Monetary Policy Report

For use at 11:00 a.m., EDT July 13, 2018 M P r onetary olicy ePort July 13, 2018 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 13, 2018 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, Jerome H. Powell, Chairman s tatement on L onger -r un g oaLs and m onetary P oLicy s trategy Adopted effective January 24, 2012; as amended effective January 30, 2018 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 4.6 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 International Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Part 2: Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Part 3: Summary of Economic Projections . . . . . . . . . . . . . . . . . . . . . . . . . 47 The Outlook for Economic Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 The Outlook for Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Appropriate Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Uncertainty and Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 List of Boxes The Labor Force Participation Rate for Prime-Age Individuals . . . . . . . . . . . . . . . . . . . . . . . . . 8 The Recent Rise in Oil Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Developments Related to Financial Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Complexities of Monetary Policy Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Interest on Reserves and Its Importance for Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . 44 Forecast Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 Note: This report reflects information that was publicly available as of noon EDT on July 12, 2018. Unless otherwise stated, the time series in the figures extend through, for daily data, July 11, 2018; for monthly data, June 2018; and, for quarterly data, 2018: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 16 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 © 2018 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 A in the box “Interest on Reserves and Its Importance for Monetary Policy,” note that neither DTCC Solutions LLC nor any of its affiliates shall be responsible for any errors or omissions in any DTCC data included in this publication, regardless of the cause and, in no event, shall DTCC or any of its affiliates be liable for any direct, indirect, special or consequential damages, costs, expenses, legal fees, or losses (including lost income or lost profit, trading losses and opportunity costs) in connection with this publication. 1 s ummary Economic activity increased at a solid pace a sizable increase in consumer energy prices. over the first half of 2018, and the labor The 12-month measure of inflation that market has continued to strengthen. Inflation excludes food and energy items (so-called core has moved up, and in May, the most recent inflation), which historically has been a better period for which data are available, inflation indicator of where overall inflation will be in measured on a 12-month basis was a little the future than the total figure, was 2 percent above the Federal Open Market Committee’s in May. This reading was ½ percentage point (FOMC) longer-run objective of 2 percent, above where it had been 12 months earlier, as boosted by a sizable increase in energy prices. the unusually low readings from last year were In this economic environment, the Committee not repeated. Measures of longer-run inflation judged that current and prospective economic expectations have been generally stable. conditions called for a further gradual removal of monetary policy accommodation. In line Economic growth. Real gross domestic product with that judgment, the FOMC raised the (GDP) is reported to have increased at an target for the federal funds rate twice in the annual rate of 2 percent in the first quarter first half of 2018, bringing it to a range of of 2018, and recent indicators suggest that 1¾ to 2 percent. economic growth stepped up in the second quarter. Gains in consumer spending slowed Economic and Financial early in the year, but they rebounded in Developments the spring, supported by strong job gains, recent and past increases in household The labor market. The labor market has wealth, favorable consumer sentiment, and continued to strengthen. Over the first higher disposable income due in part to the six months of 2018, payrolls increased an implementation of the Tax Cuts and Jobs Act. average of 215,000 per month, which is Business investment growth has remained somewhat above the average pace of 180,000 robust, and indexes of business sentiment have per month in 2017 and is considerably faster been strong. Foreign economic growth has than what is needed, on average, to provide remained solid, and net exports had a roughly jobs for new entrants into the labor force. neutral effect on real U.S. GDP growth in the The unemployment rate edged down from first quarter. However, activity in the housing 4.1 percent in December to 4.0 percent in June, market has leveled off this year. which is about ½ percentage point below the median of FOMC participants’ estimates of Financial conditions. Domestic financial its longer-run normal level. Other measures conditions for businesses and households of labor utilization were consistent with a have generally continued to support economic tight labor market. However, hourly labor growth. After rising steadily through 2017, compensation growth has been moderate, broad measures of equity prices are modestly likely held down in part by the weak pace of higher, on balance, from their levels at the end productivity growth in recent years. of last year amid some bouts of heightened volatility in financial markets. While long- Inflation. Consumer price inflation, as term Treasury yields, mortgage rates, and measured by the 12-month percentage change yields on corporate bonds have risen so far in the price index for personal consumption this year, longer-term interest rates remain expenditures, moved up from a little below low by historical standards, and corporate the FOMC’s objective of 2 percent at the end bond issuance has continued at a moderate of last year to 2.3 percent in May, boosted by pace. Moreover, most types of consumer loans 2 SUMMARy remained widely available for households with accommodative, thereby supporting strong strong creditworthiness, and credit provided by labor market conditions and a sustained return commercial banks continued to expand. The to 2 percent inflation. foreign exchange value of the U.S. dollar has appreciated somewhat against the currencies The FOMC expects that further gradual of our trading partners this year, but it increases in the target range for the federal remains below its level at the start of 2017. funds rate will be consistent with a sustained Foreign financial conditions remain generally expansion of economic activity, strong labor supportive of growth despite recent increases market conditions, and inflation near the in financial stress in several emerging market Committee’s symmetric 2 percent objective economies. over the medium term. Consistent with this outlook, in the most recent Summary of Financial stability. The U.S. financial system Economic Projections (SEP), which was remains substantially more resilient than compiled at the time of the June FOMC during the decade before the financial crisis. meeting, the median of participants’ Asset valuations continue to be elevated assessments for the appropriate level for despite declines since the end of 2017 in the the federal funds rate rises gradually over forward price-to-earnings ratio of equities and the period from 2018 to 2020 and stands the prices of corporate bonds. In the private somewhat above the median projection for nonfinancial sector, borrowing among highly its longer-run level by the end of 2019 and levered and lower-rated businesses remains through 2020. (The June SEP is presented elevated, although the ratio of household in Part 3 of this report.) However, as the debt to disposable income continues to be Committee has continued to emphasize, the moderate. Vulnerabilities stemming from timing and size of future adjustments to the leverage in the financial sector remain low, target range for the federal funds rate will reflecting in part strong capital positions depend on the Committee’s assessment of at banks, whereas some measures of hedge realized and expected economic conditions fund leverage have increased. Vulnerabilities relative to its maximum-employment objective associated with maturity and liquidity and its symmetric 2 percent inflation objective. transformation among banks, insurance companies, money market mutual funds, Balance sheet policy. The FOMC has and asset managers remain below levels that continued to implement the balance sheet generally prevailed before 2008. normalization program described in the Addendum to the Policy Normalization Principles and Plans that the Committee issued Monetary Policy about a year ago. Specifically, the FOMC has Interest rate policy. Over the first half of 2018, been reducing its holdings of Treasury and the FOMC has continued to gradually increase agency securities by decreasing, in a gradual the target range for the federal funds rate. and predictable manner, the reinvestment Specifically, the Committee decided to raise of principal payments it receives from these the target range for the federal funds rate at securities. its meetings in March and June, bringing it to the current range of 1¾ to 2 percent. The Special Topics decisions to increase the target range for the federal funds rate reflected the economy’s Prime-age labor force participation. Labor continued progress toward the Committee’s force participation rates (LFPRs) for men and objectives of maximum employment and price women between 25 and 54 years old—that is, stability. Even with these policy rate increases, the share of these individuals either working the stance of monetary policy remains or actively seeking work—trended lower MONETARy POLICy REPORT: JULy 2018 3 between 2000 and 2013. Those trends likely when deciding on a policy stance they deem reflect numerous factors, including a long-run most likely to foster the FOMC’s statutory decline in the demand for workers with lower mandate of maximum employment and stable levels of education and an increase in the prices. They also routinely consult monetary share of the population with some form of policy rules that connect prescriptions for the disability. By contrast, the prime-age LFPR policy interest rate with variables associated has increased notably since 2013, and the with the dual mandate. The use of such rules share of nonparticipants who report wanting requires, among other considerations, careful a job remains above pre-recession levels. Thus, judgments about the choice and measurement some continuation of the recent increase in of the inputs into the rules such as estimates the prime-age LFPR may be possible if labor of the neutral interest rate, which are highly demand remains strong. (See the box “The uncertain. (See the box “Complexities of Labor Force Participation Rate for Prime-Age Monetary Policy Rules” in Part 2.) Individuals” in Part 1.) Interest on reserves. The payment of interest Oil prices. Oil prices have climbed rapidly on reserves—balances held by banks in over the past year, reflecting both supply and their accounts at the Federal Reserve—is an demand factors. Although higher oil prices essential tool for implementing monetary are likely to restrain household consumption policy because it helps anchor the federal in the United States, much of the negative funds rate within the FOMC’s target range. effect on GDP from lower consumer spending This tool has permitted the FOMC to achieve is likely to be offset by increased production a gradual increase in the federal funds rate in and investment in the growing U.S. oil sector. combination with a gradual reduction in the Consequently, higher oil prices now imply Fed’s securities holdings and in the supply much less of a net overall drag on the economy of reserve balances. The FOMC judged that than they did in the past, although they will removing monetary policy accommodation continue to have important distributional through first raising the federal funds rate effects. The negative effect of upward moves and then beginning to shrink the balance in oil prices should get smaller still as U.S. oil sheet would best contribute to achieving and production grows and net oil imports decline maintaining maximum employment and further. (See the box “The Recent Rise in Oil price stability without causing dislocations in Prices” in Part 1.) financial markets or institutions that could put the economic expansion at risk. (See the box Monetary policy rules. Monetary policymakers “Interest on Reserves and Its Importance for consider a wide range of information on Monetary Policy” in Part 2.) current economic conditions and the outlook 5 P 1 art r e f d ecent conomic and inanciaL eveLoPments Domestic Developments The labor market strengthened further during the first half of the year . . . Labor market conditions have continued to 1. Net change in payroll employment strengthen so far in 2018. According to the 3-month moving averages Thousands of jobs Bureau of Labor Statistics (BLS), gains in total nonfarm payroll employment averaged 400 Private 215,000 per month over the first half of the 200 year. That pace is up from the average monthly + pace of job gains in 2017 and is considerably _0 faster than what is needed to provide jobs for Total nonfarm 200 new entrants into the labor force (figure 1).1 400 Indeed, the unemployment rate edged down 600 from 4.1 percent in December to 4.0 percent in June (figure 2). This rate is below all 800 Federal Open Market Committee (FOMC) 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 participants’ estimates of its longer-run normal level and is about ½ percentage point SOURCE: Bureau of Labor Statistics via Haver Analytics. below the median of those estimates.2 The unemployment rate in June is close to the lows last reached in 2000. The labor force participation rate (LFPR), which is the share of individuals aged 16 and older who are either working or actively looking for work, was 62.9 percent in June and has changed little, on net, since late 2013 (figure 3). The aging of the population is an important contributor to a downward trend in the overall participation rate. In particular, members of the baby-boom cohort are increasingly moving into their retirement years, a time when labor force participation is typically low. Indeed, the share of the civilian population aged 65 and over in the United States climbed from 16 percent in 2000 to 19 percent in 2017 and is projected to rise to 24 percent by 2026. Given this trend, the flat trajectory of the 1. Monthly job gains in the range of 130,000 to 160,000 are consistent with an unchanged unemployment rate and an unchanged labor force participation rate. 2. See the Summary of Economic Projections in Part 3 of this report. 6 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 2. Measures of labor underutilization Monthly Percent 18 U-6 16 U-4 14 U-5 12 10 8 Unemployment rate 6 4 2 2006 2008 2010 2012 2014 2016 2018 NOTE: 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: Bureau of Labor Statistics via Haver Analytics. LFPR during the past few years is consistent with strengthening labor market conditions. Similarly, the LFPR for individuals between 25 and 54 years old—which is much less sensitive to population aging—has been rising for the past several years. (The box “The Labor Force Participation Rate for Prime- 3. Labor force participation rates and Age Individuals” examines the prospects for employment-to-population ratio further increases in participation for these Percent Percent individuals.) The employment-to-population ratio for individuals 16 and over—the share 85 Labor force participation rate 68 of the total population who are working— 66 was 60.4 percent in June and has been 84 gradually increasing since 2011, reflecting the 64 83 combination of the declining unemployment 62 rate and the flat LFPR. 82 60 81 58 Other indicators are also consistent with Employment-to-population ratio Prime-age labor force a strong labor market. As reported in the 80 participation rate 56 Job Openings and Labor Turnover Survey 2006 2009 2012 2015 2018 (JOLTS), the rate of job openings has NOTE: The data are monthly. The prime-age labor force participation rate remained quite elevated.3 The rate of quits has is a percentage of the population aged 25 to 54. The labor force participation rate and the employment-to-population ratio are percentages of the population aged 16 and over. 3. Indeed, the number of job openings now about SOURCE: Bureau of Labor Statistics via Haver Analytics. matches the number of unemployed individuals. MONETARy POLICy REPORT: JULy 2018 7 stayed high in the JOLTS, an indication that workers are able to successfully switch jobs when they wish to. In addition, the JOLTS layoff rate has been low, and the number of people filing initial claims for unemployment insurance benefits has remained near its lowest level in decades. Other survey evidence indicates that households perceive jobs as plentiful and that businesses see vacancies as hard to fill. Another indicator, the share of workers who are working part time but would prefer to be employed full time—which is part of the U-6 measure of labor underutilization from the BLS—fell further in the first six months of the year and now stands close to its pre-recession level (as shown in figure 2). . . . and unemployment rates have fallen for all major demographic groups The continued decline in the unemployment rate has been reflected in the experiences of multiple racial and ethnic groups (figure 4). The unemployment rates for blacks or African Americans and Hispanics tend to rise considerably more than rates for whites and Asians during recessions but decline 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 2006 2008 2010 2012 2014 2016 2018 NOTE: 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: Bureau of Labor Statistics via Haver Analytics. 