Monetary Policy Report

For use at 11:00 a.m., EDT July 7, 2017 M P r onetary olicy ePort July 7, 2017 Board of Governors of the Federal Reserve System L t etter of ransmittaL Board of Governors of the Federal Reserve System Washington, D.C., July 7, 2017 The President of the Senate The Speaker of the House of Representatives The Board of Governors is pleased to submit its Monetary Policy Report pursuant to section 2B of the Federal Reserve Act. Sincerely, Janet L. Yellen, Chair S L -r g m P S tatement on onger un oaLS and onetary oLicy trategy Adopted effective January 24, 2012; as amended effective January 31, 2017 The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society. Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee’s policy decisions reflect its longer-run goals, its medium- term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee’s goals. The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances. The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants’ estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC’s Summary of Economic Projections. For example, in the most recent projections, the median of FOMC participants’ estimates of the longer-run normal rate of unemployment was 4.8 percent. In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. The Committee intends to reaffirm these principles and to make adjustments as appropriate at its annual organizational meeting each January. C ontents Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Economic and Financial Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Special Topics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Part 1: Recent Economic and Financial Developments . . . . . . . . . . . . . . . . 5 Domestic Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Financial Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 International Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Part 2: Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Part 3: Summary of Economic Projections . . . . . . . . . . . . . . . . . . . . . . . . . 41 The Outlook for Economic Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 The Outlook for Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Appropriate Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Uncertainty and Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 List of Boxes Does Education Determine Who Climbs the Economic Ladder? . . . . . . . . . . . . . . . . . . . . . . . 8 Productivity Developments in the Advanced Economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Developments Related to Financial Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Recent Developments in Corporate Bond Market Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Monetary Policy Rules and Their Role in the Federal Reserve’s Policy Process . . . . . . . . . . . . 36 Addendum to the Policy Normalization Principles and Plans . . . . . . . . . . . . . . . . . . . . . . . . 40 Forecast Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 note: This report reflects information that was publicly available as of noon EDT on July 6, 2017. Unless otherwise stated, the time series in the figures extend through, for daily data, July 5, 2017; for monthly data, June 2017; and, for quarterly data, 2017:Q1. In bar charts, except as noted, the change for a given period is measured to its final quarter from the final quarter of the preceding period. For figures 14 and 34, note that the S&P 500 Index and the Dow Jones Bank Index are products of S&P Dow Jones Indices LLC and/or its affiliates and have been licensed for use by the Board. Copyright © 2017 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution, reproduction, and/or photocopying in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC, and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent, and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein. For figure C in the box “Recent Developments in Corporate Bond Market Liquidity,” J.P. Morgan notes that information has been obtained from sources believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2017, J.P. Morgan Chase & Co. All rights reserved. 1 s ummary Economic activity increased at a moderate consumer prices. The 12-month measure of pace over the first half of the year, and the jobs inflation that excludes food and energy items market continued to strengthen. Measured on (so-called core inflation), which historically has a 12-month basis, inflation has softened some been a better indicator than the headline figure in the past few months. The Federal Open of where overall inflation will be in the future, Market Committee (FOMC) judged that, on was also 1.4 percent over the year ending in balance, current and prospective economic May; this reading was a bit lower than it had conditions called for a further gradual removal been one year earlier. Measures of longer- of policy accommodation. At its most recent run inflation expectations have been relatively meeting in June, the Committee boosted stable, on balance, though some measures the target range for the federal funds rate to remain low by historical standards. 1 to 1¼ percent. The Committee also issued additional information regarding its plans Economic growth. Real gross domestic for reducing the size of its balance sheet in a product (GDP) is reported to have risen at gradual and predictable manner. an annual rate of about 1½ percent in the first quarter of 2017, but more recent data Economic and Financial suggest growth stepped back up in the second Developments quarter. Consumer spending was sluggish in the early part of the year but appears to Labor markets. The labor market has have rebounded recently, supported by job strengthened further so far this year. Over the gains, rising household wealth, and favorable first five months of 2017, payroll employment consumer sentiment. Business investment increased 162,000 per month, on average, has turned up this year after having been somewhat slower than the average monthly weak for much of 2016, and indicators of increase for 2016 but still more than enough business sentiment have been strong. The to absorb new entrants into the labor force. housing market continues its gradual recovery. The unemployment rate fell from 4.7 percent Economic growth has also been supported by in December to 4.3 percent in May—modestly recent strength in foreign activity. below the median of FOMC participants’ estimates of its longer-run normal level. Financial conditions. On balance, domestic Other measures of labor utilization are also financial conditions for businesses and consistent with a relatively tight labor market. households have continued to support However, despite the broad-based strength economic growth. Long-term nominal in measures of employment, wage growth has Treasury yields and mortgage rates have been only modest, possibly held down by decreased so far in 2017, although yields the weak pace of productivity growth in remain somewhat above levels that prevailed recent years. last summer. Broad measures of equity prices increased further during the first half of the Inflation. Consumer price inflation, as year. Spreads of yields on corporate bonds measured by the 12-month change in the price over comparable-maturity Treasury securities index for personal consumption expenditures, decreased. Most types of consumer loans briefly reached the FOMC’s 2 percent remained widely available, while mortgage objective earlier this year, but it more recently credit stayed readily available for households has softened. The latest reading, for May, with solid credit profiles but was still difficult was 1.4 percent—still up from a year earlier to access for households with low credit when falling energy prices restrained overall scores or harder-to-document incomes. 2 SUMMARy In foreign financial markets, equity prices objective over the medium term. The federal increased and risk spreads decreased amid funds rate is likely to remain, for some time, generally firming economic growth and robust below levels that are expected to prevail in corporate earnings. The broad U.S. dollar the longer run. Consistent with this outlook, index depreciated modestly against foreign in the most recent Summary of Economic currencies. Projections (SEP), compiled at the time of the June FOMC meeting, most participants Financial stability. Vulnerabilities in the projected that the appropriate level of the U.S. financial system remained, on balance, federal funds rate would be below its longer- moderate. Contributing to the financial run level through 2018. (The June SEP is system’s improved resilience, U.S. banks have presented in Part 3 of this report.) However, substantial amounts of capital and liquidity. as the Committee has continued to emphasize, Valuation pressures across a range of assets monetary policy is not on a preset course; and several indicators of investor risk appetite the actual path of the federal funds rate will have increased further since mid-February. depend on the evolution of the economic However, these developments in asset markets outlook as informed by incoming data. In particular, the Committee is monitoring have not been accompanied by increased inflation developments closely. leverage in the financial sector, according to available metrics, or increased borrowing in Balance sheet policy. To help maintain the nonfinancial sector. Household debt as a accommodative financial conditions, the share of GDP continues to be subdued, and Committee has continued its existing policy debt owed by nonfinancial businesses, although of reinvesting principal payments from elevated, has been either flat or falling in the its holdings of agency debt and agency past two years. (See the box “Developments mortgage-backed securities in agency Related to Financial Stability” in Part 1.) mortgage-backed securities and rolling over maturing Treasury securities at auction. In Monetary Policy June, the FOMC issued an Addendum to the Policy Normalization Principles and Plans Interest rate policy. Over the first half of 2017, that provides additional details regarding the FOMC continued to gradually reduce the the approach the FOMC intends to follow amount of monetary policy accommodation. to reduce the Federal Reserve’s holdings of Specifically, the Committee decided to raise the Treasury and agency securities in a gradual target range for the federal funds rate in March and predictable manner. The Committee and in June, bringing it to the current range of currently expects to begin implementing the 1 to 1¼ percent. Even with these rate increases, balance sheet normalization program this year the stance of monetary policy remains provided that the economy evolves broadly as accommodative, supporting some further anticipated. (See the box “Addendum to the strengthening in labor market conditions and a Policy Normalization Principles and Plans” sustained return to 2 percent inflation. in Part 2.) The FOMC continues to expect that, with Special Topics gradual adjustments in the stance of monetary policy, economic activity will expand at a Education and climbing the economic ladder. moderate pace and labor market conditions Education, particularly a college degree, is will strengthen somewhat further. Inflation often seen as a path to improved economic on a 12-month basis is expected to remain opportunities. However, despite the fact that somewhat below 2 percent in the near term but young blacks and Hispanics have increased to stabilize around the Committee’s 2 percent their educational attainment over the past MONETARy POLICy REPORT: JULy 2017 3 quarter-century, their representation in the Liquidity in the corporate bond market. A series top 25 percent of the income distribution for of changes, including regulatory reforms, young people has not materially increased. since the Global Financial Crisis have likely In part, this outcome has occurred because altered financial institutions’ incentives to educational attainment has increased for provide liquidity. Many market participants young non-Hispanic whites and Asians as well. are particularly concerned with liquidity in While education continues to be an important markets for corporate bonds. However, the determinant of whether one can climb available evidence suggests that financial the economic ladder, sizable differences in markets have performed well in recent years, economic outcomes across race and ethnicity with minimal impairment in liquidity, either remain even after controlling for educational in the market for corporate bonds or in attainment. (See the box “Does Education markets for other assets. (See the box “Recent Determine Who Climbs the Economic Developments in Corporate Bond Market Ladder?” in Part 1.) Liquidity” in Part 1.) The global productivity slowdown. Over the Monetary policy rules. Monetary policymakers past decade, labor productivity growth both consider a wide range of information on in the United States and in other advanced current economic conditions and the outlook economies has slowed markedly. This before deciding on a policy stance they deem slowdown may reflect a waning of the effects most likely to foster the FOMC’s statutory from advances in information technology in mandate of maximum employment and stable the 1990s and early 2000s. Productivity growth prices. They also routinely consult monetary may also be low because of the severity of policy rules that connect prescriptions for the the Global Financial Crisis, in part because policy interest rate with variables associated spending for research and development with the dual mandate. The use of such rules was muted. Some of the factors restraining requires careful judgments about the choice productivity growth may eventually fade, and measurement of the inputs into these but it is difficult to ascertain whether the rules as well as the implications of the many recent subdued performance of productivity considerations these rules do not take into represents a new normal. (See the box account. (See the box “Monetary Policy Rules “Productivity Developments in the Advanced and Their Role in the Federal Reserve’s Policy Economies” in Part 1.) Process” in Part 2.) 5 P 1 art r e f d eCent ConomiC and inanCiaL eveLoPments Domestic Developments elevated in the first part of the year, while the rate of layoffs remained low; both are signs The labor market tightened further that firms’ demand for labor is still solid. In during the first half of the year . . . addition, the rate of quits stayed high, an Labor market conditions continued to indication that workers are confident in their strengthen in the first five months of this ability to obtain a new job. Another measure, year. On average, payrolls expanded 162,000 the share of workers who are working part per month between January and May, time but would prefer to be employed full a little slower than the average monthly time—which is part of the U-6 measure of employment gain in 2016 but still more than underutilization from the Bureau of Labor enough to absorb new entrants to the labor Statistics—fell noticeably further in the first force and therefore consistent with a further five months of 2017 (figure 3). tightening of the labor market (figure 1). . . . though unemployment rates remain The unemployment rate has declined elevated for some demographic groups 0.4 percentage point since December 2016, and in May it stood at 4.3 percent, its lowest Although the aggregate unemployment level since late 2000 and modestly below the rate was at a 16-year low in May, there are median of Federal Open Market Committee substantial disparities across demographic (FOMC) participants’ estimates of its longer- groups (figure 4). Notably, the unemployment run normal level. rate for whites averaged 4 percent during the first five months of the year, and the rate The labor force participation rate (LFPR)— for Asians was about 3½ percent. However, that is, the share of adults either working or the unemployment rates for Hispanics actively looking for work—was 62.7 percent in (5.4 percent) and African Americans May and is little changed, on net, since early (7.8 percent) were substantially higher. The 2014 (figure 2). Along with other factors, the differences in the unemployment rates across aging of the population implies a downward racial and ethnic groups are long-standing, trend in participation, so the flattening out and they also vary over the business cycle. of the LFPR during the past few years is consistent with an overall picture of improving labor market conditions. The employment- 1. Net change in payroll employment to-population ratio—that is, the share of the 3-month moving averages Thousands of jobs population that is working—was 60 percent in May and has been increasing for the past 400 Private couple of years, reflecting the combination 200 of the declining unemployment rate and the + flat LFPR. _0 Total nonfarm 200 The strengthening condition of the labor 400 market is evident in other measures as well. 600 The number of people filing initial claims for unemployment insurance has fallen to the 800 lowest level in decades. In addition, as reported 2009 2010 2011 2012 2013 2014 2015 2016 2017 in the Job Openings and Labor Turnover NOTE: The data extend through May 2017. Survey, the rate of job openings remained SOURCE: Department of Labor, Bureau of Labor Statistics. 6 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 2. Labor force participation rate and Indeed, the unemployment rates for blacks employment-to-population ratio and Hispanics both rose considerably more than the rates for whites and Asians during Monthly Percent the Great Recession, and their subsequent 68 declines have been more rapid. On balance, however, the differences in unemployment rates 66 across the groups have not narrowed relative 64 to the pre-recession period. (For additional Labor force discussion on differences in economic participation rate 62 outcomes by race and ethnicity, see the box 60 “Does Education Determine Who Climbs the Economic Ladder?”) 58 Employment-to-population ratio Growth of labor compensation has been 2003 2005 2007 2009 2011 2013 2015 2017 modest . . . NOTE: The data extend through May 2017. Both series are a percentage of the population aged 16 and over. SOURCE: Department of Labor, Bureau of Labor Statistics. Indicators of hourly compensation suggest that wage growth has remained modest. Growth of compensation per hour in the business sector—a broad-based measure of wages, salaries, and benefits—has slowed in recent quarters and was 2¼ percent over the four quarters ending in 2017:Q1 (figure 5).1 1. The recent data on compensation per hour reflect a decline in wages and salaries at the end of 2016, which 3. Measures of labor underutilization Monthly Percent 18 U-6 16 U-4 14 U-5 12 10 8 Unemployment rate 6 4 2005 2007 2009 2011 2013 2015 2017 NOTE: The data extend through May 2017. Unemployment rate measures total unemployed as a percentage of the labor force. U-4 measures total unemployed plus discouraged workers, as a percentage of the labor force plus discouraged workers. Discouraged workers are a subset of marginally attached workers who are not currently looking for work because they believe no jobs are available for them. U-5 measures total unemployed plus all marginally attached to the labor force, as a percentage of the labor force plus persons marginally attached to the labor force. Marginally attached workers are not in the labor force, want and are available for work, and have looked for a job in the past 12 months. U-6 measures total unemployed plus all marginally attached workers plus total employed part time for economic reasons, as a percentage of the labor force plus all marginally attached workers. The shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research. SOURCE: Department of Labor, Bureau of Labor Statistics. MONETARy POLICy REPORT: JULy 2017 7 4. Unemployment rate by race and ethnicity Monthly Percent 18 Black or African American 16 14 12 Hispanic or Latino 10 White 8 6 Asian 4 2 2005 2007 2009 2011 2013 2015 2017 NOTE: The data extend through May 2017. Unemployment rate measures total unemployed as a percentage of the labor force. Persons whose ethnicity is identified as Hispanic or Latino may be of any race. The shaded bar indicates a period of business recession as defined by the National Bureau of Economic Research. SOURCE: Department of Labor, Bureau of Labor Statistics. This measure can be quite volatile even at 5. Measures of change in hourly compensation annual frequencies (and a smoothed version Percent change from year earlier is shown in figure 5 for that reason). The employment cost index—which also measures both wages and the cost to employers of Atlanta Fed’s Wage Growth Tracker 4.0 providing benefits—also was up 2¼ percent in Compensation per hour, the first quarter relative to its year-ago level, business sector 3.0 about ½ percentage point faster than its gain of a year earlier. Among measures limited to 2.0 wages, average hourly earnings growth—at Employment cost index 2½ percent through May—was little changed 1.0 Average hourly earnings from a year ago, and a compensation measure computed by the Federal Reserve Bank of 2011 2013 2015 2017 Atlanta that tracks median 12-month wage growth of individuals reporting to the Current NOTE: Business-sector compensation is the four-quarter percentage change of the four-quarter moving average. For the employment cost index, change is Population Survey was about 3½ percent in over the 12 months ending in the last month of each quarter; for average hourly earnings, change is from 12 months earlier, and the data extend May, also similar to its reading from a year through May 2017; for the Atlanta Fed’s Wage Growth Tracker, the data are shown as a three-month moving average of the 12-month percent change and earlier. extend through May 2017. SOURCE: Department of Labor, Bureau of Labor Statistics; Federal Reserve Bank of Atlanta, Wage Growth Tracker. might be the result of a shifting of bonuses or other types of income into 2017 in anticipation of a possible cut in personal income tax rates. If that is the case, the current estimate of compensation growth in the first quarter might be revised up once full data become available later this summer. 