Part 1: Recent Economic and Financial Developments

Monetary Policy Report submitted to the Congress on February 7, 2020, pursuant to section 2B of the Federal Reserve Act

Domestic Developments

The labor market strengthened further last year but at a slower pace than in 2018...

Payroll employment gains were solid in the second half of 2019 and averaged 176,000 per month during the year as a whole. This pace is somewhat slower than the average monthly gains in 2018, even accounting for the anticipated effects of the Bureau of Labor Statistics' upcoming benchmark revision to payroll employment (figure 1).1However, the pace of job gains appears to have remained faster than what is needed to provide jobs for net new entrants to the labor force as the population grows.2

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Reflecting the employment gains over this period, the unemployment rate declined further in 2019 and stood at 3.5 percent in December, 0.4 percentage point below its year-earlier level and at its lowest level since 1969 (figure 2). In addition, the unemployment rate is 0.6 percentage point below the median of Federal Open Market Committee (FOMC) participants' estimates of its longer-run normal level.3

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Strengthening labor market conditions are also evident in rising labor force participation rates (LFPRs)that is, the shares of the population either working or actively seeking work. The LFPR for individuals aged 16 and over was 63.2 percent in December, above its level a year ago despite the downward pressure of about 1/4 percentage point per year associated with the aging of the population. The LFPR for prime-age individuals (between 25 and 54 years old), which is much less sensitive to the effects of population aging, has been rising over the past few years and continued to increase in 2019 (figure 3). The employment-to-population ratio for individuals aged 16 and overthat is, the share of people who are workingwas 61.0 percent in December and has been increasing since 2011.

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Other indicators are also consistent with strong labor market conditions, albeit with some slowing in the pace of improvement since 2018. As reported in the Job Openings and Labor Turnover Survey (JOLTS), job openings have remained plentiful, although the private-sector job openings rate has come down over the past year. Similarly, the quits rate in the JOLTS has remained near the top of its historical range, an indication that workers are being bid away from their current jobs or have become more confident that they can successfully switch jobs if they so wish. These data accord well with surveys of consumers that indicate households perceive jobs as plentiful. The JOLTS layoff rate and the number of people filing initial claims for unemployment insurance benefitshistorically, a good early indicator of economic downturnshave both remained quite low.

. . . and unemployment rates have fallen, on net, for all major demographic groups over the past several years

Differences in unemployment rates across ethnic and racial groups have narrowed in recent years, on net, as they typically do during economic expansions, after having widened during the 2007-09 recession (figure 4). The decline in the unemployment rate for African Americans has been particularly sizable, and its average rate in the second half of October 2019 was the lowest recorded since the data began in 1972. Although the unemployment rates for African Americans and for Hispanics remain substantially above those for whites and for Asians, those differentials in the second half of 2019 were at their narrowest levels on record. 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 (figure 5).

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Increases in labor compensation have remained moderate by historical standards...

Despite strong labor market conditions, the available indicators generally suggest that increases in hourly labor compensation have remained moderate, averaging about 3 percent over the past two years. These indicators include the employment cost index, a measure of both wages and the cost to employers of providing benefits; compensation per hour in the business sector, a broad-based but volatile measure of wages, salaries, and benefits; and average hourly earnings from the payroll survey, a monthly index that is timely but does not account for benefits (figure 6). The median 12-month wage growth of individuals reporting to the Current Population Survey calculated by the Federal Reserve Bank of Atlanta, which tends to be higher than broader-based measures of wage growth, remains near the upper portion of its range over the past couple of years.4Interestingly, wage growth over the past few years has been strongest for workers in relatively low-paying jobs, suggesting that the strong labor market is having a more pronounced benefit for these workers.

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. . . and likely have been restrained by slow growth in labor productivity over much of the expansion

These moderate rates of hourly compensation gains likely reflect the offsetting influences of a strengthening labor market and productivity growth that has been weak through much of the expansion. From 2008 to 2018, labor productivity increased a little more than 1 percent per year, on average, well below the average pace from 1996 to 2007 of nearly 3 percent and also below the average gain in the 1974-95 period (figure 7). Although considerable debate remains about the reasons for the slowdown in productivity growth over this period, the weakness may be partly attributable to the sharp pullback in capital investment, including on research and development, during the most recent recession and the relatively slow recovery that followed. More recently, labor productivity is estimated to have increased 1.5 percent over the four quarters ending in 2019:Q3a small improvement from the preceding year, especially given the volatility of the productivity data, but still moderate relative to earlier periods. While it is uncertain whether productivity growth will continue to improve, a sustained pickup in productivity growth, as well as additional labor market strengthening, would support stronger gains in labor compensation.

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Inflation was below 2 percent last year

After having been close to the FOMC's objective of 2 percent in 2018, inflation moved back below 2 percent last year, where it has been for most of the time since the end of the most recent recession. The 12-month change in the price index for personal consumption expenditures (PCE) was 1.6 percent in December 2019, as was the 12-month measure of inflation that excludes food and energy items (so-called core inflation), which historically has been a better indicator of where inflation will be in the future than the overall index (figure 8). Both measures are down from the rates recorded a year ago; the slowing partly results from particularly low readings in the monthly price data in the first quarter of 2019, which appear to reflect idiosyncratic price declines in a number of specific categories such as apparel, used cars, banking services, and portfolio management services. Indeed, core inflation picked up after the first quarter and was at an average annual rate of 1.9 percent over the remainder of the year.

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The trimmed mean PCE price index, calculated by the Federal Reserve Bank of Dallas, also suggests a transitory element to inflation readings early last year. The trimmed mean provides an alternative way to purge inflation of transitory influences, and it is less sensitive than the core index to idiosyncratic price movements such as those noted earlier.5The 12-month change in this measure was about the same in December 2019 as it was in 2018.

