monetary policy report

8/12/2019 MONETARY POLICY REPORT

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For use at 8:30 a.m., ESTFebruary 11, 2014

MONETARYPOLICYREPORTFebruary 11, 2014

Board of Governors of the Federal Reserve System


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LETTEROFTRANSMITTAL

BOARDOFGOVERNORSOFTHE

FEDERALRESERVESYSTEM

Washington, D.C., February 11, 2014

THEPRESIDENTOFTHESENATETHESPEAKEROFTHEHOUSEOFREPRESENTATIVES

The Board of Governors is pleased to submit its Monetary Policy Report pursuant tosection 2B of the Federal Reserve Act.

Sincerely,

Janet L. Yellen, Chair


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The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its sta

mandate from the Congress of promoting maximum employment, stable prices, and m

long-term interest rates. The Committee seeks to explain its monetary policy decision

as clearly as possible. Such clarity facilitates well-informed decisionmaking by househ

businesses, reduces economic and financial uncertainty, increases the effectiveness of

policy, and enhances transparency and accountability, which are essential in a democr

Inflation, employment, and long-term interest rates fluctuate over time in response to

financial disturbances. Moreover, monetary policy actions tend to influence economic

prices with a lag. Therefore, the Committees policy decisions reflect its longer-run goa

term outlook, and its assessments of the balance of risks, including risks to the financ

could impede the attainment of the Committees goals.

The inflation rate over the longer run is primarily determined by monetary policy, and

Committee has the ability to specify a longer-run goal for inflation. The Committee rejudgment that inflation at the rate of 2 percent, as measured by the annual change in

for personal consumption expenditures, is most consistent over the longer run with th

Reserves statutory mandate. Communicating this inflation goal clearly to the public h

longer-term inflation expectations firmly anchored, thereby fostering price stability an

long-term interest rates and enhancing the Committees ability to promote maximum

the face of significant economic disturbances.

The maximum level of employment is largely determined by nonmonetary factors thathe structure and dynamics of the labor market. These factors may change over time a

not be directly measurable. Consequently, it would not be appropriate to specify a fixe

for employment; rather, the Committees policy decisions must be informed by assessm

the maximum level of employment, recognizing that such assessments are necessarily

and subject to revision. The Committee considers a wide range of indicators in makin

assessments. Information about Committee participants estimates of the longer-run n

of output growth and unemployment is published four times per year in the FOMCs

Economic Projections. For example, in the most recent projections, FOMC participanthe longer-run normal rate of unemployment had a central tendency of 5.2 percent to

In setting monetary policy, the Committee seeks to mitigate deviations of inflation fro

longer-run goal and deviations of employment from the Committees assessments of

level. These objectives are generally complementary. However, under circumstances in

STATEMENTONLONGER-RUNGOALSANDMONETARYPOLIC

As amended effective January 28, 2014


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CONTENTS

Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Part 1: Recent Economic and Financial Developments. . . . . . . . . . . . .Domestic Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . International Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Part 2: Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Part 3: Summary of Economic Projections . . . . . . . . . . . . . . . . . . . . . . . . .The Outlook for Economic Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Outlook for Inflation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appropriate Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Uncertainty and Risks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Abbreviations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

List of BoxesRecent Changes in Household Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Developments Related to Financial Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Financial Stress and Vulnerabilities in the Emerging Market Economies . . . . . . . . .Forecast Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


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SUMMARYThe labor market improved further duringthe second half of 2013 and into early 2014as the economic recovery strengthened:Employment has increased at an averagemonthly pace of about 175,000 since June,and the unemployment rate fell from

7.5 percent in June to 6.6 percent in January.With these gains, payrolls have risen acumulative 3 million and the unemploymentrate has declined 1 percentage pointssince August 2012, the month before theFederal Open Market Committee (FOMC)began its current asset purchase program.Nevertheless, even with these improvements,

the unemployment rate remains well abovelevels that FOMC participants judge to besustainable in the longer run.

Consumer price inflation remained low.The price index for personal consumptionexpenditures rose at an annual rate of only1 percent in the second half of last year,noticeably below the FOMCs longer-runobjective of 2 percent. However, some of therecent softness reflects factors that seem likelyto prove transitory, and survey- and market-based measures of longer-term inflationexpectations have remained in the ranges seenover the past several years.

Economic growth picked up in the second

half of last year. Real gross domestic productis estimated to have increased at an annualrate of 3 percent, up from a 1 percentgain in the first half. Fiscal policywhich wasunusually restrictive in 2013 as a wholelikelybegan to impose somewhat less restraint on

spending, business investment, aincreased in the second half of

On the whole, the U.S. financialcontinued to strengthen. Capitaprofiles at large bank holding co

improved further. In addition, tReserve and other agencies tookto enhance the resilience of the system, including strengtheningregulations for large financial inissuing a final rule implementingrule, which restricts such firms trading activities. Use of financ

was relatively restrained, and vamost asset markets were broadlhistorical norms. Overall, the vuthe system to adverse shocks remmoderate level.

