Monetary Policy and Economic Developments

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

The following discussion is a review of U.S. monetary policy and economic developments in 2014, excerpted from the Monetary Policy Reports published in February 2015 and July 2014. Those complete reports are available on the Board's website at www.federalreserve.gov/monetarypolicy/files/20150224_mprfullreport.pdf (February 2015) and www.federalreserve.gov/monetarypolicy/files/20140715_mprfullreport.pdf (July 2014).

Other materials in this annual report related to the conduct of monetary policy can be found in section 9, "Minutes of Federal Open Market Committee Meetings," and section 11, "Statistical Tables" (see tables 1-4).

Monetary Policy Report of February 2015

Summary

The labor market improved further during the second half of last year and into early 2015, and labor market conditions moved closer to those the Federal Open Market Committee (FOMC) judges consistent with its maximum employment mandate. Since the middle of last year, monthly payrolls have expanded by about 280,000, on average, and the unemployment rate has declined nearly 1/2 percentage point on net. Nevertheless, a range of labor market indicators suggest that there is still room for improvement. In particular, at 5.7 percent, the unemployment rate is still above most FOMC participants' estimates of its longer-run normal level, the labor force participation rate remains below most assessments of its trend, an unusually large number of people continue to work part time when they would prefer full-time employment, and wage growth has continued to be slow.

A steep drop in crude oil prices since the middle of last year has put downward pressure on overall inflation. As of December 2014, the price index for personal consumption expenditures was only 3/4 percent higher than a year earlier, a rate of increase that is well below the FOMC's longer-run goal of 2 percent. Even apart from the energy sector, price increases have been subdued. Indeed, the prices of items other than food and energy products rose at an annual rate of only about 1 percent over the last six months of 2014, noticeably less than in the first half of the year. The slow pace of price increases during the second half was likely associated, in part, with falling import prices and perhaps also with some pass-through of lower oil prices. Survey-based measures of longer-term inflation expectations have remained stable; however market-based measures of inflation compensation have declined since last summer.

Economic activity expanded at a strong pace in the second half of last year. Notably reflecting solid gains in consumer spending, real gross domestic product (GDP) is estimated to have increased at an annual rate of 3-3/4 percent after a reported increase of just 1-1/4 percent in the first half of the year. The growth in GDP was supported by accommodative monetary policy, a reduction in the degree of restraint imparted by fiscal policy, and the increase in households' purchasing power arising from the drop in oil prices. The gains in GDP have occurred despite continued sluggish growth abroad and a sizable appreciation of the U.S. dollar, both of which have weighed on net exports.

Financial conditions in the United States have generally remained supportive of economic growth. Longer-term interest rates in the United States and other advanced economies have continued to move down, on net, since the middle of 2014 amid disappointing economic growth and low inflation abroad as well as the associated anticipated and actual monetary policy actions by foreign central banks. Broad indexes of U.S. equity prices have risen moderately, on net, since the end of June. Credit flows to nonfinancial businesses largely remained solid in the second half of last year. Overall borrowing conditions for households eased further, but mortgage lending standards are still tight for many potential borrowers.

The vulnerability of the U.S. financial system to financial instability has remained moderate, primarily reflecting low-to-moderate levels of leverage and maturity transformation. Asset valuation pressures have eased a little, on balance, but continue to be notable in some sectors. The capital and liquidity positions of the banking sector have improved further. Over the second half of 2014, the Federal Reserve and other agencies finalized or proposed several more rules related to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which were designed to further strengthen the resilience of the financial system.

At the time of the FOMC meeting in late January of this year, the Committee saw the outlook as broadly similar to that at the time of its December meeting, when the most recent Summary of Economic Projections (SEP) was compiled. (The December SEP is included as Part 3 of the February 2015 Monetary Policy Report on pages 39-52; it is also included in section 9 of this annual report.) The FOMC expects that, with appropriate monetary policy accommodation, economic activity will expand at a moderate pace, and that labor market indicators will continue to move toward levels the Committee judges consistent with its dual mandate of maximum employment and price stability. In addition, the Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to decline further in the near term, mainly reflecting the pass-through of lower oil prices to consumer energy prices. However, the Committee expects inflation to rise gradually toward its 2 percent longer-run objective over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.

At the end of October, and after having made further measured reductions in the pace of its asset purchases at its July and September meetings, the FOMC concluded the asset purchase program that began in September 2012. The decision to end the purchase program reflected the substantial improvement in the outlook for the labor market since the program's inception--the stated aim of the asset purchases--and a judgment that the underlying strength of the broader economy was sufficient to support ongoing progress toward the Committee's policy objectives.

Nonetheless, the Committee continued to judge that a high degree of policy accommodation remained appropriate. As a result, the FOMC has maintained the exceptionally low target range of 0 to 1/4 percent for the federal funds rate and kept the Federal Reserve's holdings of longer-term securities at sizable levels. The Committee has also continued to provide forward guidance bearing on the anticipated path of the federal funds rate. In particular, the FOMC has stressed that in deciding how long to maintain the current target range, it will consider a broad set of indicators to assess realized and expected progress toward its objectives. On the basis of its assessment, the Committee indicated in its two most recent postmeeting statements that it can be patient in beginning to normalize the stance of monetary policy.

To further emphasize the data-dependent nature of its policy stance, the FOMC has stated that if incoming information indicates faster progress toward its policy objectives than the Committee currently expects, increases in the target range for the federal funds rate will likely occur sooner than the Committee anticipates. The FOMC has also indicated that in the case of slower-than-expected progress, increases in the target range will likely occur later than currently anticipated. Moreover, the Committee continues to expect that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

As part of prudent planning, the Federal Reserve has continued to prepare for the eventual normalization of the stance and conduct of monetary policy. The FOMC announced updated principles and plans for the normalization process following its September meeting and has continued to test the operational readiness of its monetary policy tools. The Committee remains confident that it has the tools it needs to raise short-term interest rates when doing so becomes appropriate, despite the very large size of the Federal Reserve's balance sheet.

Part 1: Recent Economic and Financial Developments

The labor market continued to improve in the second half of last year and early this year. Job gains have averaged close to 280,000 per month since June, and the unemployment rate fell from 6.1 percent in June to 5.7 percent in January. Even so, the labor market likely has not yet fully recovered, and wage growth has remained slow. Since June, a steep drop in crude oil prices has exerted downward pressure on overall inflation, and non-energy price increases have been subdued as well. The price index for personal consumption expenditures (PCE) increased only 3/4 percent during the 12 months ending in December, a rate that is well below the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent; the index excluding food and energy prices was up 1-1/4 percent over this period. Survey measures of longer-run inflation expectations have been stable, but measures of inflation compensation derived from financial market quotes have moved down. Meanwhile, real gross domestic product (GDP) increased at an estimated annual rate of 3-3/4 percent in the second half of the year, up from a reported rate of just 1-1/4 percent in the first half. The growth in GDP has been supported by accommodative monetary policy and generally favorable financial conditions, the boost to households' purchasing power from lower oil prices, and improving consumer and business confidence. However, housing market activity has been advancing only slowly, and sluggish growth abroad and the higher foreign exchange value of the dollar have weighed on net exports. Longer-term interest rates in the United States and other advanced economies declined, on net, amid disappointing growth and low inflation abroad and the associated actual and anticipated accommodative monetary policy actions by foreign central banks.

Domestic Developments

The labor market has strengthened further . . .

Employment rose appreciably and the unemployment rate fell in the second half of 2014 and early this year. Payroll employment has increased by an average of about 280,000 per month since June, almost 40,000 faster than in the first half of last year (figure 1). The gain in payroll employment for 2014 as a whole was the largest for any year since 1999. In addition, the unemployment rate continued to move down, declining from 6.1 percent in June to 5.7 percent in January of this year, a rate more than 4 percentage points below its peak in 2009. Furthermore, a substantial portion of the decline in unemployment over the past year came from a decrease in the number of individuals reporting unemployment spells longer than six months.

The labor force participation rate has been roughly flat since late 2013 after having declined not only during the recession, but also during much of the recovery period when most other indicators of labor market health were improving. While much of that decline likely reflected ongoing demographic trends--such as the aging of members of the baby-boom generation into their retirement years--some of the decline likely reflected workers' perceptions of poor job opportunities. Judged against the backdrop of a declining trend, the recent stability of the participation rate likely represents some cyclical improvement. Nevertheless, the participation rate remains lower than would be expected given the unemployment rate, and thus it continues to suggest more cyclical weakness than is indicated by the unemployment rate.

Another sign that the labor market remains weaker than indicated by the unemployment rate alone is the still-elevated share of workers who are employed part time but would like to work full time. This share of involuntary part-time employees has generally shown less improvement than the unemployment rate over the past few years; in part for this reason, the more comprehensive U-6 measure of labor underutilization remains quite elevated (figure 2).

Nevertheless, most broad measures of labor market health have improved. With employment rising
and the participation rate holding steady, the employment-to-population ratio climbed noticeably higher in 2014 and early 2015 after having moved more or less sideways for much of the recovery. The quit rate, which is often perceived as a measure of worker confidence in labor market opportunities, has largely recovered to its pre-recession level. Moreover, an index constructed by Federal Reserve Board staff that aims to summarize movements in a wide array of labor market indicators also suggests that labor market conditions strengthened further in 2014, and that the gains have been quite strong in recent months.¹

. . . while gains in compensation have been modest . . .

Even as the labor market has been improving, most measures of labor compensation have continued to show only modest gains. The employment cost index (ECI) for private industry workers, which measures both wages and the cost of employer-provided benefits, rose 2-1/4 percent over the 12 months ending in December, only slightly faster than the gains of about 2 percent that had prevailed for several years. Two other prominent measures of compensation--average hourly earnings and business-sector compensation per hour--increased slightly less than the ECI over the past year and have shown fewer signs of acceleration. Over the past five years, the gains in all three of these measures of nominal compensation have fallen well short of their pre-recession averages and have only slightly outpaced inflation. That said, the drop in energy prices has pushed up real wages in recent months.

. . . and productivity growth has been lackluster

Over time, increases in productivity are the central determinant of improvements in living standards. Labor productivity in the private business sector has increased at an average annual pace of 1-1/4 percent since the recession began in late 2007. This pace is close to the average that prevailed between the mid-1970s and the mid-1990s, but it is well below the pace of the earlier post-World War II period and the period from the mid-1990s to the eve of the financial crisis. In recent years, productivity growth has been held down by, among other factors, the sharp drop in businesses' capital expenditures over the recession and the moderate recovery in expenditures since then. Productivity gains may be better supported in the future as investment continues to strengthen.

A plunge in crude oil prices has held down consumer prices . . .

