with the FOMC's continued policy accommodation.

In addition, some of the other headwinds that have held back the economy in recent years have dissipated further. Risks of heightened financial stresses in Europe appear to have diminished somewhat, consumer confidence has improved noticeably, and credit conditions in the United States generally have eased. Nonetheless, tight credit conditions for some households are still likely restraining residential investment and consumer spending, and uncertainty about the foreign outlook continues to represent a downside risk for U.S. financial markets and for sales abroad.

Conditions in the labor market have continued to improve . . .

The labor market has continued to improve gradually. Gains in payroll employment averaged about 200,000 jobs per month over the first half of 2013, slightly above the average increase in each of the previous two years. The combination of this year's output and employment increases imply that gains in labor productivity have remained slow. According to the latest published data, output per hour in the nonfarm business sector rose at an annual rate of only 1/2 percent in the first quarter of 2013, similar to its average pace in both 2011 and 2012.

Meanwhile, the unemployment rate declined to 7-1/2 percent in the second quarter of this year from around 8-1/4 percent a year earlier. A variety of alternative, broader measures of labor force underutilization have also improved over the past year, roughly in line with the official unemployment rate.

While the unemployment rate and total payroll employment have improved further, the labor force participation rate has continued to decline, on balance. As a result, the employment-population ratio, a measure that combines the unemployment rate and labor force participation rate, has changed little so far this year. To an important extent, the decline in the participation rate likely reflects changing demographics--most notably the increasing share in the population of older persons, who have lower-than-average participation rates--that would have occurred regardless of the strength of the labor market. However, it is also likely that some of the decline in the participation rate reflects an increase in the number of workers who have stopped looking for work because of poor job prospects.¹

. . . but considerable slack in labor markets remains . . .

Although labor market conditions have improved moderately so far this year, the job market remains weak overall. The unemployment rate and other measures of labor underutilization are still well above their pre-recession levels, despite payroll employment having now expanded by nearly 7 million jobs since its recent trough and the unemployment rate having fallen 2-1/2 percentage points since its peak. Moreover, unemployment has been unusually concentrated among the long-term unemployed; in June, the fraction of the unemployed who had been out of work for more than six months remained greater than one-third, although this share has continued to edge down. In addition, last month, 8 million people, or 5 percent of the workforce, were working part time because they were unable to find full-time work due to economic conditions.

. . . and gains in compensation have been slow

Increases in hourly compensation continue to be restrained by the weak condition of the labor market. The 12-month change in the employment cost index for private industry workers, which measures both wages and the cost to employers of providing benefits, has remained close to 2 percent throughout most of the recovery. Compensation per hour in the nonfarm business sector--a measure derived from the labor compensation data in the national income and product accounts--rose 2 percent over the year ending in the first quarter of 2013. Similarly, average hourly earnings for all employees--the timeliest measure of wage developments--increased 2-1/4 percent in nominal terms over the 12 months ending in June. Even with relatively slow productivity gains, the change in unit labor costs faced by firms--an estimate of the extent to which nominal hourly compensation rises in excess of labor productivity--has remained subdued.

Consumer price inflation has been especially low . . .

The price index for personal consumption expenditures (PCE) increased at an annual rate of just 1/2 percent over the first five months of the year, down from a rise of 1-1/2 percent over 2012 and below the FOMC's long-run objective of 2 percent. The very low rate of inflation so far this year partly reflects declines in consumer energy prices, but price inflation for other consumer goods and services has also been subdued. Consumer food prices have remained largely unchanged so far this year, and consumer prices excluding food and energy increased at an annual rate of 1 percent in the first five months of this year after rising 1-1/2 percent over 2012. With wages growing slowly and materials prices flat or moving downward, firms have generally not faced cost pressures that they might otherwise try to pass on.

. . . as some transitory factors weighed on prices . . .

In addition to the decline in energy prices, this year's especially low inflation reflects, in part, other special factors that are expected to be transitory. Notably, increases in both medical services prices and the nonmarket component of PCE prices have been unusually low. While the average rate of medical-price inflation as measured by the PCE index has been considerably lower during the past few years than it was earlier, the increase over the first five months of 2013--at below 1/2 percent--has been extraordinarily muted, largely reflecting the effects on medical services prices of cuts in Medicare reimbursements associated with federal budget sequestration. (In contrast, medical services prices in the consumer price index (CPI), which exclude most Medicare payments, have risen at an annual rate of nearly 2 percent so far this year.) Because medical services have a relatively large weight in PCE expenditures (as the PCE price index reflects payments by all payers, not just out-of-pocket expenses as in the CPI), price changes in this component of spending can have a sizable effect on top-line PCE inflation.

The nonmarket PCE price index covers spending components for which market prices are not observed, such as financial services rendered without explicit charge; as a result, the Bureau of Economic Analysis imputes prices for those items. Overall, this nonmarket index declined early this year before moving up again in recent months; however, these prices tend to be volatile and appear to contain little signal for future inflation.

. . . and as oil and other commodity prices declined . . .