With the economic recovery conCommittee members judged by December 2013 FOMC meeting

seen meaningful, sustainable imeconomic and labor market conthe beginning of the current assprogram, even while recognizingunemployment rate remained elthat inflation was running noticCommittees 2 percent longer-ruAccordingly, the FOMC conclu

highly accommodative policy stappropriate, but that in light of progress toward maximum empthe improvement in the outlookmarket conditions, the Committbegin to trim the pace of its ass


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2 SUMMARY

month, to $65 billion. The FOMC indicated

that if incoming information continues tobroadly support the Committees expectationof ongoing improvement in labor marketconditions and inflation moving back towardits longer-run objective, the Committee willlikely reduce the pace of asset purchases infurther measured steps at future meetings.Nonetheless, the Committee reiterated that

asset purchases are not on a preset course, andthat its decisions about their pace will remaincontingent on the Committees outlook forthe labor market and inflation as well as itsassessment of the likely efficacy and costs ofsuch purchases. The FOMC also noted that itssizable and still-increasing holdings of longer-term securities should maintain downward

pressure on longer-term interest rates, supportmortgage markets, and help make broaderfinancial conditions more accommodative.

At the same time, to emphasize itscommitment to provide a high level ofmonetary accommodation for as longas needed to support continued progresstoward maximum employment and price

stability, the Committee enhanced its forwardguidance regarding the federal funds rate.Over the year prior to December 2013, theFOMC had reaffirmed its view that a highlyaccommodative stance of monetary policywould remain appropriate for a considerabletime after the asset purchase program endsand the economic recovery strengthens.

In particular, the Committee indicated itsintention to maintain the current low targetrange for the federal funds rate at least aslong as the unemployment rate remainedabove 6 percent, inflation between oneand two years ahead was projected to be no

to be well anchored. At the Decem

FOMC meeting, with the unemplorate moving down toward the 6 pthreshold, the Committee decided additional information about howits policies to evolve after the threscrossed. Specifically, the Committeits anticipation that it will likely mthe current federal funds rate targe

past the time that the unemploymedeclines below 6 percent, especiaprojected inflation continues to ru2 percent goal.

At the time of the most recent FOin late January, Committee particithe economic outlook as little chan

the time of their December meetinthe most recent Summary of EconProjections (SEP) was compiled. (TDecember SEP is included as Partreport.) Participants viewed labor indicators as showing further impron balancenotwithstanding recereadingsand overall economic aconsistent with growing underlyin

in the broader economy. Even takiaccount the recent volatility in glomarkets, participants regarded theoutlook for the economy and the las having become more nearly balrecent months. FOMC participantthat, with appropriate policy accoeconomic activity would expand at

pace, and that the unemployment gradually decline toward levels thejudges consistent with its dual manThe Committee recognized that inpersistently below its 2 percent objpose risks to economic performanc


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PART1RECENTECONOMICANDFINANCIALDEVELOPMENTS

The labor market continued to improve over the second half of last year. Job gains havabout 175,000 per month since June, and the unemployment rate fell from 7.5 percento 6.6 percent in January of this year. Even so, the unemployment rate remains well abOpen Market Committee (FOMC) participants estimates of the long-run sustainable raremained low, as the price index for personal consumption expenditures (PCE) increas

annual rate of 1 percent from June to Decembernoticeably below the FOMCs longe2 percent. However, transitory influences appear to have been partly responsible for thon inflation last year, and measures of inflation expectations remained steady and nearaverages. Growth in economic activity picked up in the second half of 2013. Real gros

product (GDP) is estimated to have risen at an annual rate of 3 percent, up from a 1rate of increase in the first half. Fiscal policywhich was unusually restrictive in 2013 likely started to exert somewhat less restraint on economic growth in the second half oaddition, household net worth rose further as key asset prices continued to increase, cmore available while interest rates remained low, and economic conditions in the rest improved overall in spite of recent turbulence in emerging financial markets. Consumebusiness investment, and exports all increased more rapidly in the latter part of last yeathe recovery in the housing sector appeared to pause in the second half of last year folincreases in mortgage interest rates in the spring and summer.