As discussed in the box "The Effect of the Recent Decline in Oil Prices on Economic Activity" on pages 8-9 of the February 2015 Monetary Policy Report, crude oil prices have plummeted since June 2014 (figure 3). This sharp drop has caused overall consumer price inflation to slow, mainly due to falling gasoline prices: The national average of retail gasoline prices moved down from about $3.75 per gallon in June to about $2.20 per gallon in January. Crude oil prices have turned slightly higher in recent weeks, and futures markets suggest that prices are expected to edge up further in coming years; nevertheless, oil prices are still expected to remain well below the levels that had prevailed through last June.

Over the past six months, increases in food prices have moderated. Consumer food price increases had been somewhat elevated in early 2014 as a result of rising food commodity prices, but those commodity prices have since eased, and increases at the retail level have slowed accordingly.

. . . but even outside of the energy and food categories, inflation has remained subdued

Inflation for items other than food and energy (so-called core inflation) remains modest. Core PCE prices rose at an annual rate of only about 1 percent over the last six months of 2014 after having risen at a 1-3/4 percent rate in the first half of the year; for 2014 as a whole, core PCE prices were up a little more than 1-1/4 percent (figure 4). The trimmed mean PCE price index, an alternative indicator of underlying inflation constructed by the Federal Reserve Bank of Dallas, also increased more slowly in the second half of last year. Falling import prices likely held down core inflation in the second half of the year; lower oil prices, and easing prices for commodities more generally, may have played a role as well. In addition, ongoing resource slack has reinforced the low-inflation environment, though with the improving economy, downward pressure from this factor is likely waning.

Looking at the overall basket of items that people consume, price increases remain muted and below
the FOMC's longer-run objective of 2 percent. In December, the PCE price index was only 3/4 percent above its level from a year earlier. With retail surveys showing a further sharp decline in gasoline prices in January, overall consumer prices likely moved lower early this year.

Survey-based measures of longer-term inflation expectations have remained stable, while market-based measures of inflation compensation have declined

The Federal Reserve tracks indicators of inflation expectations because such expectations likely factor into wage- and price-setting decisions and so influence actual inflation. Survey-based measures of longer-term inflation expectations, including surveys of both households and professional forecasters, have been quite stable over the past 15 years; in particular, they have changed little, on net, over the past few years (figure 5). In contrast, measures of longer-term inflation compensation derived from financial market instruments have fallen noticeably during the past several months. As is discussed in more detail in the box "Challenges in Interpreting Measures of Longer-Term Inflation Expectations" on pages 12-13 of the February 2015 Monetary Policy Report, deducing the sources of changes in inflation compensation is difficult because such movements may be caused by factors other than shifts in market participants' inflation expectations.

Economic activity expanded at a strong pace in the second half of 2014

Real GDP is estimated to have increased at an annual rate of 3-3/4 percent in the second half of last year after a reported increase of just 1-1/4 percent in the first half, when output was likely restrained by severe weather and other transitory factors (figure 6). Private domestic final purchases--a measure of household and business spending that tends to exhibit less quarterly variation than GDP--also advanced at a substantial pace in the second half of last year.

The second-half gains in GDP reflected solid advances in consumer spending and in business investment spending on equipment and intangibles (E&I) as well as subdued gains for both residential investment and nonresidential structures. More generally, the growth in GDP has been supported by accommodative financial conditions, including declines in the cost of borrowing for many households and businesses; by a reduction in the restraint from fiscal policy relative to 2013; and by increases in spending spurred by continuing job gains and, more recently, by falling oil prices. The gains in GDP have occurred despite an appreciating U.S. dollar and concerns about global economic growth, which remain an important source of uncertainty for the economic outlook.

Consumer spending was supported by continuing improvement in the labor market and falling oil prices, . . .

Real PCE rose at an annual rate of 3-3/4 percent in the second half of 2014--a noticeable step-up from the sluggish rate of only about 2 percent in the first half (figure 7). The increases in spending have been supported by the improving labor market. In addition, the fall in gasoline and other energy prices has boosted purchasing power for consumers, especially those in lower- and middle-income brackets who spend a sizable share of their income on gasoline. Real disposable personal income--that is, income after taxes and adjusted for price changes--rose 3 percent at an annual rate in the second half of last year, roughly double the average rate recorded over the preceding five years.

. . . further increases in household wealth and low interest rates, . . .

Consumer spending growth was also likely supported by further increases in household net worth, as the stock market continued to rise and house prices moved up in the second half of last year. The value of corporate equities rose about 10 percent in 2014, on top of the 30 percent gain seen in 2013. Although the gains in house prices slowed last year--for example, the CoreLogic national index increased only 5 percent after having risen more substantially in 2012 and 2013--these gains affected a larger share of the population than did the gains in equities, as more individuals own homes than own stocks (figure 8). Reflecting increases in home and equity prices, aggregate household net wealth has risen appreciably from its levels during the recession and its aftermath to more than six times the value of disposable
personal income.

Coupled with low interest rates, the rise in incomes has lowered debt payment burdens for many households. The household debt service ratio--that is, the ratio of required principal and interest payments on outstanding household debt to disposable personal income--has remained at a very low level by historical standards.

. . . and increased credit availability for consumers

Consumer credit continued to expand through late 2014, as auto and student loans have remained available even to borrowers with lower credit scores. In addition, credit cards have become somewhat more accessible to individuals on the lower end of the credit spectrum, and overall credit card debt increased moderately last year.

Consumer confidence has moved up

Consistent with the improvement in the labor market and the fall in energy prices, indicators of consumer sentiment moved up noticeably in the second half of last year. The University of Michigan Surveys of Consumers' index of consumer sentiment--which incorporates households' views about their own financial situations as well as broader economic conditions--has moved up strongly, on net, in recent months and is now close to its long-run average. The Michigan survey's measure of households' expectations of real income changes in the year ahead has also continued to trend up over the past several months, perhaps reflecting the fall in gasoline prices. However, this measure remains substantially below its historical average and suggests a more guarded outlook than the headline sentiment index.

However, the pace of homebuilding has improved only slowly

After advancing reasonably well in 2012 and early 2013, the recovery in residential construction activity has slowed markedly. Single-family housing starts only edged up in 2014, and multifamily construction activity was also little changed (figure 9). And sales of both new and existing homes were flat, on net, last year. In all, real residential investment rose only 2-1/2 percent in 2014, and it remains well below its pre-recession peak. The weak recovery in construction likely relates to the rate of household formation, which, notwithstanding tentative signs of a recent pickup, has generally stayed very low despite the improvement in the labor market.

Lending policies for home purchases remained tight overall, although there are some indications that mortgage credit has started to become more widely accessible. Over the course of 2014, the fraction of home-purchase mortgages issued to borrowers with credit scores on the lower end of the spectrum edged up. Additionally, in the Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), several large banks reported having eased lending standards on prime home-purchase loans in the third and fourth quarters of last year.² In January, the Federal Housing Administration reduced its mortgage insurance premiums by about one-third of the level that had prevailed during the past four years--a step that may lower the cost of credit for households with small down payments and low credit scores. Even so, mortgages have remained difficult to obtain for many households.

Meanwhile, for borrowers who can qualify for a mortgage, the cost of credit is low. After rising appreciably around mid-2013, mortgage interest rates have since retraced much of those increases. The 30-year fixed mortgage rate declined roughly 60 basis points in 2014, and it has edged down further, on net, this year to a level not far from its all-time low in 2012. Likely related to the most recent decline in mortgage rates, refinancing activity rose modestly in January.

Overall business investment has moved up, but investment in the energy sector is starting to be affected by the drop in oil prices

Business fixed investment rose at an annual rate of 5-1/4 percent in the second half of 2014, close to the rate of increase seen in the first half. Spending on E&I capital rose at an annual rate of about 6 percent, while spending on nonresidential structures moved up about 4 percent (figure 10). Business investment has been supported by strengthening final demand as well as by low interest rates and generally accommodative financial conditions. Regarding nonresidential structures, vacancy rates for existing properties have been declining, and financing conditions for new construction have eased further--both factors that bode well for future construction. More recently, however, the steep decline in the number of drilling rigs in operation suggests that a sharp falloff in the drilling and mining component of investment in nonresidential structures may be under way.

Corporate financing conditions were generally favorable

The financial condition of large nonfinancial firms generally remained solid in the second half of last year; profitability stayed high, and default rates on nonfinancial corporate bonds were generally very low. Nonfinancial firms have continued to raise funds through capital markets at a robust pace, given sturdy corporate credit quality, historically low interest rates on corporate bonds, and highly accommodative lending conditions for most firms. Bond issuance by investment-grade nonfinancial firms, and syndicated lending to those firms, have both been particularly strong. However, speculative-grade issuance in those markets, which had remained elevated for most of 2014, diminished late in the year, because volatility increased and spreads widened and perhaps also because of greater scrutiny by regulators of syndicated leveraged loans with weaker credit quality and lower repayment capacity.

Credit also was readily available to most bank-dependent businesses. According to the October 2014 and January 2015 SLOOS reports, banks generally continued to ease price and nonprice terms on commercial and industrial (C&I) loans to firms of all sizes in the second half of 2014. That said, in the fourth quarter, several banks reported having tightened lending policies for oil and gas firms or, more broadly, in response to legislative, supervisory, or accounting changes. In addition, although overall C&I loans on banks' books registered substantial increases in the second half of 2014, loans to businesses in amounts of $1 million or less--a proxy for lending to small businesses--increased only modestly. The weak growth in these small loans appears largely due to sluggish demand; however, bank lending standards to small businesses are still reportedly somewhat tighter than the midpoint of their range over the past decade despite considerable loosening over the past few years.

Net exports held down second-half real GDP growth slightly

Exports increased at a modest pace in the second half of 2014, held back by lackluster growth abroad as well as the appreciation of the dollar. Import growth was also relatively subdued, despite the impetus from the stronger dollar, and was well below the pace observed in the first half (figure 11). All told, real net trade was a slight drag on real GDP growth in the second half of 2014.

The current account deficit was little changed in the third quarter of 2014 and, at 2-1/4 percent of nominal GDP, was near its narrowest reading since the late 1990s. The current account deficit in the first three quarters of 2014 was financed mainly by purchases of Treasury and corporate securities by foreign private investors. In contrast, the pace of foreign official purchases in the first three quarters of the year was the slowest in more than a decade, reflecting a significant slowdown in reserve accumulation by emerging market economies (EMEs).

Federal fiscal policy was less of a drag on GDP . . .

Fiscal policy at the federal level had been a factor restraining GDP growth for several years, especially in 2013. In 2014, however, the contractionary effects of tax and spending changes eased appreciably as the restraining effects of the 2013 tax increases abated and there was a slowing in the declines in federal purchases due to sequestration and the Budget Control Act of 2011 (figure 12). Moreover, some of the overall drag on demand was offset in 2014 by an increase in transfers resulting from the Affordable Care Act.

The federal unified deficit narrowed further last year, reflecting both the previous years' spending cuts and an increase in tax receipts resulting from the ongoing economic expansion. The budget deficit was 2-3/4 percent of GDP for fiscal year 2014, and the Congressional Budget Office projects that it will be about 2-1/2 percent in 2015. As a result, overall federal debt held by the public stabilized as a share of GDP in 2014, albeit at a relatively high level.