Oil prices fluctuated in 2019

After falling from more than $80 per barrel to less than $60 per barrel in late 2018, the Brent spot price of crude oil fluctuated between $60 and $70 for most of 2019. Prices generally moved up in the second half of last year, supported by expectations of supply cuts in OPEC member countries and, later on, diminished concerns about the global outlook (figure 9). Prices also spiked briefly in early January over tensions with Iran. In recent weeks, however, oil prices moved lower amid heightened fears that the coronavirus outbreak that started in China might weigh on economic growth and the demand for oil. Despite these fluctuations in oil prices, retail gasoline prices generally edged lower since mid-2019. For 2019 as a whole, consumer energy prices rose modestly more than the core index. Meanwhile, food prices posted only a small increase in 2019, held down by soft prices for farm commodities, and contributed very little to overall consumer price inflation.

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Reported prices of imports other than energy fell

Nonfuel import prices, before accounting for the effects of tariffs on the price of imported goods, have continued to decline from their mid-2018 peak, responding to lower foreign inflation and declines in non-oil commodity prices (figure 10).6After declining in the first half of 2019, prices of industrial metals appear to have bottomed out in recent months, consistent with increased optimism about global demand following positive trade developments.

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Survey-based measures of inflation expectations have been broadly stable...

Expectations of inflation likely influence actual inflation by affecting wage- and price-setting decisions. Survey-based measures of inflation expectations at medium- and longer-term horizons have remained broadly stable over the past year. In the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, the median expectation for the annual rate of increase in the PCE price index over the next 10 years has been very close to 2 percent for the past several years (figure 11). In the University of Michigan Surveys of Consumers, the median value for inflation expectations over the next 5 to 10 years has fluctuated within a narrow range around 2-1/2 percent since the end of 2016, though this level is between 1/4 and 1/2 percentage point lower than had prevailed through 2014. In the Survey of Consumer Expectations, conducted by the Federal Reserve Bank of New York, the median of respondents' expected inflation rate three years hence moved lower, on net, in the second half of last year and averaged 2.5 percent, 1/4 percentage point below its average over the preceding three years.

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. . . and market-based measures of inflation compensation have also been little changed

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 compensationderived either from differences between yields on nominal Treasury securities and those on comparable-maturity Treasury Inflation-Protected Securities (TIPS) or from inflation swapshave been little changed, on net, since the middle of 2019, with both measures below their respective ranges that persisted for most of the 10 years before the start of notable declines in mid-2014 (figure 12).7The TIPS-based measure of 5-to-10-year-forward inflation compensation and the analogous measure from inflation swaps are now about 1-3/4 percent and 2 percent, respectively.8

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Growth of gross domestic product was moderate in the second half of 2019...

Real gross domestic product (GDP) is reported to have increased at a moderate average annual rate of 2.1 percent in the second half of 2019, although growth was somewhat slower than in the first half of the year and in 2018 (figure 13). Consumer spending rose at a moderate pace, on average, and residential investment turned up after having declined since the end of 2017. In contrast, business fixed investment declined in the second half of last year, reflecting a number of factors that likely include uncertainty regarding trade tensions and the weak global growth outlook. Those factors also continued to weigh on manufacturing output, which declined over the first half of 2019 and has moved roughly sideways since then. (See the box "Manufacturing and U.S. Business Cycles.") Despite those headwinds, the economic expansion continues to be supported by steady job gains, increases in household wealth, expansionary fiscal policy, and supportive domestic financial conditions that include moderate borrowing costs and easy access to credit for many households and businesses.

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Manufacturing and U.S. Business Cycles

Historically, the manufacturing sector in the United States has been a source of economic strength and of good jobs for workers at all levels of education. It is also a highly cyclical sector that has tended to retrench dramatically during economy-wide contractions and to rebound sharply during expansions.

Concerns by some observers about a possible economy-wide recession were prompted by declines in the industrial production index for manufacturing (IP) in the first two quarters of 2019, particularly when viewed in conjunction with the stagnant manufacturing growth that was occurring in many foreign economies. Manufacturing output in the United States remained weak through the end of the year (figure A). And, for 2019 as a whole, production decreased 1.3 percent, with fairly broadbased declines across both durable and nondurable goods industries. The slump in manufacturing last year is attributable to several factors, including trade developments, weak global growth, softer business investment, lower oil prices engendering a cutback in demand by drillers, and the slower production of Boeing's 737 Max aircraft due to safety issues.1

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When considering the implications of these declines in manufacturing production for the broader economy, it is important to recognize that this weakness has likely spilled over to other sectors. Manufacturing production requires inputs from other industries, and goods that are produced need to be transported and sold. For example, a reduction in auto assemblies affects automakers' demand both for intermediate inputs like steel and for business services like accounting. In turn, the steelmakers need less iron ore, and the accountants need less tech support. The inputoutput tables for the U.S. economy imply that every dollar of factory output requires 56 cents of input from other domestic sectors.2Manufacturing currently accounts for 12 percent of gross domestic product (GDP), so its 2019 decline of 1.3 percent would have directly subtracted about 0.15 percent from GDP; including inputs purchased from upstream sectors, the drag is a bit more than 0.2 percent. After adding in the downstream activities needed to bring products to market (such as transportation, wholesaling, and retailing), last year's decline in manufacturing likely reduced GDP by less than 0.5 percentnot enough to tip an otherwise-expanding economy into recession.

That modest effect partly reflects the decline in manufacturing's share of the U.S. economy since the middle of the 20th century. Manufacturing employment has dropped from about 30 percent of total employment to less than 9 percent today, and the value added from manufacturing has fallen from more than 25 percent of GDP to a bit under 12 percent (figure B). However, although the manufacturing sector has shrunk, factory output may still be a good barometer of aggregate demand and of the economy's health.