Domestic Developments

The labor market continued to

improve, . . .The labor market continued to improve overthe second half of 2013. Payroll employmenthas increased an average of about 175,000per month since June, roughly similar to theaverage gain over the first half of last year(figure 1). In addition, the unemploymentrate declined from 7.5 percent in June to

6.6 percent in January of this year (figure 2).A variety of alternative measures of laborforce underutilizationwhich include, inaddition to the unemployed, those classifiedas discouraged, other individuals who areout of work and classified as marginally

Total nonfarm

Private

201220112010200920082007

1. Net change in payroll employment

3-month moving averages

SOURCE: Department of Labor, Bureau of Labor


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4 PART 1: RECENT ECONOMIC AND FINANCIAL DEVELOPMENTS

. . . although labor force partic

remained weak, . . .While the unemployment rate andemployment have improved furtheforce participation rate has continumove lower on net (figure 3). As a employment-to-population ratio, athat combines the unemployment labor force participation rate, has

little during the past year. Althougof the decline in participation likechanging demographicsmost nothe increasing share in the populatolder people, who have lower-thanparticipation ratesand would ha

if h l b k h d b

U-6

U-5

U-4

201220102008200620042002

2. Measures of labor underutilization

Monthly

Unemployment rate

NOTE: U-4 measures total unemployed plus discouraged workers, as a percent of the labor force plus discouraged workers. Discouraged womarginally attached workers who are not currently looking for work because they believe no jobs are available for them. U-5 measures total marginally attached to the labor force, as a percent of the labor force plus persons marginally attached to the labor force. Marginally attachethe 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 workers plus total employed part time for economic reasons, as a percent of the labor force plus all marginally attached workers. The shperiod of business recession as defined by the National Bureau of Economic Research.

SOURCE: Department of Labor, Bureau of Labor Statistics.

Employment-to-population ratio58

60

62

64

66

68

Percent

20142012201020082006200420022000

3. Labor force participation rate and

employment-to-population ratio

Monthly

Labor forceparticipation rate

NOTE: Both series are a percent of the population aged 16 and over.SOURCE: Department of Labor Bureau of Labor Statistics


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MONETARY POLICY REPORT: F

estimates of the long-run sustainable rate

of unemployment and well above ratesthat prevailed prior to the recent recession.Moreover, beyond labor force participation,some other aspects of the labor marketremain of concern. For example, the share ofthe unemployed who have been out of worklonger than six months and the percentage ofthe workforce that is working part time but

would like to work full time have declinedonly modestly over the recovery (figure 4).In addition, the quit ratean indicator ofworkers confidence in the availability of otherjobsremains low.

. . . and gains in compensation have beenslow

The relatively weak labor market has also beenevident in the behavior of wages, as the modestgains in labor compensation seen earlier in therecovery continued last year. The 12-monthchange in the employment cost index forprivate industry workers, which measures bothwages and the cost to employers of providingbenefits, has remained close to 2 percent

throughout most of the recovery (figure 5).Similarly, average hourly earnings for allemployeesthe timeliest measure of wagedevelopmentsincreased close to 2 percentover the 12 months ending in January, aboutthe same pace as over the preceding year.Compensation per hour in the nonfarmbusiness sectora measure derived fromthe labor compensation data in the nationalincome and product accounts (NIPA)canbe quite volatile even at annual frequencies,but, over the past three years, this measurehas increased at an annual average pace of2 percent, well below the average pace priorto the recent recession

Part-time workers

1

2

3

4

5

6

7

201020082006200420022000

4. Long-term unemployed and part-tim

Percent

Long-term unemplo

NOTE: The data are monthly. The long-term unethe percent of total unemployed persons who hav27 weeks or more. The part-time worker senonagricultural employees working part time for eco

SOURCE: Department of Labor, Bureau of Labor

Employmentcost index

2009200720052003

5. Measures of change in hourly compe

Quarterly

Compensation per hour,nonfarm business sector

NOTE: For nonfarm business compensation, chafor the employment cost index, change is over thelast month of each quarter.

SOURCE: Department of Labor, Bureau of Labor S


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recession (figure 6). However, with

strengthening in the pace of econoproductivity growth rose to an annnearly 3 percent over the secondlast year.

Inflation was low . . .

Inflation remained low in the seco

2013, with the PCE price index incan annual rate of only 1 percent frDecember, similar to the increase ihalf and noticeably below the FOMrun objective of 2 percent (figure 7pricesor prices of PCE goods anexcluding food and energyalso iat an annual rate of about 1 percen

second half of 2013. Other measuconsumer price inflation, such as tconsumer price index, were also lorelative to norms prevailing in the to the recent recession, though notcore PCE inflation.

Some of the recent softness in corinflation reflects factors that appeabeen transitory. In particular, afterat an average annual rate of 1 pethe end of 2009 to the end of 2012import prices fell 1 percent in 20down by the effects of dollar apprdeclining commodity prices duringhalf of last year. These factors havsince last summer, as the broad no

of the dollar has moved up only a net, and the fall in overall nonfuelprices has eased. In addition, durinfinal part of 2013, prices for a few metals reversed part of their earliesupported by a positive turnaroun

1

+

_0

1

2

3

4

5

6

Percent, annual rate

6. Change in output per hour

H1

H2

1948 73

1974 95

19962007

2009 2011 2013

NOTE: The data are from the nonfarm business sector.SOURCE: Department of Labor, Bureau of Labor Statistics.