Global oil prices have come down, on net, from their February peak of nearly $120 per barrel, though in recent weeks they have increased somewhat from their spring lows to almost $110 per barrel. Tensions in the Middle East have likely continued to put upward pressures on crude oil prices, but those pressures have been mitigated by concerns about the strength of oil demand in China and the rest of emerging Asia and by rising oil production in North America. Nonfuel commodity prices have eased since the beginning of the year, also reflecting slowing economic growth in emerging Asia. Notably, the price of iron ore, widely viewed as an indicator of Chinese demand for commodities, has fallen roughly 20 percent since early January. Along with falling commodity prices, prices of non-oil imported goods declined in the first half of 2013, also likely holding down domestic price increases this year.

. . . but longer-term inflation expectations remained in their historical range

The Federal Reserve monitors the public's expectations of inflation, in part because these expectations may influence wage- and price-setting behavior and thus actual inflation. Survey-based measures of longer-term inflation expectations have changed little, on net, so far this year. Median expected inflation over the next 5 to 10 years, as reported in the Thomson Reuters/University of Michigan Surveys of Consumers (Michigan survey), was 2.9 percent in early July, within the narrow range of the past decade.² In the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, the median expectation for the increase in the PCE price index over the next 10 years was 2 percent in the second quarter of this year, similar to its level in recent years.

Measures of medium- and longer-term inflation compensation derived from the differences between yields on nominal and inflation-protected Treasury securities have declined between 1/4 and 1/2 percentage point so far this year. Nonetheless, these measures of inflation compensation also remain within their respective ranges observed over the past several years, as the recent declines reversed the rise over the second half of last year. In general, movements in inflation compensation can reflect not only market participants' expectations of future inflation but also changes in investor risk aversion and fluctuations in the relative liquidity of nominal versus inflation-protected securities; the recent declines in inflation compensation may have been amplified by a reduction in demand for Treasury inflation-protected securities amid increased volatility in fixed-income markets.

Fiscal consolidation has quickened, leading to stronger headwinds but smaller deficits

Fiscal policy at the federal level has tightened significantly this year. As discussed in the box "Economic Effects of Federal Fiscal Policy" (the July 2013 Monetary Policy Report), fiscal policy changes--including the expiration of the payroll tax cut, the enactment of other tax increases, the effects of the budget caps on discretionary spending, the onset of the sequestration, and the declines in defense spending for overseas military operations--are estimated, collectively, to be exerting a substantial drag on economic activity this year. Even prior to the bulk of the spending cuts associated with the sequestration that started in March, total real federal purchases contracted at an annual rate of nearly 9 percent in the first quarter, reflecting primarily a significant decline in defense spending. The sequestration will induce further reductions in real federal expenditures over the next few quarters. For example, many federal agencies have announced plans to furlough workers, especially in the third quarter. However, considerable uncertainty continues to surround the timing of these effects.

These fiscal policy changes--along with the ongoing economic recovery and positive net payments to the Treasury by Fannie Mae and Freddie Mac--have resulted in a narrower federal deficit this year. Nominal outlays have declined substantially as a share of GDP since their peak during the previous recession, and tax receipts have moved up to about 17 percent of GDP, their highest level since the recession. As a result, the deficit in the federal unified budget fell to about $500 billion over the first nine months of the current fiscal year, almost $400 billion less than over the same period a year earlier. Accordingly, the Congressional Budget Office projects that the budget deficit for fiscal year 2013 as a whole will be 4 percent of GDP, markedly narrower than the deficit of 7 percent of GDP in fiscal 2012. In addition, the deficit is projected to narrow further over the next couple of years in light of ongoing policy actions and continued improvement in the economy. Despite the substantial decline in the deficit, federal debt held by the public has continued to rise and stood at 75 percent of nominal GDP in the first quarter of 2013.

At the state and local level as well, the strengthening economy has helped foster a gradual improvement in the budget situations of most jurisdictions. In the first quarter of 2013, state tax receipts came in 9 percent higher than a year earlier. (Some of the recent strength in receipts, though, likely reflects tax payments on income that was shifted into 2012 in anticipation of higher federal tax rates this year.) Consistent with improving sector finances, states and municipalities are no longer reducing their workforces; employment in the nonfederal government sector edged up over the first half of the year after contracting only slightly in 2012. However, construction expenditures by these governments have declined significantly further this year. In all, real government purchases at the state and local level decreased in the first quarter and have imposed a drag on the pace of economic growth so far this year.

The housing market recovery continued to gain traction . . .

Activity in the housing market has continued to strengthen, supported by low mortgage rates, sustained job gains, and improved sentiment on the part of potential buyers. In the Michigan survey, many households report that low interest rates and house prices make it a good time to buy a home; a growing percentage of respondents also expect that house price gains will continue. Reflecting the improving demand conditions, sales of both new and existing homes have continued to move up, on net, this year. Construction of new housing units has also trended up over the past year, contributing to solid rates of increase in real residential investment in the first half of 2013. Even so, the level of construction activity remains low by historical standards. The steep rise in mortgage interest rates since May could temper the pace of home sales and construction going forward, though the pace of purchase mortgage applications so far has shown no material signs of slowing, even as the pace of refinancing applications has tailed off sharply.