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Growth in the U.S. manufacturing sector has slowed considerably over time. Measured from business cycle peak to business cycle peak, output grew about 3.5 percent per year between 1920 and 1960, as well as from 1960 through 2001. As seen infigure C, factory production has moved up only about 0.5 percent per year since 2001, and only 2 of those 19 calendar years recorded gains of more than 3.5 percent.

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To interpret the recent weakness in manufacturing in this light, figure D shows 12-month changes in "detrended" IP, where values below zero indicate year-over-year changes in IP that are slower than its trend at the time. Notably, most expansions include periods of modest belowtrend growth. In 2019, growth averaged about 2 percentage points below trend, a slowdown fairly similar to that in the 2015-16 period. Other episodes of modest below-trend growth appear in the expansions of the early 2000s, the 1990s, the mid1980s, and the 1960s. In contrast, as shown by the red line infigure D, every recession since 1960but no expansionincludes at least some months when the 12-month change in IP was at least 7 percentage points below trend. The available data, however, suggest that the recent experience in the United States falls well short of that threshold.

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1. See, for example, Aaron Flaaen and Justin Pierce (2019), "Disentangling the Effects of the 2018-2019 Tariffs on a Globally Connected U.S. Manufacturing Sector," Finance and Economics Discussion Series 2019-086 (Washington: Board of Governors of the Federal Reserve System, December),https://dx.doi.org/10.17016/FEDS.2019.086. Also see Dario Caldara, Matteo Iacoviello, Patrick Molligo, Andrea Prestipino, and Andrea Raffo (2019), "The Economic Effects of Trade Policy Uncertainty," International Finance Discussion Papers 1256 (Washington: Board of Governors of the Federal Reserve System, September),https://dx.doi.org/10.17016/IFDP.2019.1256. Boeing slowed production of the 737 Max in the spring of 2019 and subsequently announced a temporary suspension of production beginning in early 2020.Return to text

2. The input-output tables are published by the Bureau of Economic Analysis. Our estimates are from the 2018 sectoral "Domestic Requirements" table, which shows both the intermediate products used directly by manufacturers and the intermediate products used further upstream by their suppliers. The tables do not, however, account for broader general equilibrium effects such as, for example, the lower spending by workers who may have been laid off when there were cutbacks in auto production.Return to text

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. . . and downside risks to the outlook receded somewhat

Downside risks to the economic outlook seem to have receded somewhat in the latter part of 2019. Labor market conditions and economic growth in the United States have been resilient to the global headwinds in 2019, and conflicts over trade policy diminished somewhat toward the end of the year. Economic growth abroad also shows signs of stabilizing, though the coronavirus outbreak presents a more recent risk. Reflecting these factors as well as more accommodative monetary policy stances in the United States and some foreign economies, financial conditions eased somewhat over the second half of the year. Statistical models designed to gauge the probability of recession using various indicators, including the Treasury yield curve, suggest that the likelihood of a recession occurring over the next year has fallen noticeably in recent months. Similarly, as shown in Part 3, when Federal Reserve policymakers most recently presented their economic projections, in December, fewer participants judged the risks to the outlook to be tilted to the downside compared with their projections from last June.

Ongoing improvements in the labor market continue to support household income and consumer spending

Consumer spending rose at a moderate pace, on average, in the third and fourth quarters of 2019 and posted another solid gain for the year as a whole (figure 14). The growth in real PCE in recent years reflects the continued improvements in the labor market, which have supported further increases in household income. Real disposable personal income, a measure of households' after-tax purchasing power, increased 2.6 percent in 2019, a solid gain albeit below the robust increase in 2018 that was bolstered by a reduction in personal income taxes. The personal saving rate, at 7.7 percent in the fourth quarter, was little changed from the previous year (figure 15).

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Spending was also supported by high household wealth...

The relatively high level of aggregate household net worth also supported consumer spending last year. House prices, which are of particular importance for the value of assets held by a large portion of households, continued to increase in 2019, although at a more moderate pace than in recent years (figure 16). In addition, U.S. equity prices, which fell sharply at the end of 2018, have rebounded since then. Equity wealth is more concentrated among high-wealth households with high propensities to save than is housing wealth, however, and may therefore provide less support for consumption. The ratio of aggregate household net worth to household income held steady through the third quarter of last year at 6.9, near its all-time high (figure 17).

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. . . and consumer sentiment remains strong

Consumers have remained upbeat during the past year. The Michigan index of consumer sentiment, which declined last summer as trade tensions spiked, recovered in recent months and currently stands at a high level by historical standards. The sentiment measure from the Conference Board, which has been more stable, also suggests consumers are fairly upbeat (figure 18).

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Borrowing conditions for households remain generally favorable, and borrowing costs have moved down since the middle of 2019...

Financing conditions for consumers remain supportive of growth in household spending. Interest rates on credit cards and auto loans declined, on net, during the second half of 2019, and consumer credit continued to expand at a moderate pace (figures 19). Standards and delinquency rates for these loans have been generally stable. For student loans, credit remains widely available, with over 90 percent of such credit being extended by the federal government. After peaking in 2013, delinquencies on such loans have been gradually declining, reflecting in part the continued improvements in the labor market. In the mortgage market, credit has continued to be readily available for households with solid credit profiles but remains noticeably tighter than before the most recent recession for borrowers with low credit scores.

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. . . and activity in the housing sector has picked up, likely reflecting lower interest rates

Residential investment picked up in the second half of 2019 after declining for six straight quarters. Housing starts for single-family and multifamily housing units increased sharply in the second half of last year and posted appreciable gains for the year as a whole, with starts and permits for new construction rising to the highest levels in more than 10 years (figure 20). Sales of new and existing homes also increased during 2019 (figure 21). This improvement appears to have importantly reflected the reduction in mortgage interest rates; after increasing appreciably from mid-2017 through 2018, rates declined markedly last year, fully reversing those earlier increases (figure 22). Despite the lower mortgage rates, households' perceptions of homebuying conditions have remained low, likely reflecting ongoing increases in housing prices.