Excluding foodand energy

1

+

_0

1

2

3

4

5

Percent

2013201220112010200920082007

7. Change in the chain-type price index for personalconsumption expenditures

Monthly

Total

NOTE: The data extend through December 2013; changes are from one yearearlier.

SOURCE: Department of Commerce, Bureau of Economic Analysis.


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an unusual amount of downward pressure

on inflation. Unit labor costs increased at anannual rate of 1 percent over the past twoyears, just a little below their average prior tothe recent recession.

Consumer energy and food prices changedrelatively little over the second half of 2013.The spot price of Brent crude oil, after

peaking in late August at nearly $120 perbarrel, has been relatively stable in recentmonths, trading at about $110 per barrelsince mid-September, as a continued increasein North American crude oil productionhas helped buffer the effects of some supplydisruptions elsewhere (figure 8). Meanwhile,strong harvests have put downward pressureon food commodity prices, and, as a result,consumer food priceswhich reflect bothcommodity prices and processing costswerelittle changed in the second half of last year.

. . . but inflation expectations changedlittle

The Federal Reserve monitors the publics

expectations of inflation, in part because theseexpectations may influence wage- and price-setting behavior and thus actual inflation.Despite the weakness in recent inflation data,survey- and market-based measures of longer-term inflation expectations changed little, onnet, over the second half of last year and haveremained fairly stable in recent years. Medianexpected inflation over the next 5 to 10 years,as reported in the Thomson Reuters/Universityof Michigan Surveys of Consumers, was2.9 percent in January, within the narrowrange of the past decade (figure 9).1In theSurvey of Professional Forecasters, conductedby the Federal Reserve Bank of Philadelphia

Oil

70

80

90

100

110

120

130

140

20122011201020092008

8. Prices of oil and nonfuel commodities

January 2, 2008 = 100

Nonfuelcommodities

NOTE: The data are weekly averages of daily data thrprice of oil is the spot price of Brent crude oil, and the pis an index of 23 primary-commodity prices.

SOURCE: Commodity Research Bureau.

Michigan survey expectatio

for next 5 to 10 years

SPF efor ne

9. Median inflation expectations


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longer-term inflation compensatio

from differences between yields onand inflation-protected Treasury shave remained within their respectobserved over the past several year(figure 10).

Growth in economic activity p

Real GDP is estimated to have incat an annual rate of 3 percent ovsecond half of last year, up from a1 percent pace in the first half (fiGross domestic income, or GDI, ameasure of economic output, incrmore than 3 percent over the four ending in the third quarter of last

most recent data available), 1 percfaster than the increase in GDP ovperiod (figure 12).2

Some of the strength in GDP growsecond half of 2013 reflected a picpace of inventory investment, a facannot continue indefinitely. But omore persistent factors influencing

shifted in a more favorable directioIn particular, restraint from fiscal likely started to diminish in the latof last year. In addition, further inthe prices of corporate equities anboosted household net worth, whibecame more broadly available to and businesses and interest rates re

Moreover, the boom in oil and gascontinued. Finally, economic condin the rest of the world improved onotwithstanding recent market tursome emerging market economies As a result, consumer spending, bu

5-year (carry adjusted)

2

1

+

_0

1

2

3

4

Percent

2014201220102008200620042002

10. Inflation compensation

Daily

5 to 10 years ahead

NOTE: Inflation compensation is the difference between yields on nominalTreasury securities and Treasury inflation-protected securities (TIPS) ofcomparable maturities, based on yield curves fitted to off-the-run nominalTreasury securities and on- and off-the-run TIPS. The 5-year measure isadjusted for the effect of indexation lags.

SOURCE: Federal Reserve Bank of New York; Barclays; Federal ReserveBoard staff estimates.

4

2

+

_0

2

4


2013201220112010200920082007

11. Change in real gross domestic product

H1

H2


2

3

4

4-quarter percent change

12. Gross domestic product and gross domestic income

Quarterly

Gross domestic product


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Fiscal policy was a notable headwind in

2013, . . .Relative to prior recoveries, fiscal policy inrecent years has been unusually restrictive,and the drag on GDP growth in 2013 wasparticularly large. The expiration of thetemporary payroll tax cut and tax increases forhigh-income households at the beginning of2013 restrained consumer spending. Moreover,

federal purchases were pushed down by thesequestration, budget caps on discretionaryspending, and the drawdown in foreignmilitary operations. As a result, real federalpurchases, as measured in the NIPA, fell atan annual rate of more than 7 percent overthe second half of the year (figure 13). Due tothe government shutdown in October, which

temporarily held down purchases in the fourthquarter, this decline was somewhat steeperthan in the first half.3

The federal budget deficit declined as a shareof GDP for the fourth consecutive year infiscal year 2013, reaching about 4 percent ofGDP. Although down from nearly 10 percent

in fiscal 2009, the fiscal 2013 deficit is still1 percentage points higher than its 50-yearaverage. Federal receipts rose in fiscal 2013 butstill were only 16 percent of GDP; federaloutlays, while falling, remained elevated at20 percent of GDP in the past fiscal year(figure 14). With the deficit still elevated, thedebt-to-GDP ratio increased from 69 percentat the end of fiscal 2012 to 71 percent at the

end of fiscal 2013 (figure 15).