The strengthening in housing demand has occurred despite the fact that mortgage credit remains limited for borrowers without excellent credit scores or the ability to make sizable down payments. Responses to special questions in the Federal Reserve's April Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) suggested that some banks had actually tightened standards over the past year on some loans that are eligible for purchase by the government-sponsored enterprises and loans guaranteed by the Federal Housing Administration, specifically those to borrowers with credit scores below 620 and with low down payments. Indeed, only about 10 percent of new prime mortgage originations made this spring were reported to be associated with FICO scores below 690, compared with a quarter of originations in 2005.

. . . as house prices rose further

House prices, as measured by several national indexes, have increased significantly further since the end of last year. In particular, the CoreLogic repeat-sales index rose about 7 percent (not at an annual rate) over the first five months of 2013 to reach its highest level since the third quarter of 2008. Some of the largest recent gains have occurred where the housing market has been most severely depressed. Recent increases notwithstanding, house prices remain far below the peaks reached before the recession, and the national price-to-rent ratio continues to be near its long-run average. Still, the increase in house prices has helped to materially reduce the number of "underwater" mortgages and made households somewhat less likely to default on their mortgages.

Mortgage interest rates increased but remained low by historical standards

Mortgage interest rates have increased significantly in the past couple of months from record lows reached earlier this year. However, rates are still low by historical standards, reflecting in part the Federal Reserve's ongoing purchases of mortgage-backed securities (MBS) and highly accommodative overall stance of monetary policy. The spread between rates on conforming mortgages and yields on agency-guaranteed MBS has decreased slightly since the end of 2012.

Low mortgage rates, along with rising house prices, continued to facilitate a significant pace of refinancing for most of the first half of 2013, which has helped households reduce monthly debt service payments. However, refinancing remained difficult for households without solid credit ratings and those with limited home equity. Moreover, as mortgage rates moved higher, refinancing activity began to decrease sharply in May.

Consumer spending has held up despite the drag from tax increases early this year

Real consumption expenditures rose at an annual rate of about 2 percent over the first five months of this year, about the same as in the previous two years. These increases have occurred despite higher taxes and have been supported by several factors. The gains this year in house prices and equity values have helped households recover some of the wealth lost during the recession; indeed, the ratio of household net wealth to income is estimated to have moved up sharply in the first quarter. In recent months, indicators of consumer sentiment have become more upbeat as well. Furthermore, in contrast to mortgage rates, interest rates on auto loans and credit cards have changed little, on balance, since the end of 2012. With interest rates low, the household debt service ratio--the ratio of required principal and interest payments on outstanding household debt to disposable personal income--remained near historical lows.

In addition, real disposable personal income has increased slightly, on balance, over the past year, as moderate gains in employment and wages have more than offset the implications for income of changes in tax policy.³ And household purchasing power has been supported so far this year by low consumer price inflation. On balance, moderate increases in spending have outpaced disposable income growth, pushing the personal saving rate down to around 3 percent in recent months, close to the level that prevailed before the recession.

The financial conditions of households continued to improve slowly

Although mortgage debt continued to contract amid still-tight credit conditions for some borrowers, consumer credit expanded at an annual rate of about 6 percent in the first quarter of 2013. Student loans, the vast majority of which are guaranteed or originated by the federal government and subject to minimal underwriting criteria, are estimated to have increased rapidly and now total nearly $1 trillion, making them the largest category of consumer indebtedness outside of mortgages. Auto loans are also estimated to have increased at a robust pace. Stable collateral values and favorable conditions in the asset-backed securities market may have contributed to easier standards for such loans. In contrast, revolving consumer credit (primarily credit card lending) was little changed in the first quarter, and standards and terms on credit card loans appeared to remain tight, especially for consumers with less-than-pristine credit histories. For instance, spreads of interest rates on credit card loans over reference interest rates remained historically wide. Consequently, credit card debt extended to consumers with prime credit scores remained well below its pre-crisis levels, while debt extended to those with subprime credit scores--that is, Equifax Risk Scores below 660--continued to trend down.

According to the most recent available data, indicators of distress for most types of household debt have declined since the end of 2012. For home mortgages, for example, the fraction of current mortgages becoming 30 or more days delinquent has now reached relatively low levels as a result of strict underwriting conditions for new mortgages as well as improved conditions in housing and labor markets. Measures of late-stage mortgage delinquency, such as the inventory of properties in foreclosure, also improved but remained elevated. Delinquency rates on student loans also remained high, likely reflecting in part the lack of underwriting on the federally backed loans that make up the bulk of the student loans outstanding.

The financial conditions of nonfinancial firms continued to be strong . . .

In the first quarter, the aggregate ratio of liquid to total assets for nonfinancial firms ticked up and remained near its highest level in 20 years, while the aggregate ratio of debt to assets was still well below its average over the same period. Strong balance sheets, in turn, have contributed to solid credit quality: Bond default rates, as of June, stayed low by historical standards, and the delinquency rate on commercial and industrial (C&I) loans continued to fall in the first quarter from already low levels. However, over the first half of the year, the volume of nonfinancial corporate bonds that were upgraded by Moody's Investors Service was less than the volume downgraded.