8 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Does Education Determine Who Climbs the Economic Ladder? The persistent gaps in economic outcomes by race allows us to better isolate the effect of education and ethnicity in the United States raise important from the influence of other variables, including questions about how people ascend the economic experience. Furthermore, research has shown that the ladder. Education, particularly a college degree, is often level of wages received early in an individual’s career seen as a path to improved economic opportunities. persists over time and influences that individual’s Past research has shown that human capital in the wage trajectory for years to come.2 The figure shows form of education and experience can explain about the fraction of each group that has reached the top one-third of the variation in wages across individuals.1 quartile of earnings for young adults as a whole. The However, while education continues to be an important black dashed line at 25 percent marks the fraction of determinant of whether one can climb the economic each group that would be in this top quartile if each ladder, sizable differences in economic outcomes group were equally represented in proportion to its across race and ethnicity remain even after controlling population size.3 for educational attainment. Non-Hispanic whites, for example, are Data on earnings for two cohorts of young adult overrepresented in the top 25 percent of the earnings workers (aged 25 to 34) approximately a generation distribution of young adults for both cohorts, with apart confirm both the gaps in economic outcomes just under 30 percent of the group in the top quartile and the lack of substantial upward progress for in both the 1991–95 and 2011–15 periods. Black or disadvantaged groups over the past quarter-century African American young adults are underrepresented (figure A). People of this age typically have limited in the top quartile in both periods, at about 15 percent. years of work experience, but most have completed Hispanics are likewise underrepresented, and again their schooling. Therefore, focusing on young adults there has been little improvement over time. Asians stand out in terms of both high representation and changes over time, though these measures obscure the 1. Pedro Carneiro and James J. Heckman (2003), “Human very high levels of inequality within this group.4 Capital Policy,” in Benjamin M. Friedman, ed., Inequality in America: What Role for Human Capital Policies? (Cambridge, Mass.: MIT Press), pp. 77–239. 2. See, for example, past research that shows that the average starting wage faced by a cohort is correlated with wages later on, such as George Baker, Michael Gibbs, and A. Percent of workers in top quartile of earnings Bengt Holmstrom (1994), “The Wage Policy of a Firm,” among all young adults Quarterly Journal of Economics, vol. 109 (November), pp. 921–55. Furthermore, research also shows that higher Annual Percent national unemployment rates faced by a cohort are also correlated with lower wages later on; for instance, see Paul Asian or 45 Beaudry and John DiNardo (1991), “The Effect of Implicit Pacific Islander 40 Contracts on the Movement of Wages over the Business Cycle: Evidence from Micro Data,” Journal of Political Economy, 35 vol. 99 (August), pp. 665–88; and Lisa B. Kahn (2010), “The White Equal 30 Long-Term Labor Market Consequences of Graduating from representation College in a Bad Economy,” Labour Economics, vol. 17 (April), 25 pp. 303–16. Black or African Hispanic or 20 3. In other words, if 25 percent of a group reached the top American Latino quartile, then that group’s share of the top quartile would be 15 the same as its share in the full population. 10 4. See, for example, Christian E. Weller and Jeffrey Thompson (2016), Wealth Inequality among Asian 5 Americans Greater Than among Whites, Center for American Progress (Washington: CFAP, December 20), https://www. 1991 2011 1991 2011 1991 2011 1991 2011 americanprogress.org/issues/race/reports/2016/12/20/295359/ –95 –15 –95 –15 –95 –15 –95 –15 wealth-inequality-among-asian-americans-greater-than- NOTE: Data cover the preceding calendar year. Young adults include those among-whites. aged 25 to 34. Earnings include wages, salaries, business income, and farm Note that it is possible for the within-group representation income. Threshold for crossing into the top earnings quartile is based on in the top quartile to improve for all groups because the workers aged 25 to 34 only. The black dashed line marks 25 percent, the composition of the young adult population by race and fraction of each group that would be in the top quartile if each group were equally represented in proportion to its population size. ethnicity is itself changing, with whites becoming a much SOURCE: U.S. Census Bureau, Current Population Survey, March smaller share and all other groups being stable or increasing as 1992–2016. a share of the total population. MONETARy POLICy REPORT: JULy 2017 9 Overall, the representation of black and Hispanic C. Percent of workers with a bachelor’s degree in top workers in the top earnings quartile continues to lag quartile of earnings among all young adults in the later period. This lag in representation occurs despite the gains in educational attainment—the Annual Percent critical driver of improved incomes—that blacks and Hispanics have achieved over time. For both blacks Asian or 60 Pacific Islander and Hispanics, the share achieving a bachelor’s White degree or higher has doubled over the period of study 50 Black or Hispanic or (figure B). However, even with these improvements, African Latino 40 the educational attainment gap between each of those American groups and whites persists, because the fraction of 30 whites attaining a bachelor’s degree has also increased substantially in the past quarter-century. 20 Across all groups, it is true that completing a 10 bachelor’s degree or higher roughly doubles one’s chances of reaching the top 25 percent of earners (figure C). This relationship strongly corroborates the 1991 2011 1991 2011 1991 2011 1991 2011 –95 –15 –95 –15 –95 –15 –95 –15 conventional wisdom that, for many individuals, a college education can indeed represent a path to NOTE: Data cover the preceding calendar year. Young adults include those aged 25 to 34. Earnings include wages, salaries, business income, and farm improved economic opportunities. However, even income. Threshold for crossing into the top earnings quartile is based on within this group, representation is substantially workers aged 25 to 34 only. SOURCE: U.S. Census Bureau, Current Population Survey, March unequal, with college-educated white and Asian people 1992–2016. much more likely to achieve the top quartile of income than their black or African American and Hispanic or those in the top income quartile had only a bachelor’s Latino peers. degree, and an additional 14 percent had gone on to Here the interpretation of changes over time is receive a graduate degree. By the period from 2011 a bit more nuanced, because the overall increase to 2015, these shares had risen to 42 percent and in college attainment among young adults implies 24 percent, respectively, suggesting that the average increased competition for crossing into the top quartile skill level needed to reach the top quartile of income of earnings. In the 1991–95 period, 35 percent of has increased between generations. Taken together, these observations show that B. Percent of young adults with a bachelor’s degree or educational attainment can help young adults improve higher their lifetime earning potential. However, increased levels of educational attainment across all groups have Annual Percent created greater competition for positions at the top of the economic ladder. Even among those with college Asian or Pacific Islander 70 degrees, important differences remain in representation at the top of the income distribution by race and 60 ethnicity. The relationship between educational 50 attainment and economic outcomes is complex and White heterogeneous across people, suggesting that the 40 specific nature of that attainment—the types of degrees Black or African American 30 received and the specific schools attended, among other factors—may matter much more than previously 20 thought.5 10 Hispanic or Latino 5. See, in particular, Raj Chetty, John Friedman, Emmanuel 1991 1994 1997 2000 2003 2006 2009 2012 2015 Saez, Nicholas Turner, and Danny yagan (2017), “Mobility Report Cards: The Role of Colleges in Intergenerational NOTE: Data cover the preceding calendar year. Young adults include those Mobility,” paper, Equality of Activity Project (Stanford, Calif.: aged 25 to 34. SOURCE: U.S. Census Bureau, Current Population Survey, March Stanford University, EOAP), www.equality-of-opportunity.org/ 1992–2016. papers/coll_mrc_paper.pdf. 10 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS . . . and likely restrained by slow growth of labor productivity 6. Change in business-sector output per hour These modest rates of compensation gain Percent, annual rate likely reflect the offsetting influences of a tightening labor market and persistently weak productivity growth. Since 2008, 4 labor productivity has increased only about 1 percent per year, on average, well below the 3 average pace from 1996 through 2007 and also below the gains in the 1974–95 period 2 (figure 6). For most of the period since 2011, labor productivity growth has been 1 particularly weak, although it has turned up in recent quarters. The longer-term softness in 1948– 1974– 1996– 2001– 2008– productivity growth may be partly attributable 73 95 2000 07 present to the sharp pullback in capital investment NOTE: Changes are measured from Q4 of the year immediately preceding during the most recent recession and the the period through Q4 of the final year of the period. The final period is measured from 2007:Q4 through 2017:Q1. relatively modest rebound that followed. But SOURCE: Department of Labor, Bureau of Labor Statistics. there may be other explanations, too, and considerable debate remains about the reasons for the general slowdown in productivity growth. (For a more comprehensive discussion of productivity, see the box “Productivity Developments in the Advanced Economies.”) Price inflation moved up but softened in the spring and remains below 2 percent In the early months of 2017, consumer price 7. Change in the price index for personal consumption expenditures inflation, as measured by the 12-month change in the price index for personal consumption Monthly 12-month percent change expenditures (PCE), continued its climb from the very low levels that prevailed in 2015 and Total 3.0 early 2016 when it was held down by falling 2.5 Excluding food oil and import prices. Indeed, consumer price and energy 2.0 inflation briefly reached the FOMC’s 2 percent 1.5 objective earlier this year before falling back to 1.4 percent in May (figure 7). Core 1.0 inflation, which typically provides a better Trimmed mean .5 indication than the headline measure of where + _0 overall inflation will be in the future, also was 1.4 percent over the 12 months ending in May, 2010 2011 2012 2013 2014 2015 2016 2017 a slightly slower rate than a year earlier. As is NOTE: The data extend through May 2017; changes are from one year the case with headline inflation, the 12-month earlier. SOURCE: For trimmed mean, Federal Reserve Bank of Dallas; for all else, measure of core inflation had been higher U.S. Department of Commerce, Bureau of Economic Analysis. earlier this year, reaching 1.8 percent. Both measures of inflation have recently been held down by steep and likely idiosyncratic price MONETARy POLICy REPORT: JULy 2017 11 declines for a few specific categories, including wireless telephone services and prescription drugs, which do not appear to be related to the overall trends in consumer prices. The 12-month change in the trimmed mean PCE price index—an alternative indicator of underlying inflation produced by the Federal Reserve Bank of Dallas—slowed by less than overall or core PCE price inflation over the 8. Brent spot and futures prices past several months. Weekly Dollars per barrel Oil prices declined somewhat but remain 130 Spot price 120 well above their early 2016 lows . . . 110 100 After rebounding from their early 2016 lows, 90 oil prices leveled off early this year (figure 8). f 2 u 4 t - u m re o s n c th o - n a t h ra e c a t d s 80 Since then they have declined somewhat, 70 despite OPEC’s decision in late May to renew 60 50 its November 2016 agreement to reduce its oil 40 production, thereby extending the November 30 production cuts through early 2018. Reflecting 20 lower crude oil prices as well as smaller retail 2012 2013 2014 2015 2016 2017 margins, seasonally adjusted retail gasoline NOTE: The data are weekly averages of daily data and extend through prices have also declined since the beginning July 5, 2017. SOURCE: NYMEX via Bloomberg. of the year. Nevertheless, prices of both crude oil and retail gasoline remain above their early 2016 lows, and futures prices suggest that market participants expect oil prices to rise gradually in coming years. . . . while prices of imports other than 9. Nonfuel import prices and U.S. dollar exchange rate energy have been bolstered by higher commodity prices July 2014 = 100 July 2014 = 100 Throughout 2015, nonfuel import prices 130 115 declined because of appreciation of the dollar and declines in nonfuel commodity prices 120 110 Broad nominal dollar (figure 9). Nonfuel import prices stabilized last year and have risen since then, as the dollar 110 105 stopped appreciating and supply disruptions 100 100 boosted world prices of some nonfuel commodities, especially industrial supplies 90 Nonfuel import prices 95 and metals. In recent months, depreciation of the dollar has further pushed up non-oil 2011 2012 2013 2014 2015 2016 2017 import prices, which are now slightly higher NOTE: The data are monthly, and the data for nonfuel import prices extend than in mid-2016. through May 2017. SOURCE: Department of Labor, Bureau of Labor Statistics; Federal Reserve Board, Statistical Release H.10, “Foreign Exchange Rates.” 12 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Productivity Developments in the Advanced Economies The slow pace of U.S. productivity growth has Accounting for labor productivity growth, 2005–2016 attracted much attention of late, with vigorous debate Labor Contribution Contribution on whether the slowdown represents the lingering, productivity of capital of total factor but temporary, effect of the Global Financial Crisis growth deepening productivity (GFC) or marks the start of an era of prolonged lower United States 1 .7 .3 Canada .9 1 -.1 economic growth. This discussion reviews recent Japan .9 .9 0 productivity developments in the United States and the Euro area .7 .8 0 major advanced foreign economies (AFEs) and outlines United Kingdom .5 .5 0 possible causes of the slowdown.1 Cross-country average Over the past decade, labor productivity growth 2005–2016 .8 .8 0 in advanced economies has weakened markedly 1990–2004 1.9 1.2 .7 (figure A). Labor productivity growth in the United Note: Average annual rates. States has averaged only 1 percent since 2005, about Source: The Conference Board, Total Economy Database. half the pace of the years 1990 to 2004.2 Productivity growth has been even weaker in the AFEs, with the United Kingdom experiencing a meager ½ percent economies has stagnated in the past decade against growth. As shown in the table, the widespread historical average growth of about ¾ percent. slowdown in labor productivity growth reflects weak A number of potential explanations have been put capital deepening and, more importantly, very poor forward for the abysmal performance of TFP. Some performance of total factor productivity (TFP)— authors emphasize structural factors that predate a measure of how efficiently labor and capital are the GFC. For example, Gordon (2012) sees recent combined to produce output.3 TFP across the advanced technological advances such as information technology (IT) as less revolutionary than earlier general-purpose technologies like electricity and internal combustion.4 1. Emerging market economies have also experienced Relatedly, Fernald (2015) provides evidence that declines in productivity growth in recent years, although not necessarily for the same reasons as in the advanced the effects of the IT revolution—an important factor economies. boosting productivity since the 1990s—began to fade 2. Here labor productivity is measured as overall gross in the early 2000s.5 There are signs, however, that the domestic product per hour, in contrast to the business-sector influence of IT is still spreading, as exemplified by measure shown in the main text. Productivity growth is faster in the business sector. the surge in cloud-computing technology investments 3. Capital deepening refers to increases in the amount of in recent years, and we may not yet have reaped the capital per worker. full benefits of this major technological innovation. Under this more optimistic view, slow TFP growth may reflect a temporary “productive pause” as firms spend A. Labor productivity growth resources on activities such as equipment retooling, reorganization of management practices, and workforce Annual Percent, annual rate training. After all, it took several decades for the full 1990–2004 effect of electricity to materialize.6 2005–2016 2.5 2.0 4. Robert J. Gordon (2012), “Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds,” 1.5 NBER Working Paper Series 18315 (Cambridge, Mass.: National Bureau of Economic Research, August). 1.0 5. John G. Fernald (2015), “Productivity and Potential Output before, during, and after the Great Recession,” in .5 Jonathan A. Parker and Michael Woodford, eds., NBER Macroeconomics Annual 2014, vol. 29 (Chicago: University of Chicago Press), pp. 1–51. 6. For a description of the lengthy process of diffusion United States Canada Japan Euro area K U in n g i d te o d m of electrification, see Paul A. David (1990), “The Dynamo and the Computer: An Historical Perspective on the Modern NOTE: Labor productivity is constructed as real gross domestic product per hour worked. Productivity Paradox,” American Economic Review, vol. 80 SOURCE: The Conference Board, Total Economy Database. (May), pp. 355–61. MONETARy POLICy REPORT: JULy 2017 13 Other explanations blame the weak TFP growth long-run neutral interest rate, making the policy rate on the unusual severity of the GFC. Some empirical more likely to reach its effective lower bound and thus evidence suggests that the “Schumpeterian” process constraining the ability of monetary policy to provide in which workers move toward higher-productivity economic stimulus, even in the presence of shallow firms—a key source of productivity growth following recessions. previous recessions—has been greatly impaired since the GFC.7 In addition, measures of innovation such as research and development (R&D) spending fell sharply during the GFC, as shown in figure B, partly B. Change in private real research and development in response to tight financial conditions and weak Annual Percent, annual rate demand. Declines in R&D tend to induce gradual and persistent declines in TFP, suggesting that the recent 15 low TFP growth may in part be traced to GFC-induced United States weakness in R&D.8 In this view, the recent pickup in Advanced foreign 10 R&D spending could anticipate some normalization economy range 5 in productivity growth. Finally, the slowdown in TFP + growth may also be related to the slowdown of global _0 trade in the wake of the GFC. Conventional trade 5 theories suggest that greater trade integration should bring productivity gains by facilitating the diffusion 10 of new technologies and by allowing countries to 15 specialize in the production of goods for which they have a comparative advantage. After decades of steady 1999 2003 2007 2011 2015 increases, however, trade integration appears to have plateaued in recent years (figure C). NOTE: “Advanced foreign economy range” is the min-max range for Canada, Japan, the euro area, and the United Kingdom. U.S. data refer to real In sum, it is difficult to ascertain whether the research and development (R&D) spending. Advanced foreign economy data recent subdued performance of labor productivity refer to nominal R&D spending (in national currency) deflated by the gross domestic product (GDP) deflator. The shaded bars indicate periods of global represents a new normal. Some of the GFC-related recession defined as 55 percent of world GDP in recession. factors restraining productivity growth may eventually SOURCE: Department of Commerce, Bureau of Economic Analysis for the fade, leading to a rise in productivity growth from its United States; advanced foreign economies data downloaded from OECD Science, Technology and R&D Statistics, June 7, 2017; recession data are anemic post-GFC pace. However, to the extent that from Economic Cycle Research Institute (ECRI). longer-run factors—such as the waning effects of the IT revolution—are at work, productivity growth in the future may be noticeably below historical averages. C. World trade as a share of gross domestic product Sustained low rates of productivity growth would greatly restrain the improvement of living standards. Annual Percent In addition, they would put downward pressure on the 32 30 28 7. See Lucia Foster, Cheryl Grim, and John Haltiwanger 26 (2016), “Reallocation in the Great Recession: Cleansing or 24 Not?” Journal of Labor Economics, vol. 34 (S1, January), pp. S293–S331. For an analysis of the role of sectoral labor 22 misallocation in accounting for the productivity slowdown in Nominal 20 the United Kingdom, see Christina Patterson, Ayşegül Şahin, Real 18 Giorgio Topa, and Giovanni L. violante (2016), “Working Hard in the Wrong Place: A Mismatch-Based Explanation to the 16 U.K. Productivity Puzzle,” European Economic Review, vol. 84 14 (May), pp. 42–56. 8. See Patrick Moran and Albert Queralto (2017), 1980 1985 1990 1995 2000 2005 2010 2015 “Innovation and the Productivity Growth Slowdown,” NOTE: The shaded bars indicate periods of global recession defined as unpublished paper, May, https://sites.google.com/site/ 55 percent of world gross domestic product in recession. albertqueralto/home/research—-albert-queralto/MQ_ SOURCE: World Development Indicators, World Bank; recession data are May2017.pdf. from Economic Cycle Research Institute (ECRI). 14 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Survey-based measures of inflation expectations are little changed this year . . . Expectations of inflation likely influence actual inflation by affecting wage- and price- setting decisions. Survey-based measures of inflation expectations at medium- and longer- 10. Median inflation expectations term horizons have remained relatively stable Percent so far in 2017. In the second-quarter Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia, Michigan survey expectations 4 for next 5 to 10 years the median expectation for the annual rate of increase in the PCE price index over the 3 next 10 years was 2.1 percent, the same as in the first quarter and little changed 2 SPF expectations from the readings during 2016 (figure 10). for next 10 years In the University of Michigan Surveys of 1 Consumers, the median value for inflation expectations over the next 5 to 10 years— 2005 2007 2009 2011 2013 2015 2017 which has been drifting downward for the past NOTE: The Michigan survey data are monthly. The SPF data for inflation few years—has held about flat at a low level expectations for personal consumption expenditures are quarterly and extend since late last year. from 2007:Q1 through 2017:Q2. SOURCE: University of Michigan Surveys of Consumers; Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters (SPF). . . . while market-based measures of inflation compensation fell back somewhat Inflation expectations can also be gauged by market-based measures of inflation compensation, though the inference is not straightforward because inflation compensation can be importantly affected by changes in premiums associated with 11. 