Monetary Policy Report

For use at 11:00 a.m., EST February 22, 2019 M P r onetary olicy ePort February 22, 2019 Board of Governors of the Federal Reserve System L t etter of ransmittaL Board of Governors of the Federal Reserve System Washington, D.C., February 22, 2019 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 L -r g m P S tatement on onger un oaLS and onetary oLicy trategy Adopted effective January 24, 2012; as amended effective January 29, 2019 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 4.4 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Part 1: Recent Economic and Financial Developments . . . . . . . . . . . . . . . . . 5 Domestic Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Financial Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 International Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Part 2: Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 List of Boxes Employment Disparities between Rural and Urban Areas . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Developments Related to Financial Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Monetary Policy Rules and Systematic Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 The Role of Liabilities in Determining the Size of the Federal Reserve’s Balance Sheet . . . . . 41 Federal Reserve Transparency: Rationale and New Initiatives . . . . . . . . . . . . . . . . . . . . . . . . 45 Forecast Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 note: This report reflects information that was publicly available as of noon EST on February 21, 2019. Unless otherwise stated, the time series in the figures extend through, for daily data, February 20, 2019; for monthly data, January 2019; and, for quarterly data, 2018:Q4. 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 © 2019 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. 1 s ummary Economic activity in the United States year to an estimated 1.7 percent in December, appears to have increased at a solid pace, on restrained by recent declines in consumer balance, over the second half of 2018, and the energy prices. The 12-month measure of labor market strengthened further. Inflation inflation that excludes food and energy items has been near the Federal Open Market (so-called core inflation), which historically Committee’s (FOMC) longer-run objective has been a better indicator of where overall of 2 percent, aside from the transitory effects inflation will be in the future than the headline of recent energy price movements. In this measure that includes those items, is estimated environment, the FOMC judged that, on to have been 1.9 percent in December—up balance, current and prospective economic ¼ percentage point from a year ago. Survey- conditions called for a further gradual removal based measures of longer-run inflation of policy accommodation. In particular, the expectations have generally been stable, FOMC raised the target range for the federal though market-based measures of inflation funds rate twice in the second half of 2018, compensation have moved down some since putting its level at 2¼ to 2½ percent following the first half of 2018. the December meeting. In light of softer global economic and financial conditions late Economic growth. Available indicators suggest in the year and muted inflation pressures, the that real gross domestic product (GDP) FOMC indicated at its January meeting that increased at a solid rate, on balance, in the it will be patient as it determines what future second half of last year and rose a little under adjustments to the federal funds rate may 3 percent for the year as a whole—a noticeable be appropriate to support the Committee’s pickup from the pace in recent years. congressionally mandated objectives of Consumer spending expanded at a strong maximum employment and price stability. rate for most of the second half, supported by robust job gains, past increases in household Economic and Financial wealth, and higher disposable income due in Developments part to the Tax Cuts and Jobs Act, though spending appears to have weakened toward The labor market. The labor market has year-end. Business investment grew as well, continued to strengthen since the middle of though growth seems to have slowed somewhat last year. Payroll employment growth has from a sizable gain in the first half. However, remained strong, averaging 224,000 per month housing market activity declined last year since June 2018. The unemployment rate amid rising mortgage interest rates and higher has been about unchanged over this period, material and labor costs. Indicators of both averaging a little under 4 percent—a low level consumer and business sentiment remain by historical standards—while the labor force at favorable levels, but some measures have participation rate has moved up despite the softened since the fall, likely a reflection of ongoing downward influence from an aging financial market volatility and increased population. Wage growth has also picked concerns about the global outlook. up recently. Financial conditions. Domestic financial Inflation. Consumer price inflation, as conditions for businesses and households have measured by the 12-month change in the price become less supportive of economic growth index for personal consumption expenditures, since July. Financial market participants’ moved down from a little above the FOMC’s appetite for risk deteriorated markedly in the objective of 2 percent in the middle of last latter part of last year amid investor concerns 2 SUMMARy about downside risks to the growth outlook International Developments. Foreign economic and rising trade tensions between the United growth stepped down significantly last year States and China. As a result, Treasury yields from the brisk pace in 2017. Aggregate growth and risky asset prices declined substantially in the advanced foreign economies slowed between early October and late December in markedly, especially in the euro area, and the midst of heightened volatility, although several Latin American economies continued those moves partially retraced early this year. to underperform. The pace of economic On balance since July, the expected path of the activity in China slowed noticeably in the federal funds rate over the next several years second half of 2018. Inflation pressures in shifted down, long-term Treasury yields and major advanced foreign economies remain mortgage rates moved lower, broad measures subdued, prompting central banks to maintain of U.S. equity prices increased somewhat, accommodative monetary policies. and spreads of yields on corporate bonds over those on comparable-maturity Treasury Financial conditions abroad tightened in the securities widened modestly. Credit to large second half of 2018, in part reflecting political nonfinancial firms remained solid in the second uncertainty in Europe and Latin America, half of 2018; corporate bond issuance slowed trade policy developments in the United States considerably toward the end of the year but and its trading partners, as well as concerns has rebounded since then. Despite increases about moderating global growth. Although in interest rates for consumer loans, consumer financial conditions abroad improved in recent credit expanded at a solid pace, and financing weeks, alongside those in the United States, on conditions for consumers largely remain balance since July 2018, global equity prices supportive of growth in household spending. were lower, sovereign yields in many economies The foreign exchange value of the U.S. dollar declined, and sovereign credit spreads in the strengthened slightly against the currencies of European periphery and the most vulnerable the U.S. economy’s trading partners. emerging market economies increased somewhat. Market-implied paths of policy rates in advanced foreign economies generally Financial stability. The U.S. financial system edged down. remains substantially more resilient than in the decade preceding the financial crisis. Monetary Policy Pressures associated with asset valuations eased compared with July 2018, particularly Interest rate policy. As the labor market in the equity, corporate bond, and leveraged continued to strengthen and economic loan markets. Regulatory capital and liquidity activity expanded at a strong rate, the FOMC ratios of key financial institutions, including increased the target range for the federal large banks, are at historically high levels. funds rate gradually over the second half of Funding risks in the financial system are 2018. Specifically, the FOMC decided to raise low relative to the period leading up to the the federal funds rate in September and in crisis. Borrowing by households has risen December, bringing it to the current range of roughly in line with household incomes and 2¼ to 2½ percent. is concentrated among prime borrowers. While debt owed by businesses is high and In December, against the backdrop of credit standards—especially within segments increased concerns about global growth, of the loan market focused on lower-rated or trade tensions, and volatility in financial unrated firms—deteriorated in the second half markets, the Committee indicated it would of 2018, issuance of these loans has slowed monitor global economic and financial more recently. developments and assess their implications for MONETARy POLICy REPORT: FEBRUARy 2019 3 the economic outlook. In January, the FOMC required. In addition, the Committee noted stated that it continued to view sustained that it is prepared to adjust any of the details expansion of economic activity, strong labor for completing balance sheet normalization in market conditions, and inflation near the light of economic and financial developments. Committee’s 2 percent objective as the most likely outcomes. Nonetheless, in light of Special Topics global economic and financial developments and muted inflation pressures, the Committee Labor markets in urban versus rural areas. noted that it will be patient as it determines The recovery in the U.S. labor market since what future adjustments to the target range the end of the recession has been uneven for the federal funds rate may be appropriate across the country, with rural areas showing to support these outcomes. FOMC markedly less improvement than cities and communications continued to emphasize their surrounding metropolitan areas. In that the Committee’s approach to setting the particular, the employment-to-population stance of policy should be importantly guided ratio and labor force participation rate in rural by the implications of incoming data for the areas remain well below their pre-recession economic outlook. In particular, the timing levels, while the recovery in urban areas has and size of future adjustments to the target been more complete. Differences in the mix of range for the federal funds rate will depend industries in rural and urban areas—a larger on the Committee’s assessment of realized share of manufacturing in rural areas and a and expected economic conditions relative to greater concentration of fast-growing services its maximum-employment objective and its industries in urban areas—have contributed to symmetric 2 percent inflation objective. the stronger rebound in urban areas. (See the box “Employment Disparities between Rural Balance sheet policy. The FOMC continued and Urban Areas” in Part 1.) to implement the balance sheet normalization program that has been under way since Monetary policy rules. In evaluating the October 2017. Specifically, the FOMC stance of monetary policy, policymakers reduced its holdings of Treasury and agency consider a wide range of information on the securities in a gradual and predictable manner current economic conditions and the outlook. by reinvesting only principal payments it Policymakers also consult prescriptions for the received from these securities that exceeded policy interest rate derived from a variety of gradually rising caps. Consequently, the policy rules for guidance, without mechanically Federal Reserve’s total assets declined by about following the prescriptions of any specific $260 billion since the middle of last year, rule. The FOMC’s approach for conducting ending the period close to $4 trillion. systematic monetary policy provides sufficient flexibility to address the intrinsic complexities Together with the January postmeeting and uncertainties in the economy while statement, the Committee released an keeping monetary policy predictable and updated Statement Regarding Monetary transparent. (See the box “Monetary Policy Policy Implementation and Balance Sheet Rules and Systematic Monetary Policy” in Normalization to provide additional Part 2.) information about its plans to implement monetary policy over the longer run. In Balance sheet normalization and monetary particular, the FOMC stated that it intends policy implementation. Since the financial to continue to implement monetary policy crisis, the size of the Federal Reserve’s balance in a regime with an ample supply of reserves sheet has been determined in large part so that active management of reserves is not by its decisions about asset purchases for 4 SUMMARy economic stimulus, with growth in total assets Transparency also enhances the effectiveness primarily matched by higher reserve balances of monetary policy and a central bank’s of depository institutions. However, liabilities efforts to promote financial stability. For other than reserves have grown significantly these reasons, the Federal Reserve uses a over the past decade. In the longer run, the wide variety of communications to explain size of the balance sheet will be importantly its policymaking approach and decisions determined by the various factors affecting the as clearly as possible. Through several new demand for Federal Reserve liabilities. (See the initiatives, including a review of its monetary box “The Role of Liabilities in Determining policy framework that will include outreach the Size of the Federal Reserve’s Balance to a broad range of stakeholders, the Federal Sheet” in Part 2.) Reserve seeks to enhance transparency and accountability regarding how it pursues Federal Reserve transparency and its statutory responsibilities. (See the box accountability. For central banks, transparency “Federal Reserve Transparency: Rationale provides an essential basis for accountability. and New Initiatives” in Part 2.) 5 P 1 art r e f d eCent ConomiC and inanCiaL eveLoPments Domestic Developments The labor market strengthened further during the second half of 2018 and early 1. Net change in payroll employment this year . . . Monthly Thousands of jobs Payroll employment gains have remained Private 400 strong, averaging 224,000 per month since June 2018 (figure 1). This pace is similar to the 200 + pace in the first half of last year, and it is faster _0 than the average pace of job gains in 2016 200 and 2017. Total nonfarm 400 The strong pace of job gains over this period 600 has primarily been manifest in a rising labor 800 force participation rate (LFPR)—the share of the population that is either working 2009 2011 2013 2015 2017 2019 or actively looking for work—rather than NOTE: The data are 3-month moving averages. a declining unemployment rate.1 Since SOURCE: Bureau of Labor Statistics via Haver Analytics. June 2018, the LFPR has moved up about ¼ percentage point and was 63.2 percent in 2. Labor force participation rates and January—a bit higher than the narrow range it employment-to-population ratio has maintained in recent years (figure 2). The improvement is especially notable because the Percent Percent aging of the population—and, in particular, 85 Labor force participation rate 68 the movement of members of the baby- 66 boom cohort into their retirement years—has 84 otherwise imparted a downward influence on 64 83 the LFPR. Indeed, the LFPR for individuals 62 between 25 and 54 years old—which is much 82 60 less sensitive to population aging—has 81 58 Employment-to-population ratio Prime-age labor force 1. The observed pace of payroll job gains would have 80 participation rate 56 been sufficient to push the unemployment rate lower had the LFPR not risen. Indeed, monthly payroll gains in 2001 2004 2007 2010 2013 2016 2019 the range of 115,000 to 145,000 appear consistent with NOTE: The data are monthly. The prime-age labor force participation rate an unchanged unemployment rate around 4.0 percent 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 and an unchanged LFPR around 62.9 percent (which aged 16 and over. are the June 2018 values of these rates). If instead SOURCE: Bureau of Labor Statistics via Haver Analytics. the LFPR were declining 0.2 percentage point per year—roughly the influence of population aging—the range of job gains needed to maintain an unchanged unemployment rate would be about 40,000 per month lower. There is considerable uncertainty around these estimates, as the difference between monthly payroll gains and employment changes from the Current Population Survey (the source of the unemployment rate and LFPR) can be quite volatile over short periods. 6 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 3. Measures oflabor underutilization Monthly Percent 18 U-6 16 U-4 14 U-5 12 10 8 Unemployment rate 6 4 2 2007 2009 2011 2013 2015 2017 2019 NOTE: Unemployment rate measures total unemployed as a percentage of the labor force. U-4 measures total unemployed plus discouragedworkers, 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. improved considerably more than the overall LFPR, including a ½ percentage point rise since June 2018.2 At the same time, the unemployment rate has remained little changed and has generally been running a little under 4 percent.3 Nevertheless, the unemployment rate remains at a historically low level and is ½ percentage point below the median of the Federal Open Market Committee (FOMC) participants’ estimates of its longer-run normal level (figure 3).4 Combining the movements in both unemployment and labor force participation, 2. Since 2015, the increase in the prime-age LFPR for women was nearly 2 percentage points, while the increase for men was only about 1 percentage point. In January, the LFPR for prime-age women was slightly above where it stood in 2007, whereas for men it was still about 2 percentage points below. 3. The unemployment rate in January was 4.0 percent, boosted somewhat by the partial government shutdown, as some furloughed federal workers and temporarily laid- off federal contractors are treated as unemployed in the household employment survey. 4. See the Summary of Economic Projections in Part 3 of this report. MONETARy POLICy REPORT: FEBRUARy 2019 7 the employment-to-population ratio for individuals 16 and over—the share of that segment of the population who are working— was 60.7 percent in January and has been gradually increasing since 2011. Other indicators are also consistent with a strong labor market. As reported in the Job Openings and Labor Turnover Survey (JOLTS), the job openings rate has moved higher since the first half of 2018, and in December, it was at its highest level since the data began in 2000. The quits rate in the JOLTS is also near the top of its historical range, an indication that workers have become more confident that they can successfully switch jobs when they wish to. In addition, the JOLTS layoff rate has remained low, and the number of people filing initial claims for unemployment insurance benefits has also remained low. Survey evidence indicates that households perceive jobs as plentiful and that businesses see vacancies as hard to fill. . . . and unemployment rates have fallen for all major demographic groups over the past several years The flattening in unemployment since mid- 2018 has been evident across racial and ethnic groups (figure 4). Even so, over the past several years, the decline in the unemployment rates for blacks or African Americans and for Hispanics has been particularly notable, and the unemployment rates for these groups are near their lowest readings since these series began in the early 1970s. Differences in unemployment rates across ethnic and racial groups have narrowed in recent years, as they typically do during economic expansions, after having widened during the recession; on net, unemployment rates for African Americans and Hispanics remain substantially above those for whites and Asians, with differentials generally a bit below pre-recession levels. The rise in LFPRs for prime-age individuals over the past few years has also been apparent in each of these racial and ethnic groups. Nonetheless, the LFPR for whites remains 8 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 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 2007 2009 2011 2013 2015 2017 2019 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. higher than that for other groups (figure 5). Important differences in economic outcomes 5. Prime-age labor force participation rate by race and persist across other characteristics as well ethnicity (see, for example, the box “Employment Disparities between Rural and Urban Areas,” Monthly Percent which highlights that there has been less 84 improvement since 2010 in the LFPR and White 83 employment-to-population ratio for prime-age Asian 82 individuals in rural areas compared with Hispanic or Latino 81 urban areas). 80 79 Increases in labor compensation have 78 picked up recently but remain moderate Black or African American 77 by historical standards . . . 