. . . and corporate bond and loan issuance remained robust

With corporate credit quality strong and interest rates near historically low levels through much of the first half of 2013, nonfinancial firms continued to raise funds, especially using longer-duration instruments. The pace of bond issuance by both investment- and speculative-grade nonfinancial firms remained extraordinarily brisk until interest rates rose significantly in May, while nonfinancial commercial paper (CP) outstanding was little changed. C&I loans outstanding at commercial banks in the United States continued to expand during the first half of 2013 but at a slower pace than in the second half of 2012, when firms reportedly ramped up their C&I borrowing in part to make larger-than-usual dividend and bonus payments in advance of anticipated year-end tax hikes. A relatively large fraction of respondents to the April SLOOS indicated that, over the preceding three months, they had eased standards and pricing terms for C&I loans to firms of all sizes. Meanwhile, issuance of leveraged loans extended by nonbank institutions in the syndicated loan market was very elevated, boosted by strong investor demand for these floating-rate instruments manifested through inflows to loan mutual funds and rapid growth of newly established collateralized loan obligations. More than two-thirds of the proceeds from such syndicated loan issuance, however, were reportedly used to repay existing debt.

Borrowing conditions for small businesses improved, though demand for credit remained subdued

Some indicators of borrowing conditions for small businesses have improved since the end of 2012. According to the surveys conducted by the National Federation of Independent Business (NFIB) during the first half of 2013, the fraction of small businesses that found credit more difficult to obtain than three months prior declined on net. Recent readings from the Federal Reserve's Survey of Terms of Business Lending indicate that the spreads charged by commercial banks on newly originated C&I loans with original amounts less than $1 million--a large share of which likely consist of loans to small businesses--continued to edge down, though they remained elevated.⁴ However, demand for credit from small firms apparently remained subdued compared with demand from large and middle-market firms. Relatively large fractions of respondents in recent NFIB surveys indicated that they did not have any borrowing needs, and the total dollar volume of business loans with original amounts of $1 million or less outstanding at U.S. commercial banks was little changed in the first quarter.

However, business spending on capital investment has been rising at only a modest pace

Despite the large amount of business borrowing, businesses' capital investment has been rising only modestly. Real spending on equipment and software (E&S) increased at an annual rate of 4 percent in the first quarter after having risen at a similar, below-average pace in 2012; these increases likely reflect the tepid growth in business output over the past year. Shipments and orders of nondefense capital goods and other forward-looking indicators of business spending are consistent with further moderate gains in E&S spending in the spring and summer of this year.

Business investment in structures has also been relatively low so far this year, even apart from a sharp drop-off in expenditures on wind-power facilities following a tax-related burst of construction late last year. The level of investment in drilling and mining structures has stayed elevated, supported by high oil prices and the continued exploitation of new drilling technologies. However, investment in nonresidential buildings continues to be restrained by high vacancy rates for existing properties, low commercial real estate (CRE) prices, and tight financing conditions for new construction. Indeed, banks' holdings of construction and land development loans have contracted every quarter since the first half of 2008.

Despite weak fundamentals, conditions in markets for CRE financing appeared to loosen somewhat. A moderate fraction of banks in the April SLOOS again reported having eased their lending standards on CRE loans, while a somewhat larger fraction continued to report some increase in demand for these loans. In addition, the pace of issuance of commercial mortgage-backed securities has stepped up, on balance, this year, but it remained well below its peak reached in 2007.

Foreign trade has been relatively weak

Export demand, which provided substantial support to domestic activity earlier in the recovery, has weakened since the middle of 2012, partly reflecting subdued foreign economic activity. Real exports of goods and services declined at an annual rate of 1 percent in the first quarter of 2013, though data for the first two months of the second quarter suggest that they rebounded. Exports to Japan have been particularly weak, but those to Canada continue to rise.

Real imports of goods and services edged down in the first quarter after falling substantially in the fourth quarter of 2012. Data for April and May suggest that imports recovered at a moderate pace in the second quarter. Although imports of non-oil goods and services rose, imports of oil declined further as U.S. oil production continued its climb of recent years.

Altogether, net exports were a neutral influence on the growth of real GDP in the first quarter of 2013, and partial data suggest that the same was the case in the second quarter.

The current account deficit remained at about 2-1/2 percent of GDP in the first quarter of 2013, a level little changed since 2009. The current account deficit had narrowed substantially in late 2008 and early 2009 when U.S. imports dropped sharply, in part reflecting the steep decline in oil prices.

In the first quarter of 2013, the current account deficit continued to be financed by strong financial inflows, mostly from purchases of Treasury securities by both foreign official and foreign private investors. Consistent with continued improvement in market sentiment, U.S. investors made further strong purchases of foreign securities, especially equities.

National saving is very low

Net national saving--that is, the saving of U.S. households, businesses, and governments, net of depreciation charges--remains extremely low by historical standards. In the first quarter of 2013, net national saving was 1 percent of nominal GDP, up from figures that averaged around zero over the past few years. As discussed earlier, the near-term federal deficit has narrowed because of fiscal policy changes and the economic recovery, and further declines in the federal budget deficit over the next few years should boost national saving somewhat. With the economy still weak and demand for investable funds limited, the low level of national saving is not constraining growth or leading to higher interest rates. However, if low levels of national saving persist over the longer run, they will likely be associated with both low rates of capital formation and heavy borrowing from abroad, limiting the rise in the standard of living for U.S. residents over time.