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In contrast, business fixed investment weakened in the second half of 2019...

After increasing more than 5 percent per year in 2017 and 2018, business fixed investmentspending by businesses on structures, equipment, and intangibles such as research and developmentstalled in 2019, as a moderate gain in the first quarter was offset by small declines over the rest of the year. The softness in business investment last year was evident in each of the three main components, and a portion of the weakening appears to reflect concerns over trade policy and slower foreign growth; other factors included the suspension of deliveries of the Boeing 737 Max aircraft and the continued decline in drilling and mining structures investment amid oil prices that fell back from the levels reached in 2018. Forward-looking indicators of business spendingsuch as orders of capital goods, surveys of business conditions and sentiment, and profit expectations from industry analystsall appear to have stabilized in recent months but suggest that investment is likely to remain subdued (figure 23).

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. . . despite corporate financing conditions that remained accommodative overall

Financing conditions for nonfinancial firms have remained accommodative amid lower interest rates. Flows of credit to large nonfinancial firms remained solid overall in the third quarter of 2019 (figure 24). The gross issuance of corporate bonds, although lower than in the first half of last year, was robust across credit categories. Yields on both investment- and speculative-grade corporate bonds continued to decrease and are near historical lows. Spreads on corporate bond yields over comparable-maturity Treasury securities have continued to narrow, on net, since the middle of last year and are at the lower end of their historical distributions. Respondents to the January Senior Loan Officer Opinion Survey on Bank Lending Practices, or SLOOS, reported that banks eased several terms on commercial and industrial (C&I) loans but that demand for C&I loans has continued to weaken, consistent with the slowdown in business investment. C&I loan growth at banks has slowed since the first half of last year, while commercial real estate loan growth has continued to be strong. Meanwhile, financing conditions for small businesses have remained generally accommodative, but credit growth has been subdued.

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Net exports added to GDP growth in 2019, as exports grew little but imports declined

Real exports grew only a touch in 2019, as tariffs on U.S. exports increased and foreign growth weakened (figure 25). Real imports declined last year, in part reflecting higher tariffs on imported goods and weakness in investment and manufacturing. As a result, real net exportsafter having subtracted from U.S. real GDP growth in 2018provided a modest boost to GDP growth in 2019. Relative to 2018, the nominal trade deficit is slightly less negative, and the current account deficit is little changed as a percent of GDP (figure 26).

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Federal fiscal policy actions continued to boost economic growth in 2019 while raising the federal unified budget deficit...

The effects of fiscal policy actions enacted at the federal level in earlier years continued to boost GDP growth in 2019; the Tax Cuts and Jobs Act of 2017 lowered personal and business income taxes, and rising appropriations consistent with the Bipartisan Budget Act of 2018 boosted federal purchases.9In 2019, federal purchases rose 4.3 percent, well above the 2.7 percent increase of 2018 (figure 27).

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The federal unified budget deficit widened further in fiscal year 2019 to 4-1/2 percent of nominal GDP from 3-3/4 percent of GDP in 2018, as expenditures moved up as a share of the economy while receipts moved sideways (figure 28). Expenditures, at 21 percent of GDP, are above the level that prevailed in the decade before the start of the 2007-09 recession, while receipts have continued to run below their average levels. The ratio of federal debt held by the public to nominal GDP rose to 79 percent in fiscal 2019 and was quite elevated relative to historical norms (figure 29). The Congressional Budget Office projects that this ratio will rise further over the next several years, reflecting large and rising deficits under current fiscal policy.

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. . . and the fiscal position of most state and local governments is stable

The fiscal position of most state and local governments remains stable, although there is a range of experiences across these governments. Revenues for these governments have continued to grow in recent quarters, as the economic expansion pushes up income and sales tax collections for state governments, and past house price gains continue to push up property tax collections for local governments. Boosted by a rebound in construction spending following two years of weak growth, real purchases by state and local governments rose moderately last year but still remained quite restrained, partly reflecting budget pressures associated with pension and retiree health-care obligations. State and local government payrolls increased moderately in 2019 but have only roughly regained the peak observed before the current expansion, and real outlays for construction are more than 10 percent below their pre-recession peak. The debt of these governments as a share of the economy has continued to edge lower and currently equals around 14 percent of GDP, well below the previous peak of 21 percent following the most recent recession.

Financial Developments

The expected path of the federal funds rate over the next several years shifted down

Market-based measures of the expected path of the federal funds rate over the next several years have moved down, on net, since the middle of last year and show about a 30 basis point decrease in the federal funds rate over 2020 and a relatively flat path thereafter (figure 30). Survey-based measures of the expected path of the policy rate also shifted down from the levels observed in the middle of 2019 but indicate no change to the target range for the federal funds rate over 2020 from its level at the end of 2019. According to the results of the most recent Survey of Primary Dealers and Survey of Market Participants, both conducted by the Federal Reserve Bank of New York in December, the median of respondents' modal projections implies a flat trajectory for the target range of the federal funds rate for the next few years.10Additionally, market-based measures of uncertainty about the policy rate approximately one to two years ahead declined, on balance, from their levels at the end of last June and are close to their average level in recent years.

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U.S. nominal Treasury yields decreased on net

After moving significantly lower over the first half of 2019, nominal Treasury yields also fell sharply in August, largely in response to investors' concerns regarding trade tensions between the United States and China and the global economic outlook (figure 31). Later in the year, as these concerns abated, Treasury yields rose, the yield curve steepened, and uncertainty about near-term Treasury yieldsmeasured by option-implied volatility on short- and longer-dated swap ratesdeclined. However, in the second half of January, investors' concerns about the implications of the coronavirus outbreak for the economic outlook weighed on Treasury yields and led to a flattening of the yield curve as well as some increase in uncertainty about near-term Treasury yields. Since the middle of last year, Treasury yields ended lower on net.