5-to-10-year-forward inflation compensation risk and liquidity. Measures of longer-term Weekly Percent inflation compensation—derived either from differences between yields on nominal Treasury 3.5 securities and those on comparable Treasury Inflation swaps 3.0 Inflation-Protected Securities (TIPS) or from inflation swaps—have fallen back somewhat 2.5 this year after having moved up in late 2016 TIPS breakeven rates 2.0 (figure 11).2 The TIPS-based measure of 1.5 2. Inflation compensation implied by the TIPS 1.0 breakeven inflation rate is based on the difference, at comparable maturities, between yields on nominal 2009 2011 2013 2015 2017 Treasury securities and yields on TIPS, which are indexed NOTE: The data are weekly averages of daily data and extend through to the headline consumer price index (CPI). Inflation June 30, 2017. TIPS is Treasury Inflation-Protected Securities. swaps are contracts in which one party makes payments SOURCE: Federal Reserve Bank of New York; Barclays; Federal Reserve of certain fixed nominal amounts in exchange for cash Board staff estimates. flows that are indexed to cumulative CPI inflation over MONETARy POLICy REPORT: JULy 2017 15 5-to-10-year-forward inflation compensation is now 1¾ percent, and the analogous measure of inflation swaps is now about 2 percent. Both measures are well below the 2½ to 3 percent range that persisted for most of the 10 years before 2014. Real gross domestic product growth slowed in the first quarter, but spending 12. Change in real gross domestic product and gross by households and businesses appears to domestic income have picked up in recent months Percent, annual rate After having moved up at an annual rate of Gross domestic product 2¾ percent in the second half of 2016, real Gross domestic income 5 gross domestic product (GDP) is reported to have increased about 1½ percent in the first 4 quarter of this year (figure 12).3 The step-down 3 in first-quarter growth was largely attributable to soft inventory investment and a lull in the 2 growth of consumer spending; in contrast, net Q1 exports increased a bit, residential investment 1 grew robustly, and spending by businesses surged. Indeed, business investment was 2010 2011 2012 2013 2014 2015 2016 2017 strong enough that overall private domestic SOURCE: Department of Commerce, Bureau of Economic Analysis. final purchases—that is, final purchases by U.S. households and businesses, which tend to carry more signal for future GDP growth than most other components of overall spending— moved up at an annual rate of about 3 percent in the first quarter. For more recent months, indicators of spending by consumers and businesses have been strong and suggest that growth of economic activity rebounded in the second quarter; thus, overall activity appears to have expanded moderately, on average, over the first half of the year. some horizon. Focusing on inflation compensation 5 to 10 years ahead is useful, particularly for monetary policy, because such forward measures encompass market participants’ views about where inflation will settle in the long term after developments influencing inflation in the short term have run their course. 3. Real gross domestic income (GDI), which is conceptually the same as GDP but is constructed from different source data, had been rising at roughly the same rate as real GDP for most of 2016. However, real GDI was held down by the very weak reading for personal income in the fourth quarter of last year, which may prove to have been transitory. 16 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 13. Change in real personal consumption expenditures The economic expansion continues to be and disposable personal income supported by accommodative financial conditions, including the low cost of Percent, annual rate borrowing and easy access to credit for many Personal consumption expenditures 6 Disposable personal income households and businesses, continuing job 5 gains, rising household wealth, and favorable H1 4 consumer and business sentiment. 3 2 Gains in income and wealth continue to 1 + support consumer spending . . . _0 1 After increasing strongly in the second half of 2 2016, consumer spending in the first quarter 3 of this year was tepid. Unseasonably warm 2011 2012 2013 2014 2015 2016 2017 weather depressed spending on energy services, NOTE: The values for 2017:H1 are the annualized May/Q4 changes. and purchases of motor vehicles slowed from SOURCE: Department of Commerce, Bureau of Economic Analysis. an unusually high pace late last year. However, 14. Prices of existing single-family houses household spending seems to have picked up in more recent months, as purchases of energy Monthly Percent change from year earlier services returned to seasonal norms and retail CoreLogic 20 sales firmed. All told, consumer spending price index S&P/Case-Shiller 15 increased at an annual rate of 2 percent national index 10 over the first five months of this year, only 5 a bit slower than in the past couple of years + _0 (figure 13). 5 Zillow index 10 Beyond spending, other indicators of 15 consumers’ economic well-being have 20 been strong in the aggregate. The ongoing improvement in the labor market has 2007 2009 2011 2013 2015 2017 supported further gains in real disposable NOTE: The data for the S&P/Case-Shiller index extend through April 2017. The data for the CoreLogic and Zillow indexes extend through May 2017. personal income (DPI), a measure of income SOURCE: CoreLogic Home Price Index; Zillow; S&P/Case-Shiller U.S. after accounting for taxes and adjusting for National Home Price Index. The S&P/Case-Shiller Index is a product of S&P Dow Jones Indices LLC and/or its affiliates. (For Dow Jones Indices inflation. Real DPI increased at a solid annual licensing information, see the note on the Contents page.) rate of 3 percent over the first five months of 15. Nominal house prices and price–rent ratio this year. Monthly Index Gains in the stock market and in house prices 200 190 over the first half of the year have boosted 180 household net wealth. Broad measures of U.S. CoreLogic 170 price index 160 equity prices have continued to increase in 150 recent months after moving up considerably 140 130 late last year and in the first quarter. House 120 prices have also continued to climb, adding 110 100 to the balance sheet strength of homeowners Price–rent ratio 90 (figure 14). Indeed, nominal house price 80 70 indexes are close to their peaks of the mid- 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 2000s. However, while the ratio of house prices NOTE: The data extend through May 2017. The CoreLogic price index is to rents has edged higher, it remains well below seasonally adjusted by Federal Reserve Board staff. The price–rent ratio is its previous peak (figure 15). As a result of the the ratio of nominal house prices to the consumer price index of rent of primary residence. The data are indexed to 100 in January 2000. SOURCE: For prices, CoreLogic; for rents, Department of Labor, Bureau of Labor Statistics. MONETARy POLICy REPORT: JULy 2017 17 increases in home and equity prices, aggregate 16. Wealth-to-income ratio household net worth has risen appreciably. In Quarterly Ratio fact, at the end of the first quarter of 2017, household net worth was more than six times 7.0 the value of disposable income, the highest- ever reading for that ratio (figure 16). 6.5 Consumer spending has also been supported 6.0 by low burdens from debt service payments. The household debt service burden—the ratio 5.5 of required principal and interest payments 5.0 on outstanding household debt to disposable income, measured for the household sector 1997 2001 2005 2009 2013 2017 as a whole—has remained at a very low level NOTE: The series is the ratio of household net worth to disposable personal by historical standards. As interest rates rise, income. the debt burden will move up only gradually, SOURCE: For net worth, Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States”; for income, Department of as most household debt is in fixed-interest Commerce, Bureau of Economic Analysis. products. 17. Changes in household debt . . . as does credit availability Billions of dollars, annual rate Mortgages Consumer credit has continued to expand 1,000 Consumer credit this year but more moderately than in Sum 800 2016 (figure 17). Financing conditions are 600 Q1 generally favorable, with auto and student 400 loans remaining widely available and 200 + outstanding balances continuing to expand _0 at a robust, albeit somewhat reduced, pace. 200 Even though delinquency rates on most types 400 of consumer debt have remained low by 600 historical standards, credit card and auto loan 2007 2009 2011 2013 2015 2017 delinquencies among subprime borrowers have drifted up some. Possibly in response to this NOTE: Changes are calculated from year-end to year-end except 2017 changes, which are calculated from Q1 to Q1. deteriorating credit performance, banks have SOURCE: Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” tightened standards for credit cards and auto lending. Mortgage credit has remained readily 18. Indexes of consumer sentiment and income expectations available for households with solid credit Diffusion index Index profiles, but it was still difficult to access for households with low credit scores or harder-to- 110 90 Real income expectations document incomes. 100 80 Consumer confidence is strong 90 70 80 Consumers have remained optimistic about 70 their financial situation. As measured by the 60 Michigan survey, consumer sentiment was 60 50 solid through most of 2016, likely reflecting Consumer sentiment 50 rising income and job gains. Sentiment moved up appreciably after the presidential election 2005 2007 2009 2011 2013 2015 2017 last November and has remained at a high NOTE: The consumer sentiment data are monthly and are indexed to 100 in 1966. The real income expectations data are calculated as the net percentage level so far this year (figure 18). Furthermore, of survey respondents expecting family income to go up more than prices during the next year or two plus 100 and are shown as a three-month moving average. SOURCE: University of Michigan Surveys of Consumers. 18 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 19. New and existing home sales the share of households expecting real income to rise over the next year or two has gone up Millions, annual rate Millions, annual rate markedly in the past few months and is now in 7.5 1.8 line with its pre-recession level. 7.0 Existing home sales 1.6 6.5 1.4 Activity in the housing sector has 6.0 1.2 improved modestly 5.5 1.0 5.0 Several indicators of housing activity have .8 4.5 continued to strengthen gradually this year. .6 4.0 Sales of existing homes have gained, on net, 3.5 .4 New home sales while house prices have continued to rise 3.0 .2 and mortgage rates have remained low, even 2005 2007 2009 2011 2013 2015 2017 though they are up from last year (figures 19 NOTE: The data extend through May 2017. New home sales includes only and 20). In addition, single-family housing single-family sales. Existing home sales includes single-family, condo, townhome, and co-op sales. starts registered a slight increase, on average, SOURCE: For new home sales, Census Bureau; for existing home sales, in the first five months of the year, although National Association of Realtors. multifamily housing starts have slipped 20. Mortgage rates and housing affordability (figure 21). Despite the modest increase in Percent Index construction activity, the months’ supply of homes for sale has remained near the low Housing affordability index 205 levels seen in 2016, and the aggregate vacancy 7 185 rate has fallen back to levels observed in the 6 mid-2000s. Lean inventories are likely to 165 support further gains in homebuilding activity 5 145 going forward. 125 4 Mortgage rates 105 Business investment has turned up after a 3 period of weakness . . . 85 Led by a surge in spending on drilling and 2009 2011 2013 2015 2017 mining structures, real outlays for business NOTE: The housing affordability index data are monthly through investment—that is, private nonresidential April 2017, and the mortgage rate data are weekly through July 6, 2017. At an index value of 100, a median-income family has exactly enough income to fixed investment—rose robustly at the qualify for a median-priced home mortgage. Housing affordability is seasonally adjusted by Board staff. beginning of the year after having been about SOURCE: For housing affordability index, National Association of Realtors; flat for 2016 as a whole (figure 22). The sharp for mortgage rates, Freddie Mac Primary Mortgage Market Survey. gains in drilling and mining in the first quarter 21. Private housing starts and permits mark a turnaround for the sector; energy- sector investment had declined noticeably Monthly Millions of units, annual rate following the drop in oil prices that began 2.0 in mid-2014 and ran through early 2016. Single-family starts More recently, rapid increases in the number 1.6 of drilling rigs in operation suggest that 1.2 investment in this area remained strong in the Single-family permits second quarter of this year. .8 .4 Moreover, business spending on equipment Multifamily starts and intangibles (such as research and 0 development) advanced solidly at the beginning of the year after having been 2005 2007 2009 2011 2013 2015 2017 NOTE: The data extend through May 2017. SOURCE: Department of Commerce, Bureau of the Census. MONETARy POLICy REPORT: JULy 2017 19 roughly flat in 2016. Furthermore, indicators 22. Change in real private nonresidential fixed investment of business spending are generally upbeat: Percent, annual rate Orders and shipments of capital goods have Structures posted net gains in recent months, and indexes 30 Equipment and intangible capital of business sentiment and activity remain Q1 25 elevated after having improved significantly 20 late last year. 15 10 . . . while corporate financing conditions 5 + have remained accommodative _0 5 Aggregate flows of credit to large nonfinancial 10 firms have remained solid, supported in part by continued low interest rates (figure 23). 2010 2011 2012 2013 2014 2015 2016 2017 The gross issuance of corporate bonds was SOURCE: Department of Commerce, Bureau of Economic Analysis. robust during the first half of 2017, and yields on both speculative- and investment-grade 23. Selected components of net debt financing for corporate bonds remained low by historical nonfinancial businesses standards (figure 24). Gross equity issuance by nonfinancial firms stayed solid, on average, as Billions of dollars, monthly rate seasoned equity offerings continued at a robust Commercial paper pace and the pace of initial public offerings Bonds 80 Bank loans picked up from the low levels seen in 2016. Sum Q1 60 40 Despite the pickup in business investment, 20 demand for business loans was subdued + early this year, and outstanding commercial _0 and industrial (C&I) loans on banks’ books 20 contracted in the first quarter. In the April 40 Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), banks reported a 2007 2009 2011 2013 2015 2017 broad-based decline in demand for C&I loans SOURCE: Federal Reserve Board, Statistical Release Z.1, “Financial during the first quarter of 2017 even as lending Accounts of the United States.” standards on such loans were reported to be basically unchanged.4 Banks also reported 24. Corporate bond yields, by securities rating weaker demand for commercial real estate loans as well as a continued tightening of Daily Percentage points standards on such loans. However, lending 20 to large nonfinancial firms appeared to be 18 strengthening somewhat during the second 16 Triple-B quarter. Meanwhile, measures of small 14 12 business credit demand remained weak amid High-yield 10 stable supply. 8 6 4 Double-A 2 0 1999 2002 2005 2008 2011 2014 2017 4. The SLOOS is available on the Board’s website at NOTE: The yields shown are yields on 10-year bonds. https://www.federalreserve.gov/data/sloos/sloos.htm. SOURCE: BofA Merrill Lynch Global Research, used with permission. 20 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 25. Change in real imports and exports of goods U.S. exports grew at a faster pace and services In the first quarter of 2017, U.S. real exports Percent, annual rate increased briskly and broadly following Imports moderate growth in the second half of last Exports 9 year that was driven by a surge in agricultural Q1 exports (figure 25). At the same time, real 6 import growth declined somewhat from its strong pace in the second half of last year. As 3 a result, real net exports contributed slightly + _0 to U.S. real GDP growth in the first quarter. Available trade data through May suggest that 3 the growth of real exports slowed to a modest pace in the second quarter. Nevertheless, the 2011 2012 2013 2014 2015 2016 2017 average pace of export growth appears to have SOURCE: Department of Commerce, Bureau of Economic Analysis. stepped up in the first half of 2017 compared with last year, partly reflecting stronger growth abroad and a diminishing drag from earlier 26. U.S. trade and current account balances dollar appreciation. All told, the available Quarterly Percent of nominal GDP data for the first half of this year suggest that + net exports added a touch to U.S. real GDP _0 growth and that the nominal trade deficit 1 widened slightly relative to GDP (figure 26). 2 3 Federal fiscal policy had a roughly neutral 4 effect on economic growth . . . Trade 5 Federal purchases moved sideways in 2016, 6 and policy actions had little effect on federal Current account 7 taxes or transfers (figure 27). Under currently enacted legislation, federal fiscal policy will 2001 2003 2005 2007 2009 2011 2013 2015 2017 likely again have a roughly neutral influence on NOTE: GDP is gross domestic product. SOURCE: Department of Commerce, Bureau of Economic Analysis. the growth in real GDP this year. After narrowing significantly for several 27. Change in real government expenditures on years, the federal unified deficit has widened consumption and investment from about 2½ percent of GDP in fiscal Percent, annual rate year 2015 to 3¼ percent currently. Although Federal expenditures as a share of GDP have been State and local 6 relatively stable over this period at a little 4 under 21 percent, receipts moved lower in 2016 2 and have edged down further so far this year Q1 + _0 to roughly 17½ percent of GDP (figure 28). 2 The ratio of federal debt held by the public to nominal GDP is quite elevated relative 4 to historical norms. Nevertheless, the deficit 6 remains small enough to roughly stabilize 8 this ratio in the neighborhood of 75 percent 2009 2010 2011 2012 2013 2014 2015 2016 2017 (figure 29). SOURCE: Department of Commerce, Bureau of Economic Analysis. MONETARy POLICy REPORT: JULy 2017 21 . . . and the fiscal position of most state 28. Federal receipts and expenditures and local governments is stable Annual PPeerrcceenntt ooff nnoommiinnaall GGDDPP The fiscal position of most state and local 26 governments is stable, although there is a range Expenditures of experiences across these governments. Many 24 state governments are experiencing lackluster 22 revenue growth, as income tax collections have Receipts 20 been only edging up, on average, in recent 18 quarters. In contrast, house price gains have continued to push up property tax revenues at 16 the local level. Employment growth in the state 14 and local government sector has been anemic so far this year following a pace of hiring in 1997 2001 2005 2009 2013 2017 2016 that was the strongest since 2008. Outlays NOTE: Through 2016, receipts and expenditures are for fiscal years (October to September); gross domestic product (GDP) is for the four for construction by these governments have quarters ending in Q3. For 2017, receipts and expenditures are for the been declining (figure 30). 12 months ending in May, and GDP is the average of 2016:Q4 and 2017:Q1. Receipts and expenditures are on a unified-budget basis. SOURCE: Office of Management and Budget. Financial Developments The expected path for the federal funds 29. Federal government debt held by the public rate flattened Quarterly Percent of nominal GDP The path for the expected federal funds rate 80 implied by market quotes on interest rate derivatives has flattened, on net, since the 70 end of December, moving higher for 2017 60 but slightly lower further out (figure 31). 50 The expected policy path moved up at the 40 beginning of the year, reportedly reflecting investor perceptions that expansionary fiscal 30 policy would likely be forthcoming over the 20 near term, but subsequently fell amid some waning of these expectations as well as FOMC 1967 1977 1987 1997 2007 2017 communications that were interpreted as NOTE: The data for gross domestic product (GDP) are at an annual rate. Federal debt held by the public equals federal debt less Treasury securities signaling a somewhat slower pace of policy held in federal employee defined benefit retirement accounts, evaluated at the end of the quarter. rate increases than had been anticipated. SOURCE: For GDP, Department of Commerce, Bureau of Economic Analysis; for federal debt, Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” Survey-based measures of the expected path of policy also moved up for 2017. Most of the respondents to the Federal Reserve Bank of New York’s Survey of Primary Dealers and Survey of Market Participants— which were conducted just before the June FOMC meeting—projected an additional 25 basis point increase in the FOMC’s target range for the federal funds rate, relative to what they projected in surveys conducted before the December FOMC meeting, as the most likely outcome for this year. 22 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 30. State and local employment and structures investment Expectations for the number of rate hikes in 2018 were about unchanged. Market-based Billions of chained (2009) dollars, annual rate Employees in millions measures of uncertainty about the policy rate approximately one to two years ahead 320 Employment 19.8 decreased slightly, on balance, from their year- 300 end levels. 