76 Most available indicators suggest that growth 2007 2009 2011 2013 2015 2017 2019 of hourly compensation has stepped up further NOTE: The prime-age labor force participation rate is a percentage of the since June 2018 after having firmed somewhat population aged 25 to 54. Persons whose ethnicity is identified as Hispanic or over the past few years; however, growth rates 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 remain moderate compared with those that business recession as defined by the National Bureau of Economic Research. SOURCE: Bureau of Labor Statistics. prevailed in the decade before the recession. Compensation per hour in the business sector—a broad-based measure of wages and benefits, but one that is quite volatile—rose 2¼ percent over the four quarters ending in 2018:Q3, about the same as the average annual increase over the past seven years or so (figure 6). The employment cost index, a less volatile measure of both wages and the cost MONETARy POLICy REPORT: FEBRUARy 2019 9 to employers of providing benefits, increased 6. Measures of change in hourly compensation 3 percent over the same period, while average Percent change from year earlier hourly earnings—which do not take account of benefits—increased 3.2 percent over the Compensation per hour, Atlanta Fed's 6 business sector Wage Growth Tracker 12 months ending in January of this year; the 5 annual increases in both of these measures 4 were the strongest in nearly 10 years. The 3 measure of wage growth computed by the 2 Federal Reserve Bank of Atlanta that tracks Employment cost index, 1 median 12-month wage growth of individuals private sector + reporting to the Current Population Survey _0 Average hourly earnings, showed an increase of 3.7 percent in January, private sector 1 near the upper end of its readings in the past 2003 2005 2007 2009 2011 2013 2015 2017 2019 three years and well above the average increase in the preceding few years.5 NOTE: Business-sector compensation is on a 4-quarter percentage change basis and extends through 2018:Q3. For the private-sector employment cost index, change is over the 12 months ending in the last month of each quarter; for private-sector average hourly earnings, the data are 12-month percent . . . and have likely been restrained by changes and begin in March 2007; for the Atlanta Fed's Wage Growth slow growth of labor productivity over Tracker, the data are shown as a 3-month moving average of the 12-month percent change. much of the expansion SOURCE: Bureau of Labor Statistics via Haver Analytics; Federal Reserve Bank of Atlanta, Wage Growth Tracker. These moderate rates of compensation gains likely reflect the offsetting influences 7. Change in business-sector output per hour of a strong labor market and productivity growth that has been weak through much Percent, annual rate of the expansion. From 2008 to 2017, labor productivity increased a little more than 4 1 percent per year, on average, well below the average pace from 1996 to 2007 of nearly 3 3 percent and also below the average gain in the 1974–95 period (figure 7). Although 2 considerable debate remains about the reasons for the slowdown over this period, the weakness in productivity growth may be partly 1 attributable to the sharp pullback in capital investment during the most recent recession 1948– 1974– 1996– 2001– 2008– 2018 and the relatively slow recovery that followed. 73 95 2000 07 17 More recently, however, labor productivity is NOTE: Changes are measured from Q4 of the year immediately preceding the period through Q4 of the final year of the period. The bar for 2018 reports estimated to have increased almost 2 percent growth from 2017:Q4 through 2018:Q3 at an annual rate. SOURCE: Bureau of Labor Statistics via Haver Analytics. at an annual rate in the first three quarters of 2018—still moderate relative to earlier periods, but its fastest three-quarter gain since 2010. While it is uncertain whether this faster rate of growth will persist, a sustained pickup in productivity growth, as well as additional labor market strengthening, would likely support stronger gains in labor compensation. 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. 10 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Employment Disparities between Rural and Urban Areas The U.S. labor market has recovered substantially A. Employment-to-population ratios since 2010. For people in their prime working years (ages 25 to 54), the unemployment rate has moved Monthly Percent down steadily to levels below the previous business Larger MSAs cycle peak in 2007, the labor force participation rate 82 (LFPR) has retraced much of its decline, and the share Smaller MSAs of the population who are employed—known as the 80 employment-to-population ratio, or EPOP ratio— 78 has returned to about its level before the recession. However, the labor market recovery has been uneven 76 across the country, with “rural” (or nonmetro) areas showing markedly less improvement than cities and 74 their surroundings (metro areas).1 Non-MSA 72 The extent of the initial decline and subsequent improvement in the EPOP ratio varied by metropolitan status. The gap between the EPOP ratios in rural and 1998 2001 2004 2007 2010 2013 2016 2019 larger urban areas is now noticeably wider than it was NOTE: Data are for persons aged 25 to 54. Larger metropolitan statistical before the recession, and the cyclical recovery started areas (MSAs) consist of 500,000 people or more, and smaller MSAs consist of 100,000 to 500,000 people. The shaded bars indicate periods of business later in rural areas. Specifically, as shown in figure A, recession as defined by the National Bureau of Economic Research. the prime-age EPOP is now slightly above its pre- SOURCE: References listed in box note 2. recession level in larger urban areas, whereas it is just below its pre-recession average in smaller urban areas and much below its pre-recession level in rural areas.2 B. Unemployment rates The EPOP ratio can usefully be viewed as summarizing both the LFPR—that is, the share of Monthly Percent the population that either has a job or is actively looking for work—and the unemployment rate, which 10 measures the share of the labor force without a job and Smaller MSAs 9 actively searching.3 The divergence in rural and urban EPOP ratios during the economic expansion almost 8 entirely reflects divergences in LFPRs rather than in 7 unemployment rates (figures B and C). In particular, the 6 rural and urban unemployment rates have tracked each (continued) 5 Non-MSA 4 1. For convenience, we refer to metropolitan counties with strong commuting ties to an urbanized center as “urban” and Larger MSAs 3 nonmetropolitan counties that lack such ties as “rural.” 2. For all figures in this discussion, the raw data are from 2 the U.S. Census Bureau, Current Population Survey; note that the Bureau of Labor Statistics is involved in the survey 1998 2001 2004 2007 2010 2013 2016 2019 process for the Current Population Survey. Calculations of the series shown are as described in Alison Weingarden NOTE: Data are for persons aged 25 to 54. Larger metropolitan statistical areas (MSAs) consist of 500,000 people or more, and smaller MSAs consist (2017), “Labor Market Outcomes in Metropolitan and of 100,000 to 500,000 people. The shaded bars indicate periods of business Non-metropolitan Areas: Signs of Growing Disparities,” recession as defined by the National Bureau of Economic Research. FEDS Notes (Washington: Board of Governors of the Federal SOURCE: References listed in box note 2. Reserve System, September 25), www.federalreserve. gov/econres/notes/feds-notes/labor-market-outcomes-in- metropolitan-and-non-metropolitan-areas-signs-of-growing- disparities-20170925.htm. The figures show 12-month moving averages of the monthly time-series. population” and the unemployment rate is defined as “persons 3. Specifically, the EPOP ratio equals (LFPR) x (1 – unemployed/labor force.” These numbers are multiplied by unemployment rate), where LFPR is defined as “labor force/ 100 for presentation purposes in the figures. MONETARy POLICy REPORT: FEBRUARy 2019 11 other fairly closely in this expansion, though they have C. Labor force participation rates diverged a little in the past few years. In contrast, the difference between rural and urban LFPRs has widened Monthly Percent significantly over the past decade. On average, people in rural areas tend to have 85 fewer years of schooling than people in urban areas, Smaller MSAs 84 and because the EPOP ratio tends to be lower for individuals with less education, this demographic 83 difference has contributed to the persistent rural–urban Larger MSAs 82 divide. However, these educational differences do not appear responsible for the fact that the gap between 81 rural and urban EPOP ratios have widened. Figure D shows that, in recent years, rural and urban EPOP 80 ratios diverged substantially even within educational Non-MSA 79 categories, similar to the divergence in EPOPs more generally. The left panel of figure D shows that the 78 EPOP ratio of non-college-educated adults ages 25 to 54 has been much lower in rural areas than in urban 1998 2001 2004 2007 2010 2013 2016 2019 ones beginning in 2012. The right panel of figure D NOTE: Data are for persons aged 25 to 54. Larger metropolitan statistical shows that the EPOP ratio of college-educated adults areas (MSAs) consist of 500,000 people or more, and smaller MSAs consist of 100,000 to 500,000 people. The shaded bars indicate periods of business used to be higher in rural areas than in urban ones, recession as defined by the National Bureau of Economic Research. but that is no longer so. Thus, the recent widening of SOURCE: References listed in box note 2. the rural–urban disparity in EPOP ratios has not been primarily driven by differences in years of education. Nevertheless, because the recovery in the EPOP ratio for non-college-educated adults in rural areas (continued on next page) D. Employment-to-population ratios Noncollege adults College adults Monthly Percent Monthly Percent 87 76 Non-MSA 86 74 85 72 84 MSAs 70 83 MSAs 82 68 81 Non-MSA 66 80 1998 2001 2004 2007 2010 2013 2016 2019 1998 2001 2004 2007 2010 2013 2016 2019 NOTE: Data are for persons aged 25 to 54. MSA is metropolitan statistical area. The shaded bars indicate periods of business recession as defined by the National Bureau of Economic Research. SOURCE: References listed in box note 2. 12 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Employment Disparities (continued) has been particularly weak, it is likely that broader Insurance (SSDI) benefits, and, in fact, take-up macroeconomic trends—including the ongoing shift in increased a little more in rural areas than it did in urban labor demand that has favored individuals with more ones over the past decade.4 education—have had more adverse consequences When regions are faced with adverse changes for the populations in rural areas than in urban areas. in labor demand, some residents may respond by For example, manufacturing, where employment has migrating to more prosperous areas. The more out- stagnated, accounts for a larger share of employment migration that occurs from areas with relatively fewer in rural areas than in urban areas, while fast-growing labor market opportunities, the smaller should be the services industries, such as health-care and professional observed decline in local-area EPOPs.5 However, some services that tend to employ workers with more research suggests that the average migration response education, are more concentrated in urban areas. to adverse demand shocks has decreased in recent Indeed, employment in manufacturing has not yet decades, which could amplify the labor market effects fully recovered from the recession. And, despite of local shocks and lead to persistent disparities in the strength in the past two years, the share of total EPOP ratios across areas.6 employment in manufacturing has remained near its post-recession low. 4. This increase could reflect growing public health The fact that most of the EPOP divergence is seen problems (which expands the pool of individuals who qualify for SSDI) and sluggish labor demand in rural areas (which in labor force participation rather than unemployment increases the propensity of individuals to apply for SSDI rates suggests that many rural workers who experienced benefits). a permanent job loss, perhaps due to a factory closing, 5. Although a higher rate of rural out-migration would help decided to eventually exit the labor force rather than close the EPOP gap, depopulation might exacerbate economic continue their job search. Some individuals who had difficulties for those who remain in rural areas. 6. See, for example, Mai Dao, Davide Furceri, and Prakash been working, despite ongoing health problems, may Loungani (2017), “Regional Labor Market Adjustment in the have responded to job loss and poor reemployment United States: Trend and Cycle,” Review of Economics and opportunities by applying for Social Security Disability Statistics, vol. 99 (May), pp. 243–57. MONETARy POLICy REPORT: FEBRUARy 2019 13 Price inflation is close to 2 percent Consumer price inflation has fluctuated around the FOMC’s objective of 2 percent, largely reflecting movements in energy prices. As measured by the 12-month change in 8. Change in the price index for personal consumption expenditures the price index for personal consumption expenditures (PCE), inflation is estimated Monthly 12-month percent change to have been 1.7 percent in December after being above 2 percent for much of 2018 3.0 Trimmed mean (figure 8).6 Core PCE inflation—that is, Total 2.5 Excluding food inflation excluding consumer food and energy and energy 2.0 prices—is estimated to have been 1.9 percent 1.5 in December. Because food and energy prices are often quite volatile, core inflation typically 1.0 provides a better indication than the total .5 measure of where overall inflation will be + _0 in the future. Total inflation was below core inflation for the year as a whole not only 2012 2013 2014 2015 2016 2017 2018 because of softness in energy prices, but also NOTE: The data for total and excluding food and energy extend through because food price inflation has remained December 2018; final values are staff estimates. The trimmed data extend through November 2018. relatively low. SOURCE: For trimmed mean, Federal Reserve Bank of Dallas; for all else, Bureau of Economic Analysis; all via Haver Analytics. Core inflation has moved up since 2017, when inflation was held down by some unusually large price declines in a few relatively small categories of spending, such as mobile phone services. The trimmed mean PCE price index, produced by the Federal Reserve Bank of Dallas, provides an alternative way to purge inflation of transitory influences, and it may be less sensitive than the core index to idiosyncratic price movements such as those noted earlier. The 12-month change in this measure did not decline as much as core PCE inflation in 2017, and it was 2.0 percent in November.7 Inflation likely has been increasingly supported by the strong labor market in an environment of stable inflation expectations; inflation last year was 6. The partial government shutdown has delayed publication of the Bureau of Economic Analysis’s estimate for PCE price inflation in December, and the numbers reported here are estimates based on the December consumer and producer price indexes. 7. The trimmed mean index excludes whichever prices showed the largest increases or decreases in a given month. Note that over the past 20 years, changes in the trimmed mean index have averaged about ¼ percentage point above core PCE inflation and 0.1 percentage point above total PCE inflation. 14 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS also boosted slightly by the tariffs that were imposed throughout 2018. Oil prices have dropped markedly in recent months . . . As noted, the slower pace of total inflation in late 2018 relative to core inflation largely 9. Spot andfutures prices for crude oil reflected softening in consumer energy prices Weekly Dollars per barrel toward the end of the year. After peaking 130 at about $86 per barrel in early October, the Brent spot price 120 price of crude oil subsequently fell sharply 110 and has averaged around $60 per barrel this 100 90 year (figure 9). The recent decline in oil prices 24-month-ahead futures contracts 80 has led to moderate reductions in the cost 70 of gasoline and heating oil. Supply factors, 60 including surging oil production in Saudi 50 40 Arabia, Russia, and the United States, appear 30 to be most responsible for the recent price 20 declines, but concerns about weaker global 2014 2015 2016 2017 2018 2019 growth likely also played a role. NOTE: The data are weekly averages of daily data and extend through February 20, 2019. . . . while prices of imports other than SOURCE: ICE Brent Futures via Bloomberg. energy have also declined After climbing steadily since their early 2016 lows, nonfuel import prices peaked in 10. Nonfuel import prices and industrial metals indexes May 2018 and declined for much of the rest of 2018 in response to dollar appreciation, January 2014 = 100 January 2014 = 100 lower foreign inflation, and declines in commodity prices. In particular, metal prices 120 Industrial metals fell markedly in the second half of 2018, partly 110 102 reflecting concerns about prospects for the 100 100 global economy (figure 10). Nonfuel import prices, before accounting for the effects of 90 98 tariffs on the price of imported goods, had 80 roughly a neutral influence on U.S. price Nonfuel import prices 96 70 inflation in 2018. 94 60 Survey-based measures of inflation 2014 2015 2016 2017 2018 2019 expectations have been stable . . . NOTE: The data for nonfuel import prices are monthly. The data for industrial metals are a monthly average of daily data and extend through Expectations of inflation likely influence February 20, 2019. actual inflation by affecting wage- and price- SOURCE: For nonfuel import prices, Bureau of Labor Statistics; for industrial metals, S&P GSCI Industrial Metals Spot Index via Haver setting decisions. Survey-based measures of Analytics. inflation expectations at medium- and longer- term horizons have remained generally stable over the second half of 2018. 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 MONETARy POLICy REPORT: FEBRUARy 2019 15 next 10 years has been very close to 2 percent 11. Median inflation expectations for the past several years (figure 11). In Percent the University of Michigan Surveys of Consumers, the median value for inflation expectations over the next 5 to 10 years has Michigan survey expectations 4 for next 5 to 10 years been around 2½ percent since the end of 2016, though this level is about ¼ percentage 3 point lower than had prevailed through 2014. In contrast, in the Survey of Consumer 2 SPF expectations Expectations, conducted by the Federal for next 10 years Reserve Bank of New York, the median of 1 respondents’ expected inflation rate three years hence—while relatively stable around 3 percent 2005 2007 2009 2011 2013 2015 2017 2019 since early 2018—is nonetheless at the top of the range it has occupied over the past couple NOTE: The Michigan survey data are monthly and extend through February 2019; the February data are preliminary. The SPF data for inflation of years. expectations for personal consumption expenditures are quarterly and begin in 2007:Q1. SOURCE: University of Michigan Surveys of Consumers; Federal Reserve . . . while market-based measures of Bank of Philadelphia, Survey of Professional Forecasters (SPF). inflation compensation have come down since the first half of 2018 Inflation expectations can also be gauged by market-based measures of inflation compensation. However, the inference is not straightforward, because market- based measures can be importantly affected by changes in premiums that provide compensation for bearing inflation and liquidity risks. Measures of longer-term inflation compensation—derived either from differences between yields on nominal Treasury 12. 5-to-10-year-forwardinflation compensation securities and those on comparable-maturity Weekly Percent Treasury Inflation-Protected Securities (TIPS) or from inflation swaps—moved down in 3.5 the fall and are below levels that prevailed Inflation swaps earlier in 2018 (figure 12).8 The TIPS-based 3.0 measure of 5-to-10-year-forward inflation 2.5 compensation and the analogous measure TIPS breakeven rates 2.0 from inflation swaps are now about 1¾ percent 1.5 1.0 8. Inflation compensation implied by the TIPS breakeven inflation rate is based on the difference, at 2011 2013 2015 2017 2019 comparable maturities, between yields on nominal Treasury securities and yields on TIPS, which are indexed NOTE: The data are weekly averages of daily data and extend through February 15, 2019. TIPS is Treasury Inflation-Protected Securities. to the total consumer price index (CPI). Inflation swaps SOURCE: Federal Reserve Bank of New York; Barclays; Federal Reserve Board staff estimates. 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. Inflation compensation derived from inflation swaps typically exceeds TIPS-based compensation, but week-to-week movements in the two measures are highly correlated. 