. . . and state and local government expenditures are also turning up

The expansion of economic activity has also led to continued slow improvements in the fiscal position of most state and local governments. Consistent with improving finances, states and localities expanded employment rolls in 2014. Furthermore, state and local expenditures on construction projects rose a touch last year following several years of declines.

Financial Developments

The expected path for the federal funds rate flattened

Market participants seemed to judge the incoming domestic economic data since the middle of last year, especially the employment reports, as supporting expectations for continued economic expansion in the United States; however, concerns about the foreign economic outlook weighed on investor sentiment. On balance, market-based measures of the expected (or mean) path of the federal funds rate through late 2017 have flattened, but the expected timing of the initial increase in the federal funds rate from its current target range was about unchanged. In addition, according to the results of the most recent Survey of Primary Dealers and the Survey of Market Participants, both conducted by the Federal Reserve Bank of New York just prior to the January FOMC meeting, respondents judged that the initial increase in the target federal funds rate was most likely to occur around mid-2015, little changed from the results of those surveys from last June.³ Meanwhile, in part because the passage of time brought the anticipated date of the initial increase in the federal funds rate closer, measures of policy rate uncertainty based on interest rate derivatives edged higher, on net, from their mid-2014 levels.

Longer-term Treasury yields and other sovereign benchmark yields declined

Yields on longer-term Treasury securities have continued to move down since the middle of last year on net (figure 13). In particular, the yields on 10- and 30-year nominal Treasury securities declined about 40 basis points and 60 basis points, respectively, from their levels at the end of June 2014. The decreases in longer-term yields were driven especially by reductions in longer-horizon forward rates. For example, the 5-year forward rate 5 years ahead dropped about 80 basis points over the same period. Long-term benchmark sovereign yields in advanced foreign economies (AFEs) have also moved down significantly in response to disappointing growth and very low and declining rates of inflation in a number of foreign countries as well as the associated actual and anticipated changes in monetary policy abroad.

The declines in longer-term Treasury yields and long-horizon forward rates seem to largely reflect reductions in 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. Market participants pointed to several factors that may help to explain the reduction in term premiums. First, very low and declining AFE yields and safe-haven flows associated with the deterioration in the foreign economic outlook likely have increased demand for Treasury securities. Second, the weaker foreign economic outlook coupled with the steep decline in oil prices may have led investors to put higher odds on scenarios in which U.S. inflation remains quite low for an extended period. Investors may see nominal long-term Treasury securities as an especially good hedge against such risks. Finally, market participants may have increased the probability they attach to outcomes in which U.S. economic growth is persistently subdued. Indeed, the 5-year forward real yield 5 years ahead, obtained from yields on Treasury Inflation-Protected Securities, has declined further, on net, since the middle of last year and stands well below levels commonly cited as estimates of the longer-run real short rate.

Consistent with moves in the yields on longer-term Treasury securities, yields on 30-year agency mortgage-backed securities (MBS)--an important determinant of mortgage interest rates--decreased about 30 basis points, on balance, over the second half of 2014 and early 2015.

Liquidity conditions in Treasury and agency MBS markets were generally stable . . .

On balance, indicators of Treasury market functioning remained stable over the second half of 2014 even as the Federal Reserve trimmed the pace of its asset purchases and ultimately brought the purchase program to a close at the end of October. The Treasury market experienced a sharp drop in yields and significantly elevated volatility on October 15, as technical factors reportedly amplified price movements following the release of the somewhat weaker-than-expected September U.S. retail sales data. However, market conditions recovered quickly and liquidity measures, such as bid-asked spreads, have been generally stable since then. Moreover, Treasury auctions generally continued to be well received by investors.

As in the Treasury market, liquidity conditions in the agency MBS market were generally stable, with the exception of mid-October. Dollar-roll-implied financing rates for production coupon MBS--an indicator of the scarcity of agency MBS for settlement-- suggested limited settlement pressures in these markets over the second half of 2014 and
early 2015.

. . . and short-term funding markets also continued to function well as rates moved slightly higher overall

Conditions in short-term dollar funding markets also remained stable during the second half of 2014 and early 2015. Both unsecured and secured money market rates moved modestly higher late in 2014 but remained close to their averages since the federal funds rate reached its effective lower bound. Unsecured offshore dollar funding markets generally did not exhibit signs of stress, and the repurchase agreement, or repo, market functioned smoothly with modest year-end pressures.

Money market participants continued to focus on the ongoing testing of the Federal Reserve's monetary policy tools. The offering rate in the overnight reverse repurchase agreement (ON RRP) exercise has continued to provide a soft floor for other rates on secured borrowing, and the term RRP testing operations that were conducted in December and matured in early January seemed to help alleviate year-end pressures in money markets. For a detailed discussion of the testing of monetary policy tools, see the box "Additional Testing of Monetary Policy Tools" on pages 36-37 of the February 2015 Monetary Policy Report.

Broad equity price indexes rose despite higher volatility, while risk spreads on corporate debt widened

Over the second half of 2014 and early 2015, broad measures of U.S. equity prices increased further, on balance, but stock prices for the energy sector declined substantially, reflecting the sharp drops in oil prices (figure 14). Although increased concerns about the foreign economic outlook seemed to weigh on risk sentiment, the generally positive tone of U.S. economic data releases as well as declining longer-term interest rates appeared to provide support for equity prices. Overall equity valuations by some conventional measures are somewhat higher than their historical average levels, and valuation metrics in some sectors continue to appear stretched relative to historical norms. Implied volatility for the S&P 500 index, as calculated from options prices, increased moderately, on net, from low levels over the summer.

Corporate credit spreads, particularly those for speculative-grade bonds, widened from the fairly low levels of last summer, in part because of the underperformance of energy firms. Overall, corporate bond spreads across the credit spectrum have been near their historical median levels recently. For further discussion of asset prices and other financial stability issues, see the box "Developments Related to Financial Stability" on pages 24-25 of the February 2015 Monetary Policy Report.

Bank credit and the M2 measure of the money stock continued to expand

Aggregate credit provided by commercial banks increased at a solid pace in the second half of 2014 (figure 15). The expansion in bank credit was mainly driven by moderate loan growth coupled with continued robust expansion of banks' holdings of U.S. Treasury securities, which was reportedly influenced by efforts of large banks to meet the new Basel III Liquidity Coverage Ratio requirements. The growth of loans on banks' books was generally consistent with the SLOOS reports of increased loan demand and further easing of lending standards for many loan categories over the second half of 2014. Meanwhile, delinquency and charge-off rates fell across most major loan types.

Measures of bank profitability were little changed in the second half of 2014, on net, and remained below their historical averages. Equity prices of large domestic bank holding companies (BHCs) have increased moderately, on net, since the middle of last year. Credit default swap (CDS) spreads for large BHCs were about unchanged.

The M2 measure of the money stock has increased at an average annualized rate of about 5-1/2 percent since last June, below the pace registered in the first half of 2014 and about in line with the pace of nominal GDP. The deceleration was driven by a moderation in the growth rate of liquid deposits in the banking sector relative to the first half of 2014. Although demand for currency weakened in the third quarter of 2014 relative to the first half of the year, currency growth has been strong since November.

Municipal bond markets functioned smoothly, but some issuers remained strained

Credit conditions in municipal bond markets have generally remained stable since the middle of last year. Over that period, the MCDX--an index of CDS spreads for a broad portfolio of municipal bonds--and ratios of yields on 20-year general obligation municipal bonds to those on longer-term Treasury securities increased slightly.

Nevertheless, significant financial strains were still evident for some issuers. Puerto Rico, with speculative-grade-rated general obligation bonds, continued to face challenges from subdued economic performance, severe indebtedness, and other fiscal pressures. Meanwhile, the City of Detroit emerged from bankruptcy late in 2014 after its debt restructuring plan was approved by a federal judge.

International Developments

Bond yields in the advanced foreign economies continued to decline . . .

As noted previously, long-term sovereign yields in the AFEs moved down further during the second half of 2014 and into early 2015 on continued low inflation readings abroad and heightened concerns over the strength of foreign economic growth as well as amid substantial monetary policy accommodation (figure 16). German yields fell to record lows, as the European Central Bank (ECB) implemented new liquidity facilities, purchased covered bonds and asset-backed securities, and announced it would begin buying euro-area sovereign bonds. Specifically, the ECB said that it would purchase €60 billion per month of euro-area public and private bonds through at least September 2016. Japanese yields also declined, reflecting the expansion by the Bank of Japan (BOJ) of its asset purchase program. In the United Kingdom, yields fell as data showed declining inflation and some moderation in economic growth, although they have retraced a little of that move in recent weeks, in part as market sentiment toward the U.K. outlook appears to have improved somewhat. In emerging markets, yields were mixed--falling, for the most part, in Asia and generally rising modestly in Latin America--as CDS spreads widened amid growing credit concerns, particularly in some oil-exporting countries.

. . . while the dollar has strengthened markedly

The broad nominal value of the dollar has increased markedly since the middle of 2014, with the U.S. dollar appreciating against almost all currencies (figure 17). The increase in the value of the dollar was largely driven by additional monetary easing abroad and rising concerns about foreign growth--forces similar to those that drove benchmark yields lower--in the face of expectations of solid U.S. growth and the anticipated start of monetary tightening in the United States later this year. Both the euro and the yen have depreciated about 20 percent against the dollar since mid-2014. Notwithstanding the sharp nominal appreciation of the dollar since mid-2014, the real value of the dollar, measured against a broad basket of currencies, is currently somewhat below its historical average since 1973 and well below the peak it reached in early 1985.

Foreign equity indexes were mixed over the period. Japanese equities outperformed other AFE indexes, helped by the BOJ's asset purchase expansion. Euro-area equities are up modestly from their mid-2014 levels, boosted recently by monetary easing. However, euro-area bank shares substantially underperformed broader indexes, partly reflecting low profitability, weak operating environments, and lingering vulnerabilities to economic and financial shocks. EME equities indexes were mixed, with most emerging Asian indexes rising and some of the major Latin American indexes moving down.

Economic growth in the advanced foreign economies, while still generally weak, firmed toward the end of the year

Economic growth in the AFEs, which was weak in the first half of 2014, firmed toward the end of the second half of the year, supported in part by lower oil prices and more accommodative monetary policies. The euro-area economy barely grew in the third quarter and unemployment remained near record highs, but the pace of economic activity moved up in the fourth quarter. Notwithstanding more supportive monetary policy and the recent pickup in euro-area growth, negotiations over additional financial assistance for Greece have the potential to trigger adverse market reactions and resurrect financial stresses that might impair growth in the broader euro-area economy. Japanese real GDP contracted again in the third quarter, following a tax hike-induced plunge in the second quarter, but it rebounded toward the end of the year as exports and household spending increased. In contrast, economic activity in the United Kingdom and Canada was robust in the third quarter but moderated in the fourth quarter.