8 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS The Labor Force Participation Rate for Prime-Age Individuals The overall labor force participation rate (LFPR) has increases in automation, such as the use of robotics, generally been trending lower since 2000, and while and various aspects of globalization have spurred the aging of the baby-boom generation into retirement the elimination of some types of jobs—in particular, ages provides an important reason for that decline, some manufacturing jobs that have historically been it is not the only reason. Another contributing factor, held by workers without a college education—and as shown in figure A, is that the LFPRs of prime-age emerging jobs may require a different set of skills. These men and women (those between 25 and 54 years developments may have led some workers to become old) trended lower through 2013 even though prime- discouraged over the lack of suitable job opportunities age LFPRs are largely unaffected by the aging of and drop out of the labor force.1 The rising share of the population: The prime-age male LFPR has been college-educated workers, which may partly reflect declining for six decades, and the prime-age female individuals responding over time to the declining LFPR has drifted lower since 2000 after a multidecade demand for jobs that require less education, has likely increase. Nevertheless, prime-age LFPRs have moved prevented even steeper declines in the prime-age LFPR, up notably and consistently since 2013, as improving as better-educated workers have higher LFPRs and labor market conditions have drawn some individuals may be more adaptable to unforeseen disruptions in back into the labor force and encouraged others not to particular jobs or industries. leave. These recent increases in the prime-age LFPR, Another potential factor may be that an increasing in the context of the longer-run trend decline, raise the share of the prime-age population has some difficulty question of how much additional scope there is for working because of physical or mental disabilities. further increases in prime-age labor force participation. For example, figure C shows that about 5 percent of To gauge whether further increases are possible, a both prime-age men and women report that they are useful starting point is understanding the factors behind out of the labor force and do not want a job due to the longer-run decline in the prime-age LFPR, as these disability or illness; those shares have trended higher factors may limit additional increases if they continue over the past several decades. Other research suggests to exert some downward pressure. One factor may that increased opioid use may be associated with a be a secular decline in the demand for workers with lower prime-age LFPR, although it is unclear how lower levels of education. Indeed, as shown in figure B, much of the decline in the prime-age LFPR can be the long-run declines in prime-age LFPR are much directly explained by opioid use or whether increases larger among adults without a college degree than (continued) among college-educated adults. Research suggests that 1. For evidence on displacement from technological A. Prime-age labor force participation rates changes, see David H. Autor, David Dorn, and Gordon H. Hanson (2015), “Untangling Trade and Technology: Evidence Monthly Percent from Local Labor Markets,” Economic Journal, vol. 125 (May), pp. 621–46; Daron Acemoglu and Pascual Restrepo (2017), “Robots and Jobs: Evidence from U.S. Labor Markets,” NBER 95 Working Paper Series 23285 (Cambridge, Mass.: National Men 90 Bureau of Economic Research, March), www.nber.org/ 85 papers/w23285; and Daron Acemoglu and Pascual Restrepo (2018), “Artificial Intelligence, Automation, and Work,” NBER 80 Working Paper Series 24196 (Cambridge, Mass.: National Women 75 Bureau of Economic Research, January), www.nber.org/ papers/w24196. For evidence on globalization—in particular, 70 import competition since the 2000s—see David H. Autor, 65 David Dorn, and Gordon H. Hanson (2013), “The China Syndrome: Local Labor Market Effects of Import Competition 60 in the United States,” American Economic Review, vol. 103 55 (October), pp. 2121–68. A discussion of these and other explanations is also provided in Katharine G. Abraham and 1978 1983 1988 1993 1998 2003 2008 2013 2018 Melissa S. Kearney (2018), “Explaining the Decline in the U.S. Employment-to-Population Ratio: A Review of the Evidence,” NOTE: The data are seasonally adjusted. The shaded bars indicate periods NBER Working Paper Series 24333 (Cambridge, Mass.: of business recession as defined by the National Bureau of Economic Research. National Bureau of Economic Research, February), www.nber. SOURCE: Bureau of Labor Statistics. org/papers/w24333. MONETARy POLICy REPORT: JULy 2018 9 B. Prime-age labor force participation rates by education Men Women Monthly Percent Monthly Percent Bachelor's degree 85 98 Bachelor's degree 80 94 Some college 75 Some college High school degree or less 70 90 65 86 60 55 High school degree or less 82 50 1978 1983 1988 1993 1998 2003 2008 2013 2018 1978 1983 1988 1993 1998 2003 2008 2013 2018 Note: The data are seasonally adjusted 12-month moving averages and extend through May 2018. The shaded bars indicate periods of business recession as defined by the National Bureau of Economic Research. Source: U.S. Census Bureau, Current Population Survey. in opioid use are an indirect result of poor employment responsibilities as women participate in the workforce opportunities.2 in greater numbers. For some—especially those for Caregiving responsibilities play an important role in whom childcare costs are not a major concern—not explaining why LFPRs for prime-age women are lower participating in the labor force may represent an than for men, and they may play an increasing role in unconstrained choice to care for other members of their explaining declining prime-age LFPRs for men as well. families. For others, however, this decision may reflect As shown in figure C, roughly 15 percent of prime- a lack of affordable childcare. age women report being out of the labor force for Additionally, the share of the population— caregiving reasons—by far the largest reason for prime- particularly black men—with a history of incarceration age women to report not wanting a job—but this share has increased over time. Individuals who have has been fairly flat over time. In contrast, while a much previously been incarcerated often have trouble finding smaller fraction of men are out of the labor force for work, in part because many employers choose not to caregiving reasons, that share has trended up in recent hire people with such a background and likely also decades, likely reflecting some shift in household in part because incarceration prevents people from accumulating work experience and developing skills 2. Evidence that opioid use could be significant for valuable to employers. Discrimination could also help understanding the declining LFPR is provided by Alan B. explain the lack of participation for some minority Krueger (2017), “Where Have All the Workers Gone? An groups, as they recognize that such discrimination Inquiry into the Decline of the U.S. Labor Force Participation limits their job opportunities. Rate,” Brookings Papers on Economic Activity, Fall, pp. 1–82, https://www.brookings.edu/wp-content/uploads/2018/02/ International comparisons may help clarify the kruegertextfa17bpea.pdf, while little relationship between importance of some of those factors. Since 1990, the opioid prescriptions and employment at the county level is (continued on next page) found in Janet Currie, Jonas y. Jin, and Molly Schnell (2018), “U.S. Employment and Opioids: Is There a Connection?” NBER Working Paper Series 24440 (Cambridge, Mass.: National Bureau of Economic Research, March), www.nber. Christina Park, and Claudia Sahm (2018), “Shedding Light on org/papers/w24440. Some evidence on whether the opioid Our Economic and Financial Lives,” FEDS Notes, https://www. epidemic varies with local economic conditions is provided federalreserve.gov/econres/notes/feds-notes/shedding-light-on- by Jeff Larrimore, Alex Durante, Kimberly Kreiss, Ellen Merry, our-economic-and-financial-lives-20180522.htm. 10 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS The Labor Force Participation Rate (continued) C. Prime-age nonparticipation by reason Men Women Monthly Percent Monthly Percent 6 16 Disabled 14 5 Caregiving 12 4 10 Other, does not want job 3 8 2 Disabled Wants job 6 Caregiving 1 Other, does not want job 4 0 Wants job 2 1994 1998 2002 2006 2010 2014 2018 1994 1998 2002 2006 2010 2014 2018 Note: The data are seasonally adjusted 12-month moving averages and extend through May 2018. The shaded bars indicate periods of business recession as defined by the National Bureau of Economic Research. Source: U.S. Census Bureau, Current Population Survey. prime-age LFPR in the United States has declined self-report as wanting a job (despite not having actively considerably for both men and women relative to other searched for a job recently) has been declining since advanced countries. Some factors, like automation and 2010, that share for men remains between ¼ and globalization, have affected all advanced economies to ½ percentage point above its 2007 level and earlier some degree and for some time, yet diverging long-run expansion peaks. Furthermore, prime-age men and trends in prime-age labor force participation have still women who had previously reported being out of the occurred. Research suggests that part of the relative labor force and not wanting a job due to disability or decline in the United States is explained by differential illness have been entering the labor force at increasing changes in work-family policies across countries. rates in recent years. Other parts of the divergence may be explained by Looking forward, how can policymakers support other policies, including policies designed toward additional improvements in the prime-age LFPR? keeping those affected by automation and globalization Favorable labor market conditions can likely help, attached to the labor force, or other factors—such as and monetary policy can therefore play a role through incarceration or opioid use—that differ across those supporting strong cyclical conditions as part of its countries.3 maximum-employment objective. However, structural Although many of the factors behind the factors (in contrast with cyclical ones) are also multidecade decline in the prime-age LFPR may important to address; policies to address such factors persist, some continuation of the increases in the LFPR are beyond the scope of monetary policy. over the past few years nevertheless seems possible, especially if labor market conditions remain favorable. and how this may affect differences in LFPR, see International Indeed, as shown in figure C, although the share of Monetary Fund (2018), “Labor Force Participation in Advanced nonparticipating prime-age men and women who Economies: Drivers and Prospects,” chapter 2 in World Economic Outlook: Cyclical Upswing, Structural Change 3. For recent trends on prime-age LFPRs in the United (Washington: IMF, April), pp. 71–128. For evidence on how States compared with other developed countries, see work-family policies may affect prime-age LFPRs in the United Organisation for Economic Co-operation and Development States relative to other OECD countries, see Francine D. Blau (2018), OECD Economic Surveys: United States 2018 (Paris: and Lawrence M. Kahn (2013), “Female Labor Supply: Why OECD Publishing), dx.doi.org/10.1787/eco_surveys-usa-2018- Is the United States Falling Behind?” American Economic en. For a description of policy differences across countries Review, vol. 103 (May), pp. 251–56. MONETARy POLICy REPORT: JULy 2018 11 more rapidly during expansions. Indeed, 5. Prime-age labor force participation rate by race and ethnicity the declines in the unemployment rates for blacks and Hispanics have been particularly Monthly Percent striking, and the rates have recently been at 84 or near their lowest readings since these series began in the early 1970s. Although differences White 83 Asian 82 in unemployment rates across ethnic and Hispanic or Latino 81 racial groups have narrowed in recent years, 80 they remain substantial and similar to pre- recession levels. The rise in LFPRs for prime- 79 age individuals over the past few years has 78 also been evident in each of these racial and Black or African American 77 ethnic groups, with increases again particularly 76 notable for African Americans. Even so, the 2006 2008 2010 2012 2014 2016 2018 LFPR for whites remains higher than that for NOTE: The prime-age labor force participation rate is a percentage of the the other groups (figure 5).4 population aged 25 to 54. Persons whose ethnicity is identified as Hispanic or Latino may be of any race. The data are seasonally adjusted by Board staff and are 3-month moving averages. The shaded bar indicates a period of Increases in labor compensation have business recession as defined by the National Bureau of Economic Research. SOURCE: Bureau of Labor Statistics. been moderate . . . Despite the strong labor market, the available 6. Measures of change in hourly compensation indicators generally suggest that increases Percent change from year earlier in hourly labor compensation have been moderate. Compensation per hour in the 6 Compensation per hour, business sector—a broad-based measure business sector 5 Atlanta Fed's of wages, salaries, and benefits that is quite Wage Growth Tracker 4 volatile—rose 2¾ percent over the four 3 quarters ending in 2018:Q1, slightly more than 2 the average annual increase over the preceding 1 seven or so years (figure 6). The employment + cost index—a less volatile measure of both _0 Average hourly earnings Employment cost index wages and the cost to employers of providing 1 benefits—likewise was 2¾ percent higher in 2010 2012 2014 2016 2018 the first quarter of 2018 relative to its year- NOTE: Business-sector compensation is on a 4-quarter percentage change earlier level; this increase was ½ percentage basis. For the employment cost index, change is over the 12 months ending in point faster than its gain a year earlier. Among the last month of each quarter; for average hourly earnings, change is from 12 months earlier; for the Atlanta Fed's Wage Growth Tracker, the data are measures that do not account for benefits, shown as a 3-month moving average of the 12-month percent change and extend through May 2018. average hourly earnings rose 2¾ percent in SOURCE: Bureau of Labor Statistics via Haver Analytics; Federal Reserve June relative to 12 months earlier, a gain in Bank of Atlanta, Wage Growth Tracker. line with the average increase in the preceding few years. According to the Federal Reserve Bank of Atlanta, the median 12-month wage 4. The lower levels of labor force participation for these other groups differ importantly by sex. For African Americans, men have a lower participation rate relative to white men, while the participation rate for African American women is as high as that of white women. By contrast, the lower LFPRs for Hispanics and Asians reflect lower participation among women. 12 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS growth of individuals reporting to the Current Population Survey increased about 3¼ percent in May, also similar to its readings from the past few years.5 . . . and likely have been restrained by slow growth of labor productivity Those moderate rates of compensation gains likely reflect the offsetting influences of a strong labor market and persistently 7. Change in business-sector output per hour weak productivity growth. Since 2008, labor Percent, annual rate productivity has increased only a little more than 1 percent per year, on average, well below the average pace from 1996 through 2007 of 4 2.8 percent and also below the average gain in the 1974–95 period of 1.6 percent (figure 7). 3 The weakness in productivity growth may be partly attributable to the sharp pullback 2 in capital investment during the most recent recession and the relatively slow recovery 1 that followed. However, considerable debate remains about the reasons for the recent 1948– 1974– 1996– 2001– 2008– slowdown in productivity growth and whether 73 95 2000 07 present it will persist.6 NOTE: Changes are measured from Q4 of the year immediately preceding the period through Q4 of the final year of the period. The final period is measured from 2007:Q4 through 2018:Q1. Price inflation has picked up from the SOURCE: Bureau of Labor Statistics via Haver Analytics. low readings in 2017 In 2017, inflation remained below the FOMC’s longer-run objective of 2 percent. Partly because the softness in some price categories appeared idiosyncratic, Federal Reserve policymakers expected inflation to move higher in 2018.7 This expectation appears to be 5. The Atlanta Fed’s measure differs from others in that it measures the wage growth only of workers who were employed both in the current survey month and 12 months earlier. 6. The box “Productivity Developments in the Advanced Economies” in the July 2017 Monetary Policy Report provides more information. See Board of Governors of the Federal Reserve System (2017), Monetary Policy Report (Washington: Board of Governors, July), pp. 12–13, https://www.federalreserve. gov/monetarypolicy/2017-07-mpr-part1.htm. 7. Additional details can be found in the June 2017 Summary of Economic Projections, an addendum to the minutes of the June 2017 FOMC meeting. See Board of Governors of the Federal Reserve System (2017), “Minutes of the Federal Open Market Committee, MONETARy POLICy REPORT: JULy 2018 13 on track so far. Consumer price inflation, as 8. Change in the price index for personal consumption expenditures measured by the 12-month percentage change in the price index for personal consumption Monthly 12-month percent change expenditures (PCE), moved up to 2.3 percent Total in May (figure 8). Core PCE inflation, which 3.0 Trimmed mean excludes consumer food and energy prices that 2.5 Excluding food are often quite volatile and typically provides and energy 2.0 a better indication than the total measure of 1.5 where overall inflation will be in the future, was 2 percent over the 12 months ending in 1.0 May—0.5 percentage point higher than it .5 had been one year earlier. The total measure + exceeded core inflation because of a sizable _0 increase in consumer energy prices. In 2011 2012 2013 2014 2015 2016 2017 2018 contrast, food price inflation has continued to NOTE: The data extend through May 2018; changes are from one year be low by historical standards—data through earlier. SOURCE: For trimmed mean, Federal Reserve Bank of Dallas; for all else, May show the PCE price index for food and Bureau of Economic Analysis; all via Haver Analytics. beverages having increased less than ½ percent over the past year. The higher readings in both total and core inflation relative to a year earlier reflect faster price increases for a wide range of goods and services this year and the dropping out of the 12-month calculation of the steep one-month decline in the price index for wireless telephone services in March last year. The 12-month change in the trimmed mean PCE price index—an alternative indicator of underlying inflation produced by the Federal Reserve Bank of Dallas that may be less sensitive than the core index to idiosyncratic price movements—slowed by less than core inflation over 2017 and has also increased a bit less this year. This index rose 1.8 percent over the 12 months ending in May, up a touch from the increase over the same period last year.8 June 13–14, 2017,” press release, July 5, https:// www.federalreserve.gov/newsevents/pressreleases/ monetary20170705a.htm. 8. The trimmed mean index excludes whatever prices showed the largest increases or decreases in a given month; for example, the sharp decline in prices for wireless telephone services in March 2017 was excluded from this index. 14 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 9. Brent spot and futures prices Oil prices have surged amid supply concerns . . . Weekly Dollars per barrel 130 As noted, the faster pace of total inflation Spot price 120 this year relative to core inflation reflects a 110 substantial rise in consumer energy prices. 100 Retail gasoline prices this year were driven 90 24-month-ahead futures contracts 80 higher by a rise in oil prices. The spot price of 70 Brent crude oil rose from about $65 per barrel 60 in December to around $75 per barrel in early 50 July (figure 9). Although that increase took 40 30 place against a backdrop of continued strength 20 in global demand, supply concerns have 2013 2014 2015 2016 2017 2018 become more prevalent in recent months. (For NOTE: The data are weekly averages of daily data and extend through a discussion of the reasons behind the oil price July 11, 2018. increases along with a review of the effects of SOURCE: ICE Brent Futures via Bloomberg. oil prices on U.S. economic growth, see the box “The Recent Rise in Oil Prices.”) 10. Nonfuel import prices and industrial metals indexes . . . while prices of imports other than July 2014 = 100 July 2014 = 100 energy have also increased 120 102 Nonfuel import prices rose sharply in early Nonfuel import prices 110 2018, partly reflecting the pass-through 100 100 of earlier increases in commodity prices (figure 10). In particular, metals prices posted 90 98 sizable gains late last year due to strong 80 96 global demand but have retreated somewhat Industrial metals 70 in recent weeks. 94 60 Survey-based measures of inflation expectations have been stable . . . 2012 2013 2014 2015 2016 2017 2018 NOTE: The data for nonfuel import prices are monthly and extend through Expectations of inflation likely influence actual May 2018. The data for industrial metals are a monthly average of daily data and extend through June 29, 2018. inflation by affecting wage- and price-setting SOURCE: For nonfuel import prices, Bureau of Labor Statistics; for industrial metals, S&P GSCI Industrial Metals Spot Index via Haver decisions. Survey-based measures of inflation Analytics. expectations at medium- and longer-term horizons have remained generally stable so far this year. In the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia, the median expectation for the annual rate of increase in the PCE price index over the next 10 years has been around 2 percent for the past several years (figure 11). In the University of Michigan Surveys of Consumers, the median value for inflation expectations over the next 5 to 10 years has been about 2½ percent since the end of 2016, though this level is about ¼ percentage point lower than had prevailed through 2014. In contrast, in the Survey of Consumer Expectations conducted by the MONETARy POLICy REPORT: JULy 2018 15 Federal Reserve Bank of New York, the 11. Median inflation expectations median of respondents’ expected inflation rate Percent three years hence has been moving up recently and is currently at the top of the range it has occupied over the past couple of years. Michigan survey expectations 4 for next 5 to 10 years . . . while market-based measures of 3 inflation compensation have largely moved sideways this year 2 SPF expectations Inflation expectations can also be gauged for next 10 years 1 by market-based measures of inflation compensation. However, the inference is not straightforward, because market- 2006 2008 2010 2012 2014 2016 2018 based measures can be importantly affected NOTE: The Michigan survey data are monthly. The SPF data for inflation by changes in premiums that provide expectations for personal consumption expenditures are quarterly and extend from 2007:Q1 through 2018:Q2. compensation for bearing inflation and SOURCE: University of Michigan Surveys of Consumers; Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters (SPF). liquidity risks. Measures of longer-term inflation compensation—derived either from differences between yields on nominal Treasury 12. 