. . . but fiscal drag appears to be easing

Although the expiration of emergencyunemployment compensation at the beginning

f thi ill i fi l t i t

20112010200920082007

local

13. Change in real government expendi

on consumption and investment

SOURCE: Department of Commerce, Bureau of Ec

Federal

State and

Expe

2005200119971993

Annual

14. Federal receipts and expenditures

Receipts

NOTE: The receipts and expenditures data are on are for fiscal years (October through September)(GDP) is for the four quarters ending in Q3.

SOURCE: Office of Management and Budget.

Annual

15. Federal government debt held by th


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from the tax increases at the begin

2013 has likely begun to wane. In the Bipartisan Budget Act of 2013the limits on spending associated wsequestration, and an increase in tfrom the Affordable Care Act shoua boost to demand beginning this yfiscal conditions at the state and loof government have improved, and

purchases by such governments arto have edged up in 2013 after sevedeclines.

Consumer spending rose fasterby improvements in labor mar

After increasing at an annual rate 2 percent in the first half of 2013,

rose at a 2 percent rate over the half (figure 16). Real disposable peincomewhich had been pushed lthe tax increases in the first quartemoved up in the final three quarteyear. Continued job gains helped ieconomic prospects of many housyear and boosted aggregate incom

And the net rise in consumer sentirecent months suggests that greateabout the economy on the part of should support consumer spendin2014 (figure 17).

. . . as well as increases in houworth and low interest rates

Consumer spending was also likelyby a significant increase in househworth in the second half of last yeof corporate equities and housing to rise. (For further information, sRecent Changes in Household Wddi i di f

2

1

+

_0

1

2

3


2013201220112010200920082007

16. Change in real personal consumption expenditures

H1

H2


Conference Board20

40

60

80

100

120

20142013201220112010200920082007

Monthly

17. Consumer sentiment indexes

Michigan survey

NOTE: The Conference Board data are indexed to 100 in 1985. TheMichigan survey data are indexed to 100 in 1966.

SOURCE: The Conference Board; Thomson Reuters/University of MichiganSurveys of Consumers.

6

7

8

9

Percent

18. Interest rate for new auto loans

Weekly


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MONETARY POLICY REPORT: FEB

half of the year. Nevertheless, standards and

terms for credit card debt have remained tight,and, partly as a result, credit card balanceschanged relatively little over the second half.

Business investment picked up . . .

Business fixed investment (BFI) rose at anannual rate of 4 percent in the second halfof 2013 after changing little in the first half.

Investment in equipment and intangible capitalrose at an annual rate of nearly 4 percent,while investment in nonresidential structuresincreased close to 6 percent (figure 19). Onbalance, national and regional surveys ofpurchasing managers suggest that orders fornew equipment continued to increase at theturn of the year. However, still-high vacancy

rates and relatively tight financing conditionslikely continued to limit building investment;despite the recent increases, investmentin buildings remains well below the peaksreached prior to the most recent recession.

The relatively modest rate of increase inthe demand for business output has likelyrestrained BFI in recent quarters. In 2012and the first half of 2013, business outputincreased at an annual rate of only 2 percent.However, the acceleration in overall economicactivity in the second half of 2013 may providemore impetus for business investment in theperiod ahead.

. . . as financing conditions for businesses

were generally quite favorable

Moreover, the financial condition ofnonfinancial firms remained strong in thesecond half of 2013, with profitability highand the default rate on nonfinancial corporateb d l t I t t t t

20112010200920082007

19. Change in real business fixed inves

SOURCE: Department of Commerce, Bureau of E

Structures

Equipment and intangible capital

AA

High-yield

20200820062004200220001998

20. Corporate bond yields by securities

Daily

BBB

NOTE: The yields shown are yields on 10-year boSOURCE: BofA Merrill Lynch Global Research, u

Bil

21. Selected components of net financibusinesses

Sum

Commercial paper

Bonds

Bank loans


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One reason home equity has increasehouse prices have risen in many areas; anthat aggregate mortgage debt has fallen bof foreclosures, paydowns, and other factlater. As shown in figure B, residential mo

outstanding has fallen over $1 trillion sinof 2007, making mortgages the major cothe phenomenon known as household de

American households aggregate wealth fell morethan $10 trillion in 2008 as home equity, the valueof corporate stock, and other forms of net wealthall declined, but household wealth has increased ineach of the five years since then (figure A).1Muchof the recent increase in net worth reflects capital

gains on corporate equity and real estate held byhouseholds. Since the end of 2008, stock marketwealth has increased over $10 trillion, more thanthe amount that was lost during the recession. Homeequity has recovered more slowly, rising about$3 trillion in the past two years, which is abouthalf the amount lost between 2006 and 2011. Theincrease in home equity affects a larger numberof households than the increase in stock wealthbecause housing assets are distributed more broadlyacross the population than is stock ownership. Moreinformation about the distribution of householdwealth will be available upon completion of theFederal Reserve Boards 2013 Survey of ConsumerFinances.