The fall in oil prices and other commodity prices pushed down headline inflation across the major AFEs. Most notably, 12-month euro-area inflation continued to trend down, falling to negative 0.6 percent in January. Declines in inflation and in market-based measures of inflation expectations since mid-2014 prompted the ECB to increase its monetary stimulus. Similar considerations led the BOJ to step up its pace of asset purchases in October. The Bank of Canada lowered its target for the overnight rate in January in light of the depressing effect of lower oil prices on Canadian inflation and economic activity, as oil exports are nearly 20 percent of total goods exports. Several other foreign central banks lowered their policy rates, either reaching or pushing further into negative territory, including in Denmark, Sweden, and Switzerland--the last of which did so in the context of removing its floor on the euro-Swiss franc exchange rate.

Growth in the emerging market economies improved but remained subdued

Following weak growth earlier last year, overall economic activity in the EMEs improved a bit in the second half of 2014, but performance varied across economies. Growth in Asia was generally solid, supported by external demand, particularly from the United States, and improved terms of trade due to the sharp decline in commodity prices. In contrast, the decline in commodity prices, along with macroeconomic policy challenges, weighed on economic activity in several South American countries.

In China, exports expanded rapidly in the second half of last year, but fixed investment softened, as real estate investment slowed amid a weakening property market. Responding to increased concerns over the strength of growth, the authorities announced additional targeted stimulus measures in an effort to prevent the economy from slowing abruptly. In much of the rest of emerging Asia, exports, particularly to the United States, supported a step-up in growth from the first half of the year. The Mexican economy continued to grow at a moderate pace in the second half of 2014, with solid exports to the United States but lingering softness in household demand. In Brazil, economic activity remained lackluster amid falling commodity prices, diminished business confidence, and tighter macroeconomic policy. Declining oil prices were especially disruptive for several economies with heavy dependence on oil exports, including Russia and Venezuela.

Inflation continued to be subdued in most EMEs. The fall in the price of oil contributed to a moderation of headline inflation in several EMEs, including China. However, this contribution was limited in many EMEs due to the prevalence of administered energy prices, which lower the pass-through of changes in oil prices to consumer prices. In several countries, including Indonesia and Malaysia, the fall in energy prices prompted governments to cut fuel subsidies, leading to a rise in domestic prices of fuel and in inflation late in 2014. With inflation low or declining, some central banks, including those of China, Korea, and Chile, loosened monetary policy to support growth. In other EMEs, including Brazil and Malaysia, inflationary pressures stemming from depreciating currencies or from reductions in fuel subsidies prompted central banks to raise policy rates. The central bank of Russia sharply tightened monetary policy to combat inflationary pressures and stabilize its financial markets, which came under considerable pressure in late 2014.

Part 2: Monetary Policy

The Federal Open Market Committee (FOMC) concluded its asset purchase program at the end of October in light of the substantial improvement in the outlook for the labor market since the inception of the program. To support further progress toward maximum employment and price stability, the FOMC has kept the target federal funds rate at its effective lower bound and maintained the Federal Reserve's holdings of longer-term securities at sizable levels. To give greater clarity to the public about its policy outlook, the Committee has also continued to provide qualitative guidance regarding the future path of the federal funds rate. In particular, the Committee indicated at its two most recent meetings that it can be patient in beginning to normalize the stance of monetary policy and continued to emphasize the data-dependent nature of its policy stance. Following its September meeting, and as part of prudent planning, the Committee announced updated principles and plans for the eventual normalization of monetary policy.

The FOMC concluded its asset purchases at the end of October in light of substantial improvement in the outlook for the labor market

At the end of October, the FOMC ended the asset purchase program that began in September 2012 after having made further measured reductions in the pace of its asset purchases at the prior meetings in July and September.⁴ The decision to end the purchase program reflected the substantial improvement in the outlook for the labor market since the program's inception--which had been the goal of the asset purchases--and the Committee's judgment that the overall recovery was sufficiently strong to support ongoing progress toward the Committee's policy objectives. However, the Committee judged that a high degree of policy accommodation still remained appropriate and maintained its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities (MBS) in agency MBS and of rolling over maturing Treasury securities at auction. By keeping the Federal Reserve's holdings of longer-term securities at sizable levels, this policy is expected to help maintain accommodative financial conditions by putting downward pressure on longer-term interest rates and supporting mortgage markets. In turn, those effects are expected to contribute to progress toward both the maximum employment and price stability objectives of
the FOMC.

To support further progress toward its objectives, the Committee has kept the target federal funds rate at its lower bound and updated its forward rate guidance

The Committee has maintained the exceptionally low target range of 0 to 1/4 percent for the federal funds rate to support further progress toward its objectives of maximum employment and price stability. In addition, the FOMC has provided guidance about the likely future path of the federal funds rate in an effort to give greater clarity to the public about its policy outlook. In particular, the Committee has reiterated that, in determining how long to maintain this target range, it will assess realized and expected progress toward its objectives. This assessment will continue to take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. Based on its assessment of these factors, before updating its guidance in December, the Committee had been indicating that it likely would be appropriate to maintain the current target range for the federal funds rate for a considerable time following the end of the asset purchase program, especially if projected inflation continued to run below the Committee's 2 percent longer-run goal and provided that longer-term inflation expectations remained well anchored.

In light of the conclusion of the asset purchase program at the end of October and the further progress that the economy had made toward the Committee's objectives, the FOMC updated its forward guidance at its December meeting. In particular, the Committee stated that it can be patient in beginning to normalize the stance of monetary policy, but it also emphasized that the Committee saw the revised language as consistent with the guidance in its previous statement.⁵ The Committee restated the updated forward guidance following its January meeting based on its assessment of the economic information available at that time.⁶

In her December press conference, Chair Yellen emphasized that the update to the forward guidance did not signify a change in the Committee's policy intentions, but rather was a better reflection of the Committee's focus on the economic conditions that would make an increase in the federal funds rate appropriate.⁷ Chair Yellen additionally indicated that, consistent with the new language, the Committee was unlikely to begin the normalization process for at least the following two meetings. There are a range of views within the Committee regarding the appropriate timing of the first increase in the federal funds rate, in part reflecting differences in participants' expectations for how the economy would evolve. By the time of liftoff, the Committee expects some further decline in the unemployment rate and additional improvement in labor market conditions. In addition, the Committee anticipates that, on the basis of incoming data, it will be reasonably confident that inflation will move back over the medium term to its 2 percent objective.

The Committee has reiterated that, when it decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. In addition, the Committee continues to anticipate that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. As emphasized by Chair Yellen in her recent press conferences, FOMC participants provide a number of explanations for this view, with many citing the residual effects of the financial crisis. These effects are expected to ease gradually, but they are seen as likely to continue to constrain household spending for some time.

The FOMC has stressed the data-dependent nature of its policy stance and indicated that if incoming information signals faster progress than the Committee expects, increases in the target range for the federal funds rate will likely occur sooner than the Committee anticipates. The FOMC also stated that in the case of slower-than-expected progress, increases in the target range will likely occur later than anticipated.

The size of the Federal Reserve's balance sheet stabilized with the conclusion of the asset purchase program

After the conclusion of the large-scale asset purchase program at the end of October, the Federal Reserve's total assets stabilized at around $4.5 trillion (figure 18). As a result of the asset purchases over the second half of 2014, before the completion of the program, holdings of U.S. Treasury securities in the System Open Market Account (SOMA) increased $56 billion to $2.5 trillion, and holdings of agency debt and agency MBS increased $78 billion to $1.8 trillion on net. On the liability side of the balance sheet, the increase in the Federal Reserve's assets was largely matched by increases in currency in circulation and reverse repurchase agreements.

Given the Federal Reserve's large securities holdings, interest income on the SOMA portfolio continued to support substantial remittances to the U.S. Treasury Department. Preliminary estimates suggest that the Federal Reserve provided more than $98 billion of such distributions to the Treasury in 2014 and about $500 billion on a cumulative basis since 2008.⁸

The FOMC continued to plan for the eventual normalization of monetary policy . . .

FOMC meeting participants have had ongoing discussions of issues associated with the eventual normalization of the stance and conduct of monetary policy as part of prudent planning.⁹ The discussions involved various tools that could be used to control the level of short-term interest rates, even while the balance sheet of the Federal Reserve remains very large, as well as approaches to normalizing the size and composition of the Federal Reserve's balance sheet.

To inform the public about its approach to normalization and to convey the Committee's confidence in its plans, the FOMC issued a statement regarding its intentions for the eventual normalization of policy following its September meeting. (That statement is reproduced in the box "Policy Normalization Principles and Plans" on page 35 of the February 2015 Monetary Policy Report.) As was the case before the crisis, the Committee intends to adjust the stance of monetary policy during normalization primarily through actions that influence the level of the federal funds rate and other short-term interest rates. Regarding the balance sheet, the Committee intends to reduce securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the SOMA. The Committee noted that economic and financial conditions could change, and that it was prepared to make adjustments to its normalization plans if warranted.

. . . including by testing the policy tools to be used

The Federal Reserve has continued to test the operational readiness of its policy tools, conducting daily overnight reverse repurchase agreement (ON RRP) operations, a series of term RRP operations, and several tests of the Term Deposit Facility. To date, testing has progressed smoothly, and short-term market rates have generally traded above the ON RRP rate, which suggests that the facility will be a useful supplementary tool for the FOMC to use in addition to the interest rate it pays on excess reserves (the IOER rate) to control the federal funds rate during the normalization process. Overall, testing operations reinforced the Federal Reserve's confidence in its view that it has the tools necessary to tighten policy at the appropriate time. (For more discussion of the Federal Reserve's preparations for the eventual normalization of monetary policy, see the box "Additional Testing of Monetary Policy Tools" on pages 36-37 of the February 2015 Monetary Policy Report.)

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Monetary Policy Report of July 2014

Summary

The overall condition of the labor market continued to improve during the first half of 2014. Gains in payroll employment picked up to an average monthly pace of about 230,000, and the unemployment rate fell to 6.1 percent in June, nearly 4 percentage points below its peak in 2009. Notwithstanding those improvements, a broad array of labor market indicators--such as labor force participation, hiring and quit rates, and the number of people working part time for economic reasons--generally suggests that significant slack remains in the labor market. Continued slow increases in most measures of labor compensation also corroborate the view that labor resources are not being fully utilized.

Inflation has moved up this year following unusually low readings in 2013, but it has remained somewhat below the Federal Open Market Committee's (FOMC) longer-run goal of 2 percent. The price index for personal consumption expenditures (PCE) rose 1-3/4 percent over the 12 months ending in May, up from an increase of only 1 percent a year earlier. The PCE price index excluding food and energy items rose 1-1/2 percent over the past 12 months. Meanwhile, both survey- and market-based measures of longer-term inflation expectations have remained stable.