5-to-10-year-forward inflation compensation securities and those on comparable-maturity Weekly Percent Treasury Inflation-Protected Securities (TIPS) or from inflation swaps—have moved 3.5 sideways for the most part this year after Inflation swaps having returned to levels seen in early 2017 3.0 (figure 12).9 The TIPS-based measure of 2.5 5-to-10-year-forward inflation compensation TIPS breakeven rates 2.0 and the analogous measure of inflation swaps are now about 2 percent and 2½ percent, 1.5 respectively, with both measures below the 1.0 ranges that persisted for most of the 10 years before the start of the notable declines in 2010 2012 2014 2016 2018 mid-2014.10 NOTE: The data are weekly averages of daily data and extend through July 6, 2018. TIPS is Treasury Inflation-Protected Securities. SOURCE: Federal Reserve Bank of New York; Barclays; Federal Reserve Board staff estimates. 9. Inflation compensation implied by the TIPS breakeven inflation rate is based on the difference, at comparable maturities, between yields on nominal Treasury securities and yields on TIPS, which are indexed to the total consumer price index (CPI). Inflation swaps are contracts in which one party makes payments of certain fixed nominal amounts in exchange for cash flows that are indexed to cumulative CPI inflation over 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. 10. As these measures are based on CPI inflation, one should probably subtract about ¼ to ½ percentage point—the average differential with PCE inflation over the past two decades—to infer inflation compensation on a PCE basis. 16 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS The Recent Rise in Oil Prices Oil prices have increased more than 50 percent the country’s economic and political crisis. Prices also over the past year, with the spot price of Brent crude increased after President Trump announced on May 8 oil rising from a bit below $50 per barrel to around that the United States was withdrawing from the Iran $75 per barrel (figure A). For much of the period, nuclear deal and that sanctions against Iranian oil further-dated futures prices remained relatively stable, exports would be reinstated. in the neighborhood of $55 per barrel; however, since The pattern of spot and futures prices indicates February, futures prices have moved up appreciably, that market participants generally anticipate that oil reaching over $70 per barrel. prices will decline slowly over the next few years, in Both supply and demand factors have contributed part reflecting an expectation that supply, including to the oil price increase. In particular, the broad-based U.S. shale oil production, will grow to meet demand. improvement in the outlook for the global economy In addition, the higher prices put pressure on OPEC’s was a key driver of the price increase in the second November 2016 agreement with certain non-OPEC half of 2017. In recent months, supply concerns have countries to restrain production. A stated aim of the become more prevalent, affecting both spot and further- agreement was to reduce the glut in global inventories, dated futures prices. Despite sharply rising U.S. oil and, in recent months, inventory levels have fallen production, markets have been attuned to escalating rapidly toward long-run averages. In response to both conflict between Saudi Arabia and Iran as well as the lower inventories and higher prices, OPEC leaders precipitous decline in venezuelan oil production amid slightly relaxed the production agreement in June this (continued) A. Brent spot and futures prices Daily Dollars per barrel 90 80 Spot price 70 60 December 2019 futures price 50 40 Jan. Mar. May July Sept. Nov. Jan. Mar. May July 2017 2018 SOURCE: ICE Brent Futures via Bloomberg. MONETARy POLICy REPORT: JULy 2018 17 year, reducing some of the upward pressure on prices. power abroad than in the past, as much of the negative That said, futures prices have not returned to their early effect on GDP from lower household consumption 2018 levels, implying that market participants expect is likely to be offset by increased production and some of the recent increase in prices to be long lasting. investment in the growing U.S. oil sector. On net, the What is the expected effect of the recent rise in oil drag on GDP from higher oil prices is likely a small prices on the U.S. economy? To begin with, higher oil fraction of what it was a decade ago and should get prices are likely to restrain household consumption. smaller still if U.S. oil production continues to grow In particular, the increase in oil prices since last year as projected—figure C—and the net oil import share is estimated to have translated into a roughly $300 shrinks toward zero. increase in annual expenditures on gasoline for the Indeed, if U.S. oil trade moves fully into balance, average household, from about $2,100 to $2,400. the offsetting effects of a change in the relative price of However, as U.S. oil production has grown rapidly oil might be expected to net out within the domestic over the past decade, the ratio of net U.S. oil imports economy. However, even if the United States is no to U.S. gross domestic product (GDP) has declined longer a net oil importer, to the extent that higher substantially (figure B). As a result, higher oil prices oil prices cause credit-constrained consumers to cut now imply much less of a redistribution of purchasing spending by more than oil producers expand their investment, this redistribution of purchasing power B. Net oil import share could still have negative effects on overall GDP. Quarterly Percent of nominal GDP C. U.S. crude oil production 3.5 Quarterly Million barrels per day 3.0 2.5 13 2.0 12 1.5 1.0 11 .5 10 0 9 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 8 NOTE: The data extending through 2018:Q1 are quarterly averages of daily oil futures prices, quarterly averages of monthly oil imports and exports, and quarterly GDP. The data from 2018:Q2 through 2019:Q4 are projections 2014 2015 2016 2017 2018 2019 based on quarterly averages of monthly oil futures prices, quarterly averages of monthly oil imports and exports, and quarterly GDP. NOTE: The data are quarterly averages of monthly data. The data extend SOURCE: Department of Energy via Haver Analytics; ICE Brent Futures via through 2018:Q2. Data from 2018:Q3 through 2019:Q4 are projections. Bloomberg; Bureau of Economic Analysis; staff calculations. SOURCE: Department of Energy via Haver Analytics. 18 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 13. Change in real gross domestic product and gross Real gross domestic product growth domestic income slowed in the first quarter, but spending by households appears to have picked up Percent, annual rate in recent months Gross domestic product Gross domestic income 5 After having expanded at an annual rate of 3 percent in the second half of 2017, real gross Q1 4 domestic product (GDP) is now reported to have increased 2 percent in the first quarter of 3 this year (figure 13). The step-down in growth 2 during the first quarter was largely attributable to a sharp slowing in the growth of consumer 1 spending that appears transitory, and gains in GDP appear to have rebounded in the second 2011 2012 2013 2014 2015 2016 2017 2018 quarter. Meanwhile, business investment has SOURCE: Bureau of Economic Analysis via Haver Analytics. remained strong, and net exports had little effect on output growth in the first quarter. On balance, over the first half of this year, overall 14. Change in real personal consumption expenditures and disposable personal income economic activity appears to have expanded at a solid pace. Percent, annual rate Personal consumption expenditures 6 The economic expansion continues to be Disposable personal income 5 supported by favorable consumer and business 4 sentiment, past increases in household H1 3 wealth, solid economic growth abroad, and 2 accommodative domestic financial conditions, 1 + including moderate borrowing costs and easy _0 access to credit for many households and 1 businesses. 2 3 Gains in income and wealth continue to 2012 2013 2014 2015 2016 2017 2018 support consumer spending . . . NOTE: The values for 2018:H1 are the annualized May/Q4 changes. SOURCE: Bureau of Economic Analysis via Haver Analytics. Following exceptionally strong growth in the fourth quarter of 2017, consumer spending in the first quarter of this year was tepid, 15. Personal saving rate rising at an annual rate of 0.9 percent. The Monthly Percent slowdown in growth was evident in outlays for motor vehicles and in retail sales more 12 generally; moreover, unseasonably warm weather depressed spending on energy services. 10 However, consumer spending picked up in 8 more recent months as retail sales firmed, and PCE in April and May rose at an annual rate 6 of 2¼ percent relative to the average over the 4 first quarter (figure 14). 2 Real disposable personal income (DPI), a measure of after-tax income adjusted for 2006 2008 2010 2012 2014 2016 2018 inflation, has increased at a solid annual rate NOTE: Data are through May 2018. SOURCE: Bureau of Economic Analysis via Haver Analytics. of about 3 percent so far this year. Real DPI MONETARy POLICy REPORT: JULy 2018 19 has been supported by the reduction in income 16. Prices of existing single-family houses taxes owing to the implementation of the Monthly Percent change from year earlier Tax Cuts and Jobs Act (TCJA) as well as the continued strength in the labor market. With S&P/Case-Shiller 15 national index consumer spending rising just a little less than 10 the gains in disposable income so far this year, CoreLogic 5 price index the personal saving rate has edged up after + _0 having fallen for the past two years (figure 15). 5 Zillow index Ongoing gains in household net worth likely 10 have also supported consumer spending. 15 House prices, which are of particular 20 importance for the balance sheet positions of 2008 2010 2012 2014 2016 2018 a large set of households, have been increasing at an average annual pace of about 6 percent in NOTE: The data for the S&P/Case-Shiller index extend through April 2018. The data for the Zillow index and the CoreLogic index extend through May recent years (figure 16).11 Although U.S. equity 2018. SOURCE: CoreLogic Home Price Index; Zillow; S&P/Case-Shiller U.S. prices have posted modest gains, on net, so far 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 this year, this flattening followed several years licensing information, see the note on the Contents page.) of sizable gains. Buoyed by the cumulative 17. Wealth-to-income ratio increases in home and equity prices, aggregate household net worth was 6.8 times household Quarterly Ratio income in the first quarter, down just slightly from its ratio in the fourth quarter—the 7.0 highest-ever reading for that ratio, which dates back to 1947 (figure 17). 6.5 6.0 . . . and borrowing conditions for consumers remain generally favorable . . . 5.5 Financing conditions for consumers are 5.0 generally favorable and remain supportive of growth in household spending. However, 2000 2003 2006 2009 2012 2015 2018 banks have continued to tighten standards for credit cards and auto loans for borrowers NOTE: The series is the ratio of household net worth to disposable personal income. with low credit scores, possibly in response SOURCE: For net worth, Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States”; for income, Bureau of Economic to some upward moves in the delinquency Analysis via Haver Analytics. rates of those borrowers. Mortgage credit has 18. Changes in household debt remained readily available for households with solid credit profiles. For borrowers with low Billions of dollars, annual rate credit scores, mortgage financing conditions Mortgages 1,000 Consumer credit have eased somewhat further but remain tight Sum 800 overall. In this environment, consumer credit 600 Q1 continued to increase in the first few months 400 of 2018, though the rate of increase moderated 200 some from its robust pace in the previous year + _0 (figure 18). 200 400 600 11. For the majority of households, home equity 2008 2010 2012 2014 2016 2018 makes up the largest share of their wealth. NOTE: Changes are calculated from year-end to year-end except 2018 changes, which are calculated from 2017:Q4 to 2018:Q1. SOURCE: Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” 20 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 19. Indexes of consumer sentiment and income expectations . . . while consumer confidence remains strong Diffusion index Index Consumers have remained upbeat. So far this 110 90 Real income expectations year, the Michigan survey index of consumer 100 sentiment has been near its highest level 80 90 since 2000, likely reflecting rising income, job gains, and low inflation (figure 19). Indeed, 70 80 households’ expectations for real income 70 60 changes over the next year or two now stand 60 above levels preceding the previous recession. 50 Consumer sentiment 50 Business investment has continued 2006 2008 2010 2012 2014 2016 2018 to rebound . . . 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 Investment spending by businesses has of survey respondents expecting family income to go up more than prices continued to increase so far this year, with during the next year or two plus 100 and are shown as a three-month moving average. notable gains for spending, both on equipment SOURCE: University of Michigan Surveys of Consumers. and intangibles and on nonresidential structures (figure 20). Within structures, 20. Change in real private nonresidential fixed investment the rise in oil prices propelled another steep Percent, annual rate ramp-up in investment in drilling and mining structures—albeit not yet back to the levels Structures Equipment and intangible capital 20 recorded from 2012 to 2014—while investment Q1 15 in nonresidential structures outside of the energy sector picked up after declining in 10 2017. Forward-looking indicators of business 5 investment spending remain favorable on + _0 balance. Business sentiment and the profit expectations of industry analysts have been 5 positive overall, while new orders of capital 10 goods have advanced on net this year. 2010 2011 2012 2013 2014 2015 2016 2017 2018 . . . while corporate financing conditions SOURCE: Bureau of Economic Analysis via Haver Analytics. have remained accommodative 21. Selected components of net debt financing for Aggregate flows of credit to large nonfinancial nonfinancial businesses firms remained strong in the first quarter, supported in part by relatively low interest Billions of dollars, monthly rate rates and accommodative financing conditions Commercial paper Bonds 80 (figure 21). The gross issuance of corporate Bank loans bonds stayed robust during the first half of Sum 60 2018, while yields on both investment- and Q1 40 speculative-grade corporate bonds moved 20 up notably but remained low by historical + standards (figure 22). Despite strong growth in _0 business investment, outstanding commercial 20 and industrial (C&I) loans on banks’ books 40 rose only modestly in the first quarter, although their pace of expansion in more 2008 2010 2012 2014 2016 2018 recent months has strengthened on average. In SOURCE: Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” MONETARy POLICy REPORT: JULy 2018 21 April, respondents to the Senior Loan Officer 22. Corporate bond yields, by securities rating Opinion Survey on Bank Lending Practices, Daily Percentage points or SLOOS, reported that demand for C&I 20 loans weakened in the first quarter even as 18 lending standards and terms on such loans 16 eased.12 Respondents attributed this decline in Triple-B 14 demand in part to firms drawing on internally 12 generated funds or using alternative sources of High-yield 10 financing. Meanwhile, growth in commercial 8 6 real estate loans has moderated some but 4 remains strong. In addition, financing Double-A 2 conditions for small businesses appear to 0 have remained generally accommodative, with 2000 2003 2006 2009 2012 2015 2018 lending standards little changed at most banks and with most firms reporting that they are NOTE: The yields shown are yields on 10-year bonds. SOURCE: ICE Bank of America Merrill Lynch Indices, used with able to obtain credit. Although small business permission. credit growth has been subdued, survey data 23. Mortgage rates and housing affordability suggest this sluggishness is largely due to continued weak demand for credit by small Percent Index businesses. Housing affordability index 205 7 But activity in the housing sector has 185 leveled off 6 165 Residential investment, which rose a modest 5 145 2½ percent in 2017, appears to have largely 125 moved sideways over the first five months of 4 Mortgage rates 105 the year. The slowing in residential investment 3 likely is partly a result of higher mortgage 85 interest rates. Although these rates are still 2010 2012 2014 2016 2018 low by historical standards, they have moved up and are near their highest levels in seven NOTE: The housing affordability index data are monthly through April 2018, and the mortgage rate data are weekly through July 5, 2018. At years (figure 23). In addition, higher lumber an index value of 100, a median-income family has exactly enough income to qualify for a median-priced home mortgage. Housing affordability is prices and tight supplies of skilled labor seasonally adjusted by Board staff. and developed lots reportedly have been SOURCE: For housing affordability index, National Association of Realtors; for mortgage rates, Freddie Mac Primary Mortgage Market Survey. restraining home construction. While starts of both single-family and multifamily housing 24. Private housing starts and permits units rose in the fourth quarter, single-family Monthly Millions of units, annual rate starts have been little changed, on net, since then, whereas multifamily starts continued 2.0 to climb earlier this year before flattening Single-family starts out (figure 24). Meanwhile, over the first five 1.6 months of this year, new home sales have 1.2 held at around the rate of late last year, but Single-family permits .8 sales of existing homes have eased somewhat (figure 25). Despite the continued increases .4 in house prices, the pace of construction has Multifamily starts 0 12. The SLOOS is available on the Board’s website at 2006 2008 2010 2012 2014 2016 2018 https://www.federalreserve.gov/data/sloos/sloos.htm. NOTE: The data extend through May 2018. SOURCE: U.S. Census Bureau via Haver Analytics. 22 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 25. New and existing home sales not kept up with demand. As a result, the months’ supply of inventories of homes for Millions, annual rate Millions, annual rate sale has remained at a relatively low level, and 7.5 1.6 the aggregate vacancy rate stands at the lowest 7.0 Existing home sales 1.4 level since 2003. 6.5 1.2 6.0 Net exports had a neutral effect on GDP 5.5 1.0 growth in the first quarter 5.0 .8 4.5 After being a small drag on U.S. real GDP .6 4.0 growth last year, net exports had a neutral .4 3.5 effect on growth in the first quarter. Real 3.0 New home sales .2 U.S. exports increased about 3½ percent at an annual rate, as exports of automobiles 2006 2008 2010 2012 2014 2016 2018 and consumer goods remained robust. Real NOTE: Data are monthly and extend through May 2018. New home sales includes only single-family sales. Existing home sales includes single-family, import growth slowed sharply following condo, townhome, and co-op sales. SOURCE: For new home sales, U.S. Census Bureau; for existing home a surge late last year (figure 26). Nominal sales, National Association of Realtors; all via Haver Analytics. trade data through May suggest that export growth picked up in the second quarter, led 26. Change in real imports and exports of goods by agricultural exports, while import growth and services was tepid. All told, the available data suggest Percent, annual rate that the nominal trade deficit likely narrowed Imports relative to GDP in the second quarter Exports 9 (figure 27). 6 Fiscal policy became more expansionary Q1 this year . . . 