16 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS and 2¼ percent, respectively, with both measures below their respective ranges that persisted for most of the 10 years before the start of the notable declines in mid-2014.9 Real gross domestic product growth was solid, on balance, in the second half of 2018 Real gross domestic product (GDP) rose at an annual rate of 3½ percent in the third quarter, 13. Change in real grossdomestic product and gross and available indicators point to a moderate domestic income gain in the fourth quarter.10 For the year, GDP growth appears to have been a little less than Percent, annual rate 3 percent, up from the 2½ percent pace in 2017 Gross domestic product Gross domestic income and the 2 percent pace in the preceding two 5 years (figure 13). Last year’s growth reflects, in Q3 4 part, solid growth in household and business H1 spending, on balance, as well as an increase 3 in government purchases of goods and services; by contrast, housing-sector activity 2 turned down last year. Private domestic 1 final purchases—that is, final purchases by households and businesses, which tend to provide a better indication of future GDP 2012 2013 2014 2015 2016 2017 2018 growth than most other components of overall SOURCE: Bureau of Economic Analysis via Haver Analytics. spending—likely posted a strong gain for the year. Some measures of consumer and business 14. Change in real personal consumption expenditures sentiment have recently softened—likely and disposable personal income reflecting concerns about financial market volatility, the global economic outlook, Percent, annual rate trade policy tensions, and the government Personal consumption expenditures 6 Disposable personal income shutdown—and consumer spending appears 5 to have weakened at the end of the year. H1 Q3 4 Nevertheless, the economic expansion 3 continues to be supported by steady job 2 gains, past increases in household wealth, 1 + _0 expansionary fiscal policy, and still-favorable 1 domestic financial conditions, including 2 3 9. As these measures are based on CPI inflation, one 2012 2013 2014 2015 2016 2017 2018 should probably subtract about ¼ percentage point—the SOURCE: Bureau of Economic Analysis via Haver Analytics. average differential with PCE inflation over the past two decades—to infer inflation compensation on a PCE basis. 10. The initial estimate of GDP by the Bureau of Economic Analysis for the fourth quarter was delayed because of the partial government shutdown and will now be released on February 28. MONETARy POLICy REPORT: FEBRUARy 2019 17 moderate borrowing costs and easy access to 15. Personal saving rate credit for many households and businesses. Monthly Percent Ongoing improvements in the labor 12 market continue to support household income and consumer spending . . . 10 Real consumer spending picked up after some 8 transitory weakness in the first half of 2018, 6 rising at a strong annual rate of 3½ percent in the third quarter and increasing robustly 4 through November (figure 14). However, 2 despite anecdotal reports of favorable holiday sales, retail sales were reported to have 2006 2008 2010 2012 2014 2016 2018 declined sharply in December. Real disposable NOTE: Data extend through November 2018. personal income—that is, income after taxes SOURCE: Bureau of Economic Analysis via Haver Analytics. and adjusted for price changes—looks to 16. Prices of existing single-familyhouses have increased around 3 percent over the year, boosted by ongoing improvements in Monthly Percent change from year earlier the labor market and the reduction in income S&P/Case-Shiller 15 taxes due to the implementation of the Tax national index 10 Cuts and Jobs Act (TCJA). With consumer CoreLogic 5 spending rising at about the same rate as gains price index + in disposable income in 2018 through the third _0 quarter (the latest data available), the personal 5 saving rate was roughly unchanged, on net, Zillow index 10 over this period (figure 15). 15 20 . . . although wealth gains have moderated and consumer confidence has 2009 2011 2013 2015 2017 2019 recently softened NOTE: The data for the S&P/Case-Shiller index extend through November 2018. The data for the CoreLogic index extend through December 2018. While increases in household wealth have likely SOURCE: CoreLogic Home Price Index; Zillow; S&P/Case-Shiller U.S. National Home Price Index. The S&P/Case-Shiller Index is a product of S&P continued to support consumer spending, Dow Jones Indices LLC and/or its affiliates. (For Dow Jones Indices licensing information, see the note on the Contents page.) gains in net worth slowed last year. House prices continued to move up in 2018, boosting 17. Wealth-to-income ratio the wealth of homeowners, but the pace of Quarterly Ratio growth moderated (figure 16). U.S. equity prices are, on net, similar to their levels at 7.0 the end of 2017. Still, the level of equity and housing wealth relative to income remains very 6.5 high by historical standards (figure 17).11 6.0 5.5 11. Indeed, in the third quarter of 2018—the most 5.0 recent period for which data are available—household net worth was seven times the value of disposable income, the highest-ever reading for that ratio, which dates back 1997 2000 2003 2006 2009 2012 2015 2018 to 1947. However, following the decline in stock prices NOTE: Data extend through 2018:Q3. The series is the ratio of household since the summer, this ratio has likely fallen somewhat. net worth to disposable personal income. SOURCE: For net worth, Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States”; for income, Bureau of Economic Analysis via Haver Analytics. 18 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 18. Indexes of consumer sentiment Consumer sentiment as measured by the Michigan survey flattened out at a high level Index Index through much of 2018, and the sentiment 170 120 measure from the Conference Board survey Conference Board 150 climbed through most of the year, with both 110 130 measures posting their highest annual averages 100 110 since 2000 (figure 18). However, consumer 90 90 sentiment has turned down since around 80 70 year-end, on net, with the declines primarily 50 70 reflecting consumers’ expectations for future 30 60 conditions rather than their assessment of Michigan survey 10 50 current conditions. Consumer attitudes about car buying have also weakened. Nevertheless, 2001 2004 2007 2010 2013 2016 2019 these indicators of consumers’ outlook remain NOTE: The data are monthly. Michigan data extend through February 2019; at generally favorable levels, likely reflecting the February data are preliminary. The Conference Board data are indexed to 100 in 1985. The Michigan survey data are indexed to 100 in 1966. rising income, job gains, and low inflation. SOURCE: University of Michigan Surveys of Consumers; Conference Board. Borrowing conditions for consumers 19. Changes in householddebt remain generally favorable despite Billions of dollars, annual rate interest rates being near the high end of their post-recession range Mortgages 1,000 Consumer credit Sum 800 Despite increases in interest rates for consumer 600 loans and some reported further tightening 400 in credit card lending standards, financing 200 conditions for consumers largely remain + _0 supportive of growth in household spending, 200 and consumer credit growth in 2018 expanded 400 further at a solid pace (figure 19). Mortgage 600 credit has continued to be readily available for households with solid credit profiles. For 2008 2010 2012 2014 2016 2018 borrowers with low credit scores, mortgage NOTE: Changes are calculated from year-end to year-end except 2018 underwriting standards have eased somewhat changes, which are calculated from 2017:Q3 to 2018:Q3. SOURCE: Federal Reserve Board, Statistical Release Z.1, “Financial since the first half of 2018 but remain Accounts of the United States.” noticeably tighter than before the recession. 20. Change in real private nonresidential fixed investment Financing conditions in the student loan market remain stable, with over 90 percent Percent, annual rate of such credit being extended by the federal Structures Equipment and intangible capital 20 government. Delinquencies on such loans, H1 though staying elevated, continued to improve 15 gradually on net. 10 Q3 5 Business investment growth has + moderated after strong gains early _0 in 2018 . . . 5 Investment spending by businesses rose 10 rapidly in the first half of last year, and the 2010 2011 2012 2013 2014 2015 2016 2017 2018 available data are consistent with growth SOURCE: Bureau of Economic Analysis via Haver Analytics. having slowed in the second half (figure 20). MONETARy POLICy REPORT: FEBRUARy 2019 19 The apparent slowdown reflects, in part, more moderate growth in investment in equipment and intangibles as well as a likely decline in investment in nonresidential structures after strong gains earlier in the year. Forward- looking indicators of business spending— such as business sentiment, capital spending plans, and profit expectations from industry analysts—have softened recently but remain positive overall. And while new orders of capital goods flattened out toward the end of last year, the backlog of unfilled orders for this equipment has continued to rise. . . . as corporate financing conditions tightened somewhat but remained accommodative overall Spreads of yields on nonfinancial corporate bonds over those on comparable-maturity Treasury securities widened modestly, on balance, since the middle of 2018 as investors’ risk appetite appeared to recede some. 21. Selected components of netdebt financing for Nonetheless, a net decrease in Treasury nonfinancial businesses yields over the past several months has left Billions of dollars, monthly rate interest rates on corporate bonds still low by Commercial paper historical standards, and financing conditions Bonds 80 appear to have remained accommodative Bank loans Sum 60 overall. Aggregate net flows of credit to large nonfinancial firms remained solid in the third H1 40 Q3 quarter (figure 21). The gross issuance of 20 corporate bonds and new issuance of leveraged + _0 loans both fell considerably toward the end of 20 the year but have since rebounded, mirroring movements in financial market volatility. 40 Respondents to the January Senior Loan 2008 2010 2012 2014 2016 2018 Officer Opinion Survey on Bank Lending SOURCE: Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” Practices, or SLOOS, reported that lending standards for commercial and industrial (C&I) loans remained basically unchanged in the fourth quarter after having reported easing standards over the past several quarters. However, banks reported tightening lending standards on all categories of commercial real estate (CRE) loans in the fourth quarter on net. Meanwhile, financing conditions for small businesses have remained generally 20 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 22. Private housing starts and permits accommodative. Lending volumes to small businesses rebounded a bit in recent months, Monthly Millions of units, annual rate and indicators of recent loan performance Single-family starts stayed strong. 1.2 1.0 Activity in the housing sector has been .8 declining Sin p g e le rm -fa it m s ily .6 Residential investment declined in 2018, as .4 housing starts held about flat and sales of existing homes moved lower (figures 22 .2 Multifamily starts and 23). The drop in residential investment 0 reflects rising mortgage rates—which remain higher than in 2017 despite coming down some 2008 2010 2012 2014 2016 2018 recently—as well as higher material and labor NOTE: The data extend through November 2018. SOURCE: U.S. Census Bureau via Haver Analytics. building costs, which have likely restrained new 23. New and existing home sales home construction. Consumers’ perceptions of homebuying conditions deteriorated sharply Millions, annual rate Millions, annual rate over 2018, consistent with the decline in the 7.5 1.6 affordability of housing associated with both 7.0 Existing home sales higher mortgage rates and still-rising house 1.4 6.5 prices (figure 24). 1.2 6.0 5.5 1.0 Net exports likely subtracted from GDP 5.0 .8 growth in 2018 4.5 .6 4.0 After a strong performance in the first half .4 3.5 of last year supported by robust exports of 3.0 New home sales .2 agricultural products, real exports declined in the third quarter, and available indicators 2006 2008 2010 2012 2014 2016 2018 suggest only a partial rebound in the fourth NOTE: Data are monthly. New home sales extends through November 2018 and includes only single-family sales. Existing home sales extends through quarter (figure 25). At the same time, growth December 2018 and includes single-family, condo, townhome, and co-op in real imports seems to have picked up in sales. SOURCE: For new home sales, U.S. Census Bureau; for existing home the second half of 2018. As a result, real net sales, National Association of Realtors; all via Haver Analytics. exports—which lifted U.S. real GDP growth 24. Mortgage rates andhousing affordability during the first half of 2018—appear to have Percent Index subtracted from growth in the second half. For the year as a whole, net exports likely Housing affordability index 205 subtracted a little from real GDP growth, 7 190 similar to 2016 and 2017. The nominal trade 6 deficit and the current account deficit in 2018 175 were little changed as a percent of GDP from 5 160 2017 (figure 26). 145 4 Federal fiscal policy actions boosted Mortgage rates 130 economic growth in 2018 . . . 3 115 Fiscal policy at the federal level boosted 2009 2011 2013 2015 2017 2019 GDP growth in 2018, both because of lower NOTE: The housing affordability index data are monthly through income and business taxes from the TCJA and December 2018, and the mortgage rate data are weekly through February 14, 2019. At an index value of 100, a median-income family has exactly enough income to qualify for a median-priced home mortgage. Housing affordability is seasonally adjusted by Board staff. SOURCE: For housing affordability index, National Association of Realtors; for mortgage rates, Freddie Mac Primary Mortgage Market Survey. MONETARy POLICy REPORT: FEBRUARy 2019 21 because federal purchases appear to have risen 25. Change in realimports and exports of goods significantly faster than in 2017 as a result of and services the Bipartisan Budget Act of 2018 (figure 27).12 Percent, annual rate The partial government shutdown, which Imports was in effect from December 22 through Exports Q3 10 January 25, likely held down GDP growth in 8 H1 the first quarter of this year somewhat, largely 6 because of the lost work of furloughed federal 4 government workers and temporarily affected 2 + federal contractors. _0 2 The federal unified deficit widened in fiscal 4 year 2018 to 3¾ percent of nominal GDP 6 because receipts moved lower, to roughly 2015 2016 2017 2018 16½ percent of GDP (figure 28). Expenditures SOURCE: Bureau of Economic Analysis via Haver Analytics. edged down, to 20¼ percent of GDP, but remain above the levels that prevailed in 26. U.S. trade and current accountbalances the decade before the start of the 2007–09 recession. The ratio of federal debt held by the Annual Percent of nominal GDP public to nominal GDP equaled 78 percent + at the end of fiscal 2018 and remains quite _0 elevated relative to historical norms (figure 29). 1 The Congressional Budget Office projects that 2 this ratio will rise over the next several years. 3 4 . . . and the fiscal position of most state Trade 5 and local governments is stable 6 Current account The fiscal position of most state and local 7 governments is stable, although there is a range of experiences across these governments. After 2002 2004 2006 2008 2010 2012 2014 2016 2018 several years of slow growth, revenue gains NOTE: Data for 2018 are the average of the first three quarters of the year, at an annualized rate. GDP is gross domestic product. of state governments strengthened notably as SOURCE: Bureau of Economic Analysis via Haver Analytics. sales and income tax collections have picked up over the past few quarters. At the local 27. Change in real government expenditures on level, property tax collections continue to rise consumption and investment at a solid clip, pushed higher by past house Percent, annual rate price gains. After declining a bit in 2017, real Federal state and local government purchases grew State and local 6 moderately last year, driven largely by a boost Q3 H1 4 in construction but also reflecting modest growth in employment at these governments. 2 + _0 2 12. The Joint Committee on Taxation estimated that the TCJA would reduce average annual tax revenue by a 4 little more than 1 percent of GDP starting in 2018 and 6 for several years thereafter. This revenue estimate does not account for the potential macroeconomic effects of the legislation. 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 SOURCE: Bureau of Economic Analysis. 22 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 28. Federal receipts and expenditures Financial Developments Annual Percent of nominal GDP The expected path of the federal funds rate over the next several years has 26 moved down Expenditures 24 Despite the further strengthening in the 22 labor market and continued expansion in the Receipts 20 U.S. economy, market-based measures of 18 the expected path for the federal funds rate over the next several years have declined, on 16 net, since the middle of last year (figure 30). 14 Various factors contributed to this shift, including increased investor concerns about 1997 2000 2003 2006 2009 2012 2015 2018 downside risks to the global economic NOTE: The receipts and expenditures data are on a unified-budget basis and are for fiscal years (October through September); gross domestic product outlook and rising trade tensions, as well as (GDP) data are for the four quarters ending in Q3. SOURCE: Office of Management and Budget via Haver Analytics. FOMC communications that were viewed as signaling patience and greater flexibility in the conduct of monetary policy in response to 29. Federal governmentdebt heldby the public adverse macroeconomic or financial market Quarterly Percent of nominal GDP developments. 80 Survey-based measures of the expected path 70 of the policy rate through 2020 also shifted down, on net, relative to the levels observed 60 in the first half of 2018. According to the 50 results of the most recent Survey of Primary 40 Dealers and Survey of Market Participants, 30 both conducted by the Federal Reserve Bank of New York just before the January 20 FOMC meeting, the median of respondents’ 1968 1978 1988 1998 2008 2018 modal projections for the path of the federal funds rate implies two additional 25 basis NOTE: The data extend through 2018:Q3. The data for gross domestic product (GDP) are at an annual rate. Federal debt held by the public equals point rate increases in 2019. Relative to federal debt less Treasury securities held in federal employee defined benefit retirement accounts, evaluated at the end of the quarter. the December survey, these increases are SOURCE: For GDP, Bureau of Economic Analysis via Haver Analytics; for expected to occur later in 2019. Looking federal debt, Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.” further ahead, respondents to the January survey forecast no rate increases in 2020 and in 2021.13 Meanwhile, market-based measures of uncertainty about the policy rate approximately one to two years ahead were little changed, on balance, from their levels at the end of last June. 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: FEBRUARy 2019 23 The nominal Treasury yield curve 30. Market-implied federal funds rate path continued to flatten Quarterly Percent The nominal Treasury yield curve flattened June 29, 2018 somewhat further since the first half of 2018, with the 2-year nominal Treasury yield little 2.50 changed and the 5- and 10-year nominal Treasury yields declining about 25 basis points 2.25 on net (figure 31). At the same time, yields Feb. 20, 2019 on inflation-protected Treasury securities edged up, leaving market-based measures of 2.00 inflation compensation moderately lower. In explaining movements in Treasury yields since mid-2018, market participants have 2018 2019 2020 2021 pointed to developments related to the global 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 economic outlook and trade tensions, FOMC implied path as of February 20, 2019, is compared with that as of June 29, communications, and fluctuations in oil prices. 2018. The path is estimated with a spline approach, assuming a term premium of 0 basis points. The current path extends through November 2021 and the Option-implied volatility on swap rates—an previous one through September 2021. indicator of uncertainty about Treasury SOURCE: Bloomberg; Federal Reserve Board staff estimates. yields—declined slightly on net. 31. Yields on nominal Treasury securities Consistent with changes in yields on nominal Daily Percent Treasury securities, yields on 30-year agency 7 mortgage-backed securities (MBS)—an 6 important determinant of mortgage interest 10-year 5 rates—decreased about 20 basis points, on 5-year 4 balance, since the middle of last year and remain low by historical standards (figure 32). 