Real gross domestic product is reported to have declined in the first quarter of this year, but a number of recent indicators suggest that economic activity rebounded in the second quarter. The pace of economic growth abroad also appears to have quickened in the second quarter following weakness earlier this year, which should provide support for export sales. Moreover, expansion in economic activity continues to be supported by ongoing job gains, a waning drag from fiscal policy, and accommodative financial conditions. However, the housing sector has shown little recent progress. While it has recovered notably from its earlier trough, activity in the sector leveled off in the wake of last year's increase in mortgage rates, and readings this year have, overall, continued to be disappointing.

The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to move gradually toward levels that the Committee judges consistent with its dual mandate of maximum employment and price stability. In addition, the Committee anticipates that with stable inflation expectations and strengthening economic activity, inflation will, over time, return to the Committee's 2 percent objective. Those expectations are reflected in the June Summary of Economic Projections, which is included as Part 3 of this report. (The June SEP is included as Part 3 of the July 2014 Monetary Policy Report on pages 41-54; it is also included in section 9 of this annual report.)

Financial conditions have generally remained supportive of economic growth. Longer-term interest rates have continued to be low by historical standards, and over the first half of the year those interest rates moved down significantly in the United States as well as in most other advanced economies. Overall, borrowing conditions for households have continued to slowly improve amid rising house and equity prices and the faster pace of employment growth so far this year. Credit flows to large nonfinancial businesses have remained strong, and small business lending activity has shown signs of improvement in recent months.

With respect to financial stability, signs of risk-taking that could leave segments of the U.S. financial sector vulnerable to possible adverse events have increased modestly this year, albeit from a subdued level. Prices for real estate, equities, and corporate debt have risen and valuation measures have increased, but valuations remain roughly in line with historical norms. Signs of excesses that could lead to higher future defaults and losses have emerged in some sectors, including for speculative-grade corporate bonds and leveraged loans. At the same time, financial firms' use of short-term wholesale funding has not increased materially and the capital and liquidity position of the banking sector continued to improve. The Federal Reserve and other agencies took further supervisory and regulatory steps to improve resilience, including conducting the 2014 stress tests of the largest bank holding companies (BHCs); finalizing rules to strengthen prudential standards for the largest domestic BHCs and for the U.S. operations of foreign banking firms; and raising leverage ratio standards for the largest, most interconnected firms.

To support continued progress toward maximum employment and price stability, the FOMC has maintained a highly accommodative stance of monetary policy. Specifically, the Committee has kept its target range for the federal funds rate at 0 to 1/4 percent; updated its forward guidance regarding the path of the federal funds rate; and continued to increase its sizable holdings of longer-term securities, though at a gradually diminishing pace. In particular, the Committee made additional measured reductions at each of its first four rebegularly scheduled meetings in 2014 in the monthly pace of its asset purchases. The FOMC also stated at each meeting that, if incoming information continued to broadly support the Committee's assessment of the economic outlook, the Committee would likely reduce the pace of asset purchases in further measured steps at future meetings. However, the Committee also noted that its asset purchases are not on a preset course, and that decisions about their pace will remain contingent on the economic outlook.

The FOMC has provided forward guidance for the federal funds rate based on its assessment of economic and financial conditions. As 2014 began, the Committee's forward rate guidance included quantitative thresholds relating to the unemployment rate and inflation. However, with the unemployment rate having neared its 6-1/2 percent threshold, the Committee decided at its March meeting to replace the numerical thresholds with a qualitative characterization of its approach to determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate. Specifically, the Committee stated that it will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation, taking into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends. The Committee additionally stated its anticipation that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

As part of prudent planning, the Federal Reserve has continued to prepare for the eventual normalization of the stance and conduct of monetary policy. The FOMC remains confident that it has the tools it needs to raise short-term interest rates when the time is right and to achieve the desired level of short-term interest rates thereafter, even while the Federal Reserve is holding a very large balance sheet. The Committee intends to continue its discussions about policy normalization at upcoming meetings while it proceeds with testing the operational readiness of its tools; it expects to provide to the public more information about its normalization plans later this year.

Part 1: Recent Economic and Financial Developments

Labor market conditions continued to improve over the first half of this year. Gains in payroll employment since the start of the year have averaged about 230,000 jobs per month, up a little from the average pace in 2013, and the unemployment rate declined to 6.1 percent in June, the lowest rate recorded in more than five years. Nevertheless, the jobless rate is still above Federal Open Market Committee (FOMC) participants' estimates of the longer-run normal rate. Other measures of labor utilization, as well as the continued slow increases in most measures of labor compensation, generally corroborate the view that significant slack remains in the labor market. Inflation, as measured by the price index for personal consumption expenditures (PCE), averaged 1-3/4 percent over the 12 months ending in May, higher than the unusually low level over the preceding 12 months but still somewhat below the Committee's 2 percent objective. Meanwhile, both survey- and market-based measures of longer-term inflation expectations have remained quite stable. Real gross domestic product (GDP) was reported to have decreased in the first quarter of this year, but the available information for the second quarter suggests that the decline was transitory. One area of concern, however, is the housing sector, where activity softened by more, relative to its earlier trajectory, than would have been expected based on last year's rise in mortgage interest rates. Financial conditions have generally remained supportive of economic growth. Longer-term interest rates in the United States as well as in most other advanced economies have partially reversed last year's increases, and borrowing conditions for households and small businesses have slowly improved, while credit flows to large nonfinancial corporations have remained strong.

Domestic Developments

Labor market conditions have strengthened further . . .

The labor market continued to improve in the first half of 2014. Payroll employment has increased by an average of about 230,000 per month so far this year, higher than the average gain in 2013. The unemployment rate continued to trend down, declining from 6.7 percent in December 2013 to 6.1 percent in June of this year, while the labor force participation rate was little changed, on net, over the first half of this year after having moved down considerably in the second half of last year. The unemployment rate has declined nearly 4 percentage points from its peak in 2009, although it remains elevated when judged against FOMC participants' estimates of the longer-run normal rate. Payrolls have reversed the cumulative job losses that occurred over the last recession, though that recovery has been achieved in the context of a larger population and labor force.

An index constructed by Board staff that aims to summarize movements in a broad array of labor market indicators also suggests that labor market conditions have strengthened further this year.¹⁰ While increases in that index slowed a touch at the beginning of this year, partly reflecting the effects of the unseasonably cold and snowy weather this winter, the pace has picked up again in recent months.

. . . but significant slack remains . . .

Notwithstanding those improvements, various labor market indicators suggest that a significant degree of slack remains in labor utilization. For instance, measures of labor underutilization that incorporate broader definitions of unemployment are still well above their pre-recession levels, even though they have moved down further this year. The proportion of workers employed part time because they are unable to find full-time work has similarly declined but remains elevated, and hiring and quit rates are still below their pre-recession norms. Moreover, the median duration of unemployment is still well above its long-run average.

The declines in the participation rate during the past few years, within the context of a strengthening labor market, also could be an indication of continuing labor market slack. To be sure, movements in the participation rate partly reflect the changing demographic composition of the population, most notably the increasing share of older persons, who have lower-than-average participation rates because they are more likely to be retired. As such, many of those exits from the labor force probably would have occurred even if the labor market had been stronger. However, some exits are likely occurring because the prolonged period of high unemployment has led some individuals to give up their job search, and such dynamics could have harmful consequences for economic activity in the long run.

. . . and wage growth has remained tepid

Continued slow increases in most measures of labor compensation offer further evidence of labor market slack. Compensation per hour in the nonfarm business sector is estimated to have risen at a modest pace of 2-1/4 percent over the four quarters ending in the first quarter of this year; the employment cost index for private industry workers rose at an annual rate of only 1-3/4 percent in the same period; and average hourly earnings rose about 2 percent over the 12 months ending in June, little changed from the average rate of increase in hourly earnings during the past several years. Over the past five years, the various measures of nominal hourly compensation have increased roughly 2 percent per year, on average, and after adjusting for inflation, growth of real compensation has fallen short of the gains in productivity over this period.

Consumer price inflation has moved up . . .

Inflation has moved higher this year following unusually low readings in 2013. The PCE price index rose 1-3/4 percent over the 12 months ending in May, up from the 1 percent increase recorded over the preceding 12 months. The PCE price index excluding food and energy items rose 1-1/2 percent over the 12 months ending in May, slightly less than the overall index. The FOMC continues to judge that inflation at the rate of 2 percent, as measured by the annual change in the PCE price index, is most consistent over the longer run with the Federal Reserve's statutory mandate. Thus, inflation remained somewhat below the Committee's goal. Some of the factors that contributed to the unusually low inflation in 2013, such as the softness seen in non-oil import prices, have begun to unwind and are pushing up inflation a little this year. More generally, however, with wages growing slowly and raw materials prices generally flat or moving downward, firms are not facing much in the way of cost pressures that they might otherwise try to pass on.

A portion of the recent increase in inflation reflects movements in energy and food prices that appear transitory. Consumer energy prices rose at an annual rate of nearly 6 percent over the 12 months ending in May, partly reflecting strong demand for electricity and natural gas during the cold winter. Global oil prices have been remarkably stable for much of the past year, with oil prices remaining mostly in a narrow range of between about $105 and $110 per barrel and moving above that range only temporarily in reaction to events in Iraq. Meanwhile, adverse growing conditions in both the United States and abroad have pushed up wholesale prices for various food commodities--including corn, wheat, and coffee--and these higher raw materials prices have led to somewhat larger increases in consumer food prices this year.

. . . but inflation expectations have changed little

Survey- and market-based measures of inflation expectations at medium- and longer-term horizons have remained quite stable throughout the recent period. Readings on inflation expectations 5 to 10 years ahead, as reported in the Thomson Reuters/University of Michigan Surveys of Consumers, have continued to move within a narrow range. In the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, the median expectation in the second quarter for the annual rate of increase in the PCE price index over the next 10 years was 2 percent, similar to its level in recent years. Meanwhile, market-based measures of medium- (5-year) and longer-term (5-to-10-years-ahead) inflation compensation derived from differences between yields on nominal Treasury securities and Treasury Inflation-Protected Securities have also remained within their respective ranges observed over the past few years.

The first-quarter decline in real GDP appears to have been transitory

Measures of real aggregate output--that is, GDP and gross domestic income--were both reported to have declined in the first quarter of this year.¹¹ Part of the weakness in output was likely related to severe weather early in the year.¹² But much of the drop in first-quarter GDP reflected unusually large swings in inventories and net exports, two volatile categories for which the available monthly data point to a rebound in the second quarter. In addition, a number of recent indicators of second-quarter spending, including motor vehicle sales, retail sales, and shipments of capital goods, suggests that the overall pace of consumer and business spending also picked up in the second quarter. Expansion in real activity continues to be supported by ongoing job gains, a waning drag from fiscal policy, and accommodative financial conditions. However, activity in the housing sector has yet to show persistent gains since it slowed in the wake of last year's rise in mortgage interest rates.