3 Federal fiscal policy will likely provide a + _0 moderate boost to GDP growth this year. The individual and corporate tax cuts in the TCJA 3 should lead to increased private consumption and investment, while the Bipartisan Budget 2012 2013 2014 2015 2016 2017 2018 Act of 2018 (BBA) enables increased federal SOURCE: Bureau of Economic Analysis via Haver Analytics. spending on goods and services. As the effects of the BBA had yet to show through, federal 27. U.S. trade and current account balances government purchases posted only a modest Quarterly Percent of nominal GDP gain in the first quarter (figure 28). + _0 After narrowing significantly for several years, 1 the federal unified deficit widened from about 2 2½ percent of GDP in fiscal year 2015 to 3 3½ percent in fiscal 2017, and it is on pace to move up further in fiscal 2018. Although 4 Trade expenditures as a share of GDP in 2017 5 were relatively stable at 21 percent, receipts 6 moved lower to roughly 17 percent of GDP Current account 7 and have remained at about the same level so far this year (figure 29). The ratio of federal 2002 2004 2006 2008 2010 2012 2014 2016 2018 NOTE: GDP is gross domestic product. SOURCE: Bureau of Economic Analysis via Haver Analytics. MONETARy POLICy REPORT: JULy 2018 23 debt held by the public to nominal GDP was 28. Change in real government expenditures on consumption and investment 76½ percent at the end of fiscal 2017 and is quite elevated relative to historical norms Percent, annual rate (figure 30). Federal State and local 6 . . . and the fiscal position of most state 4 Q1 and local governments is stable 2 + The fiscal position of most state and local _0 governments remains stable, although there is a 2 range of experiences across these governments 4 and some states are still struggling. After 6 several years of slow growth, revenue gains of 8 state governments have strengthened notably as sales and income tax collections have picked 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 up over the past few quarters. In addition, SOURCE: Bureau of Economic Analysis. house price gains have continued to push up 29. Federal receipts and expenditures property tax revenues at the local level. But expenditures by state and local governments Annual PPeerrcceenntt ooff nnoommiinnaall GGDDPP have been restrained. Employment growth 26 in this sector has been moderate, while real Expenditures 24 outlays for construction by these governments have largely been moving sideways at a 22 relatively low level. Receipts 20 18 Financial Developments 16 The expected path of the federal funds 14 rate has moved up 1997 2000 2003 2006 2009 2012 2015 2018 Market-based measures of the path of the NOTE: Through 2017, receipts and expenditures are for fiscal years federal funds rate continue to suggest that (October to September); gross domestic product (GDP) is for the four quarters ending in Q3. For 2018, receipts and expenditures are for the market participants expect further gradual 12 months ending in May; GDP is the average of 2017:Q4 and 2018:Q1. increases in the federal funds rate. Relative Receipts and expenditures are on a unified-budget basis. SOURCE: Office of Management and Budget via Haver Analytics. to the end of last year, the expected policy 30. Federal government debt held by the public rate path has moved up, boosted in part by investors’ perception of a strengthening in Quarterly Percent of nominal GDP the domestic economic outlook (figure 31). In particular, the policy path moved higher 80 in response to incoming economic data so far 70 this year, especially the employment reports, 60 which were seen as supporting expectations for 50 a solid pace of growth in domestic economic activity. In addition, investors reportedly 40 interpreted FOMC communications in the first 30 half of 2018 as signaling an upbeat economic 20 outlook and as reinforcing expectations for further gradual removal of monetary policy 1968 1978 1988 1998 2008 2018 accommodation. 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 held in federal employee defined benefit retirement accounts, evaluated at the end of the quarter. SOURCE: For GDP, Bureau of Economic Analysis via Haver Analytics; for federal debt, Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” 24 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 31. Market-implied federal funds rate Survey-based measures of the expected path of the policy rate over the next few years have Quarterly Percent also increased modestly since the end of last year. According to the results of the most 3.0 recent Survey of Primary Dealers and Survey July 11, 2018 of Market Participants, both conducted by 2.5 the Federal Reserve Bank of New York just 2.0 before the June FOMC meeting, the median Dec. 29, 2017 of respondents’ projections for the path of the 1.5 federal funds rate shifted up about 25 basis points for 2018 and beyond, compared with 1.0 the median of assessments last December.13 Market-based measures of uncertainty about 2017 2018 2019 2020 the policy rate approximately one to two years 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 ahead increased slightly, on balance, from their implied path as of July 11, 2018, is compared with that as of December 29, levels at the end of last year. 2017. The path is estimated with a spline approach, assuming a term premium of 0 basis points. The paths extend through 2020:Q4. SOURCE: Bloomberg; Federal Reserve Board staff estimates. The nominal Treasury yield curve has shifted up The nominal Treasury yield curve has shifted 32. Yields on nominal Treasury securities up and flattened somewhat further during the first half of 2018 after flattening considerably Daily Percent in the second half of 2017. In particular, the 7 yields on 2- and 10-year nominal Treasury 6 securities increased about 70 basis points and 10-year 30-year 45 basis points, respectively, from their levels 5 at the end of 2017 (figure 32). The increase 4 in Treasury yields seems to largely reflect 3 investors’ greater optimism about the domestic 2 growth outlook and firming expectations for 2-year 1 further gradual removal of monetary policy 0 accommodation. Expectations for increases in the supply of Treasury securities following 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 the federal budget agreement in early February NOTE: The Treasury ceased publication of the 30-year constant maturity series on February 18, 2002, and resumed that series on February 9, 2006. also appear to have contributed to the increase SOURCE: Department of the Treasury. in Treasury yields, while increased concerns about trade policy both domestically and abroad, political developments in Europe, and the foreign economic outlook weighed on longer-dated Treasury yields. Yields on 30-year agency mortgage-backed securities (MBS)—an important determinant of mortgage interest 13. The results of the Survey of Primary Dealers and the Survey of Market Participants are available on the Federal Reserve Bank of New York’s website at https://www.newyorkfed.org/markets/primarydealer_ survey_questions.html and https://www.newyorkfed.org/ markets/survey_market_participants, respectively. MONETARy POLICy REPORT: JULy 2018 25 rates—increased about 60 basis points over the 33. Yield and spread on agency mortgage-backed securities first half of the year, a bit more than the rise in Percent Basis points the 10-year nominal Treasury yield, but remain low by historical standards (figure 33). Yields 9 300 Yield on corporate debt securities—both investment 8 250 grade and high yield—rose more than Treasury 7 200 yields, leaving the spreads on corporate bond 6 Spread yields over comparable-maturity Treasury 150 5 yields notably wider than at the beginning of 100 4 the year. 50 3 Broad equity indexes rose modestly amid 2 0 some bouts of market volatility 2000200220042006200820102012201420162018 After surging as much as 20 percent in 2017, 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 broad stock market indexes rose modestly, would be priced at par, or face, value. Spread shown is to the average of the on balance, so far this year amid some bouts 5- and 10-year nominal Treasury yields. The data extend through July 11, 2018. of heightened volatility in financial markets SOURCE: Department of the Treasury; Barclays. (figure 34). The boost to equity prices from 34. Equity prices first-quarter earnings reports that generally beat analysts’ expectations was reportedly Daily December 31, 1999 = 100 offset by increased uncertainty about trade 200 policy, rising interest rates, and concerns Dow Jones bank index about political developments abroad. While 175 stock prices for companies in the technology S&P 500 index 150 and consumer discretionary sectors rose 125 notably, those of companies in the industrial 100 and financial sectors declined modestly. After 75 spiking considerably in early February, the 50 implied volatility for the S&P 500 index— 25 the VIX—declined and ended the period slightly above the low levels that prevailed in 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2017. (For a discussion of financial stability SOURCE: Standard & Poor's Dow Jones Indices via Bloomberg. (For Dow issues, see the box “Developments Related to Jones Indices licensing information, see the note on the Contents page.) Financial Stability.”) Markets for Treasury securities, mortgage- backed securities, and municipal bonds have functioned well On balance, indicators of Treasury market functioning remained broadly stable over the first half of 2018. A variety of liquidity metrics—including bid-ask spreads, bid sizes, and estimates of transaction costs—have displayed minimal signs of liquidity pressures overall, with the exception of a brief period of reduced liquidity in early February amid elevated financial market volatility. Liquidity conditions in the agency MBS market were 26 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Developments Related to Financial Stability The U.S. financial system remains substantially more A. Forward price-to-earnings ratio of S&P 500 firms resilient than during the decade before the financial crisis.1 valuations continue to be elevated for a range Monthly Ratio of assets. In the private nonfinancial sector, the ratio of total debt to gross domestic product (GDP) is about in 30 line with an estimate of its trend, and vulnerabilities 25 associated with debt remain moderate on balance. While borrowing among highly levered and lower- 20 rated firms is elevated and a future weakening in economic activity could amplify some vulnerabilities 15 in the corporate sector, the ratio of household debt to Historical median disposable income has remained stable in recent years. 10 vulnerabilities associated with leverage in the financial 5 sector appear low, reflecting in part strong capital positions of banks. However, some measures of hedge 1986 1990 1994 1998 2002 2006 2010 2014 2018 fund leverage have increased. vulnerabilities associated with maturity and liquidity transformation continue to NOTE: The data depict the aggregate forward price-to-earnings ratio of S&P 500 firms. The historical median is based on data from 1985 to the be low compared with levels that generally prevailed present. Shaded bars indicate periods of recession as defined by the National before 2008. Bureau of Economic Research. Data are based on 12-month-ahead expected valuation pressures in various asset markets earnings per share. SOURCE: Staff estimates based on Thomson Reuters, IBES. remain elevated by historical standards, although they have declined somewhat since the start of the year, as corporate bond prices have fallen and higher markets, commercial property valuations continue to earnings have helped rationalize equity prices. Market be stretched. Capitalization rates (computed as the ratio movements were outsized in February, around the time of net operating income relative to property values) of the previous Monetary Policy Report. Since then, remain low, and, in recent quarters, their spreads to volatility has receded, although it has ended up slightly yields on 10-year Treasury securities have moved down above the low levels seen in 2017. Even with higher considerably. Finally, valuation pressures in residential expected earnings due in part to changes in tax law, the real estate markets increased modestly. Aggregate price- forward equity price-to-earnings ratio for the S&P 500 to-rent ratios, adjusted for an estimate of their long-run remains in the upper end of its historical distribution trend and the carrying cost of housing, are approaching (figure A). Treasury term premiums have increased the cycle peaks of the early 1980s and early 1990s but modestly from the beginning of the year but remain remain well below the levels observed on the eve of low relative to historically observed values. Corporate the financial crisis. bond yields and their spreads to yields on comparable- With households and businesses taken together, the maturity Treasury securities have increased notably, ratio of total debt to GDP is about in line with estimates but they continue to be low by historical standards. In of its trend, although pockets of stress are evident. In particular, speculative-grade yields and spreads lie in the household sector, the net expansion of household the bottom fifth and bottom fourth of their respective debt has been in line with income growth and is historical distributions. In leveraged loan markets, concentrated among prime-rated borrowers. However, issuance has been robust, spreads have reached their delinquency rates for some forms of consumer credit lowest levels since the financial crisis, and the presence have moved up, suggesting rising strains among riskier of loan covenants has decreased further. In real estate borrowers even with unemployment very low. Banks are reportedly tightening standards on credit card and auto loans. In the nonfinancial business sector, leverage 1. An overview of the framework for assessing financial stability in the United States is provided in Lael Brainard of corporate businesses remains high, as indicated by (2018), “An Update on the Federal Reserve’s Financial Stability a positive sectoral credit-to-GDP gap. Net issuance of Agenda,” speech delivered at the Center for Global Economy risky debt has risen in recent quarters, mainly driven by and Business, Stern School of Business, New york University, the growth in leveraged loans (figure B). While current New york, April 3, https://www.federalreserve.gov/newsevents/ speech/brainard20180403a.htm. (continued) MONETARy POLICy REPORT: JULy 2018 27 B. Total net issuance of risky debt a severe global recession.2 The hypothetical “severely adverse” scenario—the most stringent scenario Quarterly Billions of dollars yet used in the Board’s stress tests, with the U.S. unemployment rate rising almost 6 percentage points to 80 10 percent—projects $578 billion in total losses for the 60 35 participating banks during the nine quarters tested. Since 2009, these firms have added about $800 billion 40 in common equity capital. The Board also evaluates the 20 capital planning processes of the participating banks, + including the firms’ planned capital actions, such as _0 dividend payments and share buybacks.3 The Board did 20 not object to the capital plans of 34 firms. Although the recent U.S. tax legislation is expected to increase 40 banks’ post-tax earnings, and hence their ability to accrete capital, it did lead to one-time losses, 2006 2008 2010 2012 2014 2016 2018 decreasing banks’ capital ratios at the end of 2017, the NOTE: Data are 4-quarter moving averages and extend through 2018:Q2. jumping-off point of the stress tests. In part because Total net issuance of risky debt is the sum of the net issuance of of these effects, evident in text figure 36, two firms speculative-grade and unrated bonds and leveraged loans. SOURCE: Mergent Fixed Investment Securities Database, S&P Leveraged were required to maintain their capital distributions Commentary & Data. at the levels they paid in recent years. Separately, one firm will be required to address the management and corporate credit conditions are favorable overall, analysis of its counterparty exposure under stress. The with low interest expenses and defaults, the elevated Board objected to the capital plan of one bank because leverage in this sector could result in higher future of qualitative concerns. default rates. In addition, weak protection from loan vulnerabilities associated with liquidity and covenants could reduce early intervention by lenders maturity transformation—that is, the financing of and lower recovery rates for investors on default. illiquid assets or long-maturity assets with short- Investors may also be exposed to significant repricing maturity debt—continue to be low, owing in part to risks because bond yields and credit risk premiums are liquidity regulations for banks and money market both low. reform. Large banks have strong liquidity positions, vulnerabilities from financial-sector leverage because their use of core deposits as a source of continue to be relatively low. Core financial funding and their holdings of high-quality liquid intermediaries, including large banks, insurance assets remain near historical highs, while their use of companies, and broker-dealers, appear well positioned short-term wholesale funding as a share of liabilities to weather economic stress. Regulatory capital ratios for is near historical lows. Since the money market fund the global systemically important banks have remained reforms implemented in October 2016, assets under well above the fully phased-in enhanced regulatory management at prime funds, institutions that proved requirements and are close to historical highs. Capital vulnerable to runs in the past, have remained far below levels at insurance companies and broker-dealers pre-reform levels. In addition, the growth in alternative also remain relatively robust by historical standards. short-term investment vehicles, which may have some However, some indicators of hedge fund leverage in (continued on next page) the equity market, such as the provision of total margin 2. See Board of Governors of the Federal Reserve System credit to equity investors, have risen to historically (2018), “Federal Reserve Board Releases Results of Supervisory elevated levels, and in the past few quarters dealers Bank Stress Tests,” press release, June 21, https://www. have reportedly eased, on net, price terms to their federalreserve.gov/newsevents/pressreleases/ hedge fund clients. bcreg20180621a.htm. The results of supervisory stress tests released in June 3. See Board of Governors of the Federal Reserve System (2018), “Federal Reserve Releases Results of Comprehensive by the Federal Reserve Board confirm that the nation’s Capital Analysis and Review (CCAR),” press release, June 29, largest banks are strongly capitalized and would be https://www.federalreserve.gov/newsevents/pressreleases/ able to lend to households and businesses even during bcreg20160629a.htm. 28 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Financial Stability (continued) similar vulnerabilities, continues to be limited, as more pronounced vulnerabilities, reflecting some investors have shifted primarily from prime funds into combination of the following: substantial corporate government funds. leverage, fiscal concerns, or excessive reliance on Risks from abroad are moderate overall. Advanced foreign funding. Globally, potential downside risks to foreign economies (AFEs), many of which have international financial markets and financial stability significant financial and real linkages to the United include political uncertainty, an intensification of trade States, continue to have notable or elevated valuations tensions, and challenges posed by rising interest rates. in some asset markets and, in a few countries, high The countercyclical capital buffer (CCyB) is a levels of household debt relative to GDP. These macroprudential tool the Federal Reserve Board can factors have contributed to some AFEs announcing use to increase the resilience of the financial system or implementing macroprudential actions, including by raising capital requirements on the largest banks. increases in countercyclical capital buffers, over the Activating the CCyB is appropriate when systemic past couple of years. More generally, AFE financial vulnerabilities are meaningfully above normal.4 The sectors continue their slow pace of deleveraging Board is closely monitoring the level and configuration that started after the global financial and euro-area of systemic vulnerabilities described earlier. sovereign debt crises. In addition, low corporate debt spreads in the past few years have yet to translate 4. See Board of Governors of the Federal Reserve System (2016), “Regulatory Capital Rules: The Federal Reserve Board’s into any marked increase in leverage in most of these Framework for Implementing the U.S. Basel III Countercyclical countries’ nonfinancial corporate sectors. Some major Capital Buffer,” final policy statement (Docket No. R-1529), emerging market economies continue to harbor Federal Register, vol. 81 (September 16), pp. 63682–88. MONETARy POLICy REPORT: JULy 2018 29 also generally stable. Overall, the functioning of Treasury and agency MBS markets has not been materially affected by the implementation of the Federal Reserve’s balance sheet normalization program, including the accompanying reduction in reinvestment of principal payments from the Federal Reserve’s securities holdings. Credit conditions in municipal bond markets have remained stable since the turn of the year. Over that period, yield spreads on 20-year general obligation municipal bonds over comparable-maturity Treasury securities edged up a bit. Money market rates have moved up in line with increases in the FOMC’s target range Conditions in domestic short-term funding markets have also remained generally stable so far in 2018. Yields on a broad set of money market instruments moved higher in response to the FOMC’s policy actions in March and June. Some money market rates rose during the first quarter more than what would normally occur with monetary tightening. For example, the spreads of certificates of deposit and term London interbank offered rates relative to overnight index swap (OIS) rates increased notably, reportedly reflecting increased issuance of Treasury bills and perhaps also the anticipated tax-induced repatriation of foreign earnings by U.S. corporations. The upward pressure on short- term funding rates, beyond that driven by expected monetary policy, eased in recent months, leading to a narrowing of spreads of some money market rates to OIS rates. However, the spreads remain wider than at the beginning of the year. Bank credit continued to expand and bank profitability improved Aggregate credit provided by commercial banks continued to increase through the first quarter of 2018 at a pace similar to the one seen in 2017. Its pace was slower than that of nominal GDP, thus leaving the ratio of total commercial bank credit to current-dollar 30 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 35. Ratio of total commercial bank credit to nominal gross GDP slightly lower than in the previous year domestic product (figure 35). Available data for the second quarter suggest that growth in banks’ core Quarterly Percent loans continued to be moderate. Measures of bank profitability improved in the first quarter 75 of 2018 after having experienced a temporary 70 decline in the last quarter of 2017. Weaker fourth-quarter measures of bank profitability 65 were partly driven by higher write-downs of deferred tax assets in response to the U.S. tax 60 legislation (figure 36). 