Financial Developments

The expected path for the federal funds rate in 2014 and 2015 steepened . . .

Market-based measures of the expected future path of the federal funds rate moved higher over the first half of the year, as investors responded to somewhat better-than-expected incoming economic data and to communications from Federal Reserve officials that were seen as suggesting a tighter stance of monetary policy than had been anticipated. The modal path of the federal funds rate--that is, the values for future federal funds rates that market participants see as most likely--derived from interest rate options shifted up considerably, especially around the June FOMC meeting, suggesting that investors may now expect the target funds rate to lift off from its current range significantly earlier than they expected at the end of 2012. However, a part of this increase may have reflected a rise in term premiums associated with increased uncertainty about the monetary policy outlook. According to a survey of primary dealers conducted shortly after the June FOMC meeting by the Open Market Desk at the Federal Reserve Bank of New York, dealers' expectations of the date of liftoff have moved up one quarter since the end of last year, to the second quarter of 2015.⁵

. . . while yields on longer-term securities increased significantly but remained low by historical standards

Reflecting the same factors, yields on longer-term Treasury securities and agency MBS are also substantially higher now than they were at the end of last year. The rise in longer-term yields appears to have been amplified by a pullback from duration risk as well as technical factors, including rapid changes in trading strategies and positions that had been predicated on the continuation of very low rates and volatility. On balance, yields on 5-, 10-, and 30-year nominal Treasury securities have increased between 65 and 85 basis points, on net, to 1-1/2 percent, 2-1/2 percent, and 3-3/4 percent, respectively, since the end of last year.

Yields on 30-year agency MBS increased more than those on Treasury securities, rising about 1-1/4 percentage points, on net, since the end of 2012, to about 3-1/2 percent. Agency MBS yields also rose significantly more than the yields on comparable nominal Treasury securities after adjusting for the effects of higher interest rates on the likelihood that borrowers will prepay their mortgages (the option-adjusted spread), likely reflecting investors' reassessment of the outlook for the Federal Reserve's MBS purchases as well as subsequent market dynamics.

Nonetheless, yields on longer-term securities continue to be low by historical standards. Those low levels reflect several factors, including subdued inflation expectations as well as still-modest economic growth prospects in the United States and other major developed economies. In addition, despite their recent rise, term premiums--the extra return investors expect to obtain from holding longer-term securities as opposed to holding and rolling over a sequence of short-term securities for the same period--remain small, reflecting both the FOMC's ongoing large-scale asset purchase program and strong demand for longer-term securities from global investors.

Indicators of market functioning in both the Treasury and agency MBS markets were generally solid over the first half of the year. In particular, the Desk's outright purchases of Treasury securities and agency MBS did not appear to have a material adverse effect on liquidity in those markets. For example, available data suggest bid-asked spreads in Treasury and agency MBS markets continued to be in line with recent averages, though some widening has been observed of late amid increased market volatility. In the Treasury market, auctions generally continued to be well received by investors. In the agency MBS market, settlement fails remained low, and implied financing rates in the "dollar roll" market--an indicator of the scarcity of agency MBS for settlement--have drifted up over the past six months, indicating reduced settlement pressures.⁶

Short-term funding markets continued to function well

Conditions in short-term funding markets remained good, with many money market rates having edged down from already low levels since the end of 2012 to near the bottom of the ranges they have occupied since the zero-lower-bound period began. In the market for repurchase agreements, bid-asked spreads and haircuts for most collateral types were reportedly little changed, while rates moved down slightly, on net, for general collateral finance repurchase agreements. Despite the high level of reserve balances and the substantially reduced volume of trading in the federal funds market since 2008, the effective federal funds rate has continued to be strongly correlated with these money market rates. Rates on asset-backed commercial paper (ABCP) also fell, and spreads on ABCP with European bank sponsors have generally converged back to those on ABCP with U.S. bank sponsors. Rates on unsecured financial CP for both U.S. and European issuers have remained low, even during the temporary flare-up of concerns about European financial stability surrounding the banking problems in Cyprus, while forward measures of funding spreads have continued to be narrow by historical standards.

Broad equity price indexes increased further . . .

Broad equity price indexes notched substantial gains and reached record levels in nominal terms, boosted by improved market sentiment regarding the economic outlook, the FOMC's sustained highly accommodative monetary policy, and stable expectations about medium-term earnings growth. Despite the increased volatility around the time of the June FOMC meeting, as of mid-July, broad measures of equity prices were 18 percent higher, on net, than their levels at the end of 2012. Nonetheless, the spread between the 12-month expected forward earnings-price ratio for the S&P 500 and a long-run real Treasury yield--a rough gauge of the equity risk premium--stayed very elevated by historical standards, suggesting that investors remain somewhat cautious in their attitudes toward equities. Outside of the period surrounding the June FOMC meeting, implied volatility for the S&P 500 index, as calculated from option prices, generally remained near the bottom end of the range it has occupied since the onset of the financial crisis.