19.6 280 Longer-term nominal Treasury yields 19.4 260 remain low 19.2 240 After rising significantly during the second 19.0 half of 2016, yields on medium- and longer- 220 Real structures term nominal Treasury securities have 2009 2011 2013 2015 2017 decreased 5 to 25 basis points, on net, so far in 2017 (figure 32). The decrease in longer- NOTE: The employment data are monthly and extend through May 2017, and the structures data are quarterly. term nominal yields since the beginning of SOURCE: For employment data, Department of Labor, Bureau of Labor Statistics; for structures data, Department of Commerce, Bureau of Economic the year largely reflects declines in inflation Analysis. compensation due in part to soft incoming 31. Market-implied federal funds rate data on inflation, with real yields little changed on net. Consistent with the changes Quarterly Percent in Treasury yields, yields on 30-year agency mortgage-backed securities (MBS)—an 2.5 important determinant of mortgage interest Dec. 30, 2016 rates—decreased slightly over the first half of 2.0 the year (figure 33). Treasury and MBS yields 1.5 picked up somewhat in late June, driven in part July 5, 2017 by increases in government yields overseas. 1.0 However, yields remain quite low by historical standards. .5 Broad equity price indexes increased 2017 2018 2019 2020 further . . . NOTE: The federal funds rate path is implied by quotes on overnight index swaps—a derivative contract tied to the effective federal funds rate. The Broad U.S. equity indexes continued to implied path as of July 5, 2017, is compared with that as of December 30, 2016. The path is estimated with a spline approach, assuming a term premium increase during the period (figure 34). Equity of 0 basis points. The data extend through 2020:Q4. SOURCE: Bloomberg; Federal Reserve Board staff estimates. prices were reportedly supported by lower interest rates and increased optimism that 32. Yields on nominal Treasury securities corporate earnings will continue to strengthen Daily Percent this year. Stock prices of companies in the technology sector increased notably on net. 7 After rising significantly toward the end of 6 10-year 30-year last year, stock prices of banks performed 5 about in line with the broader market during 4 the first half of 2017. The implied volatility 3 of the S&P 500 index one month ahead—the 2 VIX—decreased, on net, ending the period 5-year close to the bottom of its historical range. (For 1 a discussion of financial stability issues, see 0 the box “Developments Related to Financial 2001 2003 2005 2007 2009 2011 2013 2015 2017 Stability.”) NOTE: The Treasury ceased publication of the 30-year constant maturity series on February 18, 2002, and resumed that series on February 9, 2006. SOURCE: Department of the Treasury. MONETARy POLICy REPORT: JULy 2017 23 . . . and risk spreads on corporate bonds 33. Yield and spread on agency mortgage-backed securities decreased Percent Basis points Bond spreads for investment- and speculative- 9 400 grade firms decreased, and spreads for 8 350 speculative-grade firms now stand near the Yield 300 7 bottom of their historical ranges. 250 6 200 Treasury and mortgage securities markets 5 150 have functioned well 4 100 Spread 3 50 Available indicators of Treasury market 2 0 functioning remained stable over the first half of 2017. A variety of liquidity 2001 2003 2005 2007 2009 2011 2013 2015 2017 metrics—including bid-ask spreads, bid NOTE: The data are daily. Yield shown is for the Fannie Mae 30-year current coupon, the coupon rate at which new mortgage-backed securities sizes, and estimates of transaction costs— would be priced at par, or face, value. Spread shown is to the average of the either improved or remained unchanged 5- and 10-year nominal Treasury yields. SOURCE: Department of the Treasury; Barclays. over the period, displaying no notable signs of liquidity pressures. The agency MBS market also continued to function well. (For 34. Equity prices a detailed discussion of corporate bond Daily December 31, 1999 = 100 market functioning, see the box “Recent Developments in Corporate Bond Market Dow Jones bank index 175 Liquidity.”) S&P 500 index 150 Money market rates have moved up in 125 line with increases in the FOMC’s target 100 range 75 Conditions in domestic short-term funding 50 markets have remained stable so far in 2017. NASDAQ index 25 Yields on a broad set of money market instruments moved higher in response to the 2001 2003 2005 2007 2009 2011 2013 2015 2017 FOMC’s policy actions in March and June. SOURCE: Standard & Poor's Dow Jones Indices and NASDAQ index via The effective federal funds rate generally Bloomberg. (For Dow Jones Indices licensing information, see the note on the Contents page.) traded near the middle of the target range and was closely tracked by the overnight Eurodollar rate. The spread between the three-month LIBOR (London interbank offered rate) and the OIS (overnight index swap) rate has returned to historical norms over the first half of 2017, declining from the elevated levels that prevailed at the end of last year around the implementation of the Securities and Exchange Commission money market fund reform. 24 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Developments Related to Financial Stability vulnerabilities in the U.S. financial system remain A. Selected funding for large banks moderate on balance. Capital and liquidity ratios at most large U.S. banks continue to be at historical Billions of dollars highs, and reliance on short-term wholesale funding at FHLB advances these institutions has continued to decline. valuation 300 pressures across a range of assets and several indicators 250 of investor risk appetite have increased further since mid-February, but apparent high risk appetite in 200 asset markets has not led to increased borrowing in 150 the nonfinancial sector. Debt owed by nonfinancial corporations remains elevated, although it has been flat 100 or falling in the past two years. Household debt as a 50 share of gross domestic product has remained subdued, Commercial paper from money market mutual funds 0 and new borrowing has been driven primarily by households with strong credit histories. The strong capital position of the financial sector 2011 2012 2013 2014 2015 2016 2017 has contributed to the improved resilience of the U.S. NOTE: Commercial paper from money market mutual fund data are monthly and extend through May 2017. Federal Home Loan Bank (FHLB) financial system. Regulatory capital ratios at most bank data are quarterly and are seasonally adjusted. FHLB advances data for holding companies have continued to be historically different subsets of Comprehensive Capital Analysis and Review banks high, mainly as a result of the higher regulatory capital depending on their use of each funding source. SOURCE: U.S. Securities and Exchange Commission, Form N-MFP, requirements. At the same time, measures of bank “Monthly Schedule of Portfolio Holdings of Money Market Funds,” accessed profitability have increased modestly on a year-on-year via the Office of Financial Research; Federal Financial Institutions Examinations Council, Call Report Form FFIEC 031, “Consolidated Reports basis. Regulatory capital ratios at insurance companies of Condition and Income for a Bank with Domestic and Foreign Offices.” are also high by historical standards. vulnerabilities stemming from maturity and liquidity transformation in the financial sector remain low. opaque and fragile alternative vehicles. Thus, continued High-quality liquid asset holdings at all large domestic monitoring of this sector is important. The FHLBs have bank holding companies are above regulatory liquidity increased their issuance of short-maturity liabilities, coverage ratio requirements. Moreover, banks have mainly to government funds. However, the FHLBs continued to replace short-term wholesale funding, have not reduced the maturity of their own assets, such as commercial paper held by money market which increases their liquidity mismatch and potential mutual funds (also referred to as money market funds, vulnerability to funding strains. This mismatch has or MMFs), with relatively more stable core deposits. also been highlighted by the Federal Housing Finance The use of Federal Home Loan Bank (FHLB) advances Agency, which continues to evaluate ways to formalize as a source of funding for the banks, which had its supervisory expectations regarding the appropriate increased notably through 2016, has fallen slightly in amount of short-term funding of long-term assets by the first quarter of 2017 (figure A). The MMF reforms, the FHLBs.1 designed by the Securities and Exchange Commission valuation pressures have increased further across a and fully implemented in October 2016, have led to a range of assets, including Treasury securities, equities, shift of about $1.2 trillion in assets from prime funds— corporate bonds, and commercial real estate (CRE). which can hold a range of risky instruments, including commercial paper issued by banks—to government funds, which can hold only assets collateralized by 1. See Melvin L. Watt (2017), “Prepared Remarks,” speech Treasury and agency securities. This shift has reduced delivered at the 2017 Federal Home Loan Bank Directors’ Conference, Washington, May 23, https://www.fhfa.gov/ the risk of runs on MMFs. However, run risk could Media/PublicAffairs/Pages/Prepared-Remarks-of-Melvin-L- increase if investors shift out of MMFs into more Watt-Director-of-FHFA-FHLBank-Directors-Conference.aspx. MONETARy POLICy REPORT: JULy 2017 25 Term premiums on Treasury securities continue to be in long-term upward trend. The debt-to-income ratio of the lower part of their historical distribution. A sudden households has changed little over the past few years rise in term premiums to more normal levels poses a and remains at a relatively low level. Moreover, new downside risk to long-maturity Treasury prices, which borrowing is concentrated among borrowers with high could in turn affect the prices of other assets. Forward credit scores. In contrast, the leverage of nonfinancial equity price-to-earnings ratios rose a bit further and are corporations continues to be notably elevated. New now at their highest levels since the early 2000s, while borrowing is concentrated among firms with stronger a measure of the risk premium embedded in high- balance sheets, and the total outstanding amount of yield corporate bond spreads declined a touch from speculative-grade bonds and leveraged loans edged an already low level, implying high asset valuations down, especially in the oil sector. in this market as well. Prices of CRE have continued As part of its effort to reduce regulatory burden to advance at a rapid clip amid slowing rent growth while promoting the financial stability of the United and rising interest rates, though there are signs of States, the Federal Reserve Board has taken two key tightening credit conditions in CRE markets. In contrast, steps since mid-February. First, member agencies of farmland prices have declined, albeit more slowly than the Federal Financial Institutions Examination Council, prevailing rents, implying that farmland price-to-rent including the Board, issued a joint report to the ratios have continued to move up to very high levels. In Congress under the Economic Growth and Regulatory derivatives markets, investor compensation for bearing Paperwork Reduction Act of 1996 detailing their review near-term volatility risk has remained low, suggesting a of regulations affecting smaller financial institutions, sustained investor risk appetite. such as community banks, and describing burden- The ratio of private nonfinancial (household and reducing actions the agencies plan to take.2 Second, the nonfinancial business) debt to gross domestic product, Board and the Federal Deposit Insurance Corporation shown in figure B, remains below the estimates of its jointly announced the completion of their evaluation of the 2015 resolution plans of 16 domestic banks and separately issued resolution plan guidance to 4 foreign banks.3 The agencies identified shortcomings B. Private nonfinancial sector credit-to-GDP ratio in one domestic firm’s resolution plan, which must be satisfactorily addressed in the firm’s 2017 plan Quarterly Ratio by December 31. For foreign banking organizations, resolution plans are focused on their U.S. operations, 1.8 and guidance issued to these organizations reflects the significant restructuring they have undertaken to form 1.6 intermediary holding companies. 1.4 1.2 2. See Board of Governors of the Federal Reserve System 1.0 (2017), “Banking Agencies Issue Joint Report to Congress under the Economic Growth and Regulatory Paperwork .8 Reduction Act of 1996,” press release, March 21, https://www. federalreserve.gov/newsevents/pressreleases/bcreg20170321a. 1981 1985 1989 1993 1997 2001 2005 2009 2013 2017 htm. 3. See Board of Governors of the Federal Reserve System NOTE: The shaded bars indicate periods of business recession as defined by (2017), “Agencies Complete Resolution Plan Evaluation of 16 the National Bureau of Economic Research. Domestic Firms; Provide Resolution Plan Guidance to Four SOURCE: Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States”; Department of Commerce, Bureau of Foreign Banking Organizations,” press release, March 24, Economic Analysis, national income and product accounts (NIPA), Table https://www.federalreserve.gov/newsevents/pressreleases/ 1.1.5: Gross Domestic Product; Board staff calculations. bcreg20170324a.htm. 26 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Recent Developments in Corporate Bond Market Liquidity Market liquidity refers to the extent to which years. In addition, financial markets have generally investors can rapidly execute sizable securities performed well during recent episodes of financial transactions at a low cost and with a limited price stress.1 Even in instances in which liquidity conditions effect. A high degree of market liquidity facilitates in certain markets appear to have deteriorated, the informationally efficient market pricing and lowers the effects have been mild and suggest limited economic returns required by investors to hold financial assets; consequences. In the remainder of this discussion, we it therefore decreases the cost of valuable economic illustrate these points with emphasis on the market for projects and so contributes to the efficient allocation of corporate bonds. capital. Moreover, liquidity conditions that are resilient In recent years, market participants have been in the face of economic and financial shocks reduce particularly concerned with liquidity conditions in the risk of excess volatility and fire sale losses, thus the corporate bond market because the securities are helping mitigate systemic risk. traded less frequently, and the liquidity provision has Financial institutions that serve as “market makers,” relied more heavily on dealer intermediation, than in by posting prices and standing ready to buy or sell, many other markets. However, a range of conventional are critical to healthy liquidity in the markets for metrics of liquidity indicate that liquidity strains in certain assets, including corporate bonds. A series of corporate bond markets have been minimal. Figure A changes, including regulatory reforms, since the Global Financial Crisis have likely altered financial institutions’ 1. For a discussion of the behavior of bond prices during incentives to provide liquidity, raising concerns about recent flash events (that is, extremely rapid and large price decreased liquidity in these markets, especially during moves during very short periods), see Jerome H. Powell (2015), “Structure and Liquidity in Treasury Markets,” periods of market stress. However, the available speech delivered at the Brookings Institution, Washington, evidence does not point to any substantial impairment August 3, https://www.federalreserve.gov/newsevents/speech/ in liquidity in major financial markets in recent powell20150803a.htm. A. Mean bid-ask spread and market effect for corporate bonds Percent Ratio Bear Stearns Lehman Brothers 2.4 sale to J.P. Morgan bankruptcy filing QE2 QE3 Taper tantrum 1.8 Flash 1.6 2.1 crash 1.4 1.8 1.2 1.5 1.0 1.2 Bid-ask spread .8 .9 .6 .6 .4 Price effect .3 .2 2005 2007 2009 2011 2013 2015 2017 NOTE: The data are daily. The bid-ask spread is the 21-day moving average of the difference between trade size weighted-average dealer bid prices and ask prices of non-defaulted bonds on the secondary market, scaled by the midprice. Price effect data are the 21-day moving average of the Amihud (2002) measure (see footnote 2), which is defined as the daily average of the ratio of the absolute value of the percentage price changes to transaction volume for non-defaulted bonds on the secondary market that traded at least 10 times between 10:30 a.m. and 3:30 p.m. Excludes 144a bonds. SOURCE: FINRA Trade Reporting and Compliance Engine; Thomson Reuters SDC Platinum; Mergent Fixed Income Securities Database; Moody's Default and Recovery Database. MONETARy POLICy REPORT: JULy 2017 27 shows that the estimated mean effective bid-ask spread exposure, resulting in tighter bid-ask spreads.4 Indeed, for U.S. corporate bonds has remained low in recent many market participants have expressed a concern years. Before the financial crisis, bid-ask spreads that declines in dealer inventories may reflect in part a averaged about 1 percent of the price of the bond. reduced willingness or capacity of the primary dealers This measure of trading costs skyrocketed during the to make markets, which may in turn lead to lower financial crisis but has returned to the range seen liquidity. before the crisis. Measures of the effect of trades on Figure B shows that primary dealers’ inventories prices follow a similar pattern and have been fairly of corporate bonds (including foreign bonds issued stable in recent years.2 In addition, other measures in the United States), which are predominantly used related to factors associated with market liquidity, for market making, indeed began to decline sharply such as trends in average trade size and turnover, also following the Bear Stearns collapse in March 2008 suggest market liquidity conditions are benign.3 and fell further after Lehman Brothers failed in That said, some recent work suggests that these October 2008. Such a sharp decline in dealer traditional measures of transaction costs might inventories may be the result of dealers’ actions on exaggerate the degree of liquidity in part because their own, reflecting changes in risk preferences in dealers have increasingly shifted from acting as reaction to the financial crisis. In addition, changing principals to acting as agents to reduce their risk (continued on next page) 2. See yakov Amihud (2002), “Illiquidity and Stock Returns: 4. See Jaewon Choi and yesol Huh (2016), “Customer Cross-Section and Time-Series Effects,” Journal of Financial Liquidity Provision: Implications for Corporate Bond Markets, vol. 5 (January), pp. 31–56. The Amihud price effect Transaction Costs,” unpublished paper, July (revised measure is defined as the ratio of the percentage change in January 2017), https://sites.google.com/site/yesolhuh/research/ price (in absolute value) and the daily trading volume. Choi_Huh_CLP.pdf. The authors suggest that transactions in 3. For detailed definitions of trade size and turnover in the which dealers act simply as brokers (that is, agents), rather context of corporate bond markets, see Francesco Trebbi and than as intermediaries that hold assets on their balance sheets Kairong Xiao (2015), “Regulation and Market Liquidity,” NBER (principals), could reflect price concessions that dealers make Working Paper Series 21739 (Cambridge, Mass.: National to entice counterparties into the other side of a trade so that Bureau of Economic Research, November). the dealers will not need to hold the traded assets. B. Broker-dealer holdings of corporate and foreign bonds Quarterly Billions of dollars Bear Stearns Lehman Brothers QE2 QE3 Taper tantrum 480 sale to J.P. Morgan bankruptcy filing Flash crash 400 320 240 160 80 2005 2007 2009 2011 2013 2015 2017 SOURCE: Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States,” L.130 Security Brokers and Dealers, June 8, 2017. 