55 International Developments 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Political developments and signs of SOURCE: Federal Reserve Board, Statistical Release H.8, “Assets and Liabilities of Commercial Banks in the United States”; Bureau of Economic moderating growth weighed on advanced Analysis via Haver Analytics. foreign economy asset prices 36. Profitability of bank holding companies Since February, political developments Percent, annual rate Percent, annual rate in Europe and moderation in economic growth outside of the United States weighed 2.0 Return on assets 30 on some risky asset prices in advanced 1.5 20 foreign economies (AFEs). Interest rates on 1.0 sovereign bonds in several countries in the 10 . + 5 Return on equity + European periphery rose notably relative to _0 _0 core countries, and European bank shares .5 10 came under pressure, as investors focused 1.0 20 on the formation of the Italian government. 1.5 Nonetheless, peripheral bond spreads 30 2.0 remained well below their levels at the height 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 of the euro-area crisis, and the moves partly NOTE: The data are quarterly and are seasonally adjusted. retraced as a government was put in place. SOURCE: Federal Reserve Board, Form FR Y-9C, Consolidated Financial Broad stock price indexes were little changed Statements for Bank Holding Companies. on net (figure 37). In contrast to the United 37. Equity indexes for selected foreign economies States, long-term sovereign yields and market- implied paths of policy rates in the core euro Weekly Week ending January 7, 2015 = 100 area as well as the United Kingdom declined 140 somewhat, and rates were little changed in Japan (figure 38). 130 Euro area 120 Heightened investor focus on 110 vulnerabilities in emerging market United Kingdom economies led asset prices to come under 100 pressure 90 Emerging market economies Investor concerns about financial 80 vulnerabilities in several emerging market 2015 2016 2017 2018 economies (EMEs) intensified this spring NOTE: The data are weekly averages of daily data and extend through against the backdrop of rising U.S. interest July 11, 2018. rates. Broad measures of EME sovereign SOURCE: For euro area, DJ Euro Stoxx Index; for United Kingdom, FTSE 100 Stock Index; for emerging market economies, MSCI Emerging Markets Local Currency Index; all via Bloomberg. MONETARy POLICy REPORT: JULy 2018 31 bond spreads over U.S. Treasury yields 38. Nominal 10-year government bond yields in selected advanced economies widened notably, and benchmark EME equity indexes declined, as investors scrutinized Weekly Percent macroeconomic policy approaches in several countries. Turkey and Argentina, which faced 3.0 United States persistently high inflation, expansionary fiscal 2.5 policies, and large current account deficits, 2.0 were among the worst performers. Trade 1.5 policy developments between the United Germany 1.0 States and its trading partners also weighed on United Kingdom .5 EME asset prices, especially on stock prices + in China and some emerging Asian countries. Japan _0 .5 EME mutual funds saw net outflows in May and June after generally solid inflows earlier 2015 2016 2017 2018 in the year (figure 39). While movements in NOTE: The data are weekly averages of daily benchmark yields and extend asset prices and capital flows were notable for through July 11, 2018. SOURCE: Bloomberg. a number of economies, broad indicators of financial stress in EMEs remained low relative 39. Emerging market mutual fund flows and spreads to levels seen during other periods of stress in recent years. Basis points Billions of dollars Bond fund flows (right axis) The dollar appreciated 500 Equity fund flows (right axis) 60 After depreciating during 2017, the broad 450 Apr. 40 exchange value of the U.S. dollar has 400 20 appreciated moderately in recent months + 350 _0 (figure 40). Factors contributing to the 300 EMBI+ (left axis) 20 appreciation of the dollar likely include moderating growth in some foreign economies 250 June 40 combined with continued output strength 200 60 and ongoing policy tightening in the United States, downside risks stemming from political 2015 2016 2017 2018 developments in Europe and several EMEs, NOTE: The bond and equity fund flow data are quarterly sums of weekly data from January 1, 2015, to March 31, 2018, and monthly sums of weekly and the recent developments in trade policy. data from April 1, 2018, to June 30, 2018. The fund flows data exclude funds Several currencies appeared particularly located in China. The J.P. Morgan Emerging Markets Bond Index Plus (EMBI+) data are weekly averages of daily data and extend through July 4, sensitive to trade policy developments, 2018. SOURCE: For bond and equity fund flows, EPFR Global; for EMBI+, J.P. including the Canadian dollar and the Morgan Emerging Markets Bond Index Plus via Bloomberg. Mexican peso, related to the North American Free Trade Agreement negotiations, as well as the Chinese renminbi, which fell notably against the dollar in June. The pace of economic activity moderated in the AFEs In the first quarter, real GDP growth decelerated in all major AFEs and turned negative in Japan, down from robust rates of activity in 2017 (figure 41). Part of this slowing is a result of temporary factors, though, 32 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 40. U.S. dollar exchange rate indexes including unusually cold weather in Japan and the United Kingdom, labor strikes in the Weekly Week ending January 7, 2015 = 100 euro area, and disruptions in oil production in Dollar appreciation 150 Canada. In most AFEs, economic indicators for the second quarter, including purchasing Mexican peso 140 manager surveys and exports, are generally 130 consistent with solid economic growth. 120 Despite tight labor markets, 110 Euro inflation pressures remain subdued in 100 most AFEs . . . British pound 90 Broad dollar Sustained increases in oil prices provided 2015 2016 2017 2018 upward pressure on consumer price inflation NOTE: The data, which are in foreign currency units per dollar, are weekly across all AFEs in the first half of the year averages of daily data and extend through July 11, 2018. As indicated by the (figure 42). However, core inflation has arrow, increases in the data represent U.S. dollar appreciation, and decreases represent U.S. dollar depreciation. generally remained muted in most AFEs, SOURCE: Federal Reserve Board, Statistical Release H.10, “Foreign Exchange Rates.” despite further improvement in labor market conditions. In Canada, in contrast, core inflation picked up amid solid wage growth, 41. Real gross domestic product growth in selected advanced foreign economies pushing the total inflation rate above the central bank target. Percent, annual rate United Kingdom . . . prompting central banks to maintain Japan 5 highly accommodative monetary policies Euro area Canada 4 With underlying inflation still subdued, the 3 Bank of Japan and the European Central Q1 2 Bank (ECB) kept their policy rates at 1 historically low levels, although the ECB + indicated it would again reduce the pace of _0 its asset purchases starting in October. The 1 Bank of England and the Bank of Canada, which both began raising interest rates last 2014 2015 2016 2017 2018 year, signaled that further rate increases will SOURCE: For the United Kingdom, Office for National Statistics; for Japan, Cabinet Office, Government of Japan; for the euro area, Eurostat; for Canada, be gradual, given a moderation in the pace of Statistics Canada; all via Haver Analytics. economic activity. In emerging Asia, growth remained solid . . . Economic growth in China remained solid in the first quarter of 2018, as a rebound in steel production and strong external demand bolstered a recovery in industrial activity and overall growth (figure 43). Indicators of investment and retail sales have slowed in recent months, however, suggesting that the authorities’ effort to rein in credit may have softened domestic demand. Most other MONETARy POLICy REPORT: JULy 2018 33 emerging Asian economies registered strong 42. Consumer price inflation in selected advanced foreign economies growth in the first quarter of 2018, partly reflecting solid external demand. Monthly 12-month percent change . . . while growth in some Latin American 4 economies was mixed United Kingdom 3 Japan In Mexico, real GDP surged in the first quarter Canada 2 as economic activity rebounded from two major earthquakes and a hurricane last year. 1 Following a brief recovery in the first half of + 2017, Brazil’s economy stalled in the fourth _0 Euro area quarter and grew tepidly in the first quarter, 1 and a truckers’ strike paralyzed economic activity in late May. 2015 2016 2017 2018 NOTE: The data for the euro area incorporate the flash estimate for June 2018. The data for Canada, Japan, and the United Kingdom extend through May 2018. 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. 43. Real gross domestic product growth in selected emerging market economies Percent, annual rate China Korea 12 Mexico Brazil Q1 9 6 3 + _0 3 6 2014 2015 2016 2017 2018 NOTE: The data for China are seasonally adjusted by Board staff. The data for Korea, Mexico, and Brazil are seasonally adjusted by their respective government agencies. SOURCE: For China, China National Bureau of Statistics; for Korea, Bank of Korea; for Mexico, Instituto Nacional de Estadistica y Geografia; for Brazil, Instituto Brasileiro de Geografia e Estatistica; all via Haver Analytics. 35 P 2 art m P onetary oLicy The Federal Open Market Committee of the labor market and the accumulating continued to gradually increase the evidence that, after many years of running federal funds target range in the first half below the Committee’s 2 percent longer- of the year . . . run objective, inflation had moved close to 2 percent. Since December 2015, the Federal Open Market Committee (FOMC) has been . . . but monetary policy continues to gradually increasing its target range for support economic growth the federal funds rate as the economy has continued to make progress toward the Even after the gradual increases in the federal Committee’s congressionally mandated funds rate over the first half of the year, the objectives of maximum employment and Committee judges that the stance of monetary price stability. In the first half of this year, the policy remains accommodative, thereby Committee continued this gradual process of supporting strong labor market conditions scaling back monetary policy accommodation, and a sustained return to 2 percent inflation. increasing its target range for the federal funds In particular, the federal funds rate remains rate ¼ percentage point at its meetings in both somewhat below most FOMC participants’ March and June. With these increases, the estimates of its longer-run value. federal funds rate is currently in the range of 1¾ to 2 percent (figure 44).14 The Committee’s The Committee expects that a gradual decisions reflected the continued strengthening approach to increasing the target range for the federal funds rate will be consistent with a sustained expansion of economic activity, 14. See Board of Governors of the Federal Reserve System (2018), “Federal Reserve Issues strong labor market conditions, and inflation FOMC Statement,” press release, March 21, https:// near the Committee’s symmetric 2 percent www.federalreserve.gov/newsevents/pressreleases/ objective over the medium term. Consistent monetary20180321a.htm; and Board of Governors of with this outlook, in the most recent the Federal Reserve System (2018), “Federal Reserve Summary of Economic Projections (SEP), Issues FOMC Statement,” press release, June 13, https:// which was compiled at the time of the June www.federalreserve.gov/newsevents/pressreleases/ monetary20180613a.htm. FOMC meeting, the median of participants’ 44. Selected interest rates Daily Percent 5 10-year Treasury rate 4 3 2 2-year Treasury rate 1 0 Target federal funds rate 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 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. 36 PART 2: MONETARy POLICy assessments for the appropriate level of the as useful benchmarks. However, the use and target range for the federal funds rate at interpretation of such prescriptions require, year-end rises gradually over the period from among other considerations, careful judgments 2018 to 2020 and stands somewhat above the about the choice and measurement of the median projection for its longer-run level by inputs to these rules such as estimates of the the end of 2019 and through 2020.15 neutral interest rate, which are highly uncertain (see the box “Complexities of Monetary Future changes in the federal funds rate Policy Rules”). will depend on the economic outlook as informed by incoming data The FOMC has continued to implement its program to gradually reduce the The FOMC has continued to emphasize Federal Reserve’s balance sheet that, in determining the timing and size of future adjustments to the target range for The Committee has continued to implement the federal funds rate, it will assess realized the balance sheet normalization program and expected economic conditions relative described in the June 2017 Addendum to the to its maximum-employment objective and Policy Normalization Principles and Plans.16 its symmetric 2 percent inflation objective. This program is gradually and predictably This assessment will take into account a wide reducing the Federal Reserve’s securities range of information, including measures holdings by decreasing the reinvestment of the of labor market conditions, indicators of principal payments it receives from securities inflation pressures and inflation expectations, held in the System Open Market Account. and readings on financial and international Since the initiation of the balance sheet developments. normalization program in October of last year, such payments have been reinvested to the In evaluating the stance of monetary policy, extent that they exceeded gradually rising caps policymakers routinely consult prescriptions (figure 45). from a variety of policy rules, which can serve 15. See the June SEP, which appeared as an addendum 16. The addendum, adopted on June 13, 2017, is to the minutes of the June 12–13, 2018, meeting of the available at https://www.federalreserve.gov/monetarypolicy/ FOMC and is presented in Part 3 of this report. files/FOMC_PolicyNormalization.20170613.pdf. 45. Principal payments on SOMA securities Treasury securities Agency debt and mortgage-backed securities Monthly Billions of dollars Monthly Billions of dollars Redemptions Redemptions Reinvestments 80 Reinvestments 80 Monthly cap Monthly cap 70 70 60 60 50 50 40 40 30 30 20 20 10 10 2017 2018 2019 2017 2018 2019 Note: Reinvestment and redemption amounts of agency mortgage-backed securities are projections starting in June 2018. The data extend through December 2019. Source: Federal Reserve Bank of New York; Federal Reserve Board staff calculations. MONETARy POLICy REPORT: JULy 2018 37 Complexities of Monetary Policy Rules Overview reflect the three key principles of good monetary policy noted earlier. Each rule takes into account estimates Monetary policy rules are mathematical formulas of how far the economy is from achieving the Federal that relate a policy interest rate, such as the federal Reserve’s dual-mandate goals of maximum employment funds rate, to a small number of other economic and price stability. variables—typically including the deviation of inflation Four of the five rules include the difference from its target value along with an estimate of resource between the rate of unemployment that is sustainable slack in the economy. Policy rules can provide helpful in the longer run and the current unemployment guidance for policymakers. Indeed, since 2004, rate (the unemployment rate gap); the first-difference prescriptions from policy rules have been included rule includes the change in the unemployment gap in written materials that are routinely sent to the rather than its level.3 In addition, four of the five rules Federal Open Market Committee (FOMC). However, include the difference between recent inflation and the interpretation of the prescriptions of policy rules FOMC’s longer-run objective (2 percent as measured requires careful judgment about the measurement of by the annual change in the price index for personal the inputs to the rules and the implications of the many consumption expenditures, or PCE), while the price- considerations that the rules do not take into account. level rule includes the gap between the level of prices Policy rules can incorporate key principles of good today and the level of prices that would be observed monetary policy.1 One key principle is that monetary if inflation had been constant at 2 percent from a policy should respond in a predictable way to changes specified starting year (PLgap).4 The price-level rule in economic conditions. A second key principle is t thereby takes account of the deviation of inflation from that monetary policy should be accommodative when (continued on next page) inflation is below the desired level and employment is below its maximum sustainable level; conversely, Policy, proceedings of a symposium sponsored by the Federal monetary policy should be restrictive when the Reserve Bank of Kansas City, held in Jackson Hole, Wyo., opposite holds. A third key principle is that, to stabilize August 2–3 (Kansas City: Federal Reserve Bank of Kansas inflation, the policy rate should be adjusted by more City), pp. 137–59, https://www.kansascityfed.org/publicat/ than one-for-one in response to persistent increases or sympos/1984/s84.pdf. Finally, the first-difference rule was decreases in inflation. introduced by Athanasios Orphanides (2003), “Historical Monetary Policy Analysis and the Taylor Rule,” Journal Economists have analyzed many monetary policy of Monetary Economics, vol. 50 (July), pp. 983–1022. A rules, including the well-known Taylor (1993) rule. comprehensive review of policy rules is in John B. Taylor Other rules include the “balanced approach” rule, the and John C. Williams (2011), “Simple and Robust Rules for “adjusted Taylor (1993)” rule, the “price level” rule, and Monetary Policy,” in Benjamin M. Friedman and Michael Woodford, eds., Handbook of Monetary Economics, vol. 3B the “first difference” rule (figure A).2 These policy rules (Amsterdam: North-Holland), pp. 829–59. The same volume of the Handbook of Monetary Economics also discusses 1. For discussion regarding principles for the conduct of approaches other than policy rules for deriving policy rate monetary policy and monetary policy rules, see Board of prescriptions. Governors of the Federal Reserve System (2018), “Monetary 3. The Taylor (1993) rule represented slack in resource Policy Principles and Practice,” Board of Governors, https:// utilization using an output gap (the difference between the www.federalreserve.gov/monetarypolicy/monetary-policy- current level of real gross domestic product (GDP) and what principles-and-practice.htm. GDP would be if the economy was operating at maximum 2. The Taylor (1993) rule was suggested in John B. Taylor employment). The rules in figure A represent slack in resource (1993), “Discretion versus Policy Rules in Practice,” Carnegie- utilization using the unemployment gap instead, because that Rochester Conference Series on Public Policy, vol. 39 gap better captures the FOMC’s statutory goal to promote (December), pp. 195–214. The balanced-approach rule was maximum employment. Movements in these alternative analyzed in John B. Taylor (1999), “A Historical Analysis of measures of resource utilization are highly correlated. For Monetary Policy Rules,” in John B. Taylor, ed., Monetary Policy more information, see the note below figure A. Rules (Chicago: University of Chicago Press), pp. 319–41. The 4. Calculating the prescriptions of the price-level rule adjusted Taylor (1993) rule was studied in David Reifschneider requires selecting a starting year for the price level from which and John C. Williams (2000), “Three Lessons for Monetary to cumulate the 2 percent annual inflation. Figure B uses 1998 Policy in a Low-Inflation Era,” Journal of Money, Credit and as the starting year. Around that time, the underlying trend Banking, vol. 32 (November), pp. 936–66. A price-level rule of inflation and longer-term inflation expectations stabilized was discussed in Robert E. Hall (1984), “Monetary Strategy at a level consistent with PCE price inflation being close to with an Elastic Price Standard,” in Price Stability and Public 2 percent. 