. . . and market sentiment toward financial institutions continued to strengthen as credit quality improved

On average, the equity prices of domestic financial institutions have outperformed broader equity indexes since the end of last year. Improved investor sentiment toward the financial sector reportedly was driven by perceptions of reduced downside risk in the housing market as well as expectations of continued improvements in credit quality and of increased net interest margins as the yield curve steepened over the past few months. However, prices of real estate investment trust (REIT) shares underperformed, especially after interest rates started rising in May, partially reflecting a broader shift on the part of investors from income-oriented shares toward more cyclically sensitive issues. Shares of mortgage REITs were particularly affected by the sharp rise in Treasury and agency MBS yields.

Equity prices for large domestic banks have increased 24 percent since the end of 2012. However, they have yet to fully recover from the very depressed levels reached during the financial crisis. Standard measures of the profitability of bank holding companies (BHCs) edged down in the first quarter but remained in the upper end of their subdued post-crisis range. BHC profits were held down by modest noninterest income and a further narrowing of net interest margins. By contrast, profits were supported by additional reductions in noninterest expenses and decreases in provisioning for loan losses, as indicators of credit quality improved further in every major asset class. Banks' allowances for loan and lease losses continued to trend down as charge-offs of bad loans once again exceeded provisions in the first quarter.

Risk-based capital ratios (based on current Basel I definitions) of the 25 largest BHCs decreased in the first quarter because of the adoption of the new market risk capital rule, while risk-based capital ratios at smaller BHCs edged up.⁷ Nonetheless, BHCs of all sizes remained well capitalized by historical standards as they prepare for the transition to stricter Basel III requirements (see the box "Developments Related to Financial Stability" in the July 2013 Monetary Policy Report). Aggregate credit provided by commercial banks continued to increase in the first half of 2013.

M2 rose at a more moderate rate, but balances remain elevated

M2 has increased at an annual rate of about 4-3/4 percent since the end of 2012, notably slower than the pace registered last year. However, holdings of M2 assets--including their largest component, liquid deposits--remained elevated relative to what would have been expected based on historical relationships with nominal income and interest rates, likely due to investors' continued preference to hold safe and liquid assets. The monetary base--which is equal to the sum of currency and reserve balances--increased briskly over the first half of the year, driven mainly by the significant rise in reserve balances due to the Federal Reserve's asset purchases.

International Developments

Foreign bond yields have risen and asset prices have declined, on net, especially in emerging market economies

Foreign benchmark sovereign yields have moved somewhat higher, on net, since the beginning of the year. Rates moved lower in March and April, in part reflecting weak incoming data on activity; anticipation of the Bank of Japan's (BOJ) asset purchase program may have also contributed to declining Japanese government bond (JGB) yields early in the year. Since early May, however, as with U.S. Treasury securities, sovereign yields have risen worldwide, as investors responded to better-than-expected U.S. economic data and to Federal Reserve communications about monetary policy. Sovereign yields are up, on net, in Europe, Japan, and Canada and have increased substantially in Korea, Mexico, and other emerging market economies (EMEs).

Equity indexes in the major advanced foreign economies (AFEs) rose earlier in the year, especially in Japan, where stock prices continued to soar as Prime Minister Abe's ambitious stimulus program began to take shape. However, since mid-May, equity prices have declined on net. Corporate bond issuance eased somewhat in June as rates climbed higher, but year-to-date issuance totals are still strong relative to recent years. Since the start of the year, sovereign and corporate credit spreads have narrowed slightly. Financial stresses in Europe have remained well below their highs last year despite banking problems in Cyprus and political tensions in several other European countries.

The significantly higher interest rates in EMEs have been accompanied by sharp moves in other EME financial markets. Since mid-May, stock prices have declined and credit spreads have widened markedly. EME bond and equity funds have also experienced sizable outflows, as investors reassessed the economic outlook in these economies as well as the returns on EME assets relative to those in advanced economies.

The improved sentiment toward the U.S. economic outlook and anticipation of less-accommodative monetary policy have pushed the U.S. dollar higher against a broad set of currencies since the end of 2012. In particular, the dollar has appreciated sharply against the Japanese yen, on net, as the BOJ adopted a more accommodative monetary policy stance.

Activity in the advanced foreign economies remained subdued despite a pickup . . .

Activity in the AFEs improved to a still-muted pace in the first half of 2013, supported in part by stronger exports and the easing in financial stresses in Europe. The euro-area economy shrank further in the first quarter, but the pace of contraction moderated as consumption stabilized. In the United Kingdom, real GDP resumed growing, at a 1-1/4 percent pace, in the first quarter; retail sales and the purchasing managers index (PMI) suggest that growth firmed in the second quarter. First-quarter activity accelerated in Japan, reflecting a strong rebound of exports and a pickup in consumption. Canadian growth also firmed in the first quarter, and the labor market notched solid employment gains through the second quarter.