3 Meanwhile, yields on both investment-grade 2 and high-yield corporate debt declined a 1 2-year bit (figure 33). As a result, the spreads on 0 corporate bond yields over comparable- maturity Treasury yields are modestly wider 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 than at the end of June. The cumulative SOURCE: Department of the Treasury via Haver Analytics. increases over the past year have left spreads 32. Yield and spread on agency mortgage-backed securities for high-yield and investment-grade corporate bonds close to their historical medians, with Percent Basis points both spreads notably above the very low levels 9 300 that prevailed a year ago. Yield 8 250 7 200 Broad equity price indexes 6 Spread increased somewhat 150 5 100 Broad U.S. stock market indexes increased 4 50 somewhat since the middle of last year, on 3 net, amid substantial volatility (figure 34). 2 0 Concerns over the sustainability of corporate 2001200320052007200920112013201520172019 earnings growth, the global growth outlook, international trade tensions, and some Federal 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 would be priced at par, or face, value. Spread shown is to the average of the 5- and 10-year nominal Treasury yields. SOURCE: Department of the Treasury; Barclays Live. 24 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 33. Corporate bond yields, by securities rating Reserve communications that were perceived as less accommodative than expected weighed Daily Percentage points on investor sentiment for a time. There were 20 considerable differences in stock returns across 18 sectors, reflecting their varying degrees of 16 sensitivities to energy price declines, trade 14 tensions, and rising interest rates. In particular, 12 High-yield 10 stock prices of companies in the utilities 8 sector—which tend to benefit from falling 6 interest rates—and in the health-care sector Investment-grade 4 outperformed broader indexes. Conversely, 2 stock prices in the energy sector substantially 0 underperformed the broad indexes, as oil 1998 2001 2004 2007 2010 2013 2016 2019 prices dropped sharply. Basic materials—a NOTE: Investment-grade is the 10-year triple-B, which reflects the effective sector that was particularly sensitive to yield of the ICE BofAML 7-to-10-year triple-B U.S. Corporate Index (C4A4). High-yield is the 10-year high-yield and reflects the effective yield concerns about the global growth outlook of the ICE BofAML 7-to-10-year U.S. Cash Pay High Yield Index (J4A0). SOURCE: ICE Bank of America Merrill Lynch Indices, used with and trade tensions—also underperformed. permission. Bank stock prices declined slightly, on net, 34. Equity prices as the yield curve flattened and funding costs rose. Measures of implied and realized stock Daily December 31, 1999 = 100 price volatility for the S&P 500 index—the 200 VIX and the 20-day realized volatility— Dow Jones bank index 175 increased sharply in the fourth quarter of last year to near the high levels observed S&P 500 index 150 in early February 2018 amid sharp equity 125 price declines. These volatility measures 100 partially retraced following the turn of the 75 year, with the VIX returning to near the 50 30th percentile of its historical distribution 25 and with realized volatility ending the period close to the 70th percentile of its historical 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 range (figure 35). (For a discussion of financial SOURCE: Standard & Poor's Dow Jones Indices via Bloomberg. (For Dow stability issues, see the box “Developments Jones Indices licensing information, see the note on the Contents page.) Related to Financial Stability.”) 35. S&P 500 volatility Daily Percent Markets for Treasury securities, mortgage- backed securities, and municipal bonds 80 have functioned well 70 60 Available indicators of Treasury market VIX 50 functioning have generally remained stable 40 since the first half of 2018, with a variety of 30 liquidity metrics—including bid-ask spreads, 20 bid sizes, and estimates of transaction costs— 10 displaying few signs of liquidity pressures. Realized volatility 0 Liquidity conditions in the agency MBS market were also generally stable. Overall, 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 the functioning of Treasury and agency MBS NOTE: The VIX is a measure of implied volatility that represents the expected annualized change in the S&P 500 index over the following 30 markets has not been materially affected by days. For realized volatility, five-minute returns are used in an exponentially weighted moving average with 75 percent of weight distributed over the past 20 days. SOURCE: Cboe Volatility Index® (VIX®) accessed via Bloomberg. MONETARy POLICy REPORT: FEBRUARy 2019 25 the implementation of the Federal Reserve’s balance sheet normalization program over the past year and a half. Credit conditions in municipal bond markets have remained stable since the middle of last year, though yield spreads on 20 year general obligation municipal bonds over comparable-maturity ‑ Treasury securities were modestly higher on net. Money market rates have moved up in line with increases in the FOMC’s target range Conditions in domestic short-term funding 36. Ratio of total commercialbank credit to nominal gross domestic product markets have also remained generally stable since the beginning of the summer. Increases Quarterly Percent in the FOMC’s target range were transmitted effectively through money markets, with yields 75 on a broad set of money market instruments moving higher in response to the FOMC’s 70 policy actions in September and December. 65 The effective federal funds rate moved to parity with the interest rate paid on reserves and was 60 closely tracked by the overnight Eurodollar rate. Other short-term interest rates, including 55 those on commercial paper and negotiable certificates of deposits, also moved up in light 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 of increases in the policy rate. NOTE: Data for 2018:Q4 are estimated. SOURCE: Federal Reserve Board, Statistical Release H.8, “Assets and Liabilities of Commercial Banks in the United States”; Bureau of Economic Bank credit continued to expand, and Analysis via Haver Analytics. bank profitability improved Aggregate credit provided by commercial 37. Profitability ofbankholding companies banks expanded through the second half of Percent, annual rate Percent, annual rate 2018 at a stronger pace than the one observed in the first half of last year, as the strength 2.0 30 Return on assets in C&I loan growth more than offset the 1.5 20 moderation in the growth in CRE loans and 1.0 10 loans to households. In the fourth quarter of .5 Return on equity + + last year, the pace of bank credit expansion _0 _0 was about in line with that of nominal GDP, .5 10 leaving the ratio of total commercial bank 1.0 20 credit to current-dollar GDP little changed 1.5 30 relative to last June (figure 36). Overall, 2.0 measures of bank profitability improved 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 further in the third quarter despite a flattening NOTE: The data are quarterly and are seasonally adjusted. The data extend yield curve, but they remain below their pre- through 2018:Q3. crisis levels (figure 37). SOURCE: Federal Reserve Board, Form FR Y-9C, Consolidated Financial Statements for Bank Holding Companies. 26 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Developments Related to Financial Stability The Federal Reserve Board’s financial research by the Federal Reserve staff, academics, and stability monitoring framework other experts. Since the publication of the Federal Reserve Board’s The framework used by the Federal Reserve Board to first Financial Stability Report on November 28, 2018, monitor financial stability distinguishes between shocks some areas where valuation pressures were a concern to and vulnerabilities of the financial system. Shocks, have cooled, particularly those related to below- such as sudden changes to financial or economic investment-grade corporate debt.2 Regulatory capital conditions, are typically surprises and are inherently and liquidity ratios of key financial institutions, difficult to predict, whereas vulnerabilities tend to especially large banks, are at historically high levels. build up over time and are the aspects of the financial Funding risks in the financial system are low relative system that are most expected to cause widespread to the period leading up to the crisis. Borrowing by problems in times of stress. Some vulnerabilities are households has risen roughly in line with household cyclical in nature, rising and falling over time, while incomes and has been concentrated among prime others are structural, stemming from longer-term borrowers. Nonetheless, debt owed by businesses is forces shaping the nature of credit intermediation. As a high, and credit standards, especially within segments result, the framework focuses primarily on monitoring of the loan market focused on lower-rated or unrated vulnerabilities and emphasizes four broad categories firms, deteriorated in the second half of 2018. based on academic research.1 Asset valuations increased to the high end of their 1. Elevated valuation pressures are signaled by asset historical ranges in many markets over 2017 and the prices that are high relative to economic fundamentals first half of 2018, supported by the solid economic or historical norms and are often driven by an increased expansion and an apparent increase in investors’ willingness of investors to take on risk. As such, appetite for risk. However, compared with July 2018, elevated valuation pressures imply a greater possibility around the time of the previous Monetary Policy of outsized drops in asset prices. Report, valuation pressures have eased somewhat 2. Excessive borrowing by businesses and in the equity, corporate bond, and leveraged loan households leaves them vulnerable to distress if their markets. Over the same period, amid substantial market incomes decline or the assets they own fall in value. volatility, the forward equity price-to-earnings ratio of 3. Excessive leverage within the financial sector S&P 500 firms, a metric of valuations in equity markets, increases the risk that financial institutions will not have declined a touch, on net, and it currently stands just the ability to absorb losses when hit by adverse shocks. below the top quartile of its historical distribution 4. Funding risks expose the financial system to the (figure A). Spreads on both investment- and speculative- possibility that investors will “run” by withdrawing grade corporate bonds over comparable-maturity their funds from a particular institution or sector. Treasury securities widened modestly to levels close Facing a run, financial institutions may need to sell to the medians of their historical ranges since 1997 assets quickly at “fire sale” prices, thereby incurring (figure B). Spreads on newly issued leveraged loans substantial losses and potentially even becoming widened markedly in the fourth quarter of 2018. In insolvent. Historians and economists often refer to real estate markets, commercial real estate prices have widespread investor runs as “financial panics.” been growing faster than rents for several years, leaving While this framework provides a systematic way valuations stretched. to assess financial stability, some potential risks do Since the 2007–09 recession, household debt and not fit neatly into it because they are novel or difficult business debt have diverged (figure C). Over the to quantify, such as cybersecurity or developments past several years, borrowing by households has stayed in crypto-assets. In addition, some vulnerabilities are in line with income growth and has been concen- difficult to measure with currently available data, and trated among borrowers with strong credit histories. the set of vulnerabilities may evolve over time. Given (continued) these limitations, we continually rely on ongoing 1. For a review of the research literature in this area 2. See Board of Governors of the Federal Reserve System and further discussion, see Tobias Adrian, Daniel Covitz, (2018), Financial Stability Report (Washington: Board of and Nellie Liang (2015), “Financial Stability Monitoring,” Governors, November), https://www.federalreserve.gov/ Annual Review of Financial Economics, vol. 7 (December), publications/2018-november-financial-stability-report- pp. 357–95. purpose.htm. MONETARy POLICy REPORT: FEBRUARy 2019 27 A. Forward price-to-earnings ratio of S&P 500 firms C. Business- andhousehold-sector credit-to-GDP ratio Monthly Ratio Ratio Ratio 29 1.1 .75 26 1.0 Household .70 23 .9 20 .8 .65 + 17 .7 .60 14 .6 Historical median .55 11 .5 Business .50 8 .4 5 .3 .45 1989 1994 1999 2004 2009 2014 2019 1982198619901994199820022006201020142018 NOTE: Aggregate forward price-to-earnings ratio of S&P 500 firms. Data NOTE: Data are quarterly and extend through 2018:Q3. The shaded bars are based on expected earnings for 12 months ahead. The plus sign shows indicate periods of business recession as defined by the National Bureau of daily data corresponding to February 20, 2019. Economic Research. GDP is gross domestic product. SOURCE: Federal Reserve Board staff calculations using Refinitiv SOURCE: Federal Reserve Board, Statistical Release Z.1, “Financial (formerly Thomson Reuters), IBES Estimates. Accounts of the United States”; Bureau of Economic Analysis via Haver Analytics, national income and product accounts, Table 1.1.5: Gross B. Corporate bond spreads to similar-maturity Domestic Product; Board staff calculations. Treasury securities two years (figure D). Issuance of these instruments Daily Percentage points slowed significantly in November and December 2018 16 because of the sharply higher spreads demanded by 14 investors to hold them, but issuance has rebounded somewhat in early 2019. 12 Credit standards for new leveraged loans 10-year high-yield 10 deteriorated over the second half of 2018. The share 8 of newly issued large loans to corporations with high 6 leverage—defined as those with ratios of debt to 4 EBITDA (earnings before interest, taxes, depreciation, and amortization) above 6—increased through 2 2018 to levels exceeding previous peaks observed 10-year triple-B 0 in 2007 and 2014, when underwriting quality was notably poor. In addition, issuance of covenant-lite 1998 2001 2004 2007 2010 2013 2016 2019 loans—loans with few or no traditional maintenance NOTE: The 10-year triple-B reflects the effective yield of the ICE BofAML 7-to-10-year triple-B U.S. Corporate Index (C4A4), and the 10-year covenants—remained high during the second half high-yield reflects the effective yield of the ICE BofAML 7-to-10-year U.S. of 2018, although this elevated level may reflect, in Cash Pay High Yield Index (J4A0). Treasury yields from smoothed yield part, a greater prevalence of investors who do not curve estimated from off-the-run securities. SOURCE: ICE Data Indices, LLC, used with permission; Department of the traditionally monitor and exercise loan covenants.3 Treasury. Nonetheless, the strong economy has helped sustain solid credit performance of leveraged loans in 2018, By contrast, borrowing by businesses, including riskier with the default rate on such loans near the low end of firms, has expanded significantly. For speculative- its historical range. grade and unrated firms, the ratio of debt to assets has (continued on next page) increased steadily since 2010 and remains near its historical peak. Further, growth in debt to businesses 3. Collateralized loan obligations, which are predominantly backed by leveraged loans, have grown rapidly over the past with lower credit ratings and with already elevated year and, as of year-end 2018, purchase about 60 percent of levels of borrowing, such as high-yield bonds and leveraged loans at origination. Similarly, mutual funds hold leveraged loans, has been substantial over the past about 20 percent of leveraged loans. 28 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS Financial Stability (continued) D. Netissuance of risky business debt and a deeper recession than in 2018 as well as typically large declines in financial asset prices. Quarterly Billions of dollars Capital levels at insurance companies and broker- Institutional leveraged loans dealers also remained relatively robust by historical High-yield and unrated bonds 80 standards. A range of indicators suggest that hedge fund Total leverage was roughly unchanged over 2018; however, 60 comprehensive data, available with a significant time 40 lag, from early 2018 showed that leverage remained at the upper end of its range over the past eight years. 20 + vulnerabilities associated with funding risk—that _0 is, the financing of illiquid assets or long-maturity assets with short-maturity debt—continue to be low, 20 in part because of the post-crisis implementation of 40 liquidity regulations for banks and the 2016 money market reforms.4 Banks are holding higher levels of 2006 2008 2010 2012 2014 2016 2018 liquid assets, while their use of short-term wholesale NOTE: Total net issuance of risky debt is the sum of the net issuance of funding as a share of liabilities is near historical lows. speculative-grade and unrated bonds and leveraged loans. The data are Assets under management at prime funds, institutions four-quarter moving averages. SOURCE: Mergent, Fixed Investment Securities Database (FISD); S&P that proved vulnerable to runs in the past, have risen Global, Leveraged Commentary & Data. somewhat in recent months but remained far below pre-reform levels. The credit quality of nonfinancial high-yield Potential downside risks to international financial corporate bonds was roughly stable over the past stability include a downturn in global growth, several years, with the share of high-yield bonds political and policy uncertainty, an intensification outstanding that are rated B3/B- or below staying of trade tensions, and broadening stress in emerging flat and below the financial crisis peak. In contrast, market economies (EMEs). In many advanced foreign the distribution of ratings among investment-grade economies, financial conditions tightened somewhat corporate bonds deteriorated. The share of bonds rated in the second half of 2018, partly reflecting a at the lowest investment-grade level (for example, an deterioration in the fiscal outlook of Italy and Brexit S&P rating of triple-B) reached near-record levels. As of uncertainty. The United Kingdom and the European December 2018, around 42 percent of corporate bonds Union (EU) have not yet ratified the terms for the outstanding were at the lowest end of the investment- United Kingdom’s March 2019 withdrawal from the EU grade segment, amounting to about $3 trillion. (Brexit). Without such a withdrawal agreement, there vulnerabilities from financial-sector leverage will be no transition period for important trade and continue to be low relative to historical standards, in financial interactions between U.K. and EU residents, part because of regulatory reforms enacted since the and, despite preparations for a “no-deal Brexit,” a wide financial crisis. Core financial intermediaries, including range of economic and financial activities could be large banks, insurance companies, and broker-dealers, disrupted. EMEs also experienced heightened financial appear well positioned to weather economic stress. As stress in the second half of 2018. Although that stress of the third quarter of 2018, regulatory capital ratios for has receded somewhat more recently, many EMEs the U.S. global systemically important banks remained continue to harbor important vulnerabilities, reflecting well above regulatory requirements and were close one or more of substantial corporate leverage, fiscal to historical highs. Those banks will be subject to the concerns, or excessive reliance on foreign funding. 2019 Dodd-Frank Act stress tests and Comprehensive Capital Assessment and Review. Consistent with the 4. See U.S. Securities and Exchange Commission (2014), Federal Reserve Board’s public framework, this year’s “SEC Adopts Money Market Fund Reform Rules,” press release, scenarios feature a larger increase in unemployment July 23, https://www.sec.gov/news/press-release/2014-143. MONETARy POLICy REPORT: FEBRUARy 2019 29 International Developments Economic activity in most foreign economies weakened in the second half of 2018 After expanding briskly in 2017, foreign GDP growth moderated in 2018. While part of this slowdown is likely due to temporary factors, it also appears to reflect weaker underlying momentum against the backdrop of somewhat 38. Real gross domestic product growthin selected tighter financial conditions, increased policy advanced foreign economies uncertainty, and ongoing debt deleveraging. Percent, annual rate The growth slowdown was particularly United Kingdom pronounced in advanced foreign Japan 4 Euro area economies Canada H1 Q3 Q4 2 Real GDP growth in several advanced + foreign economies (AFEs) slowed markedly _0 in the second half of the year (figure 38). 2 This slowdown was concentrated in the manufacturing sector against the backdrop 4 of softening global trade flows. In Japan, real GDP contracted in the second half of 2018, 2015 2016 2017 2018 as economic activity, which was disrupted by a NOTE: The data for the euro area, Japan, and the U.K. incorporate series of natural disasters in the third quarter, preliminary estimates for 2018:Q4. The data for Canada extend through rebounded only partly in the fourth quarter. 