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Consistent with changes in the yields on nominal Treasury securities, yields on 30-year agency mortgage-backed securities (MBS)an important determinant of mortgage interest rates decreased, on balance, since the middle of last year and remained low by historical standards (figure 32). Meanwhile, yields on both investment- and speculative-grade corporate bonds continued to decline and also stayed low by historical standards (figure 33). Spreads on corporate bond yields over comparable-maturity Treasury yields narrowed moderately, on net, over the second half of 2019 and remained in the lower end of their historical distribution.

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Broad equity price indexes increased notably

Equity prices fluctuated in August and September along with investors' concerns about trade developments and the economic outlook. Later in 2019 and into 2020, as these concerns abated, equity prices rose substantially and were reportedly boosted by greater certainty among investors that monetary policy would remain accommodative in the near term (figure 34). Gains were spread across most major economic sectors, with the exception of the energy sector, for which stock prices declined markedly. Measures of implied and realized stock price volatility for the S&P 500 indexthe VIX and the 20-day realized volatilityincreased in August to fairly elevated levels but declined later in the year (figure 35). (For a discussion of financial stability issues, see the box "Developments Related to Financial Stability.")

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Developments Related to Financial Stability

The framework used by the Federal Reserve Board for assessing the resilience of the U.S. financial system focuses on financial vulnerabilities in four broad areas: asset valuations, household and business debt, leverage in the financial sector, and funding risks.1

Asset prices have risen partly because of declines in interest rates, but valuation pressures are elevated. Equity prices increased nearly 30 percent over 2019, and the forward price-to-earnings ratio has reached the recent peak seen in 2018 (figure A). In corporate debt markets, the spreads of interest rates on newly issued leveraged loans over LIBOR (London interbank offered rate) have decreased since July 2019 across the credit-quality spectrum, with spreads for the relatively higher-rated issuers reaching their post-crisis lows. Spreads on investment- and speculative-grade bonds over comparable-maturity Treasury yields narrowed since July 2019 and stand notably below their respective medians (figure B). In commercial real estate markets, prices continued to grow at a robust pace in recent quarters, with capitalization rates at historically low levels. Although house price growth slowed noticeably in 2019, house prices still appear to lie modestly above the level predicted by their historical relationship with rents.

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Vulnerabilities associated with total private-sector debt continue to be at a moderate level relative to their historical norms. Total household debt has grown at a slower pace than economic activity over the past decade, in part reflecting that mortgage credit has remained tight for borrowers with low credit scores, undocumented income, or high debt-to-income ratios. In contrast, business debt levels continue to be elevated compared with either business assets or gross domestic product, with the riskiest firms accounting for most of the increase in debt in recent years (figure C). Although the net issuance of riskier forms of business debthigh-yield bonds and institutional leveraged loanshas slowed since July 2019, it is still solid by historical standards (figure D).

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In addition, about half of investment-grade debt outstanding is currently rated in the lowest category of the investment-grade range (triple-B), a share that is near an all-time high. The concentration of investment-grade debt at the lower end of the investment-grade spectrum creates the risk that adverse developments, such as a deterioration in economic activity, could lead to a sizable volume of bond downgrades to speculative-grade ratings. Such conditions could trigger investors to sell the downgraded bonds rapidly, increasing market illiquidity and causing outsized downward price pressures.

Leverage in the financial sector appears low relative to historical norms. The banking sector is much more highly capitalized, in part due to the regulatory reforms enacted after the financial crisis. In addition, the results of the most recent stress test, released in June 2019, indicated that these banks are well positioned to continue lending to households and businesses even in the event of a severe global recession.2However, several large banks have announced plans to distribute capital to their shareholders in excess of expected earnings, implying that capital at those banks will decrease. Outside the banking sector, broker-dealers as well as property-and-casualty insurance companies continue to operate with historically low levels of leverage. Leverage at life insurance companies has risen but continues to be close to its average level over the past two decades, and leverage at hedge funds remains near the top of its range since 2014. Furthermore, the outlook for profitability of a range of financial institutions has weakened following declines in interest rates. Weaker profitability could affect their ability to absorb losses or build capital through retained earnings.

Funding risk in the banking sector remains low. Banks rely only modestly on short-term wholesale funding and maintain large amounts of high-quality liquid assets in compliance with liquidity regulations introduced after the financial crisis and the improved understanding by banks of their liquidity risks. In addition, money market mutual funds remain less prone to runs than they were before the implementation of the money market reforms, as the composition of assets under management remains heavily tilted toward the safer and more liquid government funds. Nonetheless, the volatility in repurchase agreement (repo) markets in mid-September 2019 highlighted the possibility for frictions in repo markets to spill over to other markets.3

Foreign financial, economic, and political developments could pose a number of near-term risks to the U.S. financial system. In China, fragilities in the corporate and financial sector leave it vulnerable to adverse developments. Because of the size of the Chinese economy, significant distress in China could spill over to U.S. and global markets through a retrenchment of risk appetite, U.S. dollar appreciation, and declines in trade and commodity prices.

In Europe, the risk of a "no-deal Brexit" passed at the end of January, but the United Kingdom and the European Union are still committed to conclude negotiations over their future relationshipincluding new trade arrangementsby the end of 2020. Failure to do so could trigger market and economic disruptions in Europe that may weaken systemically important financial institutions and spill over to global markets, leading to a tightening of U.S. financial conditions.