Export declines weighed heavily on first-quarter GDP

Real exports of goods and services declined at an annual rate of about 9 percent in the first quarter of 2014, coinciding with a global slowdown in trade. The decline partly reflected a retrenchment in two volatile categories, petroleum and agriculture, that had surged in the fourth quarter of 2013. With real imports of goods and services advancing in the first quarter, albeit slowly, net exports subtracted 1-1/2 percentage points--an unusually large amount--from overall GDP growth. However, available data for April and May indicate that exports rebounded in the second quarter, and net exports will likely be more supportive of growth in the second quarter.

The current account deficit widened somewhat in the first quarter of this year after having narrowed further over 2013; however, measured relative to nominal GDP, the deficit remains near its narrowest readings since the late 1990s. In the second half of 2013, the current account deficit continued to be financed mostly by purchases of Treasury and corporate securities by both foreign official investors and foreign private investors. Foreign private purchases remained strong in the first quarter of 2014, but official inflows weakened as conditions in emerging market economies (EMEs) worsened early in the quarter.

Gains in wealth and income are supporting consumer spending

Smoothing through weather-related fluctuations, consumer spending was reported to have risen at a modest annual rate of 1 percent over the first five months of this year, while disposable personal income advanced at a stronger pace of 2-1/4 percent over the same period.¹³ The faster pace of job gains so far this year has helped improve the economic prospects of many households and has contributed to a pickup in the pace of aggregate income growth, though it is not yet clear how widely these income gains have been shared across the population. In addition, personal tax payments and social security contributions, which surged last year as a consequence of higher federal payroll and income taxes, are no longer weighing as heavily on income growth.

Consumption growth this year also has been supported by ongoing gains in household net worth. House prices, which are of particular importance for the wealth position of many middle-income households, have continued to move higher, with the CoreLogic national index showing a rise of almost 9 percent over the 12 months ending in May. Meanwhile, the value of corporate equities has risen more than 15 percent over the past year and has added substantially to net wealth. Reflecting those solid gains, aggregate household net wealth is estimated to have approached 6-1/2 times the value of disposable personal income in the first quarter of this year, the highest level observed for that ratio since 2007.

Coupled with low interest rates, the rise in incomes has enabled many households to reduce their debt payment burdens. The household debt service ratio--that is, the ratio of required principal and interest payments on outstanding household debt to disposable personal income--dropped further in the first quarter of this year and stood at a very low level by historical standards.

Borrowing conditions for households are slowly improving . . .

The improvements in households' balance sheets so far this year have been accompanied by a gradual easing in borrowing conditions. For example, large banks reported a net easing of standards for home purchase loans to prime borrowers in the Federal Reserve Board's April 2014 Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS).¹⁴ SLOOS responses also indicated a net easing in credit standards for consumer loans. Even so, mortgage lending standards have remained tight for many households; indeed, standards on nontraditional mortgage loans were reported to have tightened further in the April survey. Likely reflecting, in part, the increased willingness to lend, the rate of decline in mortgage debt has slowed so far this year, and growth in other consumer credit has been robust.

. . . but consumer confidence remains tepid

Despite the strengthening in household incomes and wealth, indicators of consumer sentiment still appear somewhat depressed compared with their longer-run norms. The Michigan survey's index of consumer sentiment--which incorporates households' views about their own financial situations as well as broader economic conditions--has recovered noticeably from its recessionary low but has changed little, on net, over the past year. The responses to a separate survey question about income expectations display a similar pattern: Although an index of households' expectations of real income changes in the year ahead has recovered somewhat since 2011, it remains substantially below the historical average and suggests a more guarded outlook than the headline index.

Business investment has been lackluster, . . .

After recording modest gains in 2013, business fixed investment ticked down in the first quarter of this year, as a large decline in spending on nonresidential structures was partly offset by a small increase in outlays for equipment and intangible (E&I) capital. Although the expiration of a tax provision allowing 50 percent bonus depreciation may have pulled some capital investment forward into late 2013, looking over a longer period, the pattern of investment outlays over the past year and a half appears broadly consistent with the sluggish pace of business output growth during the period. Nevertheless, various forward-looking indicators, such as business sentiment and earnings expectations of capital goods producers, paint a fairly upbeat picture and point to a pickup in the growth of E&I investment.

Business investment in structures has been relatively weak this year, as demand for nonresidential buildings continues to be restrained by high vacancy rates for existing properties and tight financing conditions for new construction. However, the level of investment in drilling and mining structures is extremely high by historical standards, a reflection of the boom in oil and natural gas extraction.

. . . even as corporate borrowing has expanded and loan terms and standards appear to be easing

The financial condition of large nonfinancial firms has remained strong so far this year, with profitability high and the default rate on nonfinancial corporate bonds generally low. Nonfinancial firms have continued to raise funds at a robust pace, given strong corporate credit quality and historically low interest rates on corporate bonds. Indeed, bond issuance by both investment- and speculative-grade nonfinancial firms has been strong.

Moreover, credit availability in business loan markets has shown further improvement. According to the April SLOOS, banks again eased standards on commercial and industrial (C&I) loans to firms of all sizes in the first quarter, and many banks have eased price-related and other terms on such loans. In addition, according to the Federal Reserve Board's May 2014 Survey of Terms of Business Lending, loan rate spreads over market interest rates for newly originated C&I loans have continued to decline. In this environment, C&I loans on banks' books and commercial paper outstanding both have registered solid increases. Issuance of leveraged loans continued to be rapid in the first half of 2014, and issuance of collateralized loan obligations reached very high levels in the period from February to April.¹⁵ Small business lending activity has picked up as well in recent months, likely reflecting some increase in credit availability as well as a strengthening in businesses' demand for credit.

In the commercial real estate (CRE) sector, loans continued to expand at a moderate pace, and increases in banks' CRE loans remained widespread across all major CRE segments (that is, loans secured by nonfarm nonresidential properties, multifamily residential properties, and construction and land development loans). According to the April SLOOS, standards on CRE loans extended by banks also eased in the first quarter. Special survey questions asked about changes in terms on CRE loans over the past year, and many banks reported having eased interest rate spreads and increased maximum loan sizes and terms to maturity. Nevertheless, standards for construction and land development loans appear to have remained relatively tight.

The drag from federal fiscal restraint is waning . . .

Fiscal policy has been a contractionary force through most of the past three years and was especially so in 2013, when the temporary payroll tax cut expired, taxes increased for high-income households, and federal purchases were pushed down by the sequestration and caps on discretionary spending. Moreover, in the fourth quarter of last year, disruptions related to the government shutdown led to a sharp but temporary reduction in federal purchases. For 2013 as a whole, real federal purchases (as measured in the national income and product accounts) fell 6-1/4 percent, twice as large as the average decline in the previous two years.

This year, however, fiscal policy has become somewhat less restrictive for GDP growth, as the effects of the 2013 tax and spending changes are fading. While the expiration of emergency unemployment compensation at the beginning of the year has exerted a drag on consumer spending, medical benefits provided for under the Affordable Care Act will likely support increased consumption of medical services.

With few major changes in tax policy in 2014, federal receipts have edged up to around 17 percent of GDP, their highest level since before the recession. Meanwhile, nominal federal outlays as a share of GDP have continued to trend downward but have remained above the levels observed before the start of the recession. Thus, the federal unified budget deficit has narrowed again this year; the Congressional Budget Office projects that the budget deficit for fiscal year 2014 as a whole will be 3 percent of GDP, compared with the fiscal 2013 deficit of 4 percent of GDP. Overall federal debt held by the public has continued to rise, and the ratio of nominal federal debt to GDP moved up to near 75 percent in early 2014.

. . . and state and local government expenditures are turning up

At the state and local level, the ongoing strengthening in economic activity, as well as previous spending cuts, has helped foster a gradual improvement in the budget situations of most jurisdictions. Consistent with improving sector finances, states and localities have been expanding their workforces; employment accelerated in the first half of the year after rising modestly in the second half of 2013. Construction expenditures by those governments, however, have yet to show a sustained recovery.

The recovery in the housing market has lost traction

After proceeding briskly in 2012 and the first half of 2013, the recovery in residential construction seems to have faltered. Real residential investment declined for two successive quarters around the turn of the year, and the available data point to only a modest gain in the second quarter. The renewed softness of late has proven more extensive and persistent than would have been expected given the rise in mortgage interest rates around the middle of last year (see the box "The Slow Recovery of Housing Activity" on pages 16-17 of the July 2014 Monetary Policy Report). That said, household formation remains depressed relative to demographic norms, and the ongoing improvement in labor market conditions could help spur a more decisive return to those norms.

Productivity growth has been modest

In general, gains in labor productivity have been modest in recent years. Output per hour in the nonfarm business sector has risen at an annual rate of less than 1-1/2 percent since 2007, well below the pace of gains observed over the late 1990s and early 2000s. The relatively slow pace of productivity growth likely reflects, in part, the sustained weakness in capital investment over the recession and recovery period, and productivity gains may be better supported in the future as outlays for productivity-enhancing capital equipment strengthen.

Financial Developments

The expected path for the federal funds rate edged down

Market-based measures of the expected path of the federal funds rate through late 2017 edged down, on balance, over the first half of the year. After accounting for transitory factors such as weather, market participants appeared to judge the incoming economic data as somewhat better than they had expected but as still continuing to point to subdued inflationary pressures and an accommodative policy stance by the FOMC. The relatively small movements of the market-based measures are consistent with the results of the most recent Survey of Primary Dealers and the pilot survey of market participants, each conducted just prior to the June FOMC meeting by the Open Market Desk at the Federal Reserve Bank of New York. Those surveys suggest that dealers and buy-side respondents both anticipate that the initial increase in the target federal funds rate from its current range will occur in the third quarter of 2015, slightly earlier than dealers had anticipated at the beginning of this year and about the same as what buy-side respondents had anticipated.¹⁶ Finally, while some forward measures of policy rate uncertainty have risen, overall policy rate uncertainty has generally remained relatively low.

However, Treasury yields declined significantly, especially at longer maturities, as have sovereign bond yields in other advanced economies

After rising notably over the spring and summer months of 2013, yields on longer-term Treasury securities drifted down over the first half of 2014 and now stand at fairly low levels by historical standards. In particular, while the yield on 5-year nominal Treasury securities edged down only about 5 basis points from its level at the end of December 2013, the yields on the 10- and 30-year securities decreased about 50 basis points and 60 basis points, respectively. The decline in longer-term yields reflects a notable reduction in longer-horizon forward rates, with the 5-year-forward rate 5 years ahead dropping about 105 basis points since year-end. Five-year-forward inflation compensation over this period declined 20 basis points, implying that much of this reduction in nominal forward rates was concentrated in forward real rates. Yields on 30-year agency mortgage-backed securities (MBS) decreased about 35 basis points, on balance, over the same period.