2018:Q3. SOURCE: For the United Kingdom, Office for National Statistics; for Japan, Growth in the euro area slowed in the second Cabinet Office, Government of Japan; for the euro area, Eurostat; for Canada, Statistics Canada; all via Haver Analytics. half of the year: Transportation bottlenecks and complications in meeting tighter emissions 39. Consumer price inflation in selected advancedforeign standards for new motor vehicles weighed economies on German economic activity, while output contracted in Italy. Although some of these Monthly 12-month percent change headwinds appear to be fading, recent 4 indicators—especially for the manufacturing United Kingdom sector—point to only a limited recovery of 3 Japan activity in the euro area at the start of 2019. Canada 2 Inflation pressures remain contained in 1 advanced foreign economies . . . + _0 In recent months, headline inflation has fallen Euro area 1 below central bank targets in many major AFEs, reflecting large declines in energy prices 2015 2016 2017 2018 2019 (figure 39). In the euro area and Japan, low NOTE: The data for the euro area incorporate the flash estimate for January headline inflation rates also reflect subdued 2019. The data for the United Kingdom extend through January 2019. The data for Canada and Japan extend through December 2018. core inflation. In Canada and the United SOURCE: For the United Kingdom, Office for National Statistics; for Japan, Kingdom, instead, core inflation rates have Ministry of International Affairs and Communications; for the euro area, Statistical Office of the European Communities; for Canada, Statistics been close to 2 percent. Canada; all via Haver Analytics. 30 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS . . . prompting central banks to withdraw accommodation only gradually With underlying inflation still subdued, the Bank of Japan and the European Central Bank (ECB) kept their short-term policy rates at negative levels. Although the ECB concluded its asset purchase program in December, it signaled an only very gradual removal of policy accommodation going forward. The Bank of England (BOE) and the Bank of Canada, which both began raising interest rates in 2017, increased their policy rates further in the second half of 2018 but to levels that are still low by historical standards. 40. Equityindexes for selectedforeign economies The BOE noted that elevated uncertainty Weekly Week ending January 9, 2015 = 100 around the United Kingdom’s exit from the European Union (EU) weighed on the 140 country’s economic outlook. 130 Euro area Political uncertainty and slower 120 economic growth weighed on AFE 110 asset prices United Kingdom 100 Moderation in global growth, protracted Japan 90 budget negotiations between the Italian 80 government and the EU, and developments related to the United Kingdom’s withdrawal 2015 2016 2017 2018 2019 from the EU weighed on AFE asset prices NOTE: The data are weekly averages of daily data and extend through in the second half of 2018 (figure 40). Broad February 20, 2019. SOURCE: For euro area, DJ Euro Stoxx Index; for Japan, TOPIX Stock stock price indexes in the AFEs fell, interest Index; for United Kingdom, FTSE 100 Stock Index; all via Bloomberg. rates on sovereign bonds in several countries in the European periphery remained elevated, 41. Nominal10-year governmentbond yields in and European bank shares underperformed, selected advanced economies although these moves have partially retraced in recent weeks. Market-implied paths of policy Weekly Percent in major AFEs and long-term sovereign bond 3.5 yields declined somewhat, as economic data 3.0 disappointed (figure 41). United States 2.5 United Kingdom 2.0 Growth slowed in many emerging market 1.5 economies Germany 1.0 Chinese GDP growth slowed in the second .5 + half of 2018 as an earlier tightening of credit Japan _0 policy, aimed at restraining the buildup of .5 debt, caused infrastructure investment to fall 2015 2016 2017 2018 2019 sharply and squeezed household spending NOTE: The data are weekly averages of daily benchmark yields and extend (figure 42). However, increased concerns through February 20, 2019. SOURCE: Bloomberg. about a sharper-than-expected slowdown in MONETARy POLICy REPORT: FEBRUARy 2019 31 growth, as well as prospective effects of trade 42. Real gross domestic product growthin selected emerging market economies policies, prompted Chinese authorities to ease monetary and fiscal policy somewhat. Percent, annual rate Elsewhere in emerging Asia, growth remained China 12 well below its 2017 pace amid headwinds from Korea Mexico 10 moderating global growth. Tighter financial Brazil H1 8 conditions also weighed on growth in other Q3Q4 6 EMEs—notably, Argentina and Turkey. 4 2 + Economic activity strengthened _0 somewhat in Mexico and Brazil, but 2 uncertainty about policy developments 4 remains elevated 6 In Mexico, economic activity increased 2015 2016 2017 2018 at a more rapid rate in the third quarter NOTE: The data for China are seasonally adjusted by Board staff. The data for Korea, Mexico, and Brazil are seasonally adjusted by their respective after modest advances earlier in the year. government agencies. The data for Korea and Mexico incorporate preliminary estimates for 2018:Q4. The data for Brazil extend through However, growth weakened again in the fourth 2018:Q3. quarter, as perceptions that the newly elected SOURCE: For China, China National Bureau of Statistics; for Korea, Bank of Korea; for Mexico, Instituto Nacional de Estadistica y Geografia; for government would pursue less market-friendly Brazil, Instituto Brasileiro de Geografia e Estatistica; all via Haver Analytics. policies led to a sharp tightening in financial conditions. Amid a sharp peso depreciation and above-target inflation, the Bank of Mexico raised its policy rate to 8.25 percent in December. Brazilian real GDP growth rebounded in the third quarter after being held down by a nationwide trucker’s strike in May, and financial markets have rallied on expectations that Brazil’s new government will pursue economic policies that support growth. However, investors continued to focus on whether the new administration would pass significant fiscal reforms. Financial conditions in many emerging market economies were volatile but are, on net, little changed since July Financial conditions in the EMEs generally tightened in the second half of 2018, as investor concerns about vulnerabilities in several EMEs intensified against the backdrop of higher policy uncertainty, slowing global growth, and rising U.S. interest rates. Trade policy tensions between the United States and China weighed on asset prices, especially in China and other Asian economies. Broad measures of EME sovereign bond spreads over U.S. Treasury yields rose, and benchmark EME equity indexes declined. However, 32 PART 1: RECENT ECONOMIC AND FINANCIAL DEvELOPMENTS 43. Emerging market mutual fund flows and spreads financial conditions improved significantly in recent months, supported in part by more Basis points Billions of dollars positive policy developments—including the Bond fund flows (right axis) U.S.-Mexico-Canada Agreement and progress 500 Equity fund flows (right axis) 60 on U.S.–China trade negotiations—and 450 40 FOMC communications indicating a more 400 20 gradual normalization of U.S. interest rates. + 350 _0 EME mutual fund inflows resumed in recent months after experiencing outflows in the 300 Feb. 20 EMBI+ (left axis) Jan. middle of 2018 (figure 43). While movements 250 40 in asset prices and capital flows have been 200 60 sizable for a number of economies, broad indicators of financial stress in EMEs are 2015 2016 2017 2018 2019 below those seen during other periods of stress NOTE: The bond and equity fund flows data are quarterly sums of weekly in recent years. data from January 1, 2015, to December 31, 2018, and monthly sums of weekly data from January 1, 2019, to February 20, 2019. The fund flows data exclude funds located in China. The J.P. Morgan Emerging Markets Bond The dollar appreciated slightly Index Plus (EMBI+) data are weekly averages of daily data and extend through February 19, 2019. SOURCE: For bond and equity fund flows, EPFR Global; for EMBI+, J.P. The foreign exchange value of the U.S. Morgan Emerging Markets Bond Index Plus via Bloomberg. dollar is bit a higher than in July (figure 44). Concerns about the global outlook, 44. U.S. dollar exchange rate indexes uncertainty about trade policy, and monetary Weekly Week ending January 9, 2015 = 100 policy normalization in the United States contributed to the appreciation of the dollar. 150 Dollar appreciation The Chinese renminbi depreciated against the Mexican peso 140 dollar slightly, on net, amid ongoing trade 130 negotiations and increased concerns about growth prospects in China. The Mexican 120 Broad dollar peso has been volatile amid ongoing political 110 developments and trade negotiations but has, 100 on net, declined only modestly against the Chinese renminbi Euro 90 dollar. Sharp declines in oil prices also weighed on the currencies of some energy-exporting 2015 2016 2017 2018 2019 economies. NOTE: The data, which are in foreign currency units per dollar, are weekly averages of daily data and extend through February 20, 2019. As indicated by the arrow, increases in the data represent U.S. dollar appreciation, and decreases represent U.S. dollar depreciation. SOURCE: Federal Reserve Board, Statistical Release H.10, “Foreign Exchange Rates.” 33 P 2 art m P onetary oLiCy The Federal Open Market Committee reflected the solid performance of the U.S. continued to gradually increase the economy, the continued strengthening of the federal funds rate in the second half of labor market, and the fact that inflation had last year moved near the Committee’s 2 percent longer- run objective. From late 2015 through the first half of last year, the Federal Open Market Committee Looking ahead, the FOMC will be patient (FOMC) gradually increased its target range as it determines what future adjustments for the federal funds rate as the economy to the target range for the federal funds continued to make progress toward the rate may be appropriate Committee’s congressionally mandated objectives of maximum employment and With the gradual reductions in the amount price stability. In the second half of 2018, of policy accommodation to date, the federal the FOMC continued this gradual process funds rate is now at the lower end of the range of monetary policy normalization, raising of estimates of its longer-run neutral level— the federal funds rate at its September and that is, the level of the federal funds rate that is December meetings, bringing the target range neither expansionary nor contractionary. to 2¼ to 2½ percent (figure 45).14 The FOMC’s decisions to increase the federal funds rate Developments at the time of the December FOMC meeting, including volatility in financial markets and increased concerns 14. See Board of Governors of the Federal Reserve about global growth, made the appropriate System (2018), “Federal Reserve Issues FOMC Statement,” press release, September 26, https:// extent and timing of future rate increases www.federalreserve.gov/newsevents/pressreleases/ more uncertain than earlier. Against that monetary20180926a.htm; and Board of Governors of backdrop, the Committee indicated it would the Federal Reserve System (2018), “Federal Reserve monitor global economic and financial Issues FOMC Statement,” press release, December 19, developments and assess their implications https://www.federalreserve.gov/newsevents/pressreleases/ for the economic outlook. In the Summary monetary20181219a.htm. 45. 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 2019 NOTE: The 2-year and 10-year Treasury rates are the constant-maturity yields based on the most actively traded securities. SOURCE: Department of the Treasury; Federal Reserve Board. 34 PART 2: MONETARy POLICy of Economic Projections (SEP) from the prescriptions for the policy interest rate December meeting—the most recent SEP from a variety of rules, which can serve as available—participants generally revised down useful guidance to the FOMC. However, their individual assessments of the appropriate many practical considerations make it path for monetary policy relative to their undesirable for the FOMC to mechanically assessments at the time of the September follow the prescriptions of any specific rule. meeting.15 Consequently, the FOMC’s framework for conducting systematic monetary In January, the Committee stated that it policy respects key principles of good continued to view sustained expansion monetary policy and, at the same time, of economic activity, strong labor market provides flexibility to address many of the conditions, and inflation near the Committee’s limitations of these policy rules (see the box symmetric 2 percent objective as the most “Monetary Policy Rules and Systematic likely outcomes. Nonetheless, in light of Monetary Policy”). global economic and financial developments and muted inflation pressures, the Committee The FOMC has continued to implement will be patient as it determines what future its program to gradually reduce the adjustments to the federal funds rate may be Federal Reserve’s balance sheet appropriate to support these outcomes. The Committee has continued to implement the balance sheet normalization program that Future changes in the federal funds rate has been under way since October 2017.16 will depend on the economic outlook as Under this program, the FOMC has been informed by incoming data reducing its holdings of Treasury and agency The FOMC has continued to emphasize securities in a gradual and predictable manner that the actual path of monetary policy will by decreasing its reinvestment of the principal depend on the evolution of the economic payments it received from these securities. outlook as informed by incoming data. Specifically, such payments have been Specifically, in deciding on the timing and size reinvested only to the extent that they exceeded of future adjustments to the federal funds gradually rising caps (figure 46). rate, the Committee will assess realized and expected economic conditions relative to its In the third quarter of 2018, the Federal objectives of maximum employment and Reserve reinvested principal payments from 2 percent inflation. This assessment will take its holdings of Treasury securities maturing into account a wide range of information, during each calendar month in excess of including measures of labor market conditions, $24 billion. It also reinvested in agency indicators of inflation pressures and inflation mortgage-backed securities (MBS) the amount expectations, and readings on financial and of principal payments from its holdings of international developments. agency debt and agency MBS received during each calendar month in excess of $16 billion. In addition to evaluating a wide range In the fourth quarter, the FOMC increased of economic and financial data and the caps for Treasury securities and for agency information gathered from business contacts securities to their respective maximums and other informed parties around the of $30 billion and $20 billion. Of note, country, policymakers routinely consult 16. For more information, see the Addendum to 15. See the December Summary of Economic the Policy Normalization Principles and Plans, which Projections, which appeared as an addendum to the is available on the Board’s website at https://www. minutes of the December 18–19, 2018, meeting of the federalreserve.gov/monetarypolicy/files/FOMC_ FOMC and is presented in Part 3 of this report. PolicyNormalization.20170613.pdf. MONETARy POLICy REPORT: FEBRUARy 2019 35 46. 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 Treasury securities are projections starting in February 2019. Reinvestment and redemption amounts of agency debt and mortgage-backed securities are projections starting in February 2019. Cap amounts are projections beyond March 2019. The data extend through December 2019. Source: Federal Reserve Bank of New York; Federal Reserve Board staff calculations. 47. Federal Reserve assets andliabilities 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 2019 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-BackedCommercial 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 February 13, 2019. SOURCE: Federal Reserve Board, Statistical Release H.4.1, “Factors Affecting Reserve Balances.” reinvestments of agency debt and agency MBS agency debt and agency MBS at approximately ceased in October as principal payments fell $1.6 trillion (figure 47). below the maximum redemption caps. As the Federal Reserve has continued to The Federal Reserve’s total assets have gradually reduce its securities holdings, the continued to decline from about $4.3 trillion level of reserve balances in the banking last July to about $4.0 trillion at present, system has declined. In particular, the level with holdings of Treasury securities at of reserve balances has decreased by about approximately $2.2 trillion and holdings of $350 billion since the middle of last year, and 36 PART 2: MONETARy POLICy Monetary Policy Rules and Systematic Monetary Policy Monetary policy rules are mathematical formulas Economists have analyzed many monetary policy that relate a policy interest rate, such as the federal rules, including the well-known Taylor (1993) rule. funds rate, to a small number of other economic Other rules include the “balanced approach” rule, the variables—typically including the deviation of inflation “adjusted Taylor (1993)” rule, the “price level” rule, and from its target value and a measure of resource slack in the “first difference” rule (figure A).3 These policy rules the economy. The prescriptions for the policy interest embody the three key principles of good monetary rate from these rules can provide helpful guidance for policy and take into account estimates of how far the the Federal Open Market Committee (FOMC). This economy is from the Federal Reserve’s dual-mandate discussion provides information on how policy rules goals of maximum employment and price stability. Four inform the FOMC’s systematic conduct of monetary of the five rules include the difference between the rate policy, as well as practical considerations that make of unemployment that is sustainable in the longer run it undesirable for the FOMC to mechanically follow and the current unemployment rate (the unemployment the prescriptions of any specific rule. The FOMC’s rate gap); the first-difference rule includes the change approach for conducting monetary policy provides in the unemployment gap rather than its level.4 In sufficient flexibility to address the intrinsic complexities addition, four of the five rules include the difference and uncertainties in the economy while keeping (continued) monetary policy predictable and transparent. 3. The Taylor (1993) rule was suggested in John B. Taylor Policy Rules and Historical Prescriptions (1993), “Discretion versus Policy Rules in Practice,” Carnegie- Rochester Conference Series on Public Policy, vol. 39 The effectiveness of monetary policy is enhanced (December), pp. 195–214. The balanced-approach rule was analyzed in John B. Taylor (1999), “A Historical Analysis of when it is well understood by the public.1 In simple Monetary Policy Rules,” in John B. Taylor, ed., Monetary Policy models of the economy, good economic performance Rules (Chicago: University of Chicago Press), pp. 319–41. The can be achieved by following a specific monetary adjusted Taylor (1993) rule was studied in David Reifschneider policy rule that fosters public understanding and and John C. Williams (2000), “Three Lessons for Monetary Policy in a Low-Inflation Era,” Journal of Money, Credit and that incorporates key principles of good monetary Banking, vol. 32 (November), pp. 936–66. A price-level rule policy.2 One such principle is that monetary policy was discussed in Robert E. Hall (1984), “Monetary Strategy should respond in a predictable way to changes in with an Elastic Price Standard,” in Price Stability and Public economic conditions and the economic outlook. A Policy, proceedings of a symposium sponsored by the Federal second principle is that monetary policy should be Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 2–3 (Kansas City: Federal Reserve Bank of Kansas accommodative when inflation is below policymakers’ City), pp. 137–59, https://www.kansascityfed.org/publicat/ longer-run inflation objective and employment is below sympos/1984/s84.pdf. Finally, the first-difference rule is its maximum sustainable level; conversely, monetary based on a rule suggested by Athanasios Orphanides (2003), policy should be restrictive when the opposite holds. “Historical Monetary Policy Analysis and the Taylor Rule,” Journal of Monetary Economics, vol. 50 (July), pp. 983–1022. A third principle is that, to stabilize inflation, the policy A comprehensive review of policy rules is in John B. Taylor rate should be adjusted by more than one-for-one in and John C. Williams (2011), “Simple and Robust Rules for response to persistent increases or decreases Monetary Policy,” in Benjamin M. Friedman and Michael in inflation. Woodford, eds., Handbook of Monetary Economics, vol. 3B (Amsterdam: North-Holland), pp. 829–59. The same volume of the Handbook of Monetary Economics also discusses 1. For a discussion of how the public’s understanding of approaches other than policy rules for deriving policy rate monetary policy matters for the effectiveness of monetary prescriptions. policy, see Janet L. yellen (2012), “Revolution and Evolution 4. The Taylor (1993) rule represented slack in resource in Central Bank Communications,” speech delivered at the utilization using an output gap (the difference between the Haas School of Business, University of California at Berkeley, current level of real gross domestic product (GDP) and the Berkeley, Calif., November 13, https://www.federalreserve.gov/ level that GDP would be if the economy were operating at newsevents/speech/yellen20121113a.htm. maximum employment). The rules in figure A represent slack 2. For a discussion regarding principles for the conduct in resource utilization using the unemployment gap instead, of monetary policy, see Board of Governors of the Federal because that gap better captures the FOMC’s statutory goal Reserve System (2018), “Monetary Policy Principles and to promote maximum employment. However, movements in Practice,” Board of Governors, https://www.federalreserve.gov/ these alternative measures of resource utilization are highly monetarypolicy/monetary-policy-principles-and-practice.htm. correlated. For more information, see the note below figure A. MONETARy POLICy REPORT: FEBRUARy 2019 37 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 3 provides references for the policy rules. between recent inflation and the FOMC’s longer- lower bound may therefore not provide enough policy run objective (2 percent as measured by the annual accommodation. To make up for the cumulative shortfall change in the price index for personal consumption in accommodation (Z), the adjusted rule prescribes t expenditures, or PCE), while the price-level rule only a gradual return of the policy rate to the (positive) includes the gap between the level of prices today and levels prescribed by the standard Taylor (1993) rule after the level of prices that would be observed if inflation the economy begins to recover. The version of the price- had been constant at 2 percent from a specified starting level rule specified in figure A also recognizes that the year (PLgap).5 The price-level rule thereby takes federal funds rate cannot be reduced materially below t account of the deviation of inflation from the zero. If inflation runs below the 2 percent objective long-run objective in earlier periods as well as the during periods when the price-level rule prescribes current period. setting the federal funds rate well below zero, the rule The adjusted Taylor (1993) rule recognizes that will, over time, call for more accommodation to make the federal funds rate cannot be reduced materially up for the past inflation shortfall. below zero, and that following the prescriptions As shown in figure B, the different monetary policy of the standard Taylor (1993) rule after a recession rules often differ in their prescriptions for the federal during which the federal funds rate has fallen to its funds rate.6 Although almost all of the simple policy (continued on next page) 5. Calculating the prescriptions of the price-level rule requires selecting a starting year for the price level from which to cumulate the 2 percent annual rate of inflation. 