With activity weak and inflationary pressures low, several foreign central banks took additional steps to support their economies. (See the box "The Expansion of Central Bank Balance Sheets" in the July 2013 Monetary Policy Report for a broader overview of central bank actions.) The European Central Bank (ECB) and the Reserve Bank of Australia lowered their main policy rates, and the ECB stated after its July meeting that it will keep key policy rates low "for an extended period." The Bank of England extended its Funding for Lending Scheme until January 2015 and increased banks' incentives to lend to small and medium-sized businesses. In April, the BOJ announced a sharp rise in its purchases of JGBs and other assets, as well as an extension of the maturity of the JGBs that it purchases.

Authorities in some AFEs also eased fiscal policy in response to still-subdued activity. The Japanese parliament approved a fiscal stimulus package worth about 2 percent of GDP, with the bulk of the spending directed to infrastructure projects. European authorities postponed deadlines for several euro-area countries, including France and Spain, to reduce fiscal deficits below 3 percent of GDP.

. . . while growth slowed in the emerging market economies

Aggregate real GDP growth in the EMEs picked up in the fourth quarter of 2012 despite the weakness in Europe and the United States, led by a strong performance of the Chinese economy. However, EME growth slowed considerably in the first quarter, in part as a step-down in Chinese growth weighed on activity in the rest of emerging Asia and on the commodity-dependent economies of South America. Recent indicators of exports, industrial production, and PMIs suggest that EME activity remained subdued in the second quarter. Amid concerns about economic growth and lack of inflationary pressures, the central banks of several countries in Asia and Latin America further eased monetary policy over the first half of the year. However, more recently, concerns about reversal of capital inflows and currency depreciation pressures are giving EME central banks pause about further rate cuts, and a few have begun to raise rates.

In China, macroeconomic data for the second quarter indicate that growth continued to be modest by the standards of recent years. Although retail sales rose slightly faster in April and May than in the subdued first quarter, fixed investment increased at roughly its first-quarter pace.

Activity also cooled across Latin America. In Mexico, growth had already slowed in the second half of last year, weighed down by weaker U.S. manufacturing activity. Growth slowed further in the first quarter, as exports declined and domestic demand weakened. In response, the Bank of Mexico reduced its policy rate for the first time since mid-2009. Mexican activity appears to have remained subdued in the second quarter. Brazilian real GDP growth stepped down a little in the first quarter, extending the lackluster performance of the past two years. Indicators of economic activity for the second quarter, including industrial production and exports, have been mixed. Unlike many of its EME counterparts, Brazil's central bank raised its policy rate to combat rising inflation.

Part 2: Monetary Policy

With unemployment still well above normal levels and inflation below its longer-run objective, the Federal Open Market Committee (FOMC) has continued its highly accommodative monetary policy this year by maintaining its forward guidance with regard to the target for the federal funds rate and continuing its program of large-scale asset purchases.

To foster the attainment of maximum employment and price stability, the FOMC kept in place its forward guidance on the path of the federal funds rate . . .

With unemployment still elevated and declining only gradually, and inflation having moved further below the Committee's 2 percent longer-run objective, the FOMC has maintained its highly accommodative monetary policy stance this year. Because the target range for the federal funds rate remains at its effective lower bound, the Committee has been relying mainly on its forward guidance about the future path of the federal funds rate and on its program of large-scale asset purchases to make progress toward its mandated objectives.

With regard to the federal funds rate, the Committee has continued to indicate its expectation that the current exceptionally low target range of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain its target range for the federal funds rate, the Committee has stated that it would also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The FOMC also has reiterated that a highly accommodative stance of monetary policy would remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. Moreover, the Committee has indicated that when it decides to begin to remove policy accommodation, it would take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

. . . and maintained its policy of large-scale asset purchases . . .

To sustain downward pressure on longer-term interest rates, support mortgage markets, and help make broader financial conditions more accommodative, the FOMC has continued its large-scale asset purchases; the Committee also has maintained its practices of reinvesting principal payments it receives on agency debt and agency-guaranteed mortgage-backed securities (MBS) in new agency MBS and of rolling over maturing Treasury securities at auction. Over the first half of this year, purchases of longer-term securities totaled $510 billion, with the Committee purchasing additional agency MBS at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee reconfirmed at each meeting during the first half of 2013 that it would continue purchasing Treasury and agency MBS until the outlook for the labor market has improved substantially in a context of price stability.

In determining the size, pace, and composition of its asset purchases, the Committee has taken account of the likely efficacy and costs of such purchases. As noted in the minutes of the March FOMC meeting, most participants saw asset purchases as having a meaningful effect in easing financial conditions--for example, keeping longer-term interest rates, including mortgage rates, lower than they would be otherwise--and so supporting economic growth.⁸ FOMC participants generally judged that these benefits outweighed the likely costs and risks of additional purchases. However, the Committee has continued to monitor those costs and risks, including possible effects on financial stability, security market functioning, the smooth withdrawal of monetary accommodation when it eventually becomes appropriate, and the Federal Reserve's net income.⁹

. . . while providing additional information about potential adjustments to its asset purchases