1. The 2013 bar in the figure shows changes through thethird quarter, the most recent quarter for which data areavailable. House prices and stock prices increased further

in the fourth quarter, suggesting that the total increase inhousehold net worth for 2013 will have been larger thanthe amount shown here.

Billions of d

2201220112010200920082007

. anges n ouse o e t

Sum

NOTE: Changes are calculated from year-end to year

changes, which are calculated from Q3 to Q3.SOURCE: Federal Reserve Board, Statistical Release

Accounts of the United States.

Mortgages

Consumer credit

Recent Changes in Household Wealth

A. Changes in household net worth

H i


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100

50

+

_0

50

100

150

200

Billions of dollars, monthly rate

C. Changes in consumer credit

C di d

D. Percent of mortgages with negative eq

Q3 Q4 Q1 Q2Q3

Q4Q1

Q2 Q3 Q4

LTV > 125

LTV 105-125

LTV 100-105

In contrast to mortgages, consumer credit hasexpanded in each of the past four years. A detailedbreakdown of consumer credit is shown in figureC. In recent years, growth in consumer credit hasbeen driven by student loans and auto loans, whileaggregate credit card balances have been relatively

flat.Despite the marked improvements in aggregate

household net worth since the recession, manyhouseholds wealth positions have not recovered.Weak labor market conditions and the precipitousdrop in home prices continue to weigh on manyhouseholds net worth. Figure D shows that asignificant percentage of homeowners with amortgage continue to be underwaterthat is,they owe more than their homes are worthand,

for many, the depth of that negative equity is stillsubstantial.

Nonetheless, the share of homeowners withnegative equity is decreasing. By one estimate,roughly one in eight homeowners with a mortgagewas underwater as of the third quarter of 2013about half the share from two years earlier, thoughstill significantly higher than the level that prevailedbefore house prices started falling in 2006.2Three

2. These estimates are from CoreLogic. Alternativeestimates from Zillow show a somewhat larger shareof underwater households, but one that also has beendeclining since early 2012.

primary factors have contributed to thein negative equity over the past two yehome prices have increased significanhomeowners outstanding mortgage bbeen declining because of scheduled cash-in refinances, and mortgage mod

Third, foreclosures and short sales havsome homeowner liability.

Continued improvements in the hopositions of households could have brconsequences for the economy. First, improvements could help with the tramonetary policy. Banks are more willimortgages when homeowners have poequity, so improving home equity mayhomeowners to take advantage of the

interest rates. Second, because negativassociated with higher rates of forecloimprovements should reduce the numforeclosures and the associated econosocial costs. Third, to the extent that hable to borrow against their home equoutlays, including those to finance smhaving more homeowners with positivcould increase aggregate demand. Finhomeowners with negative equity mayor able to sell their homes at market pin the negative equity share could helthe operation of the housing market anmobility.


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speculative-grade debt was reporte

for uses beyond the refinancing of debt.

Conditions in business loan markecontinued to improve. According tFederal Reserve Boards January 2Loan Officer Opinion Survey on BLending Practices (SLOOS), a mofraction of respondents indicated teased standards on commercial an(C&I) loans over the second half oaddition, according to the FederalBoards November 2013 Survey ofof Business Lending, loan rate sprover banks cost of funds have conto decline. Financing conditions fobusinesses also improved: Reducti

spreads have been most notable foof loans likely made to small businthat is, loans of $1 million or less ooriginated by small domestic bankStandards on commercial real estaloans extended by banks also easedsecond half of last year, moving blonger-run norms, according to the

Still, standards for construction andevelopment loans, a subset of CRlikely remained relatively tight.

Exports strengthened

Export demand also provided signsupport to domestic economic actsecond half of 2013 (figure 23). Re

of goods and services rose at an an7 percent, consistent with improGDP growth in the latter part of tbuoyed by soaring sales both of peproductsassociated with the booproductionand of agricultural g

Large domestic banks

300

325

350

375

400

425

450

475

Basis points

201320102007200420011998

22. Average interest rate spreads on commercial and

industrial loans of $1 million or less

Quarterly

Small domestic banks

NOTE: Adjusted for changes in nonprice loan characteristics. Spreads arecomputed over market interest rates on instruments with maturitiescomparable to each loan repricing interval. Observations are weighted byloan amount.

SOURCE: Staff calculations based on data from the Federal Reserve Board,

Statistical Release E.2, Survey of Terms of Business Lending.