6. These prescriptions are calculated using (1) published Figure B uses 1998 as the starting year. Around that time, data for inflation and the unemployment rate and (2) survey- the underlying trend of inflation and longer-term inflation based estimates of the longer-run value of the neutral expectations stabilized at a level consistent with PCE price real interest rate and the longer-run value of the inflation being close to 2 percent. unemployment rate. 38 PART 2: MONETARy POLICy Monetary Policy Rules (continued) B. Historicalfederalfunds 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 valuesfor 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. The data extend through 2018:Q3, with the exception of the target federal funds rate data, which go through 2018:Q4. SOURCE: Federal Reserve Bank of Philadelphia; Wolters Kluwer, Blue Chip Economic Indicators; Federal Reserve Board staff estimates. rules would have called for values for the federal funds matters further, monetary policy affects the Federal rate that were increasing over time in recent years, the Reserve’s goal variables of inflation and employment prescribed values vary widely across rules. In general, with long and variable lags. For these reasons, there is no unique criterion for favoring one rule good monetary policy must take into account the over another. information contained in the real-time forecast of the economy. Finally, simple policy rules do not take into Systematic Monetary Policy in Practice account that the risks to the economic outlook may be asymmetric, such as during the period when the Although monetary policy rules seem appealing federal funds rate was still close to zero. At that time, for obtaining and communicating current and future the FOMC took into consideration that it would have policy rate prescriptions, the usefulness of these rules limited scope to respond to an unexpected weakening for policymakers is limited by a range of practical in the economy by cutting the federal funds rate, but considerations. According to simple monetary that it would have ample scope to increase the policy policy rules, the policy interest rate must respond rate in response to an unexpected strengthening in the mechanically to a small number of variables. However, economy. This asymmetric risk provided a rationale for these variables may not reflect important information increasing the federal funds rate more gradually than available to policymakers at the time they make prescribed by some policy rules shown in figure B.8 decisions. For example, none of the inputs into the (continued) Taylor (1993) rule include financial and credit market conditions or indicators of consumer and business sentiment; these factors are often very informative for structure of the economy cause the longer-run value of the the future course of the economy. Similarly, monetary neutral real interest rate to vary over time and thus complicate policy rules tend to include only the current values of its estimation. See Board of Governors of the Federal Reserve the selected variables in the rule. But the relationship System (2018), Monetary Policy Report (Washington: Board of between the current values of these variables and Governors, July), pp. 37–41, https://www.federalreserve.gov/ the outlook for the economy changes over time for a monetarypolicy/files/20180713_mprfullreport.pdf. 8. For further discussion regarding the challenges of using number of reasons. For example, the structure of the monetary policy rules in practice, see Board of Governors of economy is evolving over time and is not known with the Federal Reserve System (2018), “Challenges Associated certainty at any given point in time.7 To complicate with Using Rules to Make Monetary Policy,” Board of Governors, https://www.federalreserve.gov/monetarypolicy/ 7. The box “Complexities of Monetary Policy Rules” in the challenges-associated-with-using-rules-to-make-monetary- July 2018 Monetary Policy Report discusses how shifts in the policy.htm. MONETARy POLICy REPORT: FEBRUARy 2019 39 The FOMC conducts systematic monetary policy in C. Change in 10-year yield in response to Employment a framework that respects the key principles of good Situation report monetary policy while providing sufficient flexibility to address many of the practical concerns described Change in 10-year yields on Treasury securities (basis points) earlier. At the core of this framework lies the FOMC’s firm commitment to the Federal Reserve’s statutory 10 mandate of promoting maximum employment and price stability, a commitment that the Committee 5 reaffirms on a regular basis.9 To explain its monetary + policy decisions to the public as clearly as possible, 0 the FOMC communicates about the economic data – that are relevant to its policy decisions. As part of this 5 communication strategy, the Federal Reserve regularly describes the economic and financial data used to 10 inform its policy decisions in the Monetary Policy Report and the FOMC meeting minutes. These data include, but are not limited to, measures of labor -100 -50 0 50 100 Surprise in nonfarm payroll job gains (in thousands) market conditions, inflation, household spending NOTE: The data are monthly, and the sample period starts in February and business investment, asset prices, and the global 2010. The change in 10-year yields on Treasury securities is measured within economic environment. The FOMC postmeeting a 1-hour window after the data release. The surprise in nonfarm payroll job gains is measured as the difference in the actual nonfarm payroll job gains in statements and the meeting minutes detail how thousands and the median expected nonfarm payroll job gains in the the data inform the Committee’s overall economic Bloomberg Survey of Economists before the data release. outlook, the risks to this outlook, and, in turn, the SOURCE: Bureau of Labor Statistics; Bloomberg. Committee’s assessment about the appropriate stance of monetary policy. This appropriate stance depends on the FOMC’s longer-run goals, the economic outlook and the risks to the outlook, and the channels through which monetary policy actions influence economic activity and prices. The FOMC combines all of these participants adjust their expectations for policy in elements in determining the timing and size of this manner is shown in figure C. The figure plots the adjustments of the policy interest rates. The quarterly change in the 10-year yield on Treasury securities in a Summary of Economic Projections provides additional one-hour window around the release of employment information about each FOMC participant’s forecasts reports on the vertical axis against the difference in for the economy and the longer-run assessments of the the actual value of nonfarm payroll job gains and the economy, under her or his individual views concerning expectations of private-sector analysts immediately appropriate policy. before the release of the data on the horizontal axis— These policy communications help the public that is, a proxy for “surprises” in nonfarm payroll job understand the FOMC’s approach to monetary gains. When actual nonfarm payroll job gains turn out policymaking and the principles that underlie it. to be higher than market participants expect, the yield Consequently, in response to incoming information, on 10-year Treasury securities tends to increase. The market participants tend to adjust their expectations rise in the 10-year yield reflects market participants’ regarding monetary policy in the direction consistent expectation that, as a result of stronger-than-expected with achieving the maximum-employment and price- labor market data, the path of short-term interest rates stability goals of the FOMC.10 Evidence that market will be higher in the future. Conversely, the 10-year yield tends to decline after negative surprises in nonfarm payroll data, reflecting the path of short-term interest rates will be somewhat lower in the future. 9. See the Statement on Longer-Run Goals and Monetary These adjustments in the 10-year yield help stabilize Policy Strategy, which is available on the Board’s website at the economy even before the FOMC changes the level https://www.federalreserve.gov/monetarypolicy/files/FOMC_ of the federal funds rate in the direction consistent with LongerRunGoals.pdf. achieving its goals, as higher long-term interest rates 10. New economic information can be composed of data surprises or of factors that may pose risks to future economic tend to slow the labor market while lower rates tend to outcomes but are not yet reflected in the data. strengthen it. 40 PART 2: MONETARy POLICy by about $1.2 trillion since its peak in 2014.17 Treasury. Preliminary financial statement At the January meeting, the Committee results indicate that the Federal Reserve released an updated Statement Regarding remitted about $65 billion in 2018. Monetary Policy Implementation and Balance Sheet Normalization to provide additional The Federal Reserve’s implementation of information regarding its plans to implement monetary policy has continued smoothly monetary policy over the longer run.18 In this As with the previous federal funds rate statement, the Committee indicated that it increases since late 2015, the Federal Reserve intends to continue to implement monetary successfully raised the effective federal funds policy in a regime in which an ample supply rate in September and December by increasing of reserves ensures that control over the level the interest rate paid on reserve balances of the federal funds rate and other short-term and the interest rate offered on overnight interest rates is exercised primarily through the reverse repurchase agreements (ON RRPs). setting of the Federal Reserve’s administered Specifically, the Federal Reserve raised the rates, and in which active management of interest rate paid on required and excess the supply of reserves is not required. This reserve balances to 2.20 percent in September operating procedure is often called a “floor and to 2.40 percent in December. In addition, system.” The FOMC judges that this approach the Federal Reserve increased the ON RRP provides good control of short-term money offering rate to 2.00 percent in September market rates in a variety of market conditions and to 2.25 percent in December. The Federal and effective transmission of those rates to Reserve also approved a ¼ percentage point broader financial conditions. In addition, the increase in the discount rate (the primary FOMC stated that it is prepared to adjust credit rate) in both September and December. any of the details for completing balance Yields on a broad set of money market sheet normalization in light of economic and instruments moved higher, roughly in line financial developments. with the federal funds rate, in response to the FOMC’s policy decisions in September and Although reserve balances play a central role December. Usage of the ON RRP facility has in the ongoing balance sheet normalization remained low, excluding quarter-ends. process, in the longer run, the size of the balance sheet will also be importantly The effective federal funds rate moved to parity determined by trend growth in nonreserve with the interest rate paid on reserve balances liabilities. The box “The Role of Liabilities in in the months before the December meeting. Determining the Size of the Federal Reserve’s At its December meeting, the Committee made Balance Sheet” discusses various factors that a second small technical adjustment by setting influence the size of reserve and nonreserve the interest on excess reserves rate 10 basis liabilities. points below the top of the target range for the federal funds rate; this adjustment was Meanwhile, interest income on the Federal intended to foster trading in the federal funds Reserve’s securities holdings has continued to market at rates well within the FOMC’s support substantial remittances to the U.S. target range. 17. Since the start of the normalization program, The Federal Reserve will conduct a reserve balances have dropped by approximately review of its strategic framework for $600 billion. monetary policy in 2019 18. See the Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization, With labor market conditions close to which is available on the Board’s website at https:// maximum employment and inflation near the www.federalreserve.gov/newsevents/pressreleases/ monetary20190130c.htm. Committee’s 2 percent objective, the FOMC MONETARy POLICy REPORT: FEBRUARy 2019 41 The Role of Liabilities in Determining the Size of the Federal Reserve’s Balance Sheet The size of the Federal Reserve’s balance sheet influenced their size since the financial crisis. Many increased from $900 billion at the end of 2006 to about of the Federal Reserve’s liabilities arise from statutory $4.5 trillion at the end of 2014—or from 6 percent responsibilities, such as supplying currency and serving of gross domestic product (GDP) to about 25 percent as the Treasury Department’s fiscal agent. Each liability of GDP—mainly as a result of the large-scale asset provides social benefits to the economy and plays an purchase (LSAP) programs conducted in response to important role as a safe and liquid asset for the public, persistent economic weakness following the financial the banking system, the U.S. government, or other crisis. The expansion of total assets that stemmed from institutions. the LSAPs was primarily matched by higher reserve Figure A plots the evolution of the Federal Reserve’s balances of depository institutions, which peaked in main liabilities relative to nominal GDP over the post– the fall of 2014 at $2.8 trillion, or almost 16 percent World War II period. Federal Reserve notes outstanding of GDP, rising from about $10 billion at the end of have traditionally been the largest Federal Reserve 2006. Liabilities other than reserves have also grown liability and, over the past three decades, have been significantly and played a role in the expansion of slowly growing as a share of U.S. nominal GDP. U.S. the balance sheet. The magnitude of these nonreserve currency is an important medium of exchange and liabilities as well as the flows affecting their variability store of value, both domestically and abroad. Despite are not closely related to monetary policy decisions. the increasing use of electronic means of payment, Since October 2017, the Federal Reserve has been currency remains widely used in retail transactions gradually reducing its securities holdings resulting in the United States. Demand for currency tends from crisis-era purchases. Once these holdings have to increase with the size of the economy because unwound to the point at which reserve balances households and businesses need more currency to have declined to their longer-run level, the size of use in exchange for a growing volume of economic the balance sheet will be determined by factors transactions. In addition, with heavy usage of U.S. affecting the demand for Federal Reserve liabilities. currency overseas, changes in global growth as well This discussion describes the Federal Reserve’s most as in financial and geopolitical stability can also significant liabilities and reviews the factors that (continued on next page) A. Liabilities as a share of nominal grossdomestic product Annual Percent Reserve balances Other liabilities 25 Treasury General Account Currency 20 15 10 5 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 2018 Note: Data for 2018 pertain to Q3 and are from the Federal Reserve Banks Combined Quarterly Financial Report (Unaudited); data for 1950 through 2017 are from the 104th Annual Report, 2017. Source: Board of Governors of the Federal Reserve System (2018), 104th Annual Report, 2017, Table 6: Reserves of Depository Institutions, Federal Reserve Bank Credit, and Related Items (Table 6A: Year-End 1984-2017 and Month-End 2017; Table 6B: Year-End 1918-1983) (Washington: Board of Governors), pp. 302-09, https://www.federalreserve.gov/publications/files/2017-annual-report.pdf; Board of Governors of the Federal Reserve System (2018), Federal Reserve Banks Combined Quarterly Financial Report (Unaudited), Table: Combined Statements of Condition (Washington: Board of Governors, September 30), p. 3, https://www.federalreserve.gov/aboutthefed/files/quarterly-report-20180930.pdf. 42 PART 2: MONETARy POLICy The Role of Liabilities (continued) materially affect the rate of currency growth. Since the Banks’ higher demand for reserves appears to reflect in start of the Global Financial Crisis, notes in circulation part an increased focus on liquidity risk management in have more than doubled and, as of the end of 2018, the context of regulatory changes. stood at about $1.67 trillion, equivalent to about Liabilities other than currency and reserves 8 percent of U.S. GDP, implying that accommodating include the Treasury General Account (TGA), reverse demand for currency alone requires a larger balance repurchase agreements conducted with foreign official sheet than before the crisis. account holders, and deposits held by designated Reserve balances are currently the second- financial market utilities (DFMUs). By statute, the largest liability in the Federal Reserve’s balance Federal Reserve serves a special role as fiscal agent sheet, totaling $1.66 trillion at the end of 2018, or or banker for the federal government. Consequently, nearly 8 percent of nominal GDP. This liability item the U.S. Treasury holds cash balances at the Federal consists of deposits held at Federal Reserve Banks by Reserve in the TGA, using this account to receive depository institutions, including commercial banks, taxes and proceeds of securities sales and to pay the savings banks, credit unions, thrift institutions, and government’s bills, including interest and principal on most U.S. branches and agencies of foreign banks. maturing securities. Before 2008, the Treasury targeted These balances include reserves held to fulfill reserve a steady, low balance of $5 billion in the TGA on requirements as well as reserves held in excess of most days, and it used private accounts at commercial these requirements. Reserve balances allow banks to banks to manage the variability in its cash flows. Since facilitate daily payment flows, both in ordinary times 2008, the Treasury has used the TGA as the primary and in stress scenarios, without borrowing funds or account for managing cash flows. In May 2015, the selling assets. Reserve balances have been declining Treasury announced its intention to hold in the TGA a for several years, in part as a result of the ongoing level of cash generally sufficient to cover one week of balance sheet normalization program initiated in outflows, subject to a minimum balance objective of October 2017, and now stand about $1.2 trillion below roughly $150 billion. Since this policy change, the TGA their peak in 2014. At its January 2019 meeting, the balance has generally been well above this minimum; Federal Open Market Committee decided that it would at the end of 2018, it was about $370 billion, or nearly continue to implement monetary policy in a regime 2 percent of GDP. The current policy helps protect with an ample supply of reserves, which is often called against the risk that extreme weather or other technical a “floor system” or an “abundant reserves system.”1 or operational events might cause an interruption in Going forward, the banking system’s overall demand access to debt markets and leave the Treasury unable for reserve balances and the Committee’s judgment to fund U.S. government operations—a scenario that about the quantity that is appropriate for the efficient could have serious consequences for financial stability. and effective implementation of monetary policy will Reverse repurchase agreements with foreign official determine the longer-run level of reserve balances. accounts, also known as the foreign repo pool, also Although the level of reserve balances that banks will rose during recent years. The Federal Reserve has eventually demand is not yet known with certainty, it long offered this service as part of a suite of banking is likely to be appreciably higher than before the crisis. and custody services to foreign central banks, foreign governments, and international official institutions. 