During the first half of 2013, the FOMC took various steps to provide greater clarity regarding its thinking about possible adjustments in the pace of asset purchases and the eventual cessation of those purchases. In its statement after the March meeting, the Committee added that the size, pace, and composition of its asset purchases would reflect the extent of progress toward its economic objectives, in addition to the likely efficacy and costs of such purchases.¹⁰ And in May, to highlight its willingness to adjust the flow of purchases in light of incoming information, the Committee noted that it was prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changed.¹¹

At the June FOMC meeting, Committee participants generally thought it would be helpful to provide greater clarity about the Committee's approach to decisions about its asset purchase program and thereby reduce investors' uncertainty about how it might react to future economic developments. In choosing to provide this clarification, the Committee made no changes to its approach to monetary policy. Against this backdrop, Chairman Bernanke, at his postmeeting press conference, described a possible path for asset purchases that the Committee would anticipate implementing if economic conditions evolved in a manner broadly consistent with the outcomes the Committee saw as most likely.¹² The Chairman noted that such economic outcomes involved continued gains in labor markets, supported by moderate growth that picks up over the next several quarters, and inflation moving back toward its 2 percent objective over time. If the economy were to evolve broadly in line with the Committee's expectations, the FOMC would moderate the pace of purchases later this year and continue to reduce the pace of purchases in measured steps until purchases ended around the middle of next year, at which time the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains and inflation moving back toward the FOMC's 2 percent target.

In emphasizing that the Committee's policy was in no way predetermined, the Chairman noted that if economic conditions improved faster than expected, the pace of asset purchases could be reduced somewhat more quickly. Conversely, if the outlook for the economy or the labor market became less favorable, inflation did not move over time toward the Committee's 2 percent longer-term objective, or financial conditions were judged to be inconsistent with further progress in the labor markets, reductions in the pace of purchases could be delayed or the pace increased for a time. The Chairman also drew a strong distinction between the asset purchase program and the forward guidance regarding the target for the federal funds rate, noting that the Committee anticipates that there will be a considerable period between the end of asset purchases and the time when it becomes appropriate to increase the target for the federal funds rate.

The Committee's large-scale asset purchases led to a significant increase in the size of the Federal Reserve's balance sheet

As a result of the Committee's large-scale asset purchase program, Federal Reserve assets have increased significantly since the end of last year. The par value of the System Open Market Account's (SOMA) holdings of U.S. Treasury securities increased about $300 billion to $2 trillion, and the par value of its holdings of agency debt and MBS increased about $270 billion, on net, to $1.3 trillion.¹³ These asset purchases accounted for nearly all of the increase in total assets of the Federal Reserve and were accompanied by a significant rise in reserve balances over the period. As of July 10, the SOMA's holdings of Treasury and agency securities constituted 56 percent and 36 percent, respectively, of the $3.5 trillion in total Federal Reserve assets. By contrast, balances of facilities established during the financial crisis declined further from already low levels.¹⁴

Interest income on the SOMA portfolio continued to support a substantial sum of remittances to the Treasury Department. In the first quarter, the Federal Reserve provided more than $15 billion of such distributions to the Treasury.¹⁵ The Federal Reserve has also released detailed transactions data on open market operations and discount window operations with a two-year lag in compliance with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

The Committee also reviewed the principles for policy normalization

During its May and June meetings, the FOMC reviewed the Federal Reserve's principles for the eventual normalization of the stance of monetary policy, which initially were published in the minutes of the Committee's June 2011 meeting.¹⁶ The Committee's discussion included various aspects of those principles--the size and composition of the SOMA portfolio in the longer run, the use of a range of reserve-draining tools, the approach to sales of securities, the eventual framework for policy implementation, and the relationship between the principles and the economic thresholds in the Committee's forward guidance on the federal funds rate. Meeting participants, in general, continued to view the broad principles set out in 2011 as still applicable. Nonetheless, they agreed that many of the details of the eventual normalization process would likely differ from those specified two years ago, that the appropriate details would depend in part on economic and financial developments between now and the time when it becomes appropriate to begin normalizing monetary policy, and that the Committee would need to provide additional information about its intentions as that time approaches. Participants continued to think that the Federal Reserve should, in the long run, hold predominantly Treasury securities. Most, however, now anticipated that the Committee would not sell agency MBS as part of the normalization process, although some indicated that limited sales might be warranted in the longer run to reduce or eliminate residual holdings.

The Federal Reserve continued to test tools that could potentially be used to manage reserves

As part of the Federal Reserve's ongoing program to ensure the readiness of tools to manage reserves, the Federal Reserve conducted a series of small-scale transactions with eligible counterparties. During the first half of 2013, the Federal Reserve conducted four repurchase agreement (repo) operations and three reverse repurchase agreement (reverse repo) operations. Operation sizes ranged between $0.2 and $2.8 billion using all eligible collateral types. While the repo transactions were conducted only with primary dealers, two of the reverse repo operations were open to the expanded set of eligible counterparties, which include not only primary dealers, but also banks, government-sponsored enterprises, and money market funds.¹⁷ In addition, the Federal Reserve Board conducted three operations for 28-day term deposits under the Term Deposit Facility (TDF). These operations included two competitive single-price TDF auctions totaling $3 billion in deposits and an offering with a fixed-rate, full-allotment format, which totaled $10 billion in deposits.