28 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Recent Developments in Corporate Bond Market Liquidity (continued) regulations—such as the volcker rule and the C. CDS (credit default swap)–bond basis supplementary leverage ratio, which aimed to make the financial system safer and sounder—and changes Daily Basis points in technology may have contributed to the continued trend of lower dealer inventories.5 200 The factors affecting a dealer’s willingness or Investment-grade + capacity to facilitate trading may also affect other _0 activities such as arbitrage trading, which equates 200 prices for financing arrangements with economically similar risks. Therefore, impediments in arbitrage may 400 also indicate market illiquidity. One widely studied High-yield no-arbitrage relationship is the so-called CDS–bond 600 basis, the difference between bonds’ credit default 800 swap (CDS) spreads and bond-implied credit spreads.6 Figure C shows that the CDS–bond basis for corporate bonds was close to zero before the crisis, widened 2006 2008 2010 2012 2014 2016 dramatically during the crisis (indicating a significant NOTE: Data extend through December 30, 2016. The figure plots the CDS–bond basis for investment-grade and high-yield bonds. The CDS–bond unrealized arbitrage opportunity), and has returned to basis is from J.P. Morgan and is computed for investment-grade and a level closer to, but still below, zero in recent years. high-yield corporate bonds as the average difference between each bond's More recently, the CDS–bond basis has narrowed market CDS spread (interpolated to the bond maturity) and the theoretical CDS spread implied by the bond yield. See Boyarchenko and others (2016) in further. footnote 6 for details. Overall, the degree to which dealer balance sheet SOURCE: J.P. Morgan, CDS Data. (For additional information about the data from J.P. Morgan, see the note on the Contents page.) constraints affect corporate bond market liquidity depends not only on dealers’ capacity and willingness to provide liquidity, but also on the extent to which environment.7 There are indications that market nonbank financial institutions such as hedge funds, structure has changed in recent years, and trades in mutual funds, and insurance companies fill any certain situations and market segments might have been lost market-making capacity. Other factors such as more costly at times. But markets have also adjusted, changes in technology, risk preferences, and investor and some measures of dislocation have lessened with composition also interact to shape the trading these adjustments. In summary, liquidity conditions have been quite good overall since the Global Financial Crisis. The sharp deterioration of market liquidity during 2007 and 2008 illustrates clearly that the most 5. See Tobias Adrian, Nina Boyarchenko, and Or Shachar (forthcoming), “Dealer Balance Sheets and Bond Liquidity significant risk has been distress at financial institutions. Provision,” Journal of Monetary Economics. They find that Any modest potential effects of regulation on liquidity dealers subject to stricter regulations after the crisis are should be balanced with the gains to resilience at large less able to intermediate customer trades in the corporate financial institutions associated with regulation. bond market. Also see Jack Bao, Maureen O’Hara, and Alex Zhou (2016), “The volcker Rule and Market-Making in Times of Stress,” Finance and Economics Discussion Series 2016-102 (Washington: Board of Governors of the Federal 7. See Darrell Duffie (2012), “Market Making under the Reserve System, December), https://www.federalreserve.gov/ Proposed volcker Rule,” Working Paper 3118 (Stanford, econresdata/feds/2016/files/2016102pap.pdf. They show that Calif.: Stanford Graduate School of Business, January), recently downgraded bonds trade with a higher price effect available at https://www.gsb.stanford.edu/faculty-research/ after the introduction of the volcker rule, although Anderson working-papers/market-making-under-proposed-volcker- and Stulz find no such effects. See Mike Anderson and René rule. He argues that the negative effect the volcker rule may M. Stulz (2017), “Is Post-Crisis Bond Liquidity Lower?” NBER have on market liquidity in the short run may disappear in Working Paper Series 23317 (Cambridge, Mass.: National the long run as nonbanks step in to provide liquidity. See Bureau of Economic Research, April). also Hendrik Bessembinder, Stacey E. Jacobsen, William 6. For a more detailed discussion of the CDS–bond basis, F. Maxwell, and Kumar venkataraman (2016), “Capital see Nina Boyarchenko, Pooja Gupta, Nick Steele, and Commitment and Illiquidity in Corporate Bonds,” unpublished Jacqueline yen (2016), “Trends in Credit Market Arbitrage,” paper, March, http://finance.bus.utk.edu/UTSMC/documents/ Staff Report 784 (New york: Federal Reserve Bank of New BillMaxwellPapertopresent042016.pdf. The authors find that york, July; revised July 2016), https://www.newyorkfed.org/ bank dealers are less willing to provide liquidity now than in medialibrary/media/research/staff_reports/sr784.pdf. the recent past, while nonbank dealers are now more willing. MONETARy POLICy REPORT: JULy 2017 29 Bank credit continued to expand, though at a slower pace than in 2016, and bank 35. Ratio of total commercial bank credit to nominal gross domestic product profitability improved Quarterly Percent Aggregate credit provided by commercial banks continued to increase through the 75 first quarter of 2017, though at a slower pace than in 2016, leaving the ratio of total 70 commercial bank credit to nominal GDP slightly lower (figure 35). The expansion of 65 core loans slowed during 2017, consistent with banks’ reports in the April SLOOS of 60 weakened demand for most loan categories 55 and tighter lending standards for commercial real estate loans. However, the growth of core 2001 2003 2005 2007 2009 2011 2013 2015 2017 loans appeared to be picking up somewhat SOURCE: Federal Reserve Board, Statistical Release H.8, “Assets and during the second quarter. Measures of bank Liabilities of Commercial Banks in the United States”; Department of profitability have continued to improve so far Commerce, Bureau of Economic Analysis. this year but remained below their historical averages (figure 36). 36. Profitability of bank holding companies Percent, annual rate Percent, annual rate Credit conditions in municipal bond markets have generally been stable 2.0 30 Return on assets 1.5 Credit conditions in municipal bond markets 20 1.0 have generally remained stable since year-end. 10 .5 Return on equity Over that period, yield spreads on 20-year + + _0 _0 general obligation municipal bonds over .5 comparable-maturity Treasury securities were 10 1.0 little changed on balance. Puerto Rico filed to 20 1.5 enter a court-supervised process to restructure 30 2.0 its debt after it failed to reach an agreement with bondholders, and several credit rating 2001 2003 2005 2007 2009 2011 2013 2015 2017 agencies downgraded the bond ratings of the NOTE: The data are quarterly and are seasonally adjusted. state of Illinois. However, these events have SOURCE: Federal Reserve Board, Form FR Y-9C, Consolidated Financial Statements for Bank Holding Companies. had no noticeable effect on broader municipal bond markets. International Developments Foreign financial market conditions eased Financial market conditions in both the advanced foreign economies (AFEs) and the emerging market economies (EMEs) have generally eased since January. Better-than- expected data releases, robust corporate earnings, and the passage of risk events— such as national elections in some European countries—boosted investor confidence. Broad 30 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 37. Equity indexes for selected foreign economies equity indexes in advanced and emerging Weekly Week ending January 8, 2014 = 100 foreign economies rose further (figure 37). Advanced foreign economies In addition, spreads of emerging market 125 sovereign bonds over U.S. Treasury securities Emerging market economies 120 narrowed, and capital flows into emerging 115 market mutual funds picked up (figure 38). 110 Government bond yields in the AFEs generally 105 remained very low, partly reflecting investor 100 expectations that substantial monetary 95 policy accommodation would be required 90 for some time (figure 39). In the United 85 Kingdom, softer macroeconomic data and 2014 2015 2016 2017 uncertainty about future policies and growth as the country begins the process of exiting NOTE: The data are weekly averages of daily data and extend through July 5, 2017. the European Union also weighed on yields. SOURCE: For advanced foreign economies, MSCI EAFE Index via Thomson Reuters Eikon with Datastream for Office; for emerging market However, AFE government bond yields picked economies, MSCI Emerging Markets Index via Thomson Reuters Eikon with up somewhat in late June, partly reflecting Datastream for Office. investors’ focus on remarks by officials from 38. Emerging market mutual fund flows and spreads some AFE central banks suggesting possible Basis points Billions of dollars shifts toward less accommodative policy Bond fund flows (right axis) stances. In the euro area, bank supervisors 500 Equity fund flows (right axis) 30 intervened to prevent the disorderly failure of a few small to medium-sized lenders in Italy 450 15 and Spain; business disruptions were minimal, 400 + and spillovers to other European banks were _0 350 limited. 15 300 The dollar depreciated somewhat 250 EMBI+ (left axis) 30 Since the start of the year, the broad dollar index—a measure of the trade-weighted value 2014 2015 2016 2017 of the dollar against foreign currencies—has NOTE: The EMBI+ data are weekly averages of daily data and extend through July 5, 2017. The EPFR data are monthly sums of weekly data. The depreciated about 5 percent, on balance, after fund flows data exclude funds located in China. SOURCE: For bond and equity fund flows, EPFR Global; for EMBI+, J.P. rising more than 20 percent between mid- Morgan Emerging Markets Bond Index Plus via Bloomberg. 2014 and late 2016 (figure 40). The weakening 39. Nominal 10-year government bond yields in since the start of the year partly reflected selected advanced economies growing uncertainty about prospects for more expansionary U.S. fiscal policy as well as Weekly Percent mounting confidence in the foreign economic 3.0 outlook. The euro rose against the dollar United States 2.5 following the French presidential election, and 2.0 the Mexican peso appreciated substantially as Germany United Kingdom 1.5 the Mexican central bank tightened monetary policy and as investor concerns about the 1.0 Japan potential for substantial disruptions of .5 + U.S.–Mexico trade appeared to ease. _0 .5 2014 2015 2016 2017 NOTE: The data are weekly averages of daily benchmark yields and extend through July 5, 2017. SOURCE: Bloomberg. MONETARy POLICy REPORT: JULy 2017 31 Economic activity in the AFEs grew at a 40. U.S. dollar exchange rate indexes solid pace Weekly Week ending January 8, 2014 = 100 In the first quarter, real GDP grew at a solid pace in Canada, the euro area, and Japan, 170 partly reflecting robust growth in fixed 160 investment in all three economies (figure 41). 150 In contrast, economic growth slowed to a tepid Mexican peso 140 pace in the United Kingdom, reflecting weaker 130 Euro consumption growth and a decline in exports. 120 In most AFEs, economic survey indicators, Broad dollar 110 such as purchasing manager surveys, generally 100 remained consistent with continued economic growth at a solid pace during the second 2014 2015 2016 2017 quarter. NOTE: The data, which are in foreign currency units per dollar, are weekly averages of daily data and extend through July 5, 2017. SOURCE: Federal Reserve Board, Statistical Release H.10, “Foreign Inflation leveled off in most AFEs . . . Exchange Rates.” 41. Real gross domestic product growth in selected In late 2016, consumer price inflation advanced foreign economies (measured as a 12-month percent change) rose Percent, annual rate substantially in most AFEs, partly reflecting United Kingdom increases in energy prices (figure 42). Since Japan 5 then, inflation has leveled off in Japan and Euro area Canada Q1 4 declined somewhat in the euro area as upward pressure from energy prices eased, core 3 inflation stayed low, and wage growth was 2 subdued even as unemployment rates declined 1 further in both economies. In contrast, in the + United Kingdom, headline inflation rose well _0 above the Bank of England’s (BOE) 2 percent 1 target, largely reflecting upward pressure from 2013 2014 2015 2016 2017 the substantial sterling depreciation since the SOURCE: For the United Kingdom, Office for National Statistics; for Japan, Brexit referendum in June 2016. Cabinet Office, Government of Japan; for the euro area, Eurostat; for Canada, Statistics Canada; all via Haver Analytics. . . . and AFE central banks maintained 42. Inflation in selected advanced foreign economies highly accommodative monetary policies Monthly 12-month percent change AFE central banks kept their policy rates at historically low levels, and the Bank of Japan Japan 4 kept its target range for 10-year government 3 bond yields near zero. The European Central Canada 2 Bank (ECB) maintained its asset purchase program, though it slightly reduced the pace 1 of purchases, and the BOE completed the + bond purchase program it announced last _0 United Kingdom August. However, the Bank of Canada, Euro area 1 BOE, and ECB have recently suggested that if growth continues to reduce resource 2014 2015 2016 2017 slack, some policy accommodation could be NOTE: The data for the euro area incorporate the flash estimate for June 2017. The data for Canada, Japan, and the United Kingdom extend through withdrawn. The ECB remarked that the forces May 2017. SOURCE: For the United Kingdom, Office for National Statistics; for Japan, Ministry of International Affairs and Communications; for the euro area, Statistical Office of the European Communities; for Canada, Statistics Canada; all via Haver Analytics. 32 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 43. Real gross domestic product growth in selected holding down inflation could be temporary. emerging market economies The BOE indicated that some monetary accommodation might need to be removed if Percent, annual rate the tradeoff between supporting employment China Korea 12 and expediting the return of inflation to its Mexico Brazil Q1 9 target is reduced. 6 In EMEs, Asian growth was solid . . . 3 + Chinese economic activity was robust in _0 the first quarter of 2017 as a result of solid 3 domestic and external demand (figure 43). 6 More recent indicators suggest that growth moderated in the second quarter as Chinese 2013 2014 2015 2016 2017 authorities tightened financial conditions NOTE: The data for China are seasonally adjusted by Board staff. The data and as export growth slowed. In some other for Korea, Mexico, and Brazil are seasonally adjusted by their respective government agencies. emerging Asian economies, growth picked up SOURCE: For China, China National Bureau of Statistics; for Korea, Bank of Korea; for Mexico, Instituto Nacional de Estadistica y Geografia; for in early 2017 as a result of stronger external Brazil, Instituto Brasileiro de Geografia e Estatistica; all via Haver Analytics. demand and manufacturing activity. However, growth of the region’s exports, especially to China, slowed so far in the second quarter. . . . and many Latin American economies continue their tepid recovery In Mexico, growth decelerated a touch in the first quarter of 2017, partly reflecting a slowdown in private consumption following sharp hikes in domestic fuel prices. These price hikes, together with the effects of earlier peso depreciation on import prices, contributed to a sharp rise in Mexican inflation, which prompted the Bank of Mexico to further tighten monetary policy. Following a prolonged period of contraction, the Brazilian economy posted solid growth in the first quarter of 2017, partly reflecting a surge in exports and a strong harvest. However, domestic demand has remained very weak amid high unemployment and heightened political tensions, and indicators of economic activity have stepped down recently. In Brazil and some other South American economies, declining inflation has led central banks to reduce their policy interest rates. 33 P 2 art m P onetary oLiCy The Federal Open Market Committee to strengthen even as growth in economic raised the federal funds rate target range activity slowed during the first quarter. in March and June Inflation measured on a 12-month basis had moved up appreciably and was close to the Over the past year and a half, the Federal Committee’s 2 percent longer-run objective. Open Market Committee (FOMC) has been Core inflation, which excludes volatile energy gradually increasing its target range for the and food prices, continued to run somewhat federal funds rate as the economy continued below 2 percent. to make progress toward the Committee’s objectives of maximum employment and price The data available at the time of the June stability. After having raised the target range FOMC meeting suggested a rebound in for the federal funds rate last December, the economic activity in the second quarter, Committee decided to raise the target range leaving the projected average pace of growth again in March and in June, bringing it to over the first half of the year at a moderate 1 to 1¼ percent (figure 44).5 The FOMC’s level. The labor market had continued to decisions reflected the progress the economy strengthen, with the unemployment rate falling has made, and is expected to make, toward the nearly ½ percentage point since the beginning Committee’s objectives. of the year to 4.3 percent in May, a low level by historical standards and modestly below When the Committee met in March, it decided the median of FOMC participants’ estimates to raise the target range for the federal funds of its longer-run normal level. Inflation rate to ¾ to 1 percent. Available information measured on a 12-month basis had declined suggested that the labor market had continued over the previous few months but was still up significantly since last summer. Like the 5. See Board of Governors of the Federal headline inflation measure, core inflation was Reserve System (2017), “Federal Reserve Issues FOMC Statement,” press release, March 15, https:// running somewhat below 2 percent. With www.federalreserve.gov/newsevents/pressreleases/ employment expected to remain near its monetary20170315a.htm; and Board of Governors of maximum sustainable level, the Committee the Federal Reserve System (2017), “Federal Reserve continued to expect that inflation would move Issues FOMC Statement,” press release, June 14, https:// up and stabilize around 2 percent over the next www.federalreserve.gov/newsevents/pressreleases/ couple of years, in line with the Committee’s monetary20170614a.htm. 44. Selected interest rates Daily Percent 5 10-year Treasury rate 4 3 2 2-year Treasury rate 1 0 Target range for the federal funds rate 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 NOTE: The 2-year and 10-year Treasury rates are the constant-maturity yields based on the most actively traded securities. SOURCE: Department of the Treasury; Federal Reserve Board. 34 PART 2: MONETARy POLICy longer-run objective. In view of realized expected inflation developments relative to its and expected labor market conditions and symmetric inflation goal. inflation, the Committee decided to raise the target another ¼ percentage point to a range The Committee currently expects that the of 1 to 1¼ percent. ongoing strength in the economy will warrant gradual increases in the federal funds rate, Monetary policy continues to support and that the federal funds rate will likely economic growth remain, for some time, below the levels that the Committee expects to prevail in the longer Even with the gradual reductions in the run. Consistent with this outlook, in the most amount of policy accommodation to date, the recent Summary of Economic Projections, Committee judges that the stance of monetary which was compiled at the time of the June policy remains accommodative, thereby FOMC meeting, most FOMC participants supporting some further strengthening in labor projected that the appropriate level of the market conditions and a sustained return to federal funds rate would be below its longer- 2 percent inflation. In particular, the federal run level through 2018.6 funds rate appears to remain somewhat below its neutral level—that is, the level of the federal The size of the Federal Reserve’s balance funds rate that is neither expansionary nor sheet has remained stable so far this year contractionary. To help maintain accommodative financial In evaluating the stance of monetary policy, conditions, the Committee has continued policymakers routinely consult prescriptions its existing policy of reinvesting principal from a variety of policy rules, which can payments from its holdings of agency debt serve as useful benchmarks. However, the and agency mortgage-backed securities in use and interpretation of such prescriptions agency mortgage-backed securities and rolling require careful judgments about the choice over maturing Treasury securities at auction. and measurement of the inputs to these Consequently, the Federal Reserve’s total rules as well as the implications of the many assets have held steady at around $4.5 trillion, considerations these rules do not take into with holdings of U.S. Treasury securities at account (see the box “Monetary Policy Rules $2.5 trillion and holdings of agency debt and Their Role in the Federal Reserve’s and agency mortgage-backed securities at Policy Process”). approximately $1.8 trillion (figure 45). Total liabilities on the Federal Reserve’s balance Future changes in the federal funds rate sheet were also mostly unchanged over the first will depend on the economic outlook as half of 2017. informed by incoming data The Committee intends to implement a The FOMC has continued to emphasize balance sheet normalization program that, in determining the timing and size of future adjustments to the target range for In June, policymakers augmented the the federal funds rate, it will assess realized Committee’s Policy Normalization Principles and expected economic conditions relative to and Plans issued in September 2014 by its objectives of maximum employment and providing additional details regarding the 2 percent inflation. This assessment will take approach the FOMC intends to use to reduce into account a wide range of information, including measures of labor market 6. See the June 2017 Summary of Economic conditions, indicators of inflation pressures Projections, which appeared as an addendum to the and inflation expectations, and readings on minutes of the June 13–14, 2017, meeting of the Federal financial and international developments. The Open Market Committee and is included as Part 3 of Committee will carefully monitor actual and this report. MONETARy POLICy REPORT: JULy 2017 35 45. Federal Reserve assets and liabilities Weekly Trillions of dollars 4.5 Assets 4.0 Other assets 3.5 3.0 2.5 Agency debt and mortgage-backed securities holdings 2.0 Credit and liquidity 1.5 facilities 1.0 Treasury securities held outright .5 0 Federal Reserve notes in circulation .5 1.0 1.5 Deposits of depository institutions 2.0 2.5 3.0 Capital and other liabilities 3.5 Liabilities and capital 4.0 4.5 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 NOTE: “Credit and liquidity facilities” consists of primary, secondary, and seasonal credit; term auction credit; central bank liquidity swaps; support for Maiden Lane, Bear Stearns, and AIG; and other credit facilities, including the Primary Dealer Credit Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, and the Term Asset-Backed Securities Loan Facility. “Other assets” includes unamortized premiums and discounts on securities held outright. “Capital and other liabilities” includes reverse repurchase agreements, the U.S. Treasury General Account, and the U.S. Treasury Supplementary Financing Account. The data extend through June 28, 2017. SOURCE: Federal Reserve Board, Statistical Release H.4.1, “Factors Affecting Reserve Balances.” the Federal Reserve’s holdings of Treasury The Federal Reserve’s implementation of and agency securities once normalization monetary policy has continued smoothly of the federal funds rate is well under way.7 The Federal Reserve successfully raised the The Committee intends to gradually reduce effective federal funds rate in March and June the Federal Reserve’s securities holdings by of 2017 by increasing the interest rate paid decreasing its reinvestment of the principal on reserve balances along with the interest payments it receives from the securities held in rate offered on overnight reverse repurchase the System Open Market Account. Specifically, agreements (ON RRPs). Specifically, the such payments will be reinvested only to the Federal Reserve increased the interest rate extent that they exceed gradually rising caps. paid on required and excess reserve balances Initially, these caps will be set at relatively to 1.00 percent in March and 1.25 percent in low levels to limit the volume of securities June while increasing the ON RRP offering that private investors will have to absorb. The rate to 0.75 percent in March and 1.00 percent Committee currently expects that, provided in June. In addition, the Board