1. TheFinancial Stability Reportpublished on November 15, 2019, presents the most recent, detailed assessment of these vulnerabilities.Return to text

2. See Board of Governors of the Federal Reserve System (2019),Dodd-Frank Act Stress Test 2019: Supervisory Stress Test Results(Washington: Board of Governors, June),https://www.federalreserve.gov/publications/files/2019-dfast-results-20190621.pdf.Return to text

3. See the box "Money Market Developments and Monetary Policy Implementation" in Part 2.Return to text

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Markets for Treasury securities, mortgage-backed securities, and municipal bonds have functioned well

While available indicators of Treasury market functioning have generally remained stable since the first half of 2019including bid-ask spreads, bid sizes, and estimates of transaction costssome, such as measures of market depth, have decreased. However, the decline in measures of market depth has reportedly not led to any concerns about Treasury market liquidity. Liquidity conditions in the agency MBS market were also generally stable. Credit conditions in municipal bond markets remained stable as well, with yield spreads on 20year general obligation municipal bonds over comparable-maturity Treasury securities declining notably and standing near historically low levels.

Money market rates moved down in line with decreases in the FOMC's target range, except for some notable volatility in mid-September

Decreases in the FOMC's target range for the federal funds rate in July, September, and October transmitted effectively through money markets, with yields on a broad set of money market instruments moving lower in response to the FOMC's policy actions.

The effective federal funds rate moved nearly in parity with the interest rate paid on reserves and was closely tracked by the overnight Eurodollar rate. Other short-term interest rates, including those on commercial paper and negotiable certificates of deposit, also moved down in line with decreases in the policy rate. Domestic short-term funding markets were volatile in mid-Septemberamid large flows related to corporate tax payments and settlement of Treasury securitiesand experienced significant tightening of conditions. The effective federal funds rate rose above the target range on September 17 but then moved back within the target range following the Federal Reserve's open market operations, which eased pressures in money markets (see the box "Money Market Developments and Monetary Policy Implementation" in Part 2).

Bank credit continued to expand, and bank profitability remained robust

Aggregate credit provided by commercial banks continued to expand through the second half of 2019, as the strength in commercial real estate and residential real estate loan growth, helped by falling interest rates, more than offset the slowdown in C&I and consumer loans. In the second half of last year, the pace of bank credit expansion was about in line with that of nominal GDP, leaving the ratio of total commercial bank credit to current-dollar GDP little changed from its value last June (figure 36). Overall, measures of bank profitability ticked down a bit in the third quarter because of narrower net interest margins but remain near their post-crisis highs (figure 37).

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International Developments

Growth in advanced foreign economies weakened, but it appears to be stabilizing

Real GDP growth in several advanced foreign economies (AFEs) appears to have stepped down in the second half of the year (figure 38). However, incoming data suggest that the slowdown in the AFEs may have bottomed out. Household spending has generally remained resilient, sustained by low unemployment rates and rising wages. Financial conditions have improved further, supported in part by accommodative monetary policy actions. The protracted slump in global manufacturing, which weighed on external demand across the AFEs, is showing tentative signs of nearing an end. In the euro area, where manufacturing activity was particularly weak, recent indicators suggest that growth may be steadying. In Japan, real GDP appears to have contracted sharply at the end of 2019, following a consumption tax hike in October, but its effects are likely to be transitory. In the United Kingdom, Brexit-related uncertainty weighed on economic activity throughout 2019; around the turn of the year, U.K. and European Union authorities took the necessary steps to prevent a disorderly Brexit from occurring on January 31, 2020, but they still need to negotiate a new trade arrangement.

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Inflationary pressures remained subdued in many advanced foreign economies

Against a backdrop of slower economic growth, consumer prices in many AFEs continued to rise at a subdued pace, especially in the euro area and Japan (figure 39). Canada remains an exception, as inflation there hovered around 2 percent.

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Central banks in several advanced foreign economies provided accommodation

In response to subdued growth and below-target inflation, the European Central Bank introduced a new stimulus package in September of last year, including a deposit rate cut of 10 basis points to negative 0.5 percent, a restart of its Asset Purchase Programme, and more favorable terms for its targeted longer-term refinancing operations. Similarly, the Reserve Bank of Australia and the Reserve Bank of New Zealand reduced their policy rates in the second half of last year, citing concerns about the global outlook. The Bank of Canada, the Bank of England, and the Bank of Japan kept their policy rates unchanged, although communications by their officials took a more dovish tone, emphasizing increased downside risks to the global economy. In contrast, Sweden's Riksbank and Norway's Norges Bank increased their policy rates, citing favorable macroeconomic conditions and concerns about growing financial imbalances.

Financial conditions in advanced foreign economies eased further

Notwithstanding slowing global growth and bouts of political tensions, financial conditions in the AFEs, on balance, eased further in the second half of 2019, supported by accommodative central bank actions, progress on trade negotiations between the United States and China, and diminished fears of a hard Brexit. Long-term interest rates in many AFEs remained well below the levels seen at the end of 2018 (figure 40). Equity prices, as well as prices of other risky assets, increased moderately (figure 41). Sovereign bond spreads over German bund yields for euro-area peripheral countries narrowed slightly. In recent weeks, however, equity and bond markets gave up some of their gains as uncertainty about the economic effects of the coronavirus weighed on investors' sentiment.

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Growth slowed markedly in many emerging market economies, but there are tentative signs of stabilization

Chinese GDP growth slowed further in the second half of 2019 against the backdrop of increased tariffs on Chinese exports, global weakness in trade and manufacturing, and authorities' deleveraging campaign that continued to exert a drag on the economy (figure 42). However, recent data suggest that China's economic activity picked up at the end of last year, in part supported by some fiscal and monetary policy stimulus and some easing of trade tensions. In emerging Asia excluding China, economic growth was dragged down by a sharp contraction in Hong Kong, where social and political unrest resulted in severe economic disruptions, and by weakness in India, where an ongoing credit crunch continues to weigh on activity. In several other Asian economies, GDP growth held steady but at a lackluster pace amid headwinds from moderating global growth. GDP growth in Korea, Taiwan, and the Philippines rebounded in the last quarter of 2019, consistent with signs of stabilization in the global manufacturing cycle, especially in the high-tech sector. However, the recent emergence of the coronavirus could lead to disruptions in China that spill over to other Asian countries and, more generally, to the rest of the global economy.