38 PART 2: MONETARy POLICy Monetary Policy Rules (continued) A. Monetary policy rules Taylor (1993) rule 93 = + +0.5( − )+( − ) Balanced-approach rule = + +0.5( − )+2( − ) Taylor (1993) rule, adjusted 93 = { 93− , 0} Price-level rule = { + +( − )+ 0.5( ), 0} First-difference rule = −1 +0.5( − )+ ( − )−( −4 − −4 ) Note: Rt T93, Rt BA, Rt T93adj, Rt PL, and Rt FD represent the values of the nominal federal funds rate prescribed by the Taylor (1993), balanced-approach, adjusted Taylor (1993), price-level, and first-difference rules, respectively. Rt denotes the actual nominal federal funds rate for quarter t, πt is four-quarter price inflation for quarter t, ut is the unemployment rate in quarter t, and rt LR 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 the FOMC’s 2 percent longer-run objective, πLR. In addition, ut LR is the rate of unemployment in the longer run. Zt 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 the federal funds rate below zero. PLgapt is the percent deviation of the actual level of prices from a price level that rises 2 percent per year from its level in a specified starting period. 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 unemployment 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. Box note 2 provides references for the policy rules. the long-run objective in earlier periods as well as also recognizes that the federal funds rate cannot be the current period. Thus, if inflation had been running reduced materially below zero. If inflation runs below persistently above 2 percent, the price-level rule would the 2 percent objective during periods when the rule prescribe a higher level for the federal funds rate than prescribes setting the federal funds rate well below rules that use the current inflation gap. Likewise, zero, the price-level rule will, over time, provide if inflation had been running persistently below accommodation to make up for the past inflation 2 percent, the price-level rule would prescribe setting shortfall. the policy rate lower than rules that use the current The U.S. economy is complex, and the monetary inflation gap. policy rules shown in figure A do not capture many The adjusted Taylor (1993) rule recognizes that elements that are relevant to the conduct of monetary the federal funds rate cannot be reduced materially policy. Moreover, as shown in figure B, different below zero, and that following the prescriptions monetary policy rules often offer quite different of the standard Taylor (1993) rule after a recession prescriptions for the federal funds rate.5 In practice, during which interest rates have fallen to their lower there is no unique criterion for favoring one rule over bound may, for a time, not provide enough policy another. In recent years, almost all of the policy rules accommodation. To make up for the cumulative (continued) shortfall in accommodation (Z), the adjusted rule t prescribes only a gradual return of the policy rate to 5. These prescriptions are calculated using (1) published the (positive) levels prescribed by the standard Taylor data for inflation and the unemployment rate and (2) survey-based estimates of the longer-run value of the (1993) rule after the economy begins to recover. neutral real interest rate and the longer-run value of the The particular price-level rule specified in figure A unemployment rate. MONETARy POLICy REPORT: JULy 2018 39 B. Historical federal funds rate prescriptions from simple policy rules Quarterly Percent 8 Taylor (1993) rule, adjusted 6 Taylor (1993) rule 4 2 + _0 Target federal funds rate Price-level rule 2 First-difference rule 4 Balanced-approach rule 6 8 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 NOTE: The rules use historical values of inflation, the federal funds rate, and the unemployment rate. Inflation is measured as the 4-quarter percent change in the price index for personal consumption expenditures (PCE) 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. The target value of the price level is the average level of the price index for PCE excluding food and energy in 1998 extrapolated at 2 percent per year. SOURCE: Federal Reserve Bank of Philadelphia; Wolters Kluwer, Blue Chip Economic Indicators; Federal Reserve Board staff estimates. shown have called for rising values of the federal funds growth, changing demographics, and other shifts in the rate, but the pace of tightening that the rules prescribe structure of the economy. As a result, estimates of the has varied widely. neutral real interest rate in the longer run made today may differ substantially from estimates made later. Uncertainty about the neutral interest rate Academic studies have estimated the longer- in the longer run run value of the neutral real interest rate using statistical techniques to capture the variations among The Taylor (1993), balanced-approach, adjusted inflation, interest rates, real gross domestic product, Taylor (1993), and price-level rules provide unemployment, and other data series. The range of prescriptions for the level of the federal funds rate; estimates is wide but suggests that the neutral real rate all require an estimate of the neutral real interest rate has declined since the turn of the century (figure C).7 in the longer run (rLR)—that is, the level of the real There is substantial statistical uncertainty surrounding t federal funds rate that is expected to be consistent, in each estimate of the longer-run value of the neutral the longer run, with maximum employment and stable real rate, as evidenced by the width of the 95 percent inflation.6 The neutral real interest rate in the longer (continued on next page) run is determined by structural features of the economy and is not observable. In addition, its value may vary 7. The range of estimates is computed using published over time because of fluctuations in trend productivity values or values computed using the methodology from the following studies: Marco Del Negro, Domenico Giannone, Marc P. Giannoni, and Andrea Tambalotti (2017), “Safety, Liquidity, and the Natural Rate of Interest,” Brookings 6. The first-difference rule shown in figure A does not Papers on Economic Activity, Spring, pp. 235–94, https:// require an estimate of the neutral real interest rate in the www.brookings.edu/wp-content/uploads/2017/08/ longer run. However, this rule has its own shortcomings. For delnegrotextsp17bpea.pdf; Kathryn Holston, Thomas Laubach, example, research suggests that this sort of rule will result in and John C. Williams (2017), “Measuring the Natural greater volatility in employment and inflation relative to what Rate of Interest: International Trends and Determinants,” would be obtained under the Taylor (1993) and balanced- Journal of International Economics, supp. 1, vol. 108 approach rules unless the estimates of the neutral real federal (May), pp. S59–75; Benjamin K. Johannsen and Elmar funds rate in the longer run and the rate of unemployment in Mertens (2016), “The Expected Real Interest Rate in the the longer run that are included in those rules are sufficiently Long Run: Time Series Evidence with the Effective Lower far from their true values. Bound,” FEDS Notes (Washington: Board of Governors 40 PART 2: MONETARy POLICy Monetary Policy Rules (continued) uncertainty bands for the estimated values in the first C. Range of selected estimates for the neutral real federal quarter of 2018 (figure D). funds rate in the longer run The longer-run normal level of the federal funds rate under appropriate monetary policy—equal to Quarterly Percent the sum of the neutral real interest rate in the longer Range of selected estimates 5 run and the FOMC’s 2 percent inflation objective—is one benchmark for evaluating the current stance 4 of monetary policy. Uncertainty about the longer- 3 run value of the neutral real interest rate leads to 2 uncertainty about how far the current federal funds rate is from its longer-run normal level. For the Taylor 1 + (1993), balanced-approach, adjusted Taylor (1993), and _0 price-level rules, different estimates of the neutral real 1 interest rate in the longer run translate one-for-one to differences in the prescribed setting of the federal funds 2 rate. As a result, the substantial statistical uncertainty 2000 2003 2006 2009 2012 2015 2018 accompanying estimates of the neutral rate in the longer run implies substantial uncertainty surrounding NOTE: The shaded bars indicate periods of business recession as defined by the National Bureau of Economic Research. the prescriptions of each policy rule. Following the SOURCE: Federal Reserve Board staff calculations, along with references prescriptions of a policy rule with an incorrect value of listed in box note 7. the neutral rate could lead to poor economic outcomes. If the longer-run value of the neutral real interest rate then monetary policy is more likely to be constrained is currently at the low end of the range of estimates, by the lower bound on nominal interest rates in the future. Historically, the FOMC has cut the federal of the Federal Reserve System, February 9), https://www. funds rate by 5 percentage points, on average, during federalreserve.gov/econresdata/notes/feds-notes/2016/ downturns in the economy. Cutting the federal funds the-expected-real-interest-rate-in-the-long-run-time-series- evidence-with-the-effective-lower-bound-20160209.html; rate by this much in response to a future economic Michael T. Kiley (2015), “What Can the Data Tell Us about downturn may not be feasible if the neutral federal the Equilibrium Real Interest Rate?” Finance and Economics funds rate is as low as most of the estimates suggest. Discussion Series 2015-77 (Washington: Board of Governors (continued) of the Federal Reserve System, September), http://dx.doi. org/10.17016/FEDS.2015.077; Thomas Laubach and John C. Williams (2015), “Measuring the Natural Rate of Interest Governors of the Federal Reserve System, June), https:// Redux,” Hutchins Center Working Paper 15 (Washington: doi.org/10.17016/FEDS.2017.059; Thomas A. Lubik and Brookings Institution, November), https://www.brookings. Christian Matthes (2015), “Calculating the Natural Rate of edu/wp-content/uploads/2016/07/WP15-Laubach-Williams- Interest: A Comparison of Two Alternative Approaches,” natural-interest-rate-redux.pdf; Kurt F. Lewis and Francisco Economic Brief 15-10 (Richmond, va.: Federal Reserve Bank vazquez-Grande (2017), “Measuring the Natural Rate of of Richmond, October), https://www.richmondfed.org/-/media/ Interest: Alternative Specifications,” Finance and Economics richmondfedorg/publications/research/economic_brief/2015/ Discussion Series 2017-059 (Washington: Board of pdf/eb_15-10.pdf. MONETARy POLICy REPORT: JULy 2018 41 D. Point estimates and uncertainty bands for neutral real rate in the longer run as of 2018:Q1 Study Point estimate 95 percent uncertainty band Del Negro and others (2017) 1.3 (.7, 2.1) Holston and others (2017) .6 (-2.5, 3.7) Johannsen and Mertens (2016) .7 (-1.3, 2.5) Kiley (2015) .4 (-.6, 1.6) Laubach and Williams (2015) .1 (-5.4, 5.6) Lewis and Vazquez-Grande (2017) 1.8 (.5, 3.1) Lubik and Matthes (2015) 1.0 (-2.3, 4.5) Source: Federal Reserve Board staff calculations, along with references listed in box note 7. As a result, it may not be feasible to provide the levels In the years following the financial crisis, with the of accommodation prescribed by many policy rules, federal funds rate close to zero, the FOMC recognized potentially leading to elevated unemployment and that it would have limited scope to respond to an inflation averaging below the Committee’s 2 percent unexpected weakening in the economy by lowering objective.8 Rules that try to offset the cumulative short-term interest rates. This risk has, in recent years, shortfall of accommodation posed by the lower bound provided a sound rationale for following a more on nominal interest rates, such as the adjusted Taylor gradual path of rate increases than that prescribed by (1993) rule, or make up the cumulative shortfall in some policy rules. In these circumstances, increasing the level of prices, such as the price-level rule, are the policy rate quickly in order to have room to intended to mitigate the effects of the lower bound cut rates during an economic downturn could be on the economy by providing more accommodation counterproductive because it might make a downturn than prescribed by rules that do not have these more likely to happen. makeup features.9 “Rethinking Macroeconomic Policy,” a conference held at the Peterson Institute for International Economics, Washington, 8. For further discussion of these issues, see Michael T. October 12–13, https://piie.com/system/files/documents/ Kiley and John M. Roberts (2017), “Monetary Policy in a Low bernanke20171012paper.pdf; and Michael Woodford (1999), Interest Rate World,” Brookings Papers on Economic Activity, “Commentary: How Should Monetary Policy Be Conducted Spring, pp. 317–72, https://www.brookings.edu/wp-content/ in an Era of Price Stability?” in New Challenges for Monetary uploads/2017/08/kileytextsp17bpea.pdf. Policy, proceedings of a symposium sponsored by the Federal 9. Economists have found that a “makeup” policy can Reserve Bank of Kansas City (Kansas City, Mo.: Federal be the best response in theory when the policy interest Reserve Bank of Kansas City) pp. 277–316, https://www. rate is constrained at zero. See Ben S. Bernanke (2017), kansascityfed.org/publications/research/escp/symposiums/ “Monetary Policy in a New Era,” paper presented at escp-1999. 42 PART 2: MONETARy POLICy In the first quarter, the Open Market Desk The implementation of the program has at the Federal Reserve Bank of New York, proceeded smoothly without causing disruptive as directed by the Committee, reinvested price movements in Treasury and MBS principal payments from the Federal Reserve’s markets. As the caps have increased gradually holdings of Treasury securities maturing and predictably, the Federal Reserve’s total during each calendar month in excess of assets have started to decrease, from about $12 billion. The Desk also reinvested in agency $4.4 trillion last October to about $4.3 trillion mortgage-backed securities (MBS) the amount at present, with holdings of Treasury securities of principal payments from the Federal at approximately $2.4 trillion and holdings Reserve’s holdings of agency debt and agency of agency and agency MBS at approximately MBS received during each calendar month in $1.7 trillion (figure 46). excess of $8 billion. Over the second quarter, payments of principal from maturing Treasury The Federal Reserve’s implementation of securities and from the Federal Reserve’s monetary policy has continued smoothly holdings of agency debt and agency MBS were reinvested to the extent that they exceeded To implement the FOMC’s decisions to raise $18 billion and $12 billion, respectively. At the target range for the federal funds rate in its meeting in June, the FOMC increased the March and June of 2018, the Federal Reserve cap for Treasury securities to $24 billion and increased the rate of interest on excess reserves the cap for agency debt and agency MBS (IOER) along with the interest rate offered to $16 billion, both effective in July. The on overnight reverse repurchase agreements Committee has indicated that the caps for (ON RRPs). Specifically, the Federal Reserve Treasury securities and for agency securities increased the IOER rate to 1¾ percent and will increase to $30 billion and $20 billion per the ON RRP offering rate to 1½ percent in month, respectively, in October. These terminal March. In June, the Federal Reserve increased caps will remain in place until the Committee the IOER rate to 1.95 percent—5 basis points judges that the Federal Reserve is holding no below the top of the target range—and the more securities than necessary to implement ON RRP offering rate to 1¾ percent. In monetary policy efficiently and effectively. addition, the Board of Governors approved 46. Federal Reserve assets and liabilities Weekly Trillions of dollars 5.0 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 5.0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 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 July 4, 2018. SOURCE: Federal Reserve Board, Statistical Release H.4.1, “Factors Affecting Reserve Balances.” MONETARy POLICy REPORT: JULy 2018 43 a ¼ percentage point increase in the discount was trading near the top of the target range. rate (the primary credit rate) in both March At its June meeting, the Committee made a and June. Yields on a broad set of money small technical adjustment in its approach market instruments moved higher, roughly in to implementing monetary policy by setting line with the federal funds rate, in response the IOER rate modestly below the top of the to the FOMC’s policy decisions in March target range for the federal funds rate. This and June. Usage of the ON RRP facility adjustment resulted in the effective federal has declined, on net, since the turn of the funds rate running closer to the middle of the year, reflecting relatively attractive yields on target range since mid-June. In an environment alternative investments. of large reserve balances, the IOER rate has been an essential policy tool for keeping the The effective federal funds rate moved up federal funds rate within the target range set by toward the IOER rate in the months before the FOMC (see the box “Interest on Reserves the June FOMC meeting and, therefore, and Its Importance for Monetary Policy”). 