1. See footnote 18 in the main text. (continued) MONETARy POLICy REPORT: FEBRUARy 2019 43 Accounts at the Federal Reserve provide foreign official Financial Crisis, central bank balance sheets increased institutions with access to immediate dollar liquidity to in many jurisdictions. Relative to GDP, the Federal support operational needs, to clear and settle securities Reserve’s balance sheet remains smaller than those of in their accounts, and to address unexpected dollar other reserve-currency central banks in major advanced shortages or exchange rate volatility. The foreign foreign economies that currently operate with abundant repo pool has grown from an average level of around reserves—such as the European Central Bank, the $30 billion before the crisis to a current average Bank of Japan, and the Bank of England—although this of about $250 billion, equivalent to a little more difference is partly due to the Federal Reserve being than 1 percent of GDP. The rise in foreign repo pool much further along in the policy normalization process balances has reflected in part central banks’ preference after the crisis. In addition, the Federal Reserve’s to maintain robust dollar liquidity buffers. balance sheet relative to GDP is only modestly larger Finally, “other deposits” with the Federal Reserve than those of central banks, such as the Norges Bank Banks have also risen steadily over recent years, from and the Reserve Bank of New Zealand, that aim to less than $1 billion before the crisis to about $80 billion operate at a relatively low level of abundant reserves. at the end of 2018. Although “other deposits” include Of course, differences in central bank balance sheets balances held by international and multilateral also reflect differences in financial systems across organizations, government-sponsored enterprises, countries. and other miscellaneous items, the increase has largely been driven by the establishments of accounts B. Centralbankbalance sheets relative to gross domestic product for DFMUs. DFMUs provide the infrastructure for transferring, clearing, and settling payments, securities, Percent of GDP and other transactions among financial institutions. The Dodd-Frank Wall Street Reform and Consumer Federal Reserve European Central Bank Protection Act provides that DFMUs—those financial 100 Bank of Japan market utilities designated as systemically important by Bank of England the Financial Stability Oversight Council—can maintain Norges Bank 80 Reserve Bank of accounts at the Federal Reserve and earn interest on New Zealand balances maintained in those accounts. 60 Putting together all of these elements—that is, projected trend growth for currency in circulation, 40 the Committee’s decision to continue operating with ample reserves, and the higher levels for the TGA, the 20 foreign repo pool, and DFMU balances—explains why the longer-run size of the Federal Reserve’s balance Reserve currencies, Low level of Reserve currencies, Low level of sheet will be considerably larger than before the crisis. abundant excess abundant reserves abundant excess abundant reserves reserves regimes reserves regimes At the end of 2018, the Federal Reserve’s balance 2007 2018 sheet totaled $4.1 trillion, or about 20 percent of NOTE: Data for 2018 pertain to Q3, except for the Bank of England, whose data pertain to 2017:Q3. Norges Bank data exclude assets of Norway's GDP. Figure B considers the size of the balance sheet Government Pension Fund Global. in an international context. In response to the Global SOURCE: Haver Analytics. 44 PART 2: MONETARy POLICy judges it is an opportune time for the Federal Specific to the communications practices, the Reserve to conduct a review of its strategic Federal Reserve judges that transparency is framework for monetary policy—including essential to accountability and the effectiveness the policy strategy, tools, and communication of policy, and therefore the Federal Reserve practices. The goal of this assessment is seeks to explain its policymaking approach to identify possible ways to improve the and decisions to the Congress and the public Committee’s current policy framework in as clearly as possible. The box “Federal order to ensure that the Federal Reserve is Reserve Transparency: Rationale and New best positioned going forward to achieve its Initiatives” discusses the steps and new statutory mandate of maximum employment initiatives the Federal Reserve has taken to and price stability. improve transparency. MONETARy POLICy REPORT: FEBRUARy 2019 45 Federal Reserve Transparency: Rationale and New Initiatives Over the past 25 years, the Federal Reserve Chairman began holding a press conference after and other major central banks have taken steps to each FOMC meeting, doubling the frequency of the improve transparency, which provides three important press conferences that were introduced in 2011. benefits. First, transparency helps ensure that central These press conferences are held 30 minutes after banks are held accountable to the public and its the release of the postmeeting statement and provide elected representatives. Accountability is essential to additional information about the economic outlook, democratic legitimacy and is particularly important the Committee’s policy decision, and policy tools. for central banks that have been granted extensive Press conferences also allow the Chairman to answer operational independence, as is the case for the questions on monetary policy and other issues in a Federal Reserve. Second, transparency enhances timely fashion. the effectiveness of monetary policy. If the public In November 2018, the Federal Reserve announced understands the central bank’s views on the economy that it would conduct a broad review of its monetary and monetary policy, then households and businesses policy framework—specifically, of the policy strategy, will take those views into account in making their tools, and communication practices that the FOMC spending and investment plans. Third, transparency uses in the pursuit of its dual-mandate goals of supports a central bank’s efforts to promote the safety maximum employment and price stability. The Federal and soundness of financial institutions and the overall Reserve’s existing policy framework is the result of financial system, including by helping financial decades of learning and refinements and has allowed institutions know what is expected of them. Thus, for the FOMC to pursue effectively its dual-mandate each of these reasons, the Federal Reserve seeks to goals. Central banks in a number of other advanced explain its policymaking approach and decisions to the economies have also found it useful, at times, to Congress and the public as clearly as possible. conduct reviews of their monetary policy frameworks. To foster transparency and accountability, the Such a review seems particularly appropriate when the Federal Reserve uses a wide variety of communications, economy appears to have changed in ways that matter including semiannual testimony by the Chairman for the conduct of monetary policy. For example, the in conjunction with this report, the Monetary neutral level of the policy interest rate appears to have Policy Report. In addition, the Federal Open Market fallen in the United States and abroad, increasing the Committee (FOMC) has released a statement after every risk that a central bank’s policy rate will be constrained regularly scheduled meeting for almost 20 years, and by its effective lower bound in future economic detailed minutes of FOMC meetings have been released downturns. The review will consider ways to ensure since 1993.1 In 2007, the Federal Reserve expanded that the Federal Reserve’s monetary policy strategy, the economic projections that have accompanied the tools, and communications going forward provide the Monetary Policy Report since 1979 into the Summary best means to achieve and maintain the dual-mandate of Economic Projections, which FOMC participants objectives. submit every quarter. And in 2012, the FOMC first The review will include outreach to and consultation released its Statement on Longer-Run Goals and with a broad range of stakeholders in the U.S. economy Monetary Policy Strategy, which it reaffirms annually.2 through a series of “Fed Listens” events. The Reserve The Federal Reserve continues to make Banks will hold forums around the country, in a town improvements to its communications. In January, the hall format, allowing the Federal Reserve to gather perspectives from the public, including representatives of business and industry, labor leaders, community and 1. In December 2004, the FOMC decided to begin publishing the minutes three weeks after every meeting, economic development officials, academics, nonprofit expediting the publication schedule to provide the public with organizations, community bankers, local government more timely information. officials, and representatives of congressional offices in 2. The statement is reprinted at the beginning of this report Reserve Bank Districts.3 In addition, the Federal Reserve on p. ii. The FOMC also publishes transcripts of its meetings after a five-year lag. For a review of the main communication (continued on next page) tools used by the Federal Reserve and other central banks, see the document “Monetary Policy Strategies of Major Central Banks,” which is available on the webpage “Monetary Policy 3. “Fed Listens” events will be held at the Federal Reserve Principles and Practice” on the Board’s website at https://www. Bank of Dallas this February and at the Federal Reserve Bank federalreserve.gov/monetarypolicy/monetary-policy-principles- of Minneapolis this April. Other “Fed Listens” events will be and-practice.htm. announced in coming weeks. 46 PART 2: MONETARy POLICy Federal Reserve Transparency (continued) System will sponsor a research conference this June at The Supervision and Regulation Report provides the Federal Reserve Bank of Chicago, with academic an overview of banking conditions and the current speakers and non-academic panelists from outside the areas of focus of the Federal Reserve’s regulatory Federal Reserve System. policy framework, including pending rules, and key Beginning around the middle of 2019, as part of themes, trends, and priorities regarding supervisory their review of how to best pursue the Fed’s statutory programs. The report distinguishes between large mandate, Federal Reserve policymakers will discuss financial institutions and regional and community relevant economic research as well as the perspectives banking organizations because supervisory approaches offered during the outreach events. At the end of the and priorities for these institutions frequently differ. process, policymakers will assess the information and The report provides information to the public in perspectives gathered and will report their findings and conjunction with semiannual testimony before the conclusions to the public. Congress by the vice Chairman for Supervision. This review complements other recent changes The Financial Stability Report summarizes the to the Federal Reserve’s communication practices. Board’s monitoring of vulnerabilities in the financial In November 2018, the Board inaugurated two system. The Board monitors four broad categories of reports, the Supervision and Regulation Report and vulnerabilities, including elevated valuation pressures the Financial Stability Report.4 These reports provide (as signaled by asset prices that are high relative to information about the Board’s responsibility, shared economic fundamentals or historical norms), excessive with other government agencies, to foster the safety borrowing by businesses and households, excessive and soundness of the U.S. banking system and to leverage within the financial sector, and funding promote financial stability. Transparency is key to these risks (risks associated with a withdrawal of funds efforts, as it enhances public confidence, allows for the from a particular financial institution or sector, for consideration of outside ideas, and makes it easier for example as part of a “financial panic”). Assessments regulated entities to know what is expected of them of these vulnerabilities inform Federal Reserve actions and how best to comply. to promote the resilience of the financial system, including through its supervision and regulation of 4. The Supervision and Regulation Report and the financial institutions. Financial Stability Report are available on the Board’s Through all of these efforts to improve its website at, respectively, https://www.federalreserve.gov/ communications, the Federal Reserve seeks to enhance publications/2018-november-supervision-and-regulation- report-preface.htm and https://www.federalreserve.gov/ transparency and accountability regarding how it publications/2018-november-financial-stability-report- pursues its statutory responsibilities. purpose.htm. 47 P 3 art s e P ummary of ConomiC rojeCtions The following material appeared as an addendum to the minutes of the December 18–19, 2018, meeting of the Federal Open Market Committee. In conjunction with the Federal Open participants continued to expect real GDP Market Committee (FOMC) meeting held on growth to slow throughout the projection December 18–19, 2018, meeting participants horizon, with a majority of participants submitted their projections of the most likely projecting growth in 2021 to be a little below outcomes for real gross domestic product their estimate of its longer-run rate. Almost (GDP) growth, the unemployment rate, and all participants who submitted longer-run inflation for each year from 2018 to 2021 projections continued to expect that the and over the longer run.19 Each participant’s unemployment rate would run below their projections were based on information estimate of its longer-run level through available at the time of the meeting, together 2021. Most participants projected that with his or her assessment of appropriate inflation, as measured by the four-quarter monetary policy—including a path for the percentage change in the price index for federal funds rate and its longer-run value— personal consumption expenditures (PCE), and assumptions about other factors likely would increase slightly over the next two to affect economic outcomes. The longer- years, and nearly all participants expected run projections represent each participant’s that it would be at or slightly above the assessment of the value to which each variable Committee’s 2 percent objective in 2020 would be expected to converge, over time, and 2021. Compared with the Summary of under appropriate monetary policy and in the Economic Projections (SEP) from September, absence of further shocks to the economy.20 many participants marked down slightly their “Appropriate monetary policy” is defined as projections for real GDP growth and inflation the future path of policy that each participant in 2019. Table 1 and figure 1 provide summary deems most likely to foster outcomes for statistics 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 inflation, All participants who submitted longer-run would likely warrant some further gradual projections expected that, under appropriate increases in the federal funds rate. Compared monetary policy, growth in real GDP in 2019 with the September submissions, the median would run somewhat above their individual projections for the federal funds rate for the estimate of its longer-run rate. Most end of 2019 through 2021 and over the longer run were a little lower. Most participants expected that the federal funds rate at the end 19. Five members of the Board of Governors, one of 2020 and 2021 would be modestly higher more than in September 2018, were in office at the time than their estimate of its level over the longer of the December 2018 meeting and submitted economic run; however, many marked down the extent projections. 20. One participant did not submit longer-run to which it would exceed their estimate of the projections for real GDP growth, the unemployment rate, longer-run level relative to their September or the federal funds rate. projections. 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, December 2018 Percent Median1 Central tendency2 Range3 Variable Longer Longer Longer 2018 2019 2020 2021 2018 2019 2020 2021 2018 2019 2020 2021 run run run Change in real GDP ....... 3.0 2.3 2.0 1.8 1.9 3.0–3.1 2.3–2.5 1.8–2.0 1.5–2.0 1.8–2.0 3.0–3.1 2.0–2.7 1.5–2.2 1.4–2.1 1.7–2.2 September projection .. 3.1 2.5 2.0 1.8 1.8 3.0–3.2 2.4–2.7 1.8–2.1 1.6–2.0 1.8–2.0 2.9–3.2 2.1–2.8 1.7–2.4 1.5–2.1 1.7–2.1 Unemployment rate ....... 3.7 3.5 3.6 3.8 4.4 3.7 3.5–3.7 3.5–3.8 3.6–3.9 4.2–4.5 3.7 3.4–4.0 3.4–4.3 3.4–4.2 4.0–4.6 September projection .. 3.7 3.5 3.5 3.7 4.5 3.7 3.4–3.6 3.4–3.8 3.5–4.0 4.3–4.6 3.7–3.8 3.4–3.8 3.3–4.0 3.4–4.2 4.0–4.6 PCE inflation ................ 1.9 1.9 2.1 2.1 2.0 1.8–1.9 1.8–2.1 2.0–2.1 2.0–2.1 2.0 1.8–1.9 1.8–2.2 2.0–2.2 2.0–2.3 2.0 September projection .. 2.1 2.0 2.1 2.1 2.0 2.0–2.1 2.0–2.1 2.1–2.2 2.0–2.2 2.0 1.9–2.2 2.0–2.3 2.0–2.2 2.0–2.3 2.0 Core PCE inflation4 ....... 1.9 2.0 2.0 2.0 1.8–1.9 2.0–2.1 2.0–2.1 2.0–2.1 1.8–1.9 1.9–2.2 2.0–2.2 2.0–2.3 September projection .. 2.0 2.1 2.1 2.1 1.9–2.0 2.0–2.1 2.1–2.2 2.0–2.2 1.9–2.0 2.0–2.3 2.0–2.2 2.0–2.3 Memo: Projected appropriate policy path Federal funds rate ......... 2.4 2.9 3.1 3.1 2.8 2.4 2.6–3.1 2.9–3.4 2.6–3.1 2.5–3.0 2.1–2.4 2.4–3.1 2.4–3.6 2.4–3.6 2.5–3.5 September projection .. 2.4 3.1 3.4 3.4 3.0 2.1–2.4 2.9–3.4 3.1–3.6 2.9–3.6 2.8–3.0 2.1–2.4 2.1–3.6 2.1–3.9 2.1–4.1 2.5–3.5 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 consump- tion 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 econ- omy. 