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Many Latin American economies continued to underperform. Economic stagnation persisted in Mexico, reflecting both domestic factorsincluding market concerns about economic policiesand external factors, notably, renewed weakness in U.S. manufacturing production. Severe social unrest in several countriesincluding Chile, Ecuador, and Boliviadisrupted economic activity. Argentina's financial crisis continued, while Venezuela's economy likely continued to contract. Growth in Brazil, in contrast, edged up as aggregate demand continued to recover, supported by further reductions in policy interest rates.

Financial conditions in emerging market economies fluctuated but, on net, eased somewhat

Notwithstanding social and political tensions as well as concerns about the global outlook, financial conditions in the emerging market economies (EMEs) eased somewhat in the second half of 2019. Conditions were supported by the accommodative actions of the FOMC and several foreign central banks and, later in the year, by progress in the negotiations between the United States and its major trading partners as well as improved prospects about global growth. EME equity prices generally increased, especially for Brazil (figure 43). And measures of EME sovereign bond spreads over U.S. Treasury yields generally decreased (figure 44). Political tensions in Hong Kong contributed to an underperformance of Chinese risky assets. After several months of withdrawals, flows to dedicated EME mutual funds resumed in the fourth quarter of 2019, consistent with the improved sentiment toward global prospects (figure 45). However, in reaction to the emergence of the coronavirus, in late January equity and bond markets gave up some of their gains.

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The dollar fluctuated but is, on balance, little changed

The foreign exchange value of the U.S. dollar fluctuated but is, on balance, little changed compared with last July (figure 46). While concerns about global growth and trade tensions contributed to the appreciation of the dollar over the summer, monetary policy easing by the Federal Reserve and progress on U.S.-China trade negotiations led to a depreciation of the dollar, especially with respect to the Chinese renminbi. The British pound appreciated notably against the dollar as fears of a disorderly Brexit diminished.

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Note: On February 7, 2020, the "Developments Related to Financial Stability" section was updated to reflect the correct versions of charts C and D.

Footnotes

1.The annual benchmark revision to payroll employment will be published on February 7, after this report has gone to print. According to the Bureau of Labor Statistics' preliminary estimates, increases in payrolls will be revised downward roughly 40,000 per month from April 2018 through March 2019. Payroll figures after March 2019 are subject to revision as well.Return to text

2.To keep up with population growth, roughly 115,000 to 145,000 payroll jobs per month need to be created, on average, to maintain a constant unemployment rate with an unchanged labor force participation rate. 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 and participation rates) can be quite volatile over short periods.Return to text

3.See the most recent economic projections that were released after the December FOMC meeting inPart 3of this report.Return to text

4.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.Return to text

5.The trimmed mean index excludes prices that showed particularly large increases or decreases in a given month. Note that, since 1995, 12-month changes in the trimmed mean index have averaged about 0.3 percentage point above core PCE inflation and 0.2 percentage point above total PCE inflation.Return to text

6.Published import price indexes exclude tariffs. However, tariffs add to the prices that purchasers of imports actually pay, and tariff-inclusive import prices have likely increased, rather than declined, since mid-2018.Return to text

7.Inflation compensation implied by the TIPS breakeven inflation rate is based on the difference, at comparable maturities, between yields on nominal Treasury securities and yields on TIPS, which are indexed to the total consumer price index (CPI). Inflation swaps are contracts in which one party makes payments of certain fixed nominal amounts in exchange for cash flows that are indexed to cumulative CPI inflation over some horizon. Inflation compensation derived from inflation swaps typically exceeds TIPS-based compensation, but week-to-week movements in the two measures are highly correlated.Return to text

8.As these measures are based on CPI inflation, one should probably subtract about 1/4 percentage pointthe average differential with PCE inflation over the past two decadesto infer inflation compensation on a PCE basis.Return to text

9.The Congressional Budget Office (CBO) estimated that the Tax Cuts and Jobs Act would reduce annual tax revenue by around 1 percent of GDP, on average, from fiscal years 2018 through 2021. This revenue projection includes the CBO's estimated macroeconomic effects of the legislation, which add almost 1/4 percentage point to GDP growth, on average, over the same period.Return to text

10.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 athttps://www.newyorkfed.org/markets/primarydealer_survey_questions.htmlandhttps://www.newyorkfed.org/markets/survey_market_participants, respectively.Return to text

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Last Update: March 02, 2020

Part 2: Monetary Policy

Monetary Policy Report submitted to the Congress on February 7, 2020, pursuant to section 2B of the Federal Reserve Act

The Federal Open Market Committee reduced the federal funds rate to support sustained economic expansion and foster a return of inflation to the Committee's 2 percent objective

After having gradually increased its target range for the federal funds rate from late 2015 through the end of 2018, the Committee maintained its target range for the federal funds rate at 2-1/4 to 2-1/2 percent during the first half of 2019. In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the Federal Open Market Committee (FOMC) lowered the target range for the federal funds rate at its July, September, and October meetings by 25 basis points each, bringing it to 1-1/2 to 1-3/4 percent (figure 47).11At its December and January meetings, the Committee judged that the prevailing stance of monetary policy was appropriate to support sustained expansion of economic activity, strong labor market conditions, and inflation returning to its symmetric 2 percent objective.

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Future changes in the federal funds rate will depend on the economic outlook and risks to the outlook as informed by incoming data

The FOMC has continued to emphasize that the actual path of monetary policy will depend on the evolution of the economic outlook and risks to the outlook as informed by incoming data. Specifically, in deciding on the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and symmetric 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

In addition to evaluating a wide range of economic and financial data and information gathered from business contacts and other informed parties around the country, policymakers routinely consult prescriptions for the policy interest rate from various monetary policy rules, which can provide useful guidance to the FOMC. Although many practical considerations make it undesirable for the FOMC to mechanically follow the prescriptions of any specific rule, the FOMC's framework for conducting systematic monetary policy respects key principles of good monetary policy embodied by these rules, while at the same time, providing flexibility to address many of the limitations of these policy rules (see the box "Monetary Policy Rules and Uncertainty in Monetary Policy Settings").