of Governors the economy evolves broadly as anticipated, approved ¼ percentage point increases in it would likely begin to implement the the discount rate (the primary credit rate) in program this year. In addition, the Committee March and June. In both March and June, the affirmed that changing the target range for effective federal funds rate rose near the middle the federal funds rate remains its primary of its new target range amid orderly trading means of adjusting the stance of monetary conditions in money markets, closely tracked policy (see the box “Addendum to the Policy by most other overnight money market rates. Normalization Principles and Plans”). Usage of the ON RRP facility, which had increased late last year as a result of higher demand by government money market funds 7. See Board of Governors of the Federal Reserve in the wake of last October’s money fund System (2017), “FOMC Issues Addendum to the Policy reform, has declined some, on average, in Normalization Principles and Plans,” press release, recent months. However, usage has remained June 14, https://www.federalreserve.gov/newsevents/ pressreleases/monetary20170614c.htm. somewhat above its levels of one year ago. 36 PART 2: MONETARy POLICy Monetary Policy Rules and Their Role in the Federal Reserve’s Policy Process What are monetary policy rules? rate of unemployment in the longer run (uLR) and the current unemployment rate.3 Unlike the other rules, Monetary policy rules are formulas that prescribe the first-difference rule considers the change in the a tight link between a small number of economic unemployment gap rather than its level. variables—typically including the gap between actual The Taylor (1993), balanced-approach, and adjusted and target inflation along with an estimate of resource Taylor (1993) rules provide prescriptions for the level slack in the economy—and the setting of a policy of the federal funds rate and require an estimate of rate, such as the federal funds rate.1 While policy the neutral real interest rate in the longer run (rLR)— rules can provide helpful guidance for policymakers, that is, the level of the real federal funds rate that is their interpretation requires careful judgment about expected to be consistent with sustaining maximum the measurement of the inputs to these rules and the employment and stable inflation in the longer run.4 In implications of the many considerations these rules do contrast, the change and first-difference rules prescribe not take into account. how the level of the federal funds rate at a given time Policy rules can incorporate key principles of good should be altered from its previous level—that is, they monetary policy. One key principle is that monetary indicate how the existing rate should change over time. policy should respond in a predictable way to changes The adjusted Taylor (1993) rule recognizes that the in economic conditions. A second key principle is federal funds rate cannot be reduced materially below that monetary policy should be accommodative when zero, implying that interest rate policy alone may not inflation is below the desired level and employment be able to provide enough policy accommodation is below its maximum sustainable level; conversely, during periods when the unadjusted Taylor (1993) rule monetary policy should be restrictive when the prescribes setting the federal funds rate below zero. To opposite holds. A third key principle is that, to stabilize make up for the cumulative shortfall in accommodation inflation, the policy rate should be adjusted by more (Z), the adjusted rule prescribes only a gradual return than one-for-one in response to persistent increases or t of the policy rate to the (positive) levels prescribed decreases in inflation. by the unadjusted Taylor (1993) rule as the economy Economists have analyzed many monetary policy recovers. rules, including the well-known Taylor (1993) rule The small number of variables involved in policy as well as other rules discussed later: the “balanced rules makes them easy to use. However, the U.S. approach” rule, the “adjusted Taylor (1993)” rule, the “change” rule, and the “first difference” rule (figure A).2 These policy rules generally embody the Interest Rate Setting by the European Central Bank,” Journal of three key principles of good monetary policy noted Monetary Economics, vol. 43 (June), pp. 655–79. Finally, the earlier. Each rule takes into account two gaps— first-difference rule was introduced by Athanasios Orphanides the difference between inflation and its objective (2003), “Historical Monetary Policy Analysis and the Taylor Rule,” Journal of Monetary Economics, vol. 50 (July), pp. 983– (2 percent as measured by the price index for personal 1022. A comprehensive review of policy rules is in John B. consumption expenditures (PCE), in the case of the Taylor and John C. Williams (2011), “Simple and Robust Rules Federal Reserve) as well as the difference between the for Monetary Policy,” in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol. 3B (Amsterdam: North-Holland), pp. 829–59. The same volume 1. There is a lengthy academic and intellectual debate of the Handbook of Monetary Economics also discusses about using rules to guide monetary policy; prominent approaches other than policy rules for deriving policy rate examples of rules heavily discussed in the literature and prescriptions. influential on policymaking in earlier periods include the gold 3. The Taylor (1993) rule represented slack in resource standard and Milton Friedman’s constant money growth rule. utilization using an output gap (the difference between the 2. The Taylor (1993) rule was first suggested in John B. current level of real gross domestic product (GDP) and what Taylor (1993), “Discretion versus Policy Rules in Practice,” GDP would be if the economy was operating at maximum Carnegie-Rochester Conference Series on Public Policy, vol. 39 employment). The rules in figure A represent slack in resource (December), pp. 195–214. The balanced-approach rule was utilization using the unemployment gap instead, because that analyzed in John B. Taylor (1999), “A Historical Analysis of gap better captures the Federal Open Market Committee’s Monetary Policy Rules,” in John B. Taylor, ed., Monetary Policy statutory goal to promote maximum employment. Movements Rules (Chicago: University of Chicago Press), pp. 319–41. The in these alternative measures of resource utilization are highly adjusted Taylor (1993) rule was studied in David Reifschneider correlated. For more information, see the note below figure A. and John C. Williams (2000), “Three Lessons for Monetary 4. Taylor-type rules—including John Taylor’s original Policy in a Low-Inflation Era,” Journal of Money, Credit, and rule—have often been estimated assuming that the value of Banking, vol. 32 (November), pp. 936–66. The change rule the neutral real interest rate in the longer run, rLR, is equal to was discussed in John B. Taylor (1999), “The Robustness 2 percent, which roughly corresponds to the average historical and Efficiency of Monetary Policy Rules as Guidelines for value of the real federal funds rate before the financial crisis. MONETARy POLICy REPORT: JULy 2017 37 A. Monetary policy rules Taylor (1993) rule 93 = + +0.5( − )+( − ) Balanced-approach rule = + +0.5( − )+2( − ) Taylor (1993) rule, 93 = { 93 − , 0} adjusted Change rule = −1 +1.2( − )+2( − ) First-difference rule = −1 +0.5( − )+( − )−( −4 − −4 ) Note: 93, , 93 , , and represent the values of the nominal federal funds rate prescribed by the Taylor(1993), balanced-approach, adjusted Taylor (1993), change, and first-difference rules, respectively. denotes the actual nominal federal funds rate for quartert, is four-quarter price inflation for quarter t, and is the unemployment rate in quarter t. is the level of the neutral real federal funds rate in the longer run that, on average, is expected to be consistent with sustaining maximum employment and inflation at its 2percent longer- run objective, . is the rate of unemployment in thelonger run. is the cumulative sum of past deviations of the federal funds rate from the prescriptions of the Taylor (1993) rule when that rule prescribes setting thefederal funds rate below zero. The Taylor (1993) rule and other policy rules are generally written in terms of the deviation of real output from its full capacity level.In these equations, the output gap has been replaced with the gap between the rate of unem- ployment in the longer run and its actual level (using a relationship known as Okun’s law) in order to represent the rules in terms of the FOMC’s statutory goals.Historically, movements in the output and unemployment gaps have been highly correlated.Footnote 2 provides references for the policy rules. economy is highly complex, and these rules, by B. Inflation measures their very nature, do not capture that complexity. For example, while the unemployment rate is an important Quarterly 4-quarter percent change measure of the state of the labor market, it often lags Consumer price index 6 business cycle developments and does not provide a 5 complete measure of slack or tightness. In practice, Federal Open Market Committee (FOMC) policymakers 4 examine a great deal of information about the labor GDP price index 3 market to gauge its health; this information includes 2 broader measures of labor underutilization, the labor 1 force participation rate, employment, hours worked, + and the rates of job openings, hiring, layoffs, and quits, _0 as well as anecdotal information not easily reduced to PCE 1 price index numerical indexes.5 2 Another issue related to the implementation of rules 2001 2003 2005 2007 2009 2011 2013 2015 2017 involves the measurement of the variables that drive the prescriptions generated by the rules. For example, there SOURCE: Gross domestic product (GDP) and personal consumption expenditures (PCE) data are from the Bureau of Economic Analysis, Gross are many measures of inflation, and they do not always Domestic Product: Implicit Price Deflator (GDPDEF) and Personal move together or by the same amount. The broadest Consumption Expenditures, retrieved from FRED, Federal Reserve Bank of St. Louis; consumer price index data are from the Department of Labor, measure of inflation, shown by the percent change Bureau of Labor Statistics. in the gross domestic product price index, displays notable differences from measures that gauge changes in consumer prices (figure B). Even measures that focus (continued on next page) and David Ratner (2014), “Assessing the Change in Labor Market Conditions,” FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 22), https:// www.federalreserve.gov/econresdata/notes/feds-notes/2014/ 5. For a discussion of these and other metrics of the labor assessing-the-change-in-labor-market-conditions-20140522. market, see Hess Chung, Bruce Fallick, Christopher Nekarda, html. 38 PART 2: MONETARy POLICy Monetary Policy Rules and Their Role in the Federal Reserve’s Policy Process (continued) on the prices paid by consumers differ importantly. For routinely assess risks to financial stability. Furthermore, example, inflation as measured by the consumer price over the past few years, with the federal funds rate index (or CPI) has generally been somewhat higher still close to zero, the FOMC has recognized that it historically than inflation measured using the PCE price would have limited scope to respond to an unexpected index (the index to which the FOMC’s 2 percent longer- weakening in the economy by lowering short-term run inflation objective refers). Core inflation, meaning interest rates. This asymmetric risk has, in recent inflation excluding changes in food and energy prices, years, provided a sound rationale for following a more is less volatile than headline inflation and is often used gradual path of rate increases than that prescribed in estimating monetary policy rules because it has by policy rules. (Asymmetric risk need not always historically been a good predictor of future headline provide a rationale for a more gradual path; if the risks inflation (figure C). were strongly tilted toward substantial and persistent In addition, both the level of the neutral real overheating and too-high inflation, the asymmetric interest rate in the longer run and the level of the unemployment rate that is sustainable in the longer run are difficult to estimate precisely, and estimates made C. Total inflation versus core inflation in real time may differ substantially from estimates made later on, after the relevant economic data Quarterly 4-quarter percent change have been revised and additional data have become available.6 For example, since 2000, respondents to 4 the Blue Chip survey have markedly reduced their Total projections of the longer-run level of the real short- 3 term interest rate (figure D). Survey respondents have also made considerable changes over time to their 2 estimates of the rate of unemployment in the longer 1 run, with consequences for the unemployment gap. + Revisions of this magnitude to the neutral real interest _0 rate and the rate of unemployment in the longer run Excluding food and energy (core) can have important implications for the federal funds 1 rate prescribed by monetary policy rules. Sensible estimation of policy rules requires that policymakers 2001 2003 2005 2007 2009 2011 2013 2015 2017 take into account these changes in the projected values SOURCE: Bureau of Economic Analysis. of longer-run rates as they occur over time. Furthermore, the prescribed responsiveness of the federal funds rate to its determinants differs across D. Real-time estimates of the neutral real interest policy rules. For example, the sensitivity of the federal rate and the unemployment rate in the longer run funds rate to the unemployment gap in the balanced- Percent Percent approach rule is twice as large as it is in the Taylor (1993) rule. The fact that the policy interest rate 3.2 6.2 3.0 Estimated neutral real interest responds differently to the inflation and unemployment 2.8 rate in the longer run 6.0 gaps in the different policy rules means that the rules 2.6 5.8 provide different tradeoffs between stabilizing inflation 2.4 5.6 and stabilizing unemployment. 2.2 2.0 5.4 Finally, monetary policy rules do not take account of 1.8 5.2 broader risk considerations. For example, policymakers 1.6 5.0 1.4 1.2 4.8 6. The change and first-difference rules shown in figure A 1.0 Estimated unemployment 4.6 reduce the need for good estimates of longer-run rates .8 rate in the longer run because they do not require an estimate of the neutral real .6 4.4 interest rate in the longer run. However, these rules have 2001 2003 2005 2007 2009 2011 2013 2015 2017 their own shortcomings. For example, research suggests that such rules will result in greater volatility in employment and NOTE: The data for the estimated neutral real interest rate in the longer run inflation relative to what would be obtained under the Taylor and the estimated unemployment rate in the longer run are biannual and have (1993) and balanced-approach rules unless the estimates of been interpolated to yield quarterly values. The estimated neutral real interest rate in the longer run equals the three-month Treasury bill rate projected in the neutral real federal funds rate in the longer run and the the long run deflated by the long-run projected annual change in the price rate of unemployment in the longer run are sufficiently far index for gross domestic product. from their true values. SOURCE: Wolters Kluwer, Blue Chip Economic Indicators. MONETARy POLICy REPORT: JULy 2017 39 risk could argue for higher rates than prescribed by often agree about the direction (up or down) in simple rules.) which policymakers should move the federal funds rate, they frequently disagree about the appropriate level of that rate. Historical prescriptions from policy How does the FOMC use monetary policy rules differ from one another and also differ from the rules? Committee’s target for the federal funds rate, as shown In the briefing materials prepared for FOMC in figure E. (These prescriptions are calculated using meetings, Federal Reserve staff regularly report both the actual data and the estimates of the neutral prescriptions for the current setting of the federal funds real interest rate in the longer run and of the rate of rate from a number of monetary policy rules.7 FOMC unemployment in the longer run—data and estimates policymakers discussed prescriptions from monetary that were available to FOMC policymakers at the policy rules as long ago as 1995 and have consulted time.) Moreover, the rules sometimes prescribe setting them routinely since 2004. The materials that FOMC short-term interest rates well below zero—a setting policymakers see also include forecasts of how the that is not feasible. With the exception of the adjusted federal funds rate and key macro indicators would Taylor (1993) rule, which imposes a lower limit of evolve, under each of the rules, several years into the zero, all of the rules shown in figure E called for the future. Policymakers weigh this information, along with federal funds rate to turn negative in 2009 and to stay other information bearing on the economic outlook.8 below zero for several years thereafter. Thus, these rules Different monetary policy rules often offer quite indicated that the Federal Reserve should provide more different prescriptions for the federal funds rate; monetary stimulus than could be achieved by setting moreover, there is no obvious metric for favoring the federal funds rate at zero. While all of the policy one rule over another. While monetary policy rules rules have called for higher values of the federal funds rate in recent years, the pace of tightening that the rules prescribe has varied widely. Prescriptions from these 7. Prescriptions from monetary policy rules are included rules for the level of the federal funds rate in the first in the Board staff’s Tealbook (previously the Bluebook); the quarter of 2017 ranged from 37 basis points (change precise set of rules presented has changed from time to time. The transcripts and briefing materials for FOMC meetings rule) to 2.5 percent (balanced-approach rule).9 through 2011 are available on the Board’s website at https:// www.federalreserve.gov/monetarypolicy/fomc_historical. htm. In the materials from 2011, the policy rule prescriptions are contained in the Monetary Policy Strategies section of 9. As noted earlier, the adjusted rule limits increases in the Tealbook B. federal funds rate for a time during economic recoveries to 8. The briefing materials that FOMC policymakers review make up for past shortfalls in accommodation caused by the regularly include the Board staff’s baseline forecast for the zero lower limit on interest rates. This principle can also be economy and model simulations of a variety of alternative applied to the prescriptions of the other rules. If applied to the scenarios intended to provide a sense of the effects of other balanced-approach rule, for example, it would have called for plausible developments that were not included in the staff’s the federal funds rate to have remained at zero at least through baseline forecast. the first quarter of 2017. E. Historical federal funds rate prescriptions from simple policy rules Quarterly Percent 9 Federal funds Taylor (1993) rule, adjusted 6 rate target Taylor (1993) rule 3 + _0 3 First-difference rule 6 Change rule Balanced-approach rule 9 2001 2003 2005 2007 2009 2011 2013 2015 2017 NOTE: The rules use real-time historical values of inflation, the federal funds rate, and the unemployment rate. Inflation is measured as the four-quarter percent change in the price index for personal consumption expenditures excluding food and energy. Quarterly projections of long-run values for the federal funds rate and the unemployment rate are derived through interpolations of biannual projections from Blue Chip Economic Indicators. The long-run value for inflation is taken as 2 percent. SOURCE: Federal Reserve Bank of Philadelphia; Wolters Kluwer, Blue Chip Economic Indicators; Federal Reserve Board staff estimates. 