Long-term benchmark sovereign yields in advanced foreign economies (AFEs) have also moved down since late last year, with particularly marked reductions in the euro area. Market participants have pointed to several potential explanations for the declines in U.S. and foreign yields. One possible explanation is that market participants have lowered their expectations for future short-term interest rates around the globe. This downward adjustment in expectations may be due to a combination of a lower assessment of the global economy's long-run potential growth rate and a decrease in long-run inflation expectations. Indeed, the lower yields in the euro area are consistent with indications of declining inflation and weak growth in the euro area in recent months, bolstering expectations that the European Central Bank (ECB) would loosen its monetary policy, as it eventually did at its meeting in early June.

In addition, 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--may have come down, reflecting several potential factors. One potential factor is a reduction in the amount of compensation for interest rate risk that investors require to hold fixed-income securities, likely due in part to perceptions that uncertainty about the outlook for monetary policy and economic growth has decreased; indeed, swaption-implied volatility on longer-term rates has fallen noticeably since the beginning of the year. Another potential factor is increased demand for Treasury securities from price-insensitive investors, such as pension funds and commercial banks. Lastly, in light of the notable co-movements between forward interest rates at longer horizons in the United States and other advanced economies, it appears likely that there is a global component of term premiums that is affected not only by U.S. developments, but also by foreign developments, such as investors becoming increasingly confident that policy rates at the major foreign central banks will remain low for an extended period.

Broad equity price indexes increased further, and risk spreads on corporate debt declined

Although equity investors appeared to pull back from the market for a time early in the year in reaction to concerns about the strength of some EMEs and the possible implications for global growth, broad measures of U.S. equity prices have posted solid gains of 6 percent since the beginning of 2014, on balance, after having risen 30 percent in 2013. Overall, equity investors appeared to become more confident in the near-term economic outlook amid somewhat better-than-expected economic data releases, declining longer-term interest rates, and upward revisions to expected year-ahead earnings per share for firms in the S&P 500 index.

Some broad equity price indexes have increased to all-time highs in nominal terms since the end of 2013. However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities. Nevertheless, valuation metrics in some sectors do appear substantially stretched--particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year. Moreover, implied volatility for the overall S&P 500 index, as calculated from option prices, has declined in recent months to low levels last recorded in the mid-1990s and mid-2000s, reflecting improved market sentiment and, perhaps, the influence of "reach for yield" behavior by some investors.

Credit spreads in the corporate sector have also declined, on balance, in recent months. After having temporarily increased early in the year, the spreads of yields on corporate bonds to yields on Treasury securities of comparable maturities ended the first half of the year about unchanged or a bit narrower. Credit spreads on high-yield corporate bonds are near the bottom of their range over the past decade. While spreads on syndicated loans have changed little this year, they are also relatively low. For further discussion of asset prices and other financial stability issues, see the box "Developments Related to Financial Stability" on pages 22-23 of the July 2014 Monetary Policy Report.

Treasury market functioning and liquidity conditions in the MBS market were generally stable . . .

Indicators of Treasury market functioning remained stable amid ongoing reductions in the pace of the Federal Reserve's asset purchases over the first half of 2014. In particular, liquidity conditions in Treasury markets remained stable, with with bid-asked spreads in the Treasury market staying in line with recent averages. In addition, the Treasury's first-ever auction of a Floating Rate Note in January was well received, as were subsequent auctions of those notes.

Liquidity conditions in the MBS markets were also generally stable, though there have been some signs of scarcity of certain securities, as evidenced by somewhat low levels of implied financing rates in the production-coupon "dollar roll" markets during the first half of this year. However, the implied financing rates rose in recent days, suggesting easing of settlement pressures in these markets of late.¹⁷ Gross issuance of these securities remained somewhat lower than in the past two years, reflecting relatively low mortgage originations.

. . . and short-term funding markets also continued to function well

Conditions in short-term dollar funding markets also remained stable during the first half of 2014. Early in the year, yields on Treasury bills maturing between late February and mid-March of 2014--those that could have been affected by delayed payments if a debt ceiling agreement had not been reached--were elevated for a time, but those yields declined in mid-February in response to news of pending legislation to suspend the debt ceiling until March 2015. The federal funds rate remained at very low levels, and broader measures of unsecured dollar bank funding costs, such as the LIBOR, or London interbank offered rate, remain at very low levels, reflecting the absence of major funding pressures.

Money market participants continued to focus on the Federal Reserve's testing of its monetary policy tools. Daily awards at the overnight reverse repurchase agreement (ON RRP) exercise have ranged between about $50 billion and about $340 billion since early 2014. The number of counterparties participating and the dollar volume of take-up have been sensitive to the spread between market rates for repurchase agreements and the fixed ON RRP rate offered in the exercise.¹⁸ Indeed, take-up has been large at quarter-ends, when balance sheet adjustments by financial institutions tend to limit other investment options. Experience to date suggests that ON RRP operations have helped establish a floor on money market interest rates. Testing of the Term Deposit Facility, as well as take-up of and participation in its test offerings, has expanded during the first half of 2014. (For further discussion of the testing of monetary policy tools, see the box "Planning for Monetary Policy Implementation during Normalization" on pages 38-39 of the July 2014 Monetary Policy Report.)

The condition of financial institutions improved further, although profitability remained below its historical average

Regulatory capital ratios at bank holding companies (BHCs) increased further during the first half of 2014, and measures of bank liquidity remained robust. In addition, credit quality at BHCs continued to improve across major loan categories, and the ratios of loss reserves to delinquencies and to charge-offs each edged up. At the same time, standard measures of the profitability of BHCs have been little changed for the past six months. Profitability of these companies remained below its historical average, in part because of subdued income from mortgage and trading businesses and compressed net interest margins at large banks. A few large banks have also incurred sizable costs from legal settlements associated with the origination of mortgages prior to the recent financial crisis. Aggregate credit provided by commercial banks grew at a solid pace in the first half of 2014. The increase was driven by a pickup in loan growth and a rise in holdings of U.S. Treasury securities that was reportedly influenced by banks' efforts to meet new liquidity regulations. Equity prices of large domestic banks increased a bit from the beginning of the year, on net, but underperformed the overall market. Credit default swap (CDS) spreads for large BHCs remain low.

Among nonbank financial institutions, equity prices of insurance companies have also increased slightly, on net, since the beginning of the year. Nonbank financial institutions continued to grow at a very strong pace, as assets under management at hedge funds and private equity groups each reached record highs, reflecting modest increases in asset values as well as net inflows. Nevertheless, in response to the Federal Reserve Board's Senior Credit Officer Opinion Survey on Dealer Financing Terms for March and June, most dealers indicated that hedge funds had not changed their use of leverage since the beginning of the year.¹⁹ In the same survey, some dealers noted that the use of financial leverage by trading REITs, or real estate investment trusts, had decreased, continuing a trend that began in the summer of 2013. Assets under management at bond mutual funds also reached a record high.

Municipal bond markets functioned smoothly, but some issuers remained strained

Credit conditions in municipal bond markets generally appeared to remain stable over the first half of the year. Yields on 20-year general obligation municipal bonds have declined slightly since the beginning of the year, and the MCDX, an index of CDS for a broad portfolio of municipal bonds, has also moved down. However, the ratio of an index of municipal bond yields to Treasury yields has increased a bit.

Nevertheless, significant financial strains have been evident for some issuers. Standard & Poor's, Moody's Investors Service, and Fitch Ratings downgraded Puerto Rico's general obligation bonds from investment grade to speculative grade in February. In addition, the City of Detroit continues to negotiate the terms of its bankruptcy plan.

Liquid deposits in the banking sector continued to advance briskly, boosting M2

M2 has increased at an annual rate of about 7 percent since December, about the same pace registered in the second half of 2013 and somewhat faster than the pace of nominal GDP. The growth in M2 has been driven by an increase in liquid deposits as well as an uptick in demand for currency.

International Developments

As in the United States, foreign bond yields declined and asset prices increased, on net . . .

As noted earlier, foreign long-term benchmark sovereign yields have moved significantly lower since the beginning of the year. Factors contributing to the decline include expectations for lower policy interest rates, a decline in the required compensation for risk, and increased demand by price-insensitive investors for these assets. Similarly, foreign corporate and sovereign yield spreads have also declined since the start of the year. In particular, peripheral euro-area sovereign yield spreads narrowed substantially, on balance, as financial stresses in the euro area have eased and central banks in the advanced economies have emphasized that they will keep monetary policy accommodative for some time, though spreads in a few economies have moved up more recently. Sovereign yield spreads in EMEs have also declined, on net, consistent with measures adopted by EME central banks to reduce vulnerabilities and with the general increase in the prices for risky assets.

Foreign equity indexes rose, on net, during the first half of the year. Stock prices increased, on balance, in most of the AFEs. Japanese equities underperformed early in the year, but they have moved up recently on stronger-than-expected incoming economic data. And European bank stock prices declined lately in part on concerns over troubles at several banks. Equities in most EMEs have also moved higher, as market sentiment toward these economies has continued to improve. However, the Chinese stock market fell on concerns over the economic outlook. Realized volatility across most financial markets and countries has declined since January, in part as sentiment toward risky assets generally improved.

. . . and the dollar is about unchanged

The broad nominal value of the dollar is little changed, on net, since the beginning of the year. The U.S. dollar appreciated notably against the Chinese renminbi in the first months of the year. However, the People's Bank of China has since kept the value of the renminbi steady. In contrast, the dollar depreciated against most other emerging market currencies, as financial stresses earlier in the year unwound. In addition, the dollar depreciated against the British pound, as macroeconomic conditions improved in the United Kingdom and markets moved forward their expectations for the first rate hike by the Bank of England, and also depreciated against the Japan-
ese yen, as investors reduced their expectations for stronger policy accommodation in Japan.

Activity in the emerging market economies slowed in the first quarter but showed signs of picking up in the second quarter . . .

Aggregate real GDP growth in the EMEs slowed in the first quarter of this year, led by a step-down in China's economy that also weighed on activity in many of its trading partners, especially in emerging Asia. The slowing in China reflected a sharp fall in exports, as well as a restraint on domestic demand from tighter financial conditions, as the government attempted to rein in credit. In Mexico, growth remained weak in the first quarter, likely restrained by hikes in tax rates and administered fuel prices and softer U.S. demand for Mexican exports. Brazilian real GDP rose at a tepid pace in the first quarter, extending the lackluster performance of the past two years.

Recent indicators, notably exports, suggest that EME growth picked up in the second quarter. In particular, Chinese exports grew robustly in the second quarter, reversing most of the sharp decline in February, and the authorities announced a series of small targeted stimulus measures to support growth. The improvement in Chinese growth, along with firmer growth in the advanced economies, will help boost global economic activity in the rest of emerging Asia. Growth in Mexico is also expected to step up in the second quarter, in line with U.S. manufacturing output, and recent data in Brazil point to some, albeit modest, improvement.