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 September projections were made in conjunction with the meeting of the Federal Open Market Committee on September 25–26, 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 September 25–26, 2018, meeting, and one participant did not submit such projections in conjunction with the December 18–19, 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. On balance, participants continued to view growth for 2018 and 2019 were slightly lower, the uncertainty around their projections as while the median for the longer-run rate of broadly similar to the average of the past growth was a bit higher. Several participants 20 years. While most participants viewed the mentioned tighter financial conditions or a risks to the outlook as balanced, a couple softer global economic outlook as factors more participants than in September saw behind the downward revisions to their near- risks to real GDP growth as weighted to the term growth estimates. downside, and one less participant viewed the risks to inflation as weighted to the upside. The median of projections for the unemployment rate in the fourth quarter of The Outlook for Economic Activity 2019 was 3.5 percent, unchanged from the September SEP and almost 1 percentage point The median of participants’ projections for the below the median assessment of its longer- growth rate of real GDP for 2019, conditional run normal level. With participants generally on their individual assessment of appropriate continuing to expect the unemployment rate monetary policy, was 2.3 percent, slower than to bottom out in 2019 or 2020, the median the 3.0 percent pace expected for 2018. Most projections for 2020 and 2021 edged back up participants continued to expect GDP growth to 3.6 percent and 3.8 percent, respectively. to slow throughout the projection horizon, Nevertheless, most participants continued to with the median projection at 2.0 percent in project that the unemployment rate in 2021 2020 and at 1.8 percent in 2021, a touch lower would still be well below their estimates of its than the median estimate of its longer-run rate longer-run level. The median estimate of the of 1.9 percent. Relative to the September SEP, longer-run normal rate of unemployment was the medians of the projections for real GDP slightly lower than in September. MONETARy POLICy REPORT: FEBRUARy 2019 49 Figure 1. Medians, central tendencies, and ranges of economic projections, 2018–21 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 2021 Longer run Percent Unemployment rate 7 6 5 4 3 2013 2014 2015 2016 2017 2018 2019 2020 2021 Longer run Percent PCE inflation 3 2 1 2013 2014 2015 2016 2017 2018 2019 2020 2021 Longer run Percent Core PCE inflation 3 2 1 2013 2014 2015 2016 2017 2018 2019 2020 2021 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 2021 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 2021 The median of projections for total PCE price and in the longer run. The distributions of inflation was 1.9 percent in 2019, a bit lower individual projections for real GDP growth for than in the September SEP, while the medians 2019 and 2020 shifted down relative to those for 2020 and 2021 were 2.1 percent, the same in the September SEP, while the distributions as in the previous projections. The medians of for 2021 and for the longer-run rate of GDP projections for core PCE price inflation over growth were little changed. The distribution of the 2019–21 period were 2.0 percent, a touch individual projections for the unemployment lower than in September. Some participants rate in 2019 was a touch more dispersed pointed to softer incoming data or recent relative to the distribution of the September declines in oil prices as reasons for shaving projections; the distribution moved slightly their projections for inflation. higher for 2020, while the distribution for the longer-run normal rate shifted toward the Figures 3.C and 3.D provide information on lower end of its range. the distributions of participants’ views about MONETARy POLICy REPORT: FEBRUARy 2019 51 the outlook for inflation. On the whole, the real interest rate that is currently low and distributions of projections for total PCE price an inflation rate that has been rising only inflation and core PCE price inflation beyond gradually to the Committee’s 2 percent this year either shifted slightly to the left or objective. Some participants cited a weaker were unchanged relative to the September near-term trajectory for economic growth or SEP. Most participants revised down slightly a muted response of inflation to tight labor their projections of total PCE price inflation market conditions as factors contributing to for 2019. All participants expected that total the downward revisions in their assessments of PCE price inflation would be in a range from the appropriate path for the policy rate. 2.0 to 2.3 percent in 2020 and 2021. Most participants projected that core PCE inflation Uncertainty and Risks would run at 2.0 to 2.1 percent throughout the projection horizon. In assessing the appropriate path of the federal funds rate, FOMC participants take account Appropriate Monetary Policy of the range of possible economic outcomes, the likelihood of those outcomes, and the Figure 3.E shows distributions of participants’ potential benefits and costs should they occur. judgments regarding the appropriate target— As a reference, table 2 provides measures of or midpoint of the target range—for the forecast uncertainty—based on the forecast federal funds rate at the end of each year errors of various private and government from 2018 to 2021 and over the longer run. forecasts over the past 20 years—for real GDP The distributions for 2019 through 2021 were growth, the unemployment rate, and total PCE less dispersed and shifted slightly toward price inflation. Those measures are represented lower values. Compared with the projections graphically in the “fan charts” shown in prepared for the September SEP, the median the top panels of figures 4.A, 4.B, and 4.C. federal funds rate was 25 basis points lower The fan charts display the median SEP over the 2019–21 period. For the end of 2019, projections for the three variables surrounded the median of federal funds rate projections by symmetric confidence intervals derived was 2.88 percent, consistent with two 25 basis from the forecast errors reported in table 2. point rate increases over the course of 2019. If the degree of uncertainty attending these Thereafter, the medians of the projections were projections is similar to the typical magnitude 3.13 percent at the end of 2020 and 2021. Most participants expected that the federal funds Table 2. Average historical projection error ranges rate at the end of 2020 and 2021 would be Percentage points modestly higher than their estimate of its level Variable 2018 2019 2020 2021 over the longer run; however, many marked Change in real GDP1 ....... ±0.8 ±1.6 ±2.1 ±2.1 down the extent to which it would exceed their Unemployment rate1 ....... ±0.1 ±0.8 ±1.5 ±1.9 estimate of the longer-run level relative to their Total consumer prices2 .... ±0.2 ±1.0 ±1.0 ±1.0 September projections. The median of the Short-term interest rates3 . ±0.1 ±1.4 ±2.0 ±2.4 longer-run projections of the federal funds rate 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 winter was 2.75 percent, 25 basis points lower than in by various private and government forecasters. As described in the box “Forecast Uncertainty,” under certain assumptions, there is about a 70 percent probability September. that actual 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. For more information, see David Reifschneider and Peter Tulip In discussing their projections, many (2017), “Gauging the Uncertainty of the Economic Outlook Using Historical Forecasting Errors: The Federal Reserve’s Approach,” Finance and Economics participants continued to express the view Discussion Series 2017-020 (Washington: Board of Governors of the Federal Reserve System, February), https://dx.doi.org/10.17016/FEDS.2017.020. that any further increases in the federal funds 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 rate over the next few years would likely be most widely used in government and private economic forecasts. Projections are percent changes on a fourth quarter to fourth quarter basis. gradual. That anticipated pace reflected a 3. For Federal Reserve staff forecasts, measure is the federal funds rate. For few factors, such as a short-term neutral other forecasts, measure is the rate on 3-month Treasury bills. Projection errors are 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, 2018–21 and over the longer run Number of participants 2018 December projections 18 September projections 16 14 12 10 8 6 4 2 1.2 – 1.4 – 1.6 – 1.8 – 2.0 – 2.2 – 2.4 – 2.6 – 2.8 – 3.0 – 3.2 – 1.3 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 3.3 Percent range Number of participants 2019 18 16 14 12 10 8 6 4 2 1.2 – 1.4 – 1.6 – 1.8 – 2.0 – 2.2 – 2.4 – 2.6 – 2.8 – 3.0 – 3.2 – 1.3 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 3.3 Percent range Number of participants 2020 18 16 14 12 10 8 6 4 2 1.2 – 1.4 – 1.6 – 1.8 – 2.0 – 2.2 – 2.4 – 2.6 – 2.8 – 3.0 – 3.2 – 1.3 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 3.3 Percent range Number of participants 2021 18 16 14 12 10 8 6 4 2 1.2 – 1.4 – 1.6 – 1.8 – 2.0 – 2.2 – 2.4 – 2.6 – 2.8 – 3.0 – 3.2 – 1.3 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 3.3 Percent range Number of participants Longer run 18 16 14 12 10 8 6 4 2 1.2 – 1.4 – 1.6 – 1.8 – 2.0 – 2.2 – 2.4 – 2.6 – 2.8 – 3.0 – 3.2 – 1.3 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 3.3 Percent range Note: Definitions of variables and other explanations are in the notes to table 1. MONETARy POLICy REPORT: FEBRUARy 2019 53 Figure 3.B. Distribution of participants’ projections for the unemployment rate, 2018–21 and over the longer run Number of participants 2018 December projections 18 September 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 2021 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, 2018–21 and over the longer run Number of participants 2018 December projections 18 September 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 2021 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: FEBRUARy 2019 55 Figure 3.D. Distribution of participants’ projections for core PCE inflation, 2018–21 Number of participants 2018 December projections 18 September 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 2021 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, 2018–21 and over the longer run Number of participants 2018 December projections 18 September projections 16 14 12 10 8 6 4 2 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 – 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 1.88 – 2.13 – 2.38 – 2.63 – 2.88 – 3.13 – 3.38 – 3.63 – 3.88 – 4.13 – 4.38 – 4.63 – 4.88 – 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 1.88 – 2.13 – 2.38 – 2.63 – 2.88 – 3.13 – 3.38 – 3.63 – 3.88 – 4.13 – 4.38 – 4.63 – 4.88 – 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 2021 18 16 14 12 10 8 6 4 2 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 – 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 1.88 – 2.13 – 2.38 – 2.63 – 2.88 – 3.13 – 3.38 – 3.63 – 3.88 – 4.13 – 4.38 – 4.63 – 4.88 – 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: FEBRUARy 2019 57 of past forecast errors and the risks around the with three participants judging the risks to projections are broadly balanced, then future the unemployment rate as weighted to the outcomes of these variables would have about downside and two participants viewing the a 70 percent probability of being within these risks as weighted to the upside. In addition, confidence intervals. For all three variables, the balance of risks to the inflation projections this measure of uncertainty is substantial and shifted down slightly relative to September, as generally increases as the forecast horizon one less participant judged the risks to both lengthens. total and core inflation as weighted to the upside and one more participant viewed the Participants’ assessments of the level of risks as weighted to the downside. uncertainty surrounding their individual economic projections are shown in the In discussing the uncertainty and risks bottom-left panels of figures 4.A, 4.B, and 4.C. surrounding their economic projections, Participants generally continued to view participants mentioned trade tensions as the degree of uncertainty attached to their well as financial and foreign economic economic projections for real GDP growth and developments as sources of uncertainty or inflation as broadly similar to the average of downside risk to the growth outlook. For the past 20 years.21 A couple more participants the inflation outlook, the effects of trade than in September viewed the uncertainty restrictions were cited as upside risks and around the unemployment rate as higher lower energy prices and the stronger dollar as than average. downside risks. Those who commented on U.S. fiscal policy viewed it as an additional source Because the fan charts are constructed to be of uncertainty and noted that it might present symmetric around the median projections, two-sided risks to the outlook, as its effects they do not reflect any asymmetries in the could be waning faster than expected or turn balance of risks that participants may see out to be more stimulative than anticipated. in their economic projections. Participants’ assessments of the balance of risks to their Participants’ assessments of the appropriate economic projections are shown in the future path of the federal funds rate were also bottom-right panels of figures 4.A, 4.B, subject to considerable uncertainty. Because and 4.C. Most participants generally judged the Committee adjusts the federal funds the risks to the outlook for real GDP growth, rate in response to actual and prospective the unemployment rate, headline inflation, developments over time in real GDP growth, and core inflation as broadly balanced—in the unemployment rate, and inflation, other words, as broadly consistent with a uncertainty surrounding the projected path symmetric fan chart. Two more participants for the federal funds rate importantly reflects than in September saw the risks to real GDP the uncertainties about the paths for those key growth as weighted to the downside, and economic variables along with other factors. one less judged the risks as weighted to the Figure 5 provides a graphical representation upside. The balance of risks to the projection of this uncertainty, plotting the median for the unemployment rate was unchanged, SEP projection for the federal funds rate surrounded by confidence intervals derived from the results presented in table 2. As with 21. At the end of this summary, the box “Forecast the macroeconomic variables, the forecast Uncertainty” discusses the sources and interpretation uncertainty surrounding the appropriate path of uncertainty surrounding the economic forecasts and of the federal funds rate is substantial and explains the approach used to assess the uncertainty and risks attending the participants’ projections. 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 2021 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 December projections December projections 18 18 September projections September 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: FEBRUARy 2019 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 2021 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 December projections December projections 18 18 September projections September 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 2021 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 December projections December projections 18 18 September projections September 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 December projections December projections 18 18 September projections September 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: FEBRUARy 2019 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 2021 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 reported in table 2 would imply a probability of about of the Board of Governors and the presidents of 70 percent that actual GDP would expand within a the Federal Reserve Banks inform discussions of range of 2.2 to 3.8 percent in the current year, 1.4 to monetary policy among policymakers and can aid 4.6 percent in the second year, and 0.9 to 5.1 percent public understanding of the basis for policy actions. in the third and fourth years. The corresponding Considerable uncertainty attends these projections, 70 percent confidence intervals for overall inflation however. The economic and statistical models and would be 1.8 to 2.2 percent in the current year and relationships used to help produce economic forecasts 1.0 to 3.0 percent in the second, third, and fourth years. are necessarily imperfect descriptions of the real world, Figures 4.A through 4.C illustrate these confidence and the future path of the economy can be affected bounds in “fan charts” that are symmetric and centered by myriad unforeseen developments and events. Thus, on the medians of FOMC participants’ projections for in setting the stance of monetary policy, participants GDP growth, the unemployment rate, and inflation. consider not only what appears to be the most likely However, in some instances, the risks around the economic outcome as embodied in their projections, projections may not be symmetric. In particular, the but also the range of alternative possibilities, the unemployment rate cannot be negative; furthermore, likelihood of their occurring, and the potential costs to the risks around a particular projection might be tilted the economy should they occur. to either the upside or the downside, in which case Table 2 summarizes the average historical accuracy the corresponding fan chart would be asymmetrically of a range of forecasts, including those reported in positioned around the median projection. past Monetary Policy Reports and those prepared Because current conditions may differ from those by the Federal Reserve Board’s staff in advance of that prevailed, on average, over history, participants meetings of the Federal Open Market Committee provide judgments as to whether the uncertainty (FOMC). The projection error ranges shown in the attached to their projections of each economic variable table illustrate the considerable uncertainty associated is greater than, smaller than, or broadly similar to with economic forecasts. For example, suppose a typical levels of forecast uncertainty seen in the past participant projects that real gross domestic product 20 years, as presented in table 2 and reflected in (GDP) and total consumer prices will rise steadily at the widths of the confidence intervals shown in the annual rates of, respectively, 3 percent and 2 percent. top panels of figures 4.A through 4.C. Participants’ If the uncertainty attending those projections is similar current assessments of the uncertainty surrounding to that experienced in the past and the risks around their projections are summarized in the bottom-left the projections are broadly balanced, the numbers (continued) MONETARy POLICy REPORT: FEBRUARy 2019 63 panels of those figures. Participants also provide appropriate monetary policy and are on an end-of- judgments as to whether the risks to their projections year basis. However, the forecast errors should provide are weighted to the upside, are weighted to the a sense of the uncertainty around the future path of downside, or are broadly balanced. That is, while the federal funds rate generated by the uncertainty the symmetric historical fan charts shown in the top about the macroeconomic variables as well as panels of figures 4.A through 4.C imply that the risks to additional adjustments to monetary policy that would participants’ projections are balanced, participants may be appropriate to offset the effects of shocks to the judge that there is a greater risk that a given variable economy. will be above rather than below their projections. These If at some point in the future the confidence interval judgments are summarized in the lower-right panels of around the federal funds rate were to extend below figures 4.A through 4.C. zero, it would be truncated at zero for purposes of As with real activity and inflation, the outlook the fan chart shown in figure 5; zero is the bottom of for the future path of the federal funds rate is subject the lowest target range for the federal funds rate that to considerable uncertainty. This uncertainty arises has been adopted by the Committee in the past. This primarily because each participant’s assessment of approach to the construction of the federal funds rate the appropriate stance of monetary policy depends fan chart would be merely a convention; it would importantly on the evolution of real activity and not have any implications for possible future policy inflation over time. If economic conditions evolve decisions regarding the use of negative interest rates to in an unexpected manner, then assessments of the provide additional monetary policy accommodation appropriate setting of the federal funds rate would if doing so were appropriate. In such situations, the change from that point forward. The final line in Committee could also employ other tools, including table 2 shows the error ranges for forecasts of short- forward guidance and asset purchases, to provide term interest rates. They suggest that the historical additional accommodation. confidence intervals associated with projections of While figures 4.A through 4.C provide information the federal funds rate are quite wide. It should be on the uncertainty around the economic projections, noted, however, that these confidence intervals are not figure 1 provides information on the range of views strictly consistent with the projections for the federal across FOMC participants. A comparison of figure 1 funds rate, as these projections are not forecasts of with figures 4.A through 4.C shows that the dispersion the most likely quarterly outcomes but rather are of the projections across participants is much smaller projections of participants’ individual assessments of than the average forecast errors over the past 20 years. 65 a bbreviations AFE advanced foreign economy BOE Bank of England C&I commercial and industrial CRE commercial real estate DFMU designated financial market utility EBITDA earnings before interest, taxes, depreciation, and amortization ECB European Central Bank EME emerging market economy EPOP employment-to-population EU European Union FOMC Federal Open Market Committee; also, the Committee GDP gross domestic product JOLTS Job Openings and Labor Turnover Survey LFPR labor force participation rate LSAP large-scale asset purchase MBS mortgage-backed securities Michigan survey University of Michigan Surveys of Consumers 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 SSDI Social Security Disability Insurance TCJA Tax Cuts and Jobs Act TGA Treasury General Account TIPS Treasury Inflation-Protected Securities VIX implied volatility for the S&P 500 index For use at 11:00 a.m., EST February 22, 2019 M P r onetary olicy ePort February 22, 2019 Board of Governors of the Federal Reserve System

Federal Reserve (2019, February 21). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_20190222

@misc{wtfs_monetary_policy_report_20190222,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {2019},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_20190222},
  note = {Retrieved via When the Fed Speaks corpus}
}