40 PART 2: MONETARy POLICy Addendum to the Policy Normalization Principles and Plans Adopted effective September 16, 2014; as amended effective June 14, 2017 All participants agreed to augment the Committee’s {{The Committee also anticipates that the caps Policy Normalization Principles and Plans by providing will remain in place once they reach their the following additional details regarding the approach respective maximums so that the Federal the FOMC intends to use to reduce the Federal Reserve’s securities holdings will continue to Reserve’s holdings of Treasury and agency securities decline in a gradual and predictable manner once normalization of the level of the federal funds rate until the Committee judges that the Federal is well under way.1 Reserve is holding no more securities than • The Committee intends to gradually reduce the necessary to implement monetary policy Federal Reserve’s securities holdings by decreasing efficiently and effectively. its reinvestment of the principal payments it • Gradually reducing the Federal Reserve’s securities receives from securities held in the System Open holdings will result in a declining supply of reserve Market Account. Specifically, such payments will balances. The Committee currently anticipates be reinvested only to the extent that they exceed reducing the quantity of reserve balances, over gradually rising caps. time, to a level appreciably below that seen in {{For payments of principal that the Federal recent years but larger than before the financial Reserve receives from maturing Treasury crisis; the level will reflect the banking system’s securities, the Committee anticipates that demand for reserve balances and the Committee’s the cap will be $6 billion per month initially decisions about how to implement monetary and will increase in steps of $6 billion at policy most efficiently and effectively in the future. three-month intervals over 12 months until it The Committee expects to learn more about the reaches $30 billion per month. underlying demand for reserves during the process {{For payments of principal that the Federal of balance sheet normalization. Reserve receives from its holdings of agency • The Committee affirms that changing the target debt and mortgage-backed securities, the range for the federal funds rate is its primary Committee anticipates that the cap will means of adjusting the stance of monetary policy. be $4 billion per month initially and will However, the Committee would be prepared increase in steps of $4 billion at three-month to resume reinvestment of principal payments intervals over 12 months until it reaches received on securities held by the Federal Reserve $20 billion per month. if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee’s target for the federal funds rate. 1. The Committee’s Policy Normalization Principles and Plans were adopted on September 16, 2014, and are available Moreover, the Committee would be prepared to at www.federalreserve.gov/monetarypolicy/files/FOMC_ use its full range of tools, including altering the PolicyNormalization.pdf. On March 18, 2015, the Committee size and composition of its balance sheet, if future adopted an addendum to the Policy Normalization Principles economic conditions were to warrant a more and Plans, which is available at www.federalreserve.gov/ accommodative monetary policy than can be monetarypolicy/files/FOMC_PolicyNormalization.20150318. pdf. achieved solely by reducing the federal funds rate. 41 P 3 art s e P ummary of ConomiC rojeCtions The following material appeared as an addendum to the minutes of the June 13–14, 2017, meeting of the Federal Open Market Committee. In conjunction with the Federal Open All participants who submitted longer-run Market Committee (FOMC) meeting held projections expected that, under appropriate on June 13–14, 2017, meeting participants monetary policy, growth in real gross domestic submitted their projections of the most product (GDP) this year would run somewhat likely outcomes for real output growth, the above their individual estimates of its longer- unemployment rate, and inflation for each run rate. Over half of these participants year from 2017 to 2019 and over the longer expected that economic growth would slow a run.8 Each participant’s projection was based bit in 2018, and almost all of them expected on information available at the time of the that in 2019 economic growth would run at or meeting, together with his or her assessment near its longer-run level. All participants who of appropriate monetary policy, including a submitted longer-run projections expected that path for the federal funds rate and its longer- the unemployment rate would run below their run value, and assumptions about other estimates of its longer-run normal level in 2017 factors likely to affect economic outcomes.9 and remain below that level through 2019. The longer-run projections represent each The majority of participants also lowered participant’s assessment of the value to which their estimates of the longer-run normal rate each variable would be expected to converge, of unemployment by 0.1 to 0.2 percentage over time, under appropriate monetary point. All participants projected that inflation, policy and in the absence of further shocks as measured by the four-quarter percentage to the economy.10 “Appropriate monetary change in the price index for personal policy” is defined as the future path of policy consumption expenditures (PCE), would run that each participant deems most likely to below 2 percent in 2017 and then step up in foster outcomes for economic activity and the next two years; over half of them projected inflation that best satisfy his or her individual that inflation would be at the Committee’s interpretation of the Federal Reserve’s 2 percent objective in 2019, and all judged that objectives of maximum employment and stable inflation would be within a couple of tenths of prices. a percentage point of the objective in that year. Table 1 and figure 1 provide summary statistics for the projections. As shown in figure 2, participants generally 8. Four members of the Board of Governors, one expected that evolving economic conditions fewer than in March 2017, were in office at the time of the June 2017 meeting and submitted economic would likely warrant further gradual increases projections. The office of the president of the Federal in the federal funds rate to achieve and sustain Reserve Bank of Richmond was vacant at the time maximum employment and 2 percent inflation. of this FOMC meeting; First Vice President Mark L. Although some participants raised or lowered Mullinix submitted economic projections. their federal funds rate projections since 9. All participants submitted their projections in advance of the FOMC meeting; no projections were March, the median projections for the federal revised following the release of economic data on the funds rate in 2017 and 2018 were essentially morning of June 14. unchanged, and the median projection in 10. One participant did not submit longer-run 2019 was slightly lower; the median projection projections for real output growth, the unemployment for the longer-run federal funds rate was rate, or the federal funds rate. 42 PART 3: SUMMARy OF ECONOMIC PROJECTIONS Table 1. Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents under their individual assessments of projected appropriate monetary policy, June 2017 Percent Median1 Central tendency2 Range3 Variable Longer Longer Longer 2017 2018 2019 2017 2018 2019 2017 2018 2019 run run run Change in real GDP ...... 2.2 2.1 1.9 1.8 2.1–2.2 1.8 –2.2 1.8 –2.0 1.8 –2.0 2.0 –2.5 1.7–2.3 1.4 –2.3 1.5 –2.2 March projection ........ 2.1 2.1 1.9 1.8 2.0 –2.2 1.8 –2.3 1.8 –2.0 1.8 –2.0 1.7–2.3 1.7–2.4 1.5 –2.2 1.6 –2.2 Unemployment rate. . . . . . . 4.3 4.2 4.2 4.6 4.2– 4.3 4.0 – 4.3 4.1– 4.4 4.5 – 4.8 4.1– 4.5 3.9 – 4.5 3.8 – 4.5 4.5 –5.0 March projection ........ 4.5 4.5 4.5 4.7 4.5 – 4.6 4.3– 4.6 4.3– 4.7 4.7–5.0 4.4 – 4.7 4.2– 4.7 4.1– 4.8 4.5 –5.0 PCE inflation ............. 1.6 2.0 2.0 2.0 1.6 –1.7 1.8 –2.0 2.0 –2.1 2.0 1.5 –1.8 1.7–2.1 1.8 –2.2 2.0 March projection ........ 1.9 2.0 2.0 2.0 1.8 –2.0 1.9 –2.0 2.0 –2.1 2.0 1.7–2.1 1.8 –2.1 1.8 –2.2 2.0 Core PCE inflation4 ....... 1.7 2.0 2.0 1.6 –1.7 1.8 –2.0 2.0 –2.1 1.6 –1.8 1.7–2.1 1.8 –2.2 March projection ........ 1.9 2.0 2.0 1.8 –1.9 1.9 –2.0 2.0 –2.1 1.7–2.0 1.8 –2.1 1.8 –2.2 Memo: Projected appropriate policy path Federal funds rate ........ 1.4 2.1 2.9 3.0 1.1–1.6 1.9 –2.6 2.6 –3.1 2.8 –3.0 1.1–1.6 1.1–3.1 1.1– 4.1 2.5 –3.5 March projection ........ 1.4 2.1 3.0 3.0 1.4 –1.6 2.1–2.9 2.6 –3.3 2.8 –3.0 0.9 –2.1 0.9 –3.4 0.9 –3.9 2.5 –3.8 Note: Projections of change in real gross domestic product (GDP) and projections for both measures of inflation are percent changes from the fourth quarter of the previous year to the fourth quarter of the year indicated. PCE inflation and core PCE inflation are the percentage rates of change in, respectively, the price index for personal consumption expenditures (PCE) and the price index for PCE excluding food and energy. Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated. Each participant’s projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy. The projections for the federal funds rate are the value of the midpoint of the projected appropriate target range for the federal funds rate or the projected appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. The March projections were made in conjunction with the meeting of the Federal Open Market Committee on March 14–15, 2017. One participant did not submit longer-run projections for the change in real GDP, the unemployment rate, or the federal funds rate in conjunction with the March 14–15, 2017, meeting, and one participant did not submit such projections in conjunction with the June 13–14, 2017, meeting. 1. For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections. 2. The central tendency excludes the three highest and three lowest projections for each variable in each year. 3. The range for a variable in a given year includes all participants’ projections, from lowest to highest, for that variable in that year. 4. Longer-run projections for core PCE inflation are not collected. unchanged. However, the economic outlook confidence intervals that are computed from is uncertain, and participants noted that their the forecast errors of various private and economic projections and assessments of government projections made over the past appropriate monetary policy could change in 20 years. The width of the confidence interval response to incoming information. for each variable at a given point is a measure of forecast uncertainty at that horizon. For In general, participants viewed the uncertainty all three macroeconomic variables, these attached to their projections as broadly charts illustrate that forecast uncertainty is similar to the average of the past 20 years, substantial and generally increases as the although a couple of participants saw the forecast horizon lengthens. Reflecting, in part, uncertainty associated with their real GDP the uncertainty about the future evolution growth forecasts as higher than average. of GDP growth, the unemployment rate, Most participants judged the risks around and inflation, participants’ assessments of their projections for economic growth, the appropriate monetary policy are also subject unemployment rate, and inflation as broadly to considerable uncertainty. To illustrate the balanced. uncertainty regarding the appropriate path for monetary policy, figure 5 shows a comparable Figures 4.A through 4.C for real GDP fan chart around the median projections growth, the unemployment rate, and inflation, for the federal funds rate.11 As with the respectively, present “fan charts” as well as charts of participants’ current assessments 11. The fan chart for the federal funds rate depicts of the uncertainty and risks surrounding the uncertainty about the future path of appropriate the economic projections. The fan charts monetary policy and is closely connected with the (the panels at the top of these three figures) uncertainty about the future value of economic variables. show the median projections surrounded by In contrast, the dot plot shown in figure 2 displays the MONETARy POLICy REPORT: JULy 2017 43 Figure 1. Medians, central tendencies, and ranges of economic projections, 2017–19 and over the longer run Percent Change in real GDP Median of projections Central tendency of projections Range of projections 3 2 Actual 1 2012 2013 2014 2015 2016 2017 2018 2019 Longer run Percent Unemployment rate 8 7 6 5 4 2012 2013 2014 2015 2016 2017 2018 2019 Longer run Percent PCE inflation 3 2 1 2012 2013 2014 2015 2016 2017 2018 2019 Longer run Percent Core PCE inflation 3 2 1 2012 2013 2014 2015 2016 2017 2018 2019 Longer run Note: Definitions of variables and other explanations are in the notes to table 1. The data for the actual values of the variables are annual. 44 PART 3: SUMMARy OF ECONOMIC PROJECTIONS Figure 2. FOMC participants’ assessments of appropriate monetary policy: Midpoint of target range or target level for the federal funds rate Percent 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2017 2018 2019 Longer run Note: Each shaded circle indicates the value (rounded to the nearest 1/8 percentage point) of an individual participant’s judgment of the midpoint of the appropriate target range for the federal funds rate or the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. One participant did not submit longer-run projections for the federal funds rate. macroeconomic variables, forecast uncertainty was 1.8 percent. Compared with the March for the federal funds rate is substantial and Summary of Economic Projections (SEP), the increases at longer horizons. medians of the forecasts for real GDP growth over the period from 2017 to 2019, as well The Outlook for Economic Activity as the median assessment of the longer-run growth rate, were mostly unchanged. Fewer The median of participants’ projections for than half of the participants incorporated the growth rate of real GDP, conditional expectations of fiscal stimulus into their on their individual assumptions about projections, and a couple indicated that they appropriate monetary policy, was 2.2 percent had marked down the magnitude of expected in 2017, 2.1 percent in 2018, and 1.9 percent fiscal stimulus relative to March. in 2019; the median of projections for the longer-run normal rate of real GDP growth All participants revised down their projections for the unemployment rate in the fourth quarter of 2017 and of 2018, and almost all dispersion of views across individual participants about the appropriate level of the federal funds rate. also revised down their projections for the MONETARy POLICy REPORT: JULy 2017 45 unemployment rate in the fourth quarter of would continue to run a bit below 2 percent 2019. Many who did so cited recent lower- in 2018, while only one participant expected than-expected readings on unemployment. inflation above 2 percent in that year—and, The median of the projections for the in that case, just modestly so. More than unemployment rate was 4.3 percent in 2017 half projected that inflation would be equal and 4.2 percent in each of 2018 and 2019, to the Committee’s objective in 2019. A few 0.2 percentage point and 0.3 percentage participants projected that inflation would point lower than in the March projections, run slightly below 2 percent in that year, while respectively. The majority of participants also several projected that it would run a little revised down their estimates of the longer- above 2 percent. The median of projections run normal rate of unemployment by 0.1 or for core PCE price inflation was 1.7 percent 0.2 percentage point, and the median longer- in 2017, a decline of 0.2 percentage point run level was 4.6 percent, down 0.1 percentage from March; the median projection for 2018 point from March. and 2019 was 2.0 percent, as in the March projections. Figures 3.A and 3.B show the distributions of participants’ projections for real GDP growth Figures 3.C and 3.D provide information on and the unemployment rate from 2017 to 2019 the distributions of participants’ views about and in the longer run. The distribution of the outlook for inflation. The distributions of individual projections for real GDP growth for projections for headline PCE price inflation this year shifted up, with some participants and for core PCE price inflation in 2017 now expecting real GDP growth between shifted down noticeably from March, while the 2.4 and 2.5 percent and none seeing it below distributions for both measures of inflation in 2 percent. The distributions of projected real 2018 shifted down slightly. Many participants GDP growth in 2018, 2019, and in the longer cited recent surprisingly low readings on run were broadly similar to the distributions inflation as a factor contributing to the of the March projections. The distributions of revisions in their inflation forecasts. individual projections for the unemployment rate shifted down noticeably for 2017 Appropriate Monetary Policy and 2018. Most participants projected an unemployment rate of 4.2 or 4.3 percent at the Figure 3.E provides the distribution of end of this year, and the majority anticipated participants’ judgments regarding the an unemployment rate between 4.0 and appropriate target or midpoint of the target 4.3 percent at the end of 2018. Participants’ range for the federal funds rate at the end projections also shifted down in 2019 but of each year from 2017 to 2019 and over were more dispersed than the distributions of the longer run.12 The distribution for 2017 their projected unemployment rates in the two was less dispersed than that in March, while earlier years. The distribution of projections the distribution for 2018 was slightly less for the longer-run normal unemployment rate shifted down modestly. 12. One participant’s projections for the federal funds rate, real GDP growth, the unemployment rate, The Outlook for Inflation and inflation were informed by the view that there are multiple possible medium-term regimes for the U.S. The median of projections for headline PCE economy, that these regimes are persistent, and that the price inflation this year was 1.6 percent, economy shifts between regimes in a way that cannot be down 0.3 percentage point from March. As forecast. Under this view, the economy currently is in a regime characterized by expansion of economic activity in March, median projected inflation was with low productivity growth and a low short-term real 2.0 percent in 2018 and 2019. About half of interest rate, but longer-term outcomes for variables the participants anticipated that inflation other than inflation cannot be usefully projected. 46 PART 3: SUMMARy OF ECONOMIC PROJECTIONS Figure 3.A. Distribution of participants’ projections for the change in real GDP, 2017 –19 and over the longer run Number of participants 2017 June projections 18 March projections 16 14 12 10 8 6 4 2 1.2 – 1.4– 1.6 – 1.8 – 2.0 – 2.2 – 2.4 – 1.3 1.5 1.7 1.9 2.1 2.3 2.5 Percent range Number of participants 2018 18 16 14 12 10 8 6 4 2 1.2 – 1.4– 1.6 – 1.8 – 2.0 – 2.2 – 2.4 – 1.3 1.5 1.7 1.9 2.1 2.3 2.5 Percent range Number of participants 2019 18 16 14 12 10 8 6 4 2 1.2 – 1.4– 1.6 – 1.8 – 2.0 – 2.2 – 2.4 – 1.3 1.5 1.7 1.9 2.1 2.3 2.5 Percent range Number of participants Longer run 18 16 14 12 10 8 6 4 2 1.2 – 1.4– 1.6 – 1.8 – 2.0 – 2.2 – 2.4 – 1.3 1.5 1.7 1.9 2.1 2.3 2.5 Percent range Note: Definitions of variables and other explanations are in the notes to table 1. MONETARy POLICy REPORT: JULy 2017 47 Figure 3.B. Distribution of participants’ projections for the unemployment rate, 2017 –19 and over the longer run Number of participants 2017 June projections 18 March projections 16 14 12 10 8 6 4 2 3.6 – 3.8 – 4.0 – 4.2 – 4.4 – 4.6 – 4.8 – 5.0 – 3.7 3.9 4.1 4.3 4.5 4.7 4.9 5.1 Percent range Number of participants 2018 18 16 14 12 10 8 6 4 2 3.6 – 3.8 – 4.0 – 4.2 – 4.4 – 4.6 – 4.8 – 5.0 – 3.7 3.9 4.1 4.3 4.5 4.7 4.9 5.1 Percent range Number of participants 2019 18 16 14 12 10 8 6 4 2 3.6 – 3.8 – 4.0 – 4.2 – 4.4 – 4.6 – 4.8 – 5.0 – 3.7 3.9 4.1 4.3 4.5 4.7 4.9 5.1 Percent range Number of participants Longer run 18 16 14 12 10 8 6 4 2 3.6 – 3.8 – 4.0 – 4.2 – 4.4 – 4.6 – 4.8 – 5.0 – 3.7 3.9 4.1 4.3 4.5 4.7 4.9 5.1 Percent range Note: Definitions of variables and other explanations are in the notes to table 1. 48 PART 3: SUMMARy OF ECONOMIC PROJECTIONS Figure 3.C. Distribution of participants’ projections for PCE inflation, 2017 –19 and over the longer run Number of participants 2017 June projections 18 March projections 16 14 12 10 8 6 4 2 1.5 – 1.7 – 1.9 – 2.1 – 1.6 1.8 2.0 2.2 Percent range Number of participants 2018 18 16 14 12 10 8 6 4 2 1.5 – 1.7 – 1.9 – 2.1 – 1.6 1.8 2.0 2.2 Percent range Number of participants 2019 18 16 14 12 10 8 6 4 2 1.5 – 1.7 – 1.9 – 2.1 – 1.6 1.8 2.0 2.2 Percent range Number of participants Longer run 18 16 14 12 10 8 6 4 2 1.5 – 1.7 – 1.9 – 2.1 – 1.6 1.8 2.0 2.2 Percent range Note: Definitions of variables and other explanations are in the notes to table 1. MONETARy POLICy REPORT: JULy 2017 49 Figure 3.D. Distribution of participants’ projections for core PCE inflation, 2017–19 Number of participants 2017 June projections 18 March projections 16 14 12 10 8 6 4 2 1.5 – 1.7– 1.9 – 2.1– 1.6 1.8 2.0 2.2 Percent range Number of participants 2018 18 16 14 12 10 8 6 4 2 1.5 – 1.7– 1.9 – 2.1– 1.6 1.8 2.0 2.2 Percent range Number of participants 2019 18 16 14 12 10 8 6 4 2 1.5 – 1.7– 1.9 – 2.1– 1.6 1.8 2.0 2.2 Percent range Note: Definitions of variables and other explanations are in the notes to table 1. 50 PART 3: SUMMARy OF ECONOMIC PROJECTIONS Figure 3.E. Distribution of participants’ judgments of the midpoint of the appropriate target range for the federal funds rate or the appropriate target level for the federal funds rate, 2017–19 and over the longer run Number of participants 2017 June projections 18 March projections 16 14 12 10 8 6 4 2 0.88 – 1.13 – 1.38 – 1.63 – 1.88 – 2.13 – 2.38 – 2.63 – 2.88 – 3.13 – 3.38 – 3.63 – 3.88 – 4.13 – 1.12 1.37 1.62 1.87 2.12 2.37 2.62 2.87 3.12 3.37 3.62 3.87 4.12 4.37 Percent range Number of participants 2018 18 16 14 12 10 8 6 4 2 0.88 – 1.13 – 1.38 – 1.63 – 1.88 – 2.13 – 2.38 – 2.63 – 2.88 – 3.13 – 3.38 – 3.63 – 3.88 – 4.13 – 1.12 1.37 1.62 1.87 2.12 2.37 2.62 2.87 3.12 3.37 3.62 3.87 4.12 4.37 Percent range Number of participants 2019 18 16 14 12 10 8 6 4 2 0.88 – 1.13 – 1.38 – 1.63 – 1.88 – 2.13 – 2.38 – 2.63 – 2.88 – 3.13 – 3.38 – 3.63 – 3.88 – 4.13 – 1.12 1.37 1.62 1.87 2.12 2.37 2.62 2.87 3.12 3.37 3.62 3.87 4.12 4.37 Percent range Number of participants Longer run 18 16 14 12 10 8 6 4 2 0.88 – 1.13 – 1.38 – 1.63 – 1.88 – 2.13 – 2.38 – 2.63 – 2.88 – 3.13 – 3.38 – 3.63 – 3.88 – 4.13 – 1.12 1.37 1.62 1.87 2.12 2.37 2.62 2.87 3.12 3.37 3.62 3.87 4.12 4.37 Percent range Note: Definitions of variables and other explanations are in the notes to table 1. MONETARy POLICy REPORT: JULy 2017 51 dispersed. The distributions in 2019 and in Table 2. Average historical projection error ranges the longer run were broadly similar to those Percentage points in March. The median projections of the Variable 2017 2018 2019 federal funds rate continued to show gradual Change in real GDP1 ....... ±1.4 ±2.0 ±2.2 increases, with the median assessment for Unemployment rate1 ....... ±0.4 ±1.2 ±1.8 2017 standing at 1.38 percent, consistent Total consumer prices2 ..... ±0.8 ±1.0 ±1.0 with three 25 basis point increases this year. Short-term interest rates3 ... ±0.7 ±2.0 ±2.2 Thereafter, the medians of the projections Note: Error ranges shown are measured as plus or minus the root mean squared error of projections for 1997 through 2016 that were released in the summer by var- were 2.13 percent at the end of 2018 and ious private and government forecasters. As described in the box “Forecast Uncer- tainty,” under certain assumptions, there is about a 70 percent probability that actual 2.94 percent at the end of 2019; the median of outcomes for real GDP, unemployment, consumer prices, and the federal funds rate the longer-run projections of the federal funds will be in ranges implied by the average size of projection errors made in the past. For more information, see David Reifschneider and Peter Tulip (2017), “Gauging rate was 3.00 percent. the Uncertainty of the Economic Outlook Using Historical Forecasting Errors: The Federal Reserve’s Approach,” Finance and Economics Discussion Series 2017-020 (Washington: Board of Governors of the Federal Reserve System, February), avail- able at www.federalreserve.gov/econresdata/feds/2017/files/2017020pap.pdf. In discussing their June projections, many 1. Definitions of variables are in the general note to table 1. participants continued to express the view 2. Measure is the overall consumer price index, the price measure that has been most widely used in government and private economic forecasts. Projection is that the appropriate upward trajectory of percent change, fourth quarter of the previous year to the fourth quarter of the year indicated. the federal funds rate over the next few years 3. For Federal Reserve staff forecasts, measure is the federal funds rate. For other would likely be gradual. That anticipated pace forecasts, measure is the rate on 3-month Treasury bills. Historical projections are the average level, in percent, in the fourth quarter of the year indicated. reflected a few factors, such as a neutral real interest rate that was currently low and was expected to move up only slowly as well as a gradual return of inflation to the Committee’s forecast uncertainty is incorporated graphically 2 percent