Inflation remained subdued in most EMEs, and central banks in some countries, such as Chile, Mexico, and Thailand, cut rates to support growth. In contrast, the central banks of a few EMEs, such as Brazil and India, where inflation remained elevated, raised policy rates.

. . . while economic growth in most advanced foreign economies remained moderate

Indicators suggest that average economic growth in the AFEs remained moderate in the first half of 2014. The severe winter weather that hampered growth in the United States also weighed on real GDP in Canada, where growth slowed to an annualized 1-1/4 percent pace in the first quarter. However, data including the purchasing managers index are consistent with Canadian growth bouncing back in the second quarter. In Japan, GDP growth surged in the first quarter at a nearly 7 percent pace, led by household spending ahead of the April hike in the Japanese consumption tax, but recent retail sales data suggest that activity fell back sharply in April. In the United Kingdom, GDP growth remained robust in the first quarter at 3-1/4 percent, and the unemployment rate fell about 1 percentage point between mid-2013 and the first quarter of 2014. The euro area's recovery continued at a subdued pace--with GDP rising at an annual rate of around 3/4 percent in the first quarter--and recent indicators point to a firming in growth in the second quarter as financial and credit conditions continue to normalize.

Inflation during the first half of the year has been around 2 percent in Canada and somewhat below that level in the United Kingdom. In Japan, the April tax hike as well as rising import prices in response to recent yen depreciation pushed up the 12-month rate of consumer price inflation in April. However, inflation excluding taxes remained much lower, and the Bank of Japan continued its aggressive program of asset purchases aimed at achieving its inflation target of 2 percent in a stable manner. In the euro area, inflation slowed to just 1/2 percent in May, and the ECB responded in June by cutting its key policy rates--taking the deposit rate into negative territory--and by announcing measures to ease credit conditions. (For further discussion of monetary policy at foreign central banks, see the box "Prospects for Monetary Policy Normalization in the Advanced Economies" on pages 30-31 of the July 2014 Monetary Policy Report.)

Part 2: Monetary Policy

To support further progress toward maximum employment and price stability, monetary policy has remained highly accommodative. The Federal Reserve kept the target federal funds rate at its effective lower bound, updated its forward guidance regarding the path of the federal funds rate, and added to its sizable holdings of longer-term securities, albeit at a reduced pace. The Federal Reserve has also continued to plan for the eventual normalization of monetary policy.

The Federal Open Market Committee continued to use large-scale asset purchases and forward rate guidance to support further progress toward maximum employment and price stability

The Committee has continued to judge that a highly accommodative stance of monetary policy remains warranted to support progress toward its dual mandate of maximum employment and price stability. With the target range for the federal funds rate remaining at its effective lower bound, the Federal Open Market Committee (FOMC) has made further use of nontraditional policy tools to provide appropriate monetary stimulus. In particular, the FOMC has used large-scale asset purchases to put downward pressure on longer-term interest rates and to ease financial conditions more broadly so as to promote the more rapid achievement of its dual objectives. In addition, the FOMC has provided guidance about the likely future path of the federal funds rate in an effort to give greater clarity to the public about its policy outlook and intentions. In light of the cumulative progress toward its monetary policy objectives and the outlook for further progress over coming years, the Committee made adjustments during the first half of 2014 to both its asset purchase program and its forward guidance about the path of the federal funds rate.

The FOMC made further measured reductions in the pace of its asset purchases . . .

During the first half of 2014, the Committee made further measured reductions in the pace of its asset purchases, following the initial modest reduction announced at the December 2013 meeting.²⁰ These actions reflected the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program in the fall of 2012 as well as the Committee's judgment that there was sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective.

Specifically, at its four meetings in the first half of 2014, the Committee reduced the monthly pace of its purchases of agency mortgage-backed securities (MBS) and of longer-term Treasury securities by $5 billion each. Accordingly, beginning in July, the Committee is adding to its holdings of agency MBS at a pace of $15 billion per month (compared with $35 billion per month at the beginning of the year) and is adding to its holdings of longer-term Treasury securities at a pace of $20 billion per month (compared with $40 billion per month at the beginning of the year). The FOMC also maintained its existing policy of reinvesting principal payments from its holdings of agency debt and agency MBS in agency MBS and of rolling over maturing Treasury securities at auction.

While making measured reductions in the pace of its purchases, the Committee noted that its sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help make broader financial conditions more accommodative. More accommodative financial conditions, in turn, should promote a stronger economic recovery, a further improvement in labor market conditions, and a return of inflation, over time, toward the Committee's 2 percent objective.

At each of its meetings so far this year, the FOMC reiterated that it would closely monitor incoming information on economic and financial developments, and that it would continue asset purchases and employ its other policy tools as appropriate until the outlook for the labor market had improved substantially in a context of price stability. The Committee also noted that if incoming information broadly supports its expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, it would likely reduce the pace of asset purchases in further measured steps at future meetings. However, the Committee also emphasized that asset purchases are not on a preset course, and that decisions about their pace would remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.

. . . updated its forward guidance with a qualitative description of the factors that will influence its decision to begin raising the federal funds rate . . .

As 2014 began, the Committee's forward guidance included quantitative thresholds, stating that the exceptionally low target range for the federal funds rate of 0 to 1/4 percent would be appropriate at least as long as the unemployment rate remained above 6-1/2 percent, inflation between one and two years ahead was projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continued to be well anchored.²¹ The Committee also indicated that in determining how long to maintain a highly accommodative stance of monetary policy, it would consider not only the unemployment rate but also other indicators, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. Based on its assessment of these factors, the Committee noted that it likely would be appropriate to maintain the current target range for the federal funds rate well past the time the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

At the time of the March meeting, with the unemployment rate quickly approaching the threshold of 6-1/2 percent, the FOMC decided to update its forward guidance by providing a qualitative description of the factors that would influence its decision regarding the appropriate time of the first increase in the target federal funds rate from its current 0 to 1/4 percent target range.²² The Committee agreed that while reliance on a single indicator--the unemployment rate--had been useful for communications purposes when employment conditions were much further from mandate-consistent levels, with labor market conditions improving, the Committee would base its judgment concerning progress in the labor market on a much broader set of indicators from that point forward. Specifically, the Committee indicated that in determining how long to maintain the current target range, it would assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment would take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. Based on its assessment of these factors, the Committee indicated that it likely would be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continued to run below the Committee's 2 percent longer-run goal and provided that longer-term inflation expectations remained well anchored. To help forestall misinterpretation of the new forward guidance, the Committee noted that the change in its guidance did not indicate any change in its policy intentions as set forth in its recent statements.

. . . and added information regarding the likely behavior of the target federal funds rate after the rate is raised above its effective lower bound

The Committee also stated that, when it decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. In addition, the Committee indicated its anticipation that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

Committee participants have noted that a prolonged period of low interest rates could lead investors to take on excessive risk, potentially posing risks to longer-term financial stability. The Federal Reserve will continue to monitor the financial system for any signs of the buildup of such risks and will take appropriate steps to address such risks as needed (see the box "Developments Related to Financial Stability" on pages 22-23 of the July 2014 Monetary Policy Report).

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

As a result of the FOMC's ongoing large-scale asset purchase program, Federal Reserve assets have increased further since the end of last year. Holdings of U.S. Treasury securities in the System Open Market Account (SOMA) increased $200 billion to $2.4 trillion, and holdings of agency debt and MBS increased $160 billion, on net, to $1.7 trillion.²³ On the liability side of the balance sheet, the increase in the Federal Reserve's assets was largely matched by increases in reserve balances, currency in circulation, deposits with Federal Reserve banks, and reverse repurchase agreements.

Given the Federal Reserve's large and growing balance sheet, interest income on the SOMA portfolio continued to support substantial remittances to the U.S. Treasury. Last year, remittances totaled $80 billion, and remittances over the first quarter of this year remained very high. Cumulative remittances to the Treasury from 2008 through the first quarter of 2014 exceeded $420 billion.²⁴

The Federal Reserve continued to plan for the eventual normalization of monetary policy

At its April meeting, the FOMC discussed issues associated with the eventual normalization of the stance and conduct of monetary policy during a period when the Federal Reserve's balance sheet will be very large.²⁵ The Committee's discussion of this topic was undertaken as part of prudent planning and did not imply that normalization will begin soon. The Committee discussed various tools that could be used to raise short-term interest rates--and to control the level of short-term interest rates once they are above the effective lower bound--even while the balance sheet of the Federal Reserve remains very large. Those tools included the rate of interest paid on excess reserve balances, fixed-rate overnight reverse repurchase agreement (ON RRP) operations, term reverse repurchase agreements, and the Term Deposit Facility (TDF). Participants considered how various combinations of tools could have different implications for the degree of control over short-term interest rates, the Federal Reserve's balance sheet and remittances to the Treasury, the functioning of the federal funds market, and financial stability in both normal times and periods of stress.

At the June FOMC meeting, participants continued their discussion of normalization issues and considered some possible strategies for implementing and communicating monetary policy during that process.²⁶ Most participants agreed that adjustments in the rate of interest on excess reserves (IOER) should play a central role during the normalization process. It was generally agreed that an ON RRP facility with an interest rate set below the IOER rate could play a useful supporting role by helping to firm the floor under money market interest rates. A few participants commented that the Committee should also be prepared to use its other policy tools, including term deposits and term reverse repurchase agreements, if necessary. Most participants thought that the federal funds rate should continue to play a role in the Committee's operating framework and communications during normalization, with many of them indicating a preference for continuing to announce a target range. While generally agreeing that an ON RRP facility could play an important role in the policy normalization process, participants discussed several possible concerns about using such a facility, including the potential for substantial shifts in investments toward the facility and away from financial and nonfinancial firms in times of financial stress, the potential expansion of the Federal Reserve's role in financial intermediation, and the extent to which monetary policy operations might be conducted with nontraditional counterparties. Participants discussed design features that could help address these concerns. Several participants emphasized that, although the ON RRP rate would be useful in controlling short-term interest rates during normalization, they did not anticipate that such a facility would be a permanent part of the Committee's longer-run operating framework. Overall, participants generally expressed a preference for a simple and clear approach to normalization, and it was observed that it would be useful for the Committee to develop its plans and communicate them to the public later this year, well before the first steps in normalizing policy become appropriate, and to maintain flexibility about the evolution of the normalization process as well as the Committee's longer-run operating framework.

The Federal Reserve has continued to test the operational readiness of its policy tools, conducting daily ON RRP operations and several tests of the TDF during the first half of 2014. To date, testing has progressed smoothly, and, in recent months, short-term market rates have generally traded above the ON RRP rate. (For more discussion of the Federal Reserve's preparations for the eventual normalization of monetary policy, see the box "Planning for Monetary Policy Implementation during Normalization" on pages 38-39 of the July 2014 Monetary Policy Report.)

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