44 PART 2: MONETARy POLICy Interest on Reserves and Its Importance for Monetary Policy The financial crisis that began in 2007 triggered the As the economic expansion continued and deepest recession in the United States since the Great unemployment declined—and with labor market Depression. In response, the Federal Open Market conditions projected to continue improving—the Committee (FOMC) cut its target for the federal funds FOMC decided that it would scale back policy rate to nearly zero by late 2008. Other short-term support by increasing the level of short-term interest interest rates declined roughly in line with the federal rates and by reducing the Federal Reserve’s securities funds rate. Additional monetary stimulus was necessary holdings. To that end, the Committee began gradually to address the significant economic downturn and raising its target range for the federal funds rate in the associated downward pressure on inflation. The December 2015. Later, in October 2017, it began FOMC undertook other monetary policy actions to gradually reducing holdings of Treasury and agency put downward pressure on longer-term interest rates, securities; this gradual reduction results in a decline in including large-scale purchases of longer-term Treasury the supply of reserve balances. The FOMC judged that securities and agency-guaranteed mortgage-backed removing monetary policy stimulus through this mix of securities. first raising the federal funds rate and then beginning These policy actions made financial conditions more to shrink the balance sheet would best contribute to accommodative and helped spur an economic recovery achieving and maintaining maximum employment and that has become a long-lasting economic expansion. price stability without causing dislocations in financial The unemployment rate has declined from 10 percent markets or institutions that could put the economic to less than 4 percent over the course of the recovery expansion at risk. and expansion, and inflation has been low and fairly Interest on reserves—the payment of interest on stable. The FOMC’s actions were critical to fostering balances held by banks in their accounts at the Federal progress toward maximum employment and stable Reserve—has been an essential policy tool that has prices—the statutory goals for the conduct of monetary permitted the FOMC to achieve a gradual increase in policy established by the Congress. the federal funds rate in combination with a gradual The Federal Reserve’s large-scale asset purchases reduction in the Fed’s securities holdings and in the had the side effect of generating a sizable increase in supply of reserve balances.3 Interest on reserves is a the supply of reserve balances, which are the balances monetary policy tool used by all of the world’s major that banks maintain in their accounts at the Federal central banks. Reserve.1 From the onset of the financial crisis in Interest on reserves is the principal tool the FOMC August 2007 until October 2014, when the FOMC uses to anchor the federal funds rate in the target range. ended the last of its asset purchase programs, the The federal funds rate, in turn, establishes an important supply of reserve balances rose from about $15 billion benchmark for the borrowing and lending decisions to about $2½ trillion.2 Reserve balances rose well in the banking sector (figure A). When the Federal above the level necessary to meet reserve requirements, Reserve increases the target range for the federal funds thus swelling the quantity of excess reserves held by the rate and the interest rate it pays on reserve balances, banking system. banks bid up the rates in short-term funding markets to levels consistent with those increases; rates in other short-term funding markets—such as commercial paper rates, Treasury bill rates, and rates on repurchase 1. All depository institutions (commercial banks, savings (continued) banks, thrift institutions, credit unions, and most U.S. branches and agencies of foreign banks) that maintain reserve balances are eligible to earn interest on those balances. We refer to 3. The Financial Services Regulatory Relief Act of 2006 these institutions as “banks.” authorized the Federal Reserve Banks to pay interest on 2. For a detailed discussion of how the changes in Federal balances held by or on behalf of depository institutions at Reserve securities holdings affect the Federal Reserve’s Federal Reserve Banks, subject to regulations of the Board of balance sheet and sectors of the U.S. economy, see Jane Governors, effective October 1, 2011. The effective date of this Ihrig, Lawrence Mize, and Gretchen C. Weinbach (2017), authority was changed to October 1, 2008, by the Emergency “How Does the Fed Adjust Its Securities Holdings and Who Is Economic Stabilization Act of 2008. The Congress authorized Affected?” Finance and Economics Discussion Series 2017- the payment of interest on reserves to help minimize the 099 (Washington: Board of Governors of the Federal Reserve incentives for costly reserve avoidance schemes and to provide System, September), https://www.federalreserve.gov/econres/ the Federal Reserve with a policy tool that could be useful for feds/files/2017099pap.pdf. monetary policy implementation more broadly. MONETARy POLICy REPORT: JULy 2018 45 A. Overnight money market rates B. Term money market rates Daily Basis points Daily Basis points Target range 250 Target range 250 Interest on reserves 225 225 200 200 Eurodollar 175 175 150 150 Treasury GCF repo 125 3-month AA financial 125 commercial paper 100 100 75 Interest on reserves 75 Federal funds 50 50 25 3-month Treasury bill 25 0 0 2016 2017 2018 2016 2017 2018 NOTE: The upper bound of the target range is the interest on reserves rate NOTE: The upper bound of the target range is the interest on reserves rate until June 13, 2018, after which it is 5 basis points higher. The federal funds until June 13, 2018, after which it is 5 basis points higher. and Eurodollar rates closely track one another over the period shown. GCF is SOURCE: For U.S. Treasury bill, Department of the Treasury; for AA General Collateral Finance. financial commercial paper, interest on reserves, and target range, Federal SOURCE: For Treasury GCF repo, DTCC Solutions LLC, an affiliate of The Reserve Board. Depository Trust & Clearing Corporation; for federal funds, Federal Reserve Bank of New York; for Eurodollar, Bloomberg; for interest on reserves and target range, Federal Reserve Board. agreements—all tend to move higher as well (figure B). is higher than the interest it pays on reserve balances. This increase in the general level of short-term rates, Each year, the Federal Reserve remits its earnings— together with the expected future path of short-term that is, its income net of expenses—to the Treasury rates, then influences the level of other financial asset Department; in 2017, remittances totaled more than prices and overall financial conditions in the economy. $80 billion. Thus, changing the interest rate on reserves has proven Had the Federal Reserve not been able to pay to be an effective tool for transmitting changes in the interest on reserve balances at the same time that FOMC’s target range for the federal funds rate to other excess reserves in the banking system were large, it interest rates in the economy. would not have been able to gradually raise the federal The rate of interest the Federal Reserve pays on funds rate and other short-term interest rates while banks’ reserve balances is far lower than the rate that reserve balances were abundant; the FOMC would banks can earn on alternative safe assets, including have had to take a different approach to scaling back most U.S. government or agency securities, municipal monetary policy accommodation. This approach likely securities, and loans to businesses and consumers.4 would have involved a rapid and sizable reduction Indeed, the bank prime rate—the base rate that banks in the Federal Reserve’s securities holdings in order use for loans to many of their customers—is currently to put sufficient upward pressure on interest rates. around 300 basis points above the level of interest on (continued on next page) reserves. Banks continue to find lending attractive, and bank lending has been expanding at a solid pace Regulation D defines short-term interest rates for the purposes since 2012. Households have begun to see interest of this authority as “rates on obligations with maturities of rates on retail deposits rising as well. Moreover, the no more than one year, such as the primary credit rate and configuration of interest rates implies that the return rates on term federal funds, term repurchase agreements, the Federal Reserve earns on its holdings of securities commercial paper, term Eurodollar deposits, and other similar instruments.” The rate of interest on reserves has been well within a range of short-term interest rates as defined in Board 4. The Congress’s authorization allows the Federal regulations. For current rates on a number of short-term money Reserve to pay interest on deposits maintained by depository market instruments, see Board of Governors of the Federal institutions at a rate not to exceed the “general level of Reserve System, Statistical Release H.15, “Selected Interest short-term interest rates.” The Federal Reserve Board’s Rates,” www.federalreserve.gov/releases/h15/current. 46 PART 2: MONETARy POLICy Interest on Reserves (continued) Getting the pace of asset sales just right for achieving yet known, that level is likely to be much lower than it the Federal Reserve’s objectives would have been is today, though appreciably higher than it was before extremely challenging. Such an approach to removing the crisis.6 In addition, the amount of U.S. currency— accommodation would have run the risk of disrupting Federal Reserve notes—that people in the United States financial markets, with adverse effects on the economy. and elsewhere want to hold has increased substantially Indeed, as observed during the early summer of since the crisis. If banks want to hold more reserve 2013, market reactions to changes in the outlook for balances and the public wants to hold more U.S. the Federal Reserve’s holdings of long-term securities currency than before the crisis, the Federal Reserve will can have outsized effects in bond markets. At that time, need to supply the reserves and currency, so the Federal FOMC communications that pointed to the eventual Reserve’s securities holdings also will have to be larger cessation of asset purchases seemed to alarm investors than before the financial crisis.7 and reportedly contributed to a rise in longer-term rates Interest on reserves will remain an important policy of 150 basis points over just a few months. That rise in tool for keeping the federal funds rate within the target rates quickly pushed up the cost of mortgage credit and range set by the FOMC and thus managing the level of rates on other forms of borrowing for households and short-term interest rates, even as the ongoing reduction businesses. in the Federal Reserve’s securities holdings generates a Thus, Federal Reserve policymakers judged that gradual decline in the amount of reserve balances on the best strategy for adjusting the stance of monetary which the Federal Reserve pays interest. In June 2018, policy would be gradual increases in the target range the Federal Reserve made a small technical adjustment for the federal funds rate, supplemented later on by to de-link the rate of interest on reserves from the top gradual reductions in the Federal Reserve’s securities of the Committee’s target range for the federal funds holdings. The ongoing, gradual reduction in the Federal rate. At the June 2018 FOMC meeting, the Committee Reserve’s securities holdings that the FOMC set in increased the federal funds target range by 25 basis motion in 2017 will bring the level of reserve balances points, while the rate of interest on reserve balances down substantially over the next few years. The size was increased by 20 basis points. This change is of reserves that banks eventually want to hold will intended to ensure that the federal funds rate continues reflect balances held to meet reserve requirements and to trade well within the Committee’s target range. The payments needs as well as balances held to address spread between the effective federal funds rate and the regulatory and structural changes in the banking system rate of interest on reserves could continue to narrow since the financial crisis.5 Although the level of reserve over time as the Federal Reserve’s securities holdings balances that banks will eventually want to hold is not and the supply of reserve balances gradually decline. 5. For a discussion of the changes in the banking system 6. Uncertainty about the eventual level of reserve balances since the financial crisis and their potential effects on the is another reason that the FOMC has been reducing the demand for reserve balances, see Randal K. Quarles (2018), Federal Reserve’s holdings of securities, and the supply of “Liquidity Regulation and the Size of the Fed’s Balance Sheet,” reserve balances, gradually. speech delivered at “Currencies, Capital, and Central Bank 7. Currency grows roughly in line with nominal gross Balances: A Policy Conference,” Hoover Institution, Stanford domestic product. In December 2008, currency in circulation University, Stanford, Calif., May 4, https://www.federalreserve. was around $850 billion, compared with $1.6 trillion at the gov/newsevents/speech/quarles20180504a.htm. end of June 2018. 47 P 3 art s e P ummary of conomic rojections The following material appeared as an addendum to the minutes of the June 12–13, 2018, 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, throughout the on June 12–13, 2018, meeting participants projection period, the unemployment rate submitted their projections of the most likely would run below their estimates of its longer- outcomes for real gross domestic product run level. All participants projected that (GDP) growth, the unemployment rate, and inflation, as measured by the four-quarter inflation for each year from 2018 to 2020 percentage change in the price index for and over the longer run.17 Each participant’s personal consumption expenditures (PCE), projections were based on information would run at or slightly above the Committee’s available at the time of the meeting, together 2 percent objective by the end of 2018 and with his or her assessment of appropriate remain roughly flat through 2020. Compared monetary policy—including a path for the with the Summary of Economic Projections federal funds rate and its longer-run value— (SEP) from March, most participants slightly and assumptions about other factors likely marked up their projections of real GDP to affect economic outcomes. The longer- growth in 2018 and somewhat lowered their run projections represent each participant’s projections for the unemployment rate from assessment of the value to which each variable 2018 through 2020; participants indicated would be expected to converge, over time, that these revisions reflected, in large part, under appropriate monetary policy and in the strength in incoming data. A large majority of absence of further shocks to the economy.18 participants made slight upward adjustments “Appropriate monetary policy” is defined as to their projections of inflation in 2018. the future path of policy that each participant Table 1 and figure 1 provide summary statistics deems most likely to foster outcomes for for the projections. economic activity and inflation that best satisfy his or her individual interpretation of As shown in figure 2, participants generally the statutory mandate to promote maximum continued to expect that the evolution of employment and price stability. the economy relative to their objectives of maximum employment and 2 percent All participants who submitted longer-run inflation would likely warrant further gradual projections expected that, in 2018, real GDP increases in the federal funds rate. The central would expand at a pace exceeding their tendencies of participants’ projections of the individual estimates of the longer-run growth federal funds rate for both 2018 and 2019 rate of real GDP. Participants generally saw were roughly unchanged, but the medians real GDP growth moderating somewhat in for both years were 25 basis points higher each of the following two years but remaining relative to March. Nearly all participants who above their estimates of the longer-run rate. submitted longer-run projections expected that, during part of the projection period, 17. Three members of the Board of Governors were in evolving economic conditions would make it office at the time of the June 2018 meeting. appropriate for the federal funds rate to move 18. One participant did not submit longer-run somewhat above their estimates of its longer- projections for real GDP growth, the unemployment rate, or the federal funds rate. run level. 48 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 2018 Percent Median1 Central tendency2 Range3 Variable Longer Longer Longer 2018 2019 2020 2018 2019 2020 2018 2019 2020 run run run Change in real GDP ..... 2.8 2.4 2.0 1.8 2.7–3.0 2.2–2.6 1.8–2.0 1.8–2.0 2.5–3.0 2.1–2.7 1.5–2.2 1.7–2.1 March projection ...... 2.7 2.4 2.0 1.8 2.6–3.0 2.2–2.6 1.8–2.1 1.8–2.0 2.5–3.0 2.0–2.8 1.5–2.3 1.7–2.2 Unemployment rate. . . . . . 3.6 3.5 3.5 4.5 3.6–3.7 3.4–3.5 3.4–3.7 4.3–4.6 3.5–3.8 3.3–3.8 3.3–4.0 4.1–4.7 March projection ...... 3.8 3.6 3.6 4.5 3.6–3.8 3.4–3.7 3.5–3.8 4.3–4.7 3.6–4.0 3.3–4.2 3.3–4.4 4.2–4.8 PCE inflation ............ 2.1 2.1 2.1 2.0 2.0–2.1 2.0–2.2 2.1–2.2 2.0 2.0–2.2 1.9–2.3 2.0–2.3 2.0 March projection ...... 1.9 2.0 2.1 2.0 1.8–2.0 2.0–2.2 2.1–2.2 2.0 1.8–2.1 1.9–2.3 2.0–2.3 2.0 Core PCE inflation4 ...... 2.0 2.1 2.1 1.9–2.0 2.0–2.2 2.1–2.2 1.9–2.1 2.0–2.3 2.0–2.3 March projection ...... 1.9 2.1 2.1 1.8–2.0 2.0–2.2 2.1–2.2 1.8–2.1 1.9–2.3 2.0–2.3 Memo: Projected appropriate policy path Federal funds rate ....... 2.4 3.1 3.4 2.9 2.1–2.4 2.9–3.4 3.1–3.6 2.8–3.0 1.9–2.6 1.9–3.6 1.9–4.1 2.3–3.5 March projection ...... 2.1 2.9 3.4 2.9 2.1–2.4 2.8–3.4 3.1–3.6 2.8–3.0 1.6–2.6 1.6–3.9 1.6–4.9 2.3–3.5 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 20–21, 2018. 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 20–21, 2018, meeting, and one participant did not submit such projections in conjunction with the June 12–13, 2018, 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. In general, participants continued to view mentioned accommodative monetary policy the uncertainty attached to their economic and financial conditions, strength in the global projections as broadly similar to the outlook, continued momentum in the labor average of the past 20 years. As in March, market, or positive readings on business and most participants judged the risks around consumer sentiment as important factors their projections for real GDP growth, the shaping the economic outlook. Compared with unemployment rate, and inflation to be the March SEP, the median of participants’ broadly balanced. projections for the rate of real GDP growth was 0.1 percentage point higher for this year The Outlook for Economic Activity and unchanged for the next two years. The median of participants’ projections for Almost all participants expected the the growth rate of real GDP, conditional on unemployment rate to decline somewhat their individual assessments of appropriate further over the projection period. The monetary policy, was 2.8 percent for this year median of participants’ projections for the and 2.4 percent for next year. The median unemployment rate was 3.6 percent for the was 2.0 percent for 2020, a touch above the final quarter of this year and 3.5 percent median projection of longer-run growth. Most for the final quarters of 2019 and 2020. The participants continued to cite fiscal policy as median of participants’ estimates of the a driver of strong economic activity over the longer-run unemployment rate was unchanged next couple of years. Many participants also at 4.5 percent. MONETARy POLICy REPORT: JULy 2018 49 Figure 1. Medians, central tendencies, and ranges of economic projections, 2018–20 and over the longer run Percent Change in real GDP Median of projections Central tendency of projections Range of projections 3 Actual 2 1 2013 2014 2015 2016 2017 2018 2019 2020 Longer run Percent Unemployment rate 7 6 5 4 3 2013 2014 2015 2016 2017 2018 2019 2020 Longer run Percent PCE inflation 3 2 1 2013 2014 2015 2016 2017 2018 2019 2020 Longer run Percent Core PCE inflation 3 2 1 2013 2014 2015 2016 2017 2018 2019 2020 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. 