Monetary Policy Rules and Uncertainty in Monetary Policy Settings

Monetary policy rules are mathematical formulas that relate a policy interest rate, such as the federal funds rate, to a small number of other economic variablestypically including the deviation of inflation from its target value and a measure of resource slack in the economy. The prescriptions for the policy interest rate from these rules can provide helpful guidance for the Federal Open Market Committee (FOMC).1

This discussion examines prescriptions from selected policy rules and considers how these prescriptions often depend on judgments and assumptions about economic variables that are inherently uncertain and may change over time. Notably, many policy rules depend on estimates of resource slack and of the longer-run neutral real interest rate, both of which are not directly observable and are estimated with a high degree of uncertainty. As a result, the policy stance that these rules prescribeand whether that stance is appropriate in light of underlying economic conditionsis also uncertain. Such a situation cautions against mechanically following the prescriptions of any specific rule.

Policy Rules: Some Key Design Principles and Historical Prescriptions

In many models of the economy, good economic performance can be achieved by following a monetary policy rule that fosters public understanding and that incorporates key principles of good monetary policy.2One such principle is that monetary policy should respond in a predictable way to changes in economic conditions. A second principle is that monetary policy should be accommodative when inflation is below policymakers' longer-run inflation objective and employment is below its maximum sustainable level; conversely, monetary policy should be restrictive when the opposite holds. A third principle is that, to stabilize inflation, the policy rate should be adjusted over time by more than one-for-one in response to persistent increases or decreases in inflation.

Economists have analyzed many monetary policy rules, including the well-known Taylor (1993) rule, the "balanced approach" rule, the "adjusted Taylor (1993)" rule, the "price level" rule, and the "first difference" rule (figure A).3These policy rules embody the three key principles of good monetary policy and take into account estimates of how far the economy is from the Federal Reserve's dual-mandate goals of maximum employment and price stability. The Taylor (1993), balanced-approach, adjusted Taylor (1993), and price-level rules provide prescriptions for thelevelof the federal funds rate; all require an estimate of the neutral real interest rate in the longer run (rtLR)that is, the level of the real federal funds rate that is expected to be consistent, in the longer run, with maximum employment and stable inflation.4The rules feature the unemployment rate gap, measured as the difference between an estimate of the rate of unemployment that is sustainable in the longer run (utL) and the current unemployment rate; the first-difference rule includes the change in the unemployment gap rather than its level.5In addition, four of the five rules include the difference between recent inflation and the FOMC's longer-run objective of 2 percent, whereas the price-level rule includes the gap between the level of prices today and the level of prices that would have been realized if inflation had been constant at 2 percent from a specified starting year.6The price-level rule thereby takes account of the deviation of inflation from the longer-run objective in earlier periods as well as in the current period, in contrast with the other rules that do not make up past misses of the inflation objective.

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The adjusted Taylor (1993) rule recognizes that the federal funds rate cannot be reduced materially below zero and that following the prescriptions of the standard Taylor (1993) rule after a recession during which the federal funds rate has fallen to its effective lower bound may therefore not provide enough policy accommodation. To make up for the cumulative shortfall in accommodation, the adjusted Taylor (1993) rule prescribes only a gradual return of the policy rate to the (positive) levels prescribed by the standard Taylor (1993) rule after the economy begins to recover. Similarly, the price-level rule specified in figure A recognizes that the federal funds rate cannot be reduced materially below zero. If inflation runs below the 2 percent objective during periods when the policy rate is constrained by the effective lower bound, this rule will, over time, call for more accommodation to make up for the past inflation shortfall.

Figure Bshows historical prescriptions for the federal funds rate from the five rules described earlier. For each period, the figure reports the policy rates prescribed by the rules given prevailing economic conditions and estimates ofutLRandrtLRat the time. The prescribed values often vary widely across rules. Because there is no definitive standard for favoring one rule over another, consulting a range of rules is generally preferable to relying on any particular rule.

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Estimates ofrtLRandutLR: Uncertainty and Revisions

As already noted, the level of the neutral real interest rate and the unemployment rate that is sustainable in the longer run is not directly observable and can be estimated only imprecisely. The neutral real interest rate in the longer run is determined by structural features of the economy, including trend productivity growth, demographics, and risk-taking behavior. The unemployment rate that can be sustained in the longer run is also determined largely by nonmonetary factors, such as demographics, educational attainment, and the structure and dynamics of the labor market. These various determining factors may change over time and may not be directly measurable, hence leading to time-varying and uncertain estimates ofutLandrtL.

Since 2000, forecasters in the Blue Chip survey have markedly reduced their estimates of the longer-run level of the real short-term interest rate (figure C). FOMC participants have also lowered their estimates of the real federal funds rate in the longer run since the Summary of Economic Projections, or SEP, began reporting this information in 2012. Similarly, in recent years, FOMC participants as well as outside forecasters and analysts generally have lowered their estimates of the longer-run unemployment rate considerably.7

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Figure Dillustrates the imprecision with which the longer-run neutral real interest rate is estimated by reporting values from several time-series models, along with measures of the uncertainty surrounding these values.8The models use statistical techniques to capture the variations among inflation, interest rates, real gross domestic product, unemployment, and other data series. The point estimates are dispersed across models, ranging from 0.3 to 2.1 percent. Moreover, the 95 percent uncertainty bands around the estimates illustrate the substantial uncertainty inherent in such estimates.9

D. Point estimates and uncertainty bands for the neutral real interest rate in the longer run

Make Ful