objective. Several participants judged in the top panels of figures 4.A, 4.B, and that a slightly more accommodative path 4.C, which display fan charts plotting the of monetary policy than in their previous median SEP projections for the three variables projections would likely be appropriate, citing surrounded by symmetric confidence intervals an apparently slower rate of progress toward derived from the RMSEs presented in table 2. the Committee’s 2 percent inflation objective. If the degree of uncertainty attending these In their discussions of appropriate monetary projections is similar to the typical magnitude policy, half of the participants commented of past forecast errors and if the risks around on the Committee’s reinvestment policy; all the projections are broadly balanced, future of those who did so expected a change in outcomes of these variables would have reinvestment policy before the end of this year. about a 70 percent probability of occurring within these confidence intervals. For all three Uncertainty and Risks variables, this measure of forecast uncertainty is substantial and generally increases as the Projections of economic variables are subject forecast horizon lengthens. to considerable uncertainty. In assessing the path of monetary policy that, in their view, FOMC participants may judge that the is likely to be most appropriate, FOMC width of the historical fan charts shown in participants take account of the range of figures 4.A through 4.C does not adequately possible outcomes, the likelihood of those capture their current assessments of the degree outcomes, and the potential benefits and costs of uncertainty that surrounds their economic to the economy should they occur. Table 2 projections. Participants’ assessments of the provides one measure of forecast uncertainty current level of uncertainty surrounding their for the change in real GDP, the unemployment economic projections are shown in the bottom- rate, and total consumer price inflation—the left panels of figures 4.A, 4.B, and 4.C. All or root mean squared error (RMSE) for forecasts nearly all participants viewed the uncertainty made over the past 20 years. This measure of attached to their economic projections as 52 PART 3: SUMMARy OF ECONOMIC PROJECTIONS broadly similar to the average of the past Participants’ assessments of the future 20 years, with three fewer participants than in path of the federal funds rate consistent March seeing uncertainty about GDP growth, with appropriate policy are also subject to the unemployment rate, and inflation as higher considerable uncertainty, reflecting in part than its historical average.13 In their discussion uncertainty about the evolution of GDP of the uncertainty attached to their current growth, the unemployment rate, and inflation projections, most participants again expressed over time. The final line in table 2 shows the the view that, at this point, uncertainty RMSEs for forecasts of short-term interest surrounding prospective changes in fiscal and rates. These RMSEs are not strictly consistent other government policies is very large or that with the SEP projections for the federal funds there is not yet enough information to make rate, in part because the SEP projections are reasonable assumptions about the timing, not forecasts of the likeliest outcomes but nature, and magnitude of the changes. rather reflect each participant’s individual assessment of appropriate monetary policy. The fan charts—which are constructed so as to However, the associated confidence intervals be symmetric around the median projections— provide a sense of the likely uncertainty also may not fully reflect participants’ around the future path of the federal funds current assessments of the balance of risks rate generated by the uncertainty about the to their economic projections. Participants’ macroeconomic variables and additional assessments of the balance of risks to their adjustments to monetary policy that may be economic projections are shown in the bottom- appropriate to offset the effects of shocks to right panels of figures 4.A, 4.B, and 4.C. As the economy. in March, most participants judged the risks to their projections of real GDP growth, the Figure 5 shows a fan chart plotting the median unemployment rate, headline inflation, and SEP projections for the appropriate path of the core inflation as broadly balanced—in other federal funds rate surrounded by confidence words, as broadly consistent with a symmetric intervals derived from the results presented in fan chart. Three participants judged the risks table 2. As with the macroeconomic variables, to the unemployment rate as weighted to the forecast uncertainty is substantial and downside, and one participant judged the risks increases at longer horizons.14 as weighted to the upside (as shown in the lower-right panel of figure 4.B). In addition, the balance of risks to participants’ inflation projections shifted down slightly from March (shown in the lower-right panels of figure 4.C), 14. If at some point in the future the confidence as two fewer participants judged the risks to interval around the federal funds rate were to extend below zero, it would be truncated at zero for purposes inflation to be weighted to the upside and of the chart shown in figure 5; zero is the bottom of two more viewed the risks as weighted to the the lowest target range for the federal funds rate that downside. has been adopted by the Committee in the past. This approach to the construction of the federal funds rate 13. At the end of this summary, the box “Forecast fan chart would be merely a convention and would not Uncertainty” discusses the sources and interpretation have any implication for possible future policy decisions of uncertainty in the economic forecasts and explains regarding the use of negative interest rates to provide the approach used to assess the uncertainty and risks additional monetary policy accommodation if doing so attending the participants’ projections. were appropriate. MONETARy POLICy REPORT: JULy 2017 53 Figure 4.A. Uncertainty and risks in projections of GDP growth Median projection and confidence interval based on historical forecast errors Percent Change in real GDP Median of projections 70% confidence interval 4 3 2 Actual 1 0 2012 2013 2014 2015 2016 2017 2018 2019 FOMC participants’ assessments of uncertainty and risks around their economic projections Number of participants Number of participants Uncertainty about GDP growth Risks to GDP growth June projections June projections 18 18 March projections March projections 16 16 14 14 12 12 10 10 8 8 6 6 4 4 2 2 Lower Broadly Higher Weighted to Broadly Weighted to similar downside balanced upside Note: The blue and red lines in the top panel show actual values and median projected values, respectively, of the percent change in real gross domestic product (GDP) from the fourth quarter of the previous year to the fourth quarter of the year indicated. The confidence interval around the median projected values is assumed to be symmetric and is based on root mean squared errors of various private and government forecasts made over the previous 20 years; more information about these data is available in table 2. Because current conditions may differ from those that prevailed, on average, over the previous 20 years, the width and shape of the confidence interval estimated on the basis of the historical forecast errors may not reflect FOMC participants’ current assessments of the uncertainty and risks around their projections; these current assessments are summarized in the lower panels. Generally speaking, participants who judge the uncertainty about their projections as “broadly similar” to the average levels of the past 20 years would view the width of the confidence interval shown in the historical fan chart as largely consistent with their assessments of the uncertainty about their projections. Likewise, partici- pants who judge the risks to their projections as “broadly balanced” would view the confidence interval around their projec- tions as approximately symmetric. For definitions of uncertainty and risks in economic projections, see the box “Forecast Uncertainty.” 54 PART 3: SUMMARy OF ECONOMIC PROJECTIONS Figure 4.B. Uncertainty and risks in projections of the unemployment rate Median projection and confidence interval based on historical forecast errors Percent Unemployment rate Median of projections 10 70% confidence interval 9 8 7 6 Actual 5 4 3 2 1 2012 2013 2014 2015 2016 2017 2018 2019 FOMC participants’ assessments of uncertainty and risks around their economic projections Number of participants Number of participants Uncertainty about the unemployment rate Risks to the unemployment rate June projections June projections 18 18 March projections March projections 16 16 14 14 12 12 10 10 8 8 6 6 4 4 2 2 Lower Broadly Higher Weighted to Broadly Weighted to similar downside balanced upside Note: The blue and red lines in the top panel show actual values and median projected values, respectively, of the average civilian unemployment rate in the fourth quarter of the year indicated. The confidence interval around the median projected values is assumed to be symmetric and is based on root mean squared errors of various private and government forecasts made over the previous 20 years; more information about these data is available in table 2. Because current conditions may differ from those that prevailed, on average, over the previous 20 years, the width and shape of the confidence interval estimated on the basis of the historical forecast errors may not reflect FOMC participants’ current assessments of the uncertainty and risks around their projections; these current assessments are summarized in the lower panels. Generally speaking, participants who judge the uncertainty about their projections as “broadly similar” to the average levels of the past 20 years would view the width of the confidence interval shown in the historical fan chart as largely consistent with their assessments of the uncertainty about their projections. Likewise, participants who judge the risks to their projections as “broadly balanced” would view the confidence interval around their projections as approximately symmetric. For definitions of uncertainty and risks in economic projections, see the box “Forecast Uncertainty.” MONETARy POLICy REPORT: JULy 2017 55 Figure 4.C. Uncertainty and risks in projections of PCE inflation Median projection and confidence interval based on historical forecast errors Percent PCE inflation Median of projections 70% confidence interval 3 2 1 Actual 0 2012 2013 2014 2015 2016 2017 2018 2019 FOMC participants’ assessments of uncertainty and risks around their economic projections Number of participants Number of participants Uncertainty about PCE inflation Risks to PCE inflation June projections June projections 18 18 March projections March projections 16 16 14 14 12 12 10 10 8 8 6 6 4 4 2 2 Lower Broadly Higher Weighted to Broadly Weighted to similar downside balanced upside Number of participants Number of participants Uncertainty about core PCE inflation Risks to core PCE inflation June projections June projections 18 18 March projections March projections 16 16 14 14 12 12 10 10 8 8 6 6 4 4 2 2 Lower Broadly Higher Weighted to Broadly Weighted to similar downside balanced upside Note: The blue and red lines in the top panel show actual values and median projected values, respectively, of the percent change in the price index for personal consumption expenditures (PCE) from the fourth quarter of the previous year to the fourth quarter of the year indicated. The confidence interval around the median projected values is assumed to be symmetric and is based on root mean squared errors of various private and government forecasts made over the previous 20 years; more information about these data is available in table 2. Because current conditions may differ from those that prevailed, on average, over the previous 20 years, the width and shape of the confidence interval estimated on the basis of the historical forecast errors may not reflect FOMC participants’ current assessments of the uncertainty and risks around their projections; these current assessments are summarized in the lower panels. Generally speaking, participants who judge the uncertainty about their projections as “broadly similar” to the average levels of the past 20 years would view the width of the confidence interval shown in the historical fan chart as largely consistent with their assessments of the uncertainty about their projections. Likewise, participants who judge the risks to their projections as “broadly balanced” would view the confidence interval around their projections as approximately symmetric. For definitions of uncertainty and risks in economic projections, see the box “Forecast Uncertainty.” 56 PART 3: SUMMARy OF ECONOMIC PROJECTIONS Figure 5. Uncertainty in projections of the federal funds rate Median projection and confidence interval based on historical forecast errors Percent Federal funds rate Midpoint of target range 6 Median of projections 70% confidence interval* 5 4 3 2 Actual 1 0 2012 2013 2014 2015 2016 2017 2018 2019 Note: The blue and red lines are based on actual values and median projected values, respectively, of the Committee’s target for the federal funds rate at the end of the year indicated. The actual values are the midpoint of the target range; the median projected values are based on either the midpoint of the target range or the target level. The confidence interval around the median projected values is based on root mean squared errors of various private and government forecasts made over the previous 20 years. The confidence interval is not strictly consistent with the projections for the federal funds rate, primarily because these projections are not forecasts of the likeliest outcomes for the federal funds rate, but rather projections of participants’ individual assessments of appropriate monetary policy. Still, historical forecast errors provide a broad sense of the uncertainty around the future path of the federal funds rate generated by the uncertainty about the macroeconomic variables as well as additional adjustments to monetary policy that may be appropriate to offset the effects of shocks to the economy. The confidence interval is assumed to be symmetric except when it is truncated at zero—the bottom of the lowest target range for the federal funds rate that has been adopted in the past by the Committee. This truncation would not be intended to indicate the likelihood of the use of negative interest rates to provide additional monetary policy accommodation if doing so was judged appropriate. In such situations, the Committee could also employ other tools, including forward guidance and large-scale asset purchases, to provide additional accommodation. Because current conditions may differ from those that prevailed, on average, over the previous 20 years, the width and shape of the confidence interval estimated on the basis of the historical forecast errors may not reflect FOMC participants’ current assessments of the uncertainty and risks around their projections. * The confidence interval is derived from forecasts of the average level of short-term interest rates in the fourth quarter of the year indicated; more information about these data is available in table 2. The shaded area encompasses less than a 70 percent confidence interval if the confidence interval has been truncated at zero. MONETARy POLICy REPORT: JULy 2017 57 Forecast Uncertainty uncertainty surrounding their projections are summarized in the bottom-left panels of those figures. Participants also provide judgments as to whether the risks to their The economic projections provided by the members of projections are weighted to the upside, are weighted to the Board of Governors and the presidents of the Federal the downside, or are broadly balanced. That is, while the Reserve Banks inform discussions of monetary policy symmetric historical fan charts shown in the top panels of among policymakers and can aid public understanding figures 4.A through 4.C imply that the risks to participants’ of the basis for policy actions. Considerable uncertainty projections are balanced, participants may judge that attends these projections, however. The economic and there is a greater risk that a given variable will be above statistical models and relationships used to help produce rather than below their projections. These judgments economic forecasts are necessarily imperfect descriptions are summarized in the lower-right panels of figures 4.A of the real world, and the future path of the economy through 4.C. can be affected by myriad unforeseen developments and As with real activity and inflation, the outlook for events. Thus, in setting the stance of monetary policy, the future path of the federal funds rate is subject to participants consider not only what appears to be the most considerable uncertainty. This uncertainty arises primarily likely economic outcome as embodied in their projections, because each participant’s assessment of the appropriate but also the range of alternative possibilities, the likelihood stance of monetary policy depends importantly on of their occurring, and the potential costs to the economy the evolution of real activity and inflation over time. If should they occur. economic conditions evolve in an unexpected manner, Table 2 summarizes the average historical accuracy then assessments of the appropriate setting of the federal of a range of forecasts, including those reported in past funds rate would change from that point forward. The Monetary Policy Reports and those prepared by the final line in table 2 shows the error ranges for forecasts of Federal Reserve Board’s staff in advance of meetings of the short-term interest rates. They suggest that the historical Federal Open Market Committee (FOMC). The projection confidence intervals associated with projections of the error ranges shown in the table illustrate the considerable federal funds rate are quite wide. It should be noted, uncertainty associated with economic forecasts. For however, that these confidence intervals are not strictly example, suppose a participant projects that real gross consistent with the projections for the federal funds domestic product (GDP) and total consumer prices will rate, as these projections are not forecasts of the most rise steadily at annual rates of, respectively, 3 percent and likely quarterly outcomes but rather are projections 2 percent. If the uncertainty attending those projections of participants’ individual assessments of appropriate is similar to that experienced in the past and the risks monetary policy and are on an end-of-year basis. around the projections are broadly balanced, the numbers However, the forecast errors should provide a sense of the reported in table 2 would imply a probability of about uncertainty around the future path of the federal funds rate 70 percent that actual GDP would expand within a range generated by the uncertainty about the macroeconomic of 1.6 to 4.4 percent in the current year, 1.0 to 5.0 percent variables as well as additional adjustments to monetary in the second year, and 0.8 to 5.2 percent in the third policy that would be appropriate to offset the effects of year. The corresponding 70 percent confidence intervals shocks to the economy. for overall inflation would be 1.2 to 2.8 percent in the If at some point in the future the confidence interval current year, and 1.0 to 3.0 percent in the second and third around the federal funds rate were to extend below zero, years. Figures 4.A through 4.C illustrate these confidence it would be truncated at zero for purposes of the fan chart bounds in “fan charts” that are symmetric and centered on shown in figure 5; zero is the bottom of the lowest target the medians of FOMC participants’ projections for GDP range for the federal funds rate that has been adopted growth, the unemployment rate, and inflation. However, by the Committee in the past. This approach to the in some instances, the risks around the projections may construction of the federal funds rate fan chart would be not be symmetric. In particular, the unemployment rate merely a convention; it would not have any implications cannot be negative; furthermore, the risks around a for possible future policy decisions regarding the use of particular projection might be tilted to either the upside or negative interest rates to provide additional monetary the downside, in which case the corresponding fan chart policy accommodation if doing so were appropriate. In would be asymmetrically positioned around the median such situations, the Committee could also employ other projection. tools, including forward guidance and asset purchases, to Because current conditions may differ from those that provide additional accommodation. prevailed, on average, over history, participants provide While figures 4.A through 4.C provide information on judgments as to whether the uncertainty attached to the uncertainty around the economic projections, figure 1 their projections of each economic variable is greater provides information on the range of views across FOMC than, smaller than, or broadly similar to typical levels participants. A comparison of figure 1 with figures 4.A of forecast uncertainty seen in the past 20 years, as through 4.C shows that the dispersion of the projections presented in table 2 and reflected in the widths of the across participants is much smaller than the average confidence intervals shown in the top panels of figures forecast errors over the past 20 years. 4.A through 4.C. Participants’ current assessments of the 59 a bbreviations AFE advanced foreign economy BOE Bank of England C&I commercial and industrial DPI disposable personal income ECB European Central Bank EME emerging market economy FOMC Federal Open Market Committee; also, the Committee GDP gross domestic product LFPR labor force participation rate LIBOR London interbank offered rate MBS mortgage-backed securities Michigan survey University of Michigan Surveys of Consumers OIS overnight index swap ON RRP overnight reverse repurchase agreement OPEC Organization of the Petroleum Exporting Countries PCE personal consumption expenditures SEP Summary of Economic Projections SLOOS Senior Loan Officer Opinion Survey on Bank Lending Practices S&P Standard & Poor’s TIPS Treasury Inflation-Protected Securities For use at 11:00 a.m., EDT July 7, 2017 M P r onetary olicy ePort July 7, 2017 Board of Governors of the Federal Reserve System

Federal Reserve (2017, July 6). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20170707

@misc{wtfs_monetary_policy_report_20170707,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2017},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20170707},
  note = {Retrieved via When the Fed Speaks corpus}
}