50 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 2018 2019 2020 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. Figures 3.A and 3.B show the distributions of The Outlook for Inflation participants’ projections for real GDP growth and the unemployment rate from 2018 to 2020 The medians of participants’ projections for and over the longer run. The distribution of total and core PCE price inflation in 2018 were individual projections for real GDP growth 2.1 percent and 2.0 percent, respectively, and this year shifted up noticeably from that in the the median for each measure was 2.1 percent March SEP. By contrast, the distributions of in 2019 and 2020. Compared with the March projected real GDP growth in 2019 and 2020 SEP, the medians of participants’ projections and over the longer run were little changed. for total PCE price inflation for this year and The distributions of individual projections for next were revised up slightly. Some participants the unemployment rate in 2018 to 2020 pointed to incoming data on energy prices shifted down relative to the distributions as a reason for their upward revisions. The in March, while the downward shift in the median of participants’ forecasts for core PCE distribution of longer-run projections was price inflation was up a touch for this year and very modest. unchanged for subsequent years. MONETARy POLICy REPORT: JULy 2018 51 Figures 3.C and 3.D provide information on funds rate over the next few years would the distributions of participants’ views about likely involve gradual increases. This view the outlook for inflation. The distributions was predicated on several factors, including a of both total and core PCE price inflation judgment that a gradual path of policy firming for 2018 shifted to the right relative to the likely would appropriately balance the risks distributions in March. The distributions of associated with, among other considerations, projected inflation in 2019, 2020, and over the possibilities that U.S. fiscal policy could the longer run were roughly unchanged. have larger or more persistent positive effects Participants generally expected each measure on real activity and that shifts in trade policy to be at or slightly above 2 percent in or developments abroad could weigh on 2019 and 2020. the expansion. As always, the appropriate path of the federal funds rate would depend Appropriate Monetary Policy on evolving economic conditions and their implications for participants’ economic Figure 3.E provides the distribution of outlooks and assessments of risks. participants’ judgments regarding the appropriate target—or midpoint of the target Uncertainty and Risks range—for the federal funds rate at the end of each year from 2018 to 2020 and over the In assessing the path for the federal funds rate longer run. The distributions of projected that, in their view, is likely to be appropriate, policy rates through 2020 shifted modestly FOMC participants take account of the range higher, consistent with the revisions to of possible economic outcomes, the likelihood participants’ projections of real GDP growth, of those outcomes, and the potential benefits the unemployment rate, and inflation. As and costs should they occur. As a reference, in their March projections, a large majority table 2 provides measures of forecast of participants anticipated that evolving uncertainty, based on the forecast errors of economic conditions would likely warrant various private and government forecasts the equivalent of a total of either three or over the past 20 years, for real GDP growth, four increases of 25 basis points in the target the unemployment rate, and total PCE price range for the federal funds rate over 2018. inflation. Those measures are represented There was a slight reduction in the dispersion of participants’ views, with no participant Table 2. Average historical projection error ranges regarding the appropriate target at the end of Percentage points the year to be below 1.88 percent. For each subsequent year, the dispersion of participants’ Variable 2018 2019 2020 year-end projections was somewhat smaller Change in real GDP1 ....... ±1.3 ±2.0 ±2.1 than that in the March SEP. Unemployment rate1 ....... ±0.4 ±1.2 ±1.8 Total consumer prices2 ..... ±0.7 ±1.0 ±1.0 The medians of participants’ projections Short-term interest rates3 ... ±0.7 ±2.0 ±2.2 of the federal funds rate rose gradually to Note: Error ranges shown are measured as plus or minus the root mean squared error of projections for 1998 through 2017 that were released in the summer by var- 2.4 percent at the end of this year, 3.1 percent 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 at the end of 2019, and 3.4 percent at the end outcomes for real GDP, unemployment, consumer prices, and the federal funds rate will be in ranges implied by the average size of projection errors made in the past. of 2020. The median of participants’ longer- For more information, see David Reifschneider and Peter Tulip (2017), “Gauging run estimates, at 2.9 percent, was unchanged the Uncertainty of the Economic Outlook Using Historical Forecasting Errors: The Federal Reserve’s Approach,” Finance and Economics Discussion Series 2017-020 relative to the March SEP. (Washington: Board of Governors of the Federal Reserve System, February), www .federalreserve.gov/econresdata/feds/2017/files/2017020pap.pdf. 1. Definitions of variables are in the general note to table 1. 2. Measure is the overall consumer price index, the price measure that has been In discussing their projections, many most widely used in government and private economic forecasts. Projections are percent changes on a fourth quarter to fourth quarter basis. participants continued to express the view 3. For Federal Reserve staff forecasts, measure is the federal funds rate. For other forecasts, measure is the rate on 3-month Treasury bills. Projection errors are that the appropriate trajectory of the federal calculated using average levels, in percent, in the fourth quarter. 52 PART 3: SUMMARy OF ECONOMIC PROJECTIONS Figure 3.A. Distribution of participants’ projections for the change in real GDP, 2018–20 and over the longer run Number of participants 2018 June projections 18 March projections 16 14 12 10 8 6 4 2 1.4 – – – – – – –1. 6 – – 1 .8 2.0 2.2 2.4 2.6 2.8 3.0 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 Percent range Number of participants 2019 18 16 14 12 10 8 6 4 2 1.4 – – – – – – –1. 6 – – 1 .8 2.0 2.2 2.4 2.6 2.8 3.0 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 Percent range Number of participants 2020 18 16 14 12 10 8 6 4 2 1.4 – – – – – – –1. 6 – – 1 .8 2.0 2.2 2.4 2.6 2.8 3.0 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 Percent range Number of participants Longer run 18 16 14 12 10 8 6 4 2 1.4 – – – – – – –1. 6 – – 1 .8 2.0 2.2 2.4 2.6 2.8 3.0 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 Percent range Note: Definitions of variables and other explanations are in the notes to table 1. MONETARy POLICy REPORT: JULy 2018 53 Figure 3.B. Distribution of participants’ projections for the unemployment rate, 2018–20 and over the longer run Number of participants 2018 June projections 18 March projections 16 14 12 10 8 6 4 2 3.0– 3.2– 3.4– 3.6– 3.8– 4.0– 4.2– 4.4– 4.6– 4.8– 5.0– 3.1 3.3 3.5 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 3.0– 3.2– 3.4– 3.6– 3.8– 4.0– 4.2– 4.4– 4.6– 4.8– 5.0– 3.1 3.3 3.5 3.7 3.9 4.1 4.3 4.5 4.7 4.9 5.1 Percent range Number of participants 2020 18 16 14 12 10 8 6 4 2 3.0– 3.2– 3.4– 3.6– 3.8– 4.0– 4.2– 4.4– 4.6– 4.8– 5.0– 3.1 3.3 3.5 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 3.0– 3.2– 3.4– 3.6– 3.8– 4.0– 4.2– 4.4– 4.6– 4.8– 5.0– 3.1 3.3 3.5 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. 54 PART 3: SUMMARy OF ECONOMIC PROJECTIONS Figure 3.C. Distribution of participants’ projections for PCE inflation, 2018–20 and over the longer run Number of participants 2018 June projections 18 March projections 16 14 12 10 8 6 4 2 1.7– 1.9– 2.1– 2.3– 1.8 2.0 2.2 2.4 Percent range Number of participants 2019 18 16 14 12 10 8 6 4 2 1.7– 1.9– 2.1– 2.3– 1.8 2.0 2.2 2.4 Percent range Number of participants 2020 18 16 14 12 10 8 6 4 2 1.7– 1.9– 2.1– 2.3– 1.8 2.0 2.2 2.4 Percent range Number of participants Longer run 18 16 14 12 10 8 6 4 2 1.7– 1.9– 2.1– 2.3– 1.8 2.0 2.2 2.4 Percent range Note: Definitions of variables and other explanations are in the notes to table 1. MONETARy POLICy REPORT: JULy 2018 55 Figure 3.D. Distribution of participants’ projections for core PCE inflation, 2018–20 Number of participants 2018 June projections 18 March projections 16 14 12 10 8 6 4 2 1.7– 1.9– 2.1– 2.3– 1.8 2.0 2.2 2.4 Percent range Number of participants 2019 18 16 14 12 10 8 6 4 2 1.7– 1.9– 2.1– 2.3– 1.8 2.0 2.2 2.4 Percent range Number of participants 2020 18 16 14 12 10 8 6 4 2 1.7– 1.9– 2.1– 2.3– 1.8 2.0 2.2 2.4 Percent range Note: Definitions of variables and other explanations are in the notes to table 1. 56 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, 2018–20 and over the longer run Number of participants 2018 June projections 18 March projections 16 14 12 10 8 6 4 2 1.63– 1.88– 2.13– 2.38– 2.63– 2.88– 3.13– 3.38– 3.63– 3.88– 4.13– 4.38– 4.63– 4.88– 1.87 2.12 2.37 2.62 2.87 3.12 3.37 3.62 3.87 4.12 4.37 4.62 4.87 5.12 Percent range Number of participants 2019 18 16 14 12 10 8 6 4 2 1.63– 1.88– 2.13– 2.38– 2.63– 2.88– 3.13– 3.38– 3.63– 3.88– 4.13– 4.38– 4.63– 4.88– 1.87 2.12 2.37 2.62 2.87 3.12 3.37 3.62 3.87 4.12 4.37 4.62 4.87 5.12 Percent range Number of participants 2020 18 16 14 12 10 8 6 4 2 1.63– 1.88– 2.13– 2.38– 2.63– 2.88– 3.13– 3.38– 3.63– 3.88– 4.13– 4.38– 4.63– 4.88– 1.87 2.12 2.37 2.62 2.87 3.12 3.37 3.62 3.87 4.12 4.37 4.62 4.87 5.12 Percent range Number of participants Longer run 18 16 14 12 10 8 6 4 2 1.63– 1.88– 2.13– 2.38– 2.63– 2.88– 3.13– 3.38– 3.63– 3.88– 4.13– 4.38– 4.63– 4.88– 1.87 2.12 2.37 2.62 2.87 3.12 3.37 3.62 3.87 4.12 4.37 4.62 4.87 5.12 Percent range Note: Definitions of variables and other explanations are in the notes to table 1. MONETARy POLICy REPORT: JULy 2018 57 graphically in the “fan charts” shown in participants saw the risks to their projections the top panels of figures 4.A, 4.B, and 4.C. as broadly balanced. Specifically, for GDP The fan charts display the median SEP growth, only one participant viewed the risks projections for the three variables surrounded as tilted to the downside, and the number of by symmetric confidence intervals derived participants who viewed the risks as tilted from the forecast errors reported in table 2. to the upside dropped from four to two. If the degree of uncertainty attending these For the unemployment rate, the number of projections is similar to the typical magnitude participants who saw the risks as tilted toward of past forecast errors and the risks around the low readings dropped from four to two. For projections are broadly balanced, then future inflation, all but one participant judged the outcomes of these variables would have about risks to either total or core PCE price inflation a 70 percent probability of being within these as broadly balanced. confidence intervals. For all three variables, this measure of uncertainty is substantial and In discussing the uncertainty and risks generally increases as the forecast horizon surrounding their projections, several lengthens. participants continued to point to fiscal developments as a source of upside risk, Participants’ assessments of the level of many participants cited developments related uncertainty surrounding their individual to trade policy as posing downside risks to economic projections are shown in the their growth forecasts, and a few participants bottom-left panels of figures 4.A, 4.B, also pointed to political developments in and 4.C. Nearly all participants viewed Europe or the global outlook more generally the degree of uncertainty attached to their as downside-risk factors. A few participants economic projections for real GDP growth, noted that the appreciation of the dollar the unemployment rate, and inflation as posed downside risks to the inflation outlook. broadly similar to the average of the past A few participants also noted the risk of 20 years, a view that was essentially unchanged inflation moving higher than anticipated as the from March.19 unemployment rate falls. Because the fan charts are constructed to be Participants’ assessments of the appropriate symmetric around the median projections, future path of the federal funds rate were also they do not reflect any asymmetries in the subject to considerable uncertainty. Because balance of risks that participants may see the Committee adjusts the federal funds in their economic projections. Participants’ rate in response to actual and prospective assessments of the balance of risks to their developments over time in real GDP growth, economic projections are shown in the the unemployment rate, and inflation, bottom-right panels of figures 4.A, 4.B, and uncertainty surrounding the projected path 4.C. Most participants judged the risks to for the federal funds rate importantly reflects their projections of real GDP growth, the the uncertainties about the paths for those unemployment rate, total inflation, and core key economic variables. Figure 5 provides a inflation as broadly balanced—in other words, graphical representation of this uncertainty, as broadly consistent with a symmetric fan plotting the median SEP projection for the chart. Compared with March, even more federal funds rate surrounded by confidence intervals derived from the results presented 19. At the end of this summary, the box “Forecast in table 2. As with the macroeconomic Uncertainty” discusses the sources and interpretation variables, forecast uncertainty surrounding the of uncertainty surrounding the economic forecasts and appropriate path of the federal funds rate is explains the approach used to assess the uncertainty and risks attending the participants’ projections. substantial and increases for longer horizons. 58 PART 3: SUMMARy OF ECONOMIC PROJECTIONS 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 Actual 2 1 0 2013 2014 2015 2016 2017 2018 2019 2020 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, 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 2018 59 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 2013 2014 2015 2016 2017 2018 2019 2020 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.” 60 PART 3: SUMMARy OF ECONOMIC PROJECTIONS 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 2013 2014 2015 2016 2017 2018 2019 2020 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.” MONETARy POLICy REPORT: JULy 2018 61 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 1 Actual 0 2013 2014 2015 2016 2017 2018 2019 2020 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. 62 PART 3: SUMMARy OF ECONOMIC PROJECTIONS Forecast Uncertainty The economic projections provided by the members of in the bottom-left panels of those figures. Participants the Board of Governors and the presidents of the Federal also provide judgments as to whether the risks to their Reserve Banks inform discussions of monetary policy projections are weighted to the upside, are weighted to among policymakers and can aid public understanding the downside, or are broadly balanced. That is, while the of the basis for policy actions. Considerable uncertainty symmetric historical fan charts shown in the top panels of attends these projections, however. The economic and figures 4.A through 4.C imply that the risks to participants’ statistical models and relationships used to help produce projections are balanced, participants may judge that economic forecasts are necessarily imperfect descriptions there is a greater risk that a given variable will be above of the real world, and the future path of the economy rather than below their projections. These judgments can be affected by myriad unforeseen developments and are summarized in the lower-right panels of figures 4.A events. Thus, in setting the stance of monetary policy, through 4.C. participants consider not only what appears to be the As with real activity and inflation, the outlook for most likely economic outcome as embodied in their the future path of the federal funds rate is subject to projections, but also the range of alternative possibilities, considerable uncertainty. This uncertainty arises primarily the likelihood of their occurring, and the potential costs to because each participant’s assessment of the appropriate the economy should they occur. stance of monetary policy depends importantly on Table 2 summarizes the average historical accuracy the evolution of real activity and inflation over time. If of a range of forecasts, including those reported in past economic conditions evolve in an unexpected manner, Monetary Policy Reports and those prepared by the then assessments of the appropriate setting of the federal Federal Reserve Board’s staff in advance of meetings of the funds rate would change from that point forward. The Federal Open Market Committee (FOMC). The projection final line in table 2 shows the error ranges for forecasts of error ranges shown in the table illustrate the considerable short-term interest rates. They suggest that the historical uncertainty associated with economic forecasts. For confidence intervals associated with projections of the example, suppose a participant projects that real gross federal funds rate are quite wide. It should be noted, domestic product (GDP) and total consumer prices will however, that these confidence intervals are not strictly rise steadily at annual rates of, respectively, 3 percent and consistent with the projections for the federal funds 2 percent. If the uncertainty attending those projections rate, as these projections are not forecasts of the most is similar to that experienced in the past and the risks likely quarterly outcomes but rather are projections around the projections are broadly balanced, the numbers of participants’ individual assessments of appropriate reported in table 2 would imply a probability of about monetary policy and are on an end-of-year basis. 70 percent that actual GDP would expand within a range However, the forecast errors should provide a sense of the of 1.7 to 4.3 percent in the current year, 1.0 to 5.0 percent uncertainty around the future path of the federal funds rate in the second year, and 0.9 to 5.1 percent in the third generated by the uncertainty about the macroeconomic year. The corresponding 70 percent confidence intervals variables as well as additional adjustments to monetary for overall inflation would be 1.3 to 2.7 percent in the policy that would be appropriate to offset the effects of current year and 1.0 to 3.0 percent in the second and third shocks to the economy. years. Figures 4.A through 4.C illustrate these confidence If at some point in the future the confidence interval bounds in “fan charts” that are symmetric and centered on around the federal funds rate were to extend below zero, the medians of FOMC participants’ projections for GDP it would be truncated at zero for purposes of the fan chart growth, the unemployment rate, and inflation. However, shown in figure 5; zero is the bottom of the lowest target in some instances, the risks around the projections may range for the federal funds rate that has been adopted not be symmetric. In particular, the unemployment rate by the Committee in the past. This approach to the cannot be negative; furthermore, the risks around a construction of the federal funds rate fan chart would be particular projection might be tilted to either the upside or merely a convention; it would not have any implications the downside, in which case the corresponding fan chart for possible future policy decisions regarding the use of would be asymmetrically positioned around the median negative interest rates to provide additional monetary projection. policy accommodation if doing so were appropriate. In Because current conditions may differ from those that such situations, the Committee could also employ other prevailed, on average, over history, participants provide tools, including forward guidance and asset purchases, to judgments as to whether the uncertainty attached to provide additional accommodation. their projections of each economic variable is greater While figures 4.A through 4.C provide information on than, smaller than, or broadly similar to typical levels the uncertainty around the economic projections, figure 1 of forecast uncertainty seen in the past 20 years, as provides information on the range of views across FOMC presented in table 2 and reflected in the widths of the participants. A comparison of figure 1 with figures 4.A confidence intervals shown in the top panels of figures through 4.C shows that the dispersion of the projections 4.A through 4.C. Participants’ current assessments of the across participants is much smaller than the average uncertainty surrounding their projections are summarized forecast errors over the past 20 years. 63 a bbreviations AFE advanced foreign economy BBA Bipartisan Budget Act of 2018 BLS Bureau of Labor Statistics C&I commercial and industrial Desk Open Market Desk at the Federal Reserve Bank of New York DPI disposable personal income ECB European Central Bank EME emerging market economy FOMC Federal Open Market Committee; also, the Committee GDP gross domestic product IOER interest on excess reserves JOLTS Job Openings and Labor Turnover Survey LFPR labor force participation rate MBS mortgage-backed securities Michigan survey University of Michigan Surveys of Consumers OIS overnight index swap ON RRP overnight reverse repurchase agreement PCE personal consumption expenditures SEP Summary of Economic Projections SLOOS Senior Loan Officer Opinion Survey on Bank Lending Practices S&P Standard & Poor’s TCJA Tax Cuts and Jobs Act TIPS Treasury Inflation-Protected Securities VIX implied volatility for the S&P 500 index For use at 11:00 a.m., EDT July 13, 2018 M P r onetary olicy ePort July 13, 2018 Board of Governors of the Federal Reserve System

Federal Reserve (2018, July 12). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20180713

@misc{wtfs_monetary_policy_report_20180713,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2018},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20180713},
  note = {Retrieved via When the Fed Speaks corpus}
}