6

3

+

_0

3

6

9

12


2013201220112010200920082007

23. Change in real imports and exports of goodsand services

H1

H2


Imports

Exports


20/58


The growth of real imports of goods and

services stepped down to an annual rate of1 percent in the second half of last year.Among the major categories, imports of non-oil goods and services rose more moderately,while oil imports continued to decline.

Altogether, real net trade added an estimated percentage point to GDP growth over thesecond half of 2013, whereas in the first halfit made a small negative contribution. Owingin part to the improvement in net petroleumtrade, the nominal trade deficit shrank, onbalance, over the second half of 2013. Thatdecrease contributed to the narrowing of thecurrent account deficit to 2 percent of GDPin the third quarter, a level generally not seensince the late 1990s (figure 24).

The current account deficit continued to befinanced by strong financial inflows in thethird quarter of 2013, mostly in the form ofpurchases of Treasury and corporate securitiesby both foreign official and foreign privateinvestors (figure 25). Partial monthly datasuggest that these trends likely continued in

the fourth quarter. U.S. investors continued tofinance direct investment projects abroad at arapid pace in the third quarter. Although U.S.purchases of foreign securities edged down inthe summer, consistent with stresses observedin emerging markets, they appear to haverebounded in the final part of the year.

The recovery in housing investmentpaused with the backup in interestrates . . .

After increasing at close to a 15 percentannual rate in 2012 and the first part of 2013,residential investment was little changed in

Currentaccount

22007200520032001199919971995

24. U.S. trade and current account balan

Quarterly

Trade

NOTE: The data for the current account extend thSOURCE: Department of Commerce, Bureau of Ec

B

20122011201020092008

25. U.S. net financial inflows

NOTE: Negative numbers indicate a balancegenerated when U.S. residents, on net, purchaseforeign residents, on net, sell U.S. assets. A neprivate or U.S. official indicates an increase iofficial flows include the foreign currency acquirbanks draw on their swap lines with the Federal Res

SOURCE: Department of Commerce, Bureau of Ec

U.S. private (including banking)

Foreign private (including banking)

U.S. official

Foreign official


21/58


since then (figure 26). Soon after th

mortgage refinancing dropped sharwhile home sales declined somewhissuance of new single-family housleveled off (figure 27). However, rehistorical norms, mortgage rates reand housing is still quite affordablesteady growth in jobs is likely contsupport growth in housing demandbecause new home construction is below levels consistent with populagrowth, the potential for further grhousing sector is considerable.

. . . and mortgage credit contintight, . . .

Lending policies for home purchas

quite tight overall, but there are soindications that mortgage credit is to become more widely available. Anet fraction of SLOOS respondenthaving eased standards on prime rloans during the second half of lasAnd, in a sign that lending conditiohome refinance are becoming less rthe credit scores of individuals refimortgages at the end of last year won average, than scores for individurefinancing earlier in the year. Howscores of individuals receiving morhome purchases have yet to drop (fi

. . . but house prices continued

Home prices continued to rise in thhalf of the year, although somewhquickly than in the first half (figurethe 12 months ending in Decemberprices increased 11 percent. Much gain in home prices has been conce

th t th l t d li i

Interest rate

0

2,000

4,000

6,000

8,000

10,000

March 16, 1990 = 100

3

4

5

6

7

8

9

10

11

2014201020062002199819941990

26. Mortgage interest rate and mortgage refinance

index

Percent

Refinance index

NOTE: The interest rate data are weekly through February 5, 2014, and arefor 30-year fixed-rate mortgages. The refinance data are a seasonally adjusted4-week moving average through January 31, 2014.

SOURCE: For interest rate, Federal Home Loan Mortgage Corporation; forrefinance index, Mortgage Bankers Association.

Multifamily starts

Single-family permits

.2

.6

1.0

1.4

1.8

2.2

Millions of units, annual rate

2013201120092007200520032001

27. Private housing starts and permits

Monthly

Single-family starts

NOTE: The data extend through December 2013.SOURCE: Department of Commerce, Bureau of the Census.


22/58


Financial Developments

The expected path for the federal fundsrate through mid-2017 moved lower . . .

Market-based measures of the expected (ormean) future path of the federal funds ratethrough mid-2017 moved lower, on balance,over the second half of 2013 and early 2014,mostly reflecting FOMC communications

that were broadly seen as indicating that ahighly accommodative stance of monetarypolicy would be maintained for longer thanhad been expected. Measures of the expectedpolicy path rose in the summer in conjunctionwith longer-term interest rates, as investorsincreasingly expected the Committee to startreducing the pace of asset purchases at the

September FOMC meeting. However, thoseincreases were more than retraced over theweeks surrounding the September meeting,in part because the decision to keep thepace of asset purchases unchanged and theaccompanying communications by the FederalReserve were viewed as more accommodativethan investors had anticipated. Expectationsfor the path of the federal funds rate throughmid-2016 have changed little, on net, sincemid-October. Federal Reserve communicationssince last September, including the enhancedforward guidance included in the Decemberand January FOMC statements, reportedlyhelped keep federal funds rate expectationsnear their earlier levels despite generallystronger-than-expected economic data and

the modest reductions in the pace of FederalReserve asset purchases announced at theDecember and January FOMC meetings.

The modalpath of the federal funds ratethatis, the values for future federal funds rates that

202009200720052003

28. Credit scores on new prime mortga

Monthly

90th percentile

10th percen

Median

NOTE: The data extend through December 2mortgages only.

SOURCE: McDash Analytics, LLC, a wholly owProcessing Services, Inc.

S&P/Case-Shiller20-city index

CoreLogicprice index

201020072004

29. Prices of existing single-family hou

Monthly

FHFAindex

NOTE: The data for the FHFA index and the extend through November 2013, and the data for thethrough December 2013. Each index has been norm100. Both the CoreLogic price index and the FHFA

transactions only. The S&P/Case-Shiller index refletransactions in selected metropolitan areas.

SOURCE: Federal Housing Finance Agency (FHFS&P Capital IQ Solutions Capital IQ Platform; stdata provided by CoreLogic.


23/58


by the Open Market Desk at the F

Reserve Bank of New York just prJanuary FOMC meeting showed texpectations of the date of liftoff out about two quarters since the myear, to the fourth quarter of 2015

. . . while yields on longer-termincreased but remained low by

standardsDespite the lower expected path offederal funds rate, yields on longerTreasury securities and agency mobacked securities (MBS) rose modover the second half of 2013 (figur31). These increases likely reflecteddata that were generally better tha

expected, as well as market adjustmrising expectations that the Commstart reducing the pace of its asseta step that was taken at the Decemmeeting. Subsequently, yields declflight-to-safety flows in response toemerging market turbulence (see thFinancial Stress and VulnerabilitEmerging Market Economies). Oon 5-, 10-, and 30-year nominal Trsecurities have increased between aand 20 basis points from their leveof June 2013. Yields on 30-year agedged up, on balance, over the sam

Nonetheless, yields on longer-termcontinue to be low by historical sta

Those low levels reflect several factincluding subdued inflation expectwell as market perceptions of a stiglobal economic outlook. In additpremiumsthe extra return investto obtain from holding longer-term

10-year 30-year

1

2

3

4

5

6

7

Percent

20142012201020082006200420022000

30. Yields on nominal Treasury securities

Daily

5-year

NOTE: The Treasury ceased publication of the 30-year constant maturityseries on February 18, 2002, and resumed that series on February 9, 2006.

SOURCE: Department of the Treasury.

Yield

0

50

100

150

200

250

300

350

400

Basis points

2

3

4

5

6

7

8

9

20142012201020082006200420022000

31. Yield and spread on agency mortgage-backedsecurities

Percent

Spread

NOTE: The data are daily. Yield shown is for the Fannie Mae 30-yearcurrent coupon, the coupon rate at which new mortgage-backed securitieswould be priced at par, or face, value. Spread shown is to the average of the5- and 10-year nominal Treasury yields.

SOURCE: Department of the Treasury; Barclays.


24/58


selloff in the summer, remained within the

low range they have occupied since the onsetof the financial crisis, reflecting both theFOMCs large-scale asset purchases and strongdemand for longer-term securities from globalinvestors.

Indicators of Treasury market functioningwere solid, on balance, over the second halfof 2013 and early in 2014. For example,available data suggest that bidasked spreadsin the Treasury market stayed in line withrecent averages. Moreover, Treasury auctionsgenerally continued to be well received byinvestors. Liquidity conditions in the agencyMBS market deteriorated somewhat for a timeover the summer, amid heightened volatility,and a bit again toward year-end but have

largely returned to normal levels since theturn of the year. Over the past seven months,the number of trades in the MBS market thatfailed to settle remained low, and impliedfinancing rates in the dollar roll marketanindicator of the scarcity of agency MBS forsettlementhave been stable (figure 32).6

Short-term funding markets continued tofunction well, on balance, despite somestrains during the debt ceiling standoff

In the fall of 2013, many short-term fundingmarkets were adversely affected for a time byconcerns about the possibility of a delay inraising the federal debt limit. The Treasurybill market experienced the largest effect as

yields on bills maturing between mid-Octoberand early November rose sharply, some billauctions saw reduced demand, and liquidity inthis market deteriorated, especially for certainsecurities that were seen as being at risk ofdelayed payment. Conditions in other short-

4.0 percentcoupon

201320122011

32. Dollar-roll-implied financing rates Fannie Mae 30-year

Daily

3.5 p

co

Fails charge Fails chargeannounced implemented

NOTE: The 4.0 percent coupon data series begins SOURCE: J.P. Morgan.


25/58


strained for a time. However, these

eased quickly after an agreement tthe debt limit was reached in mid-Oand, overall, the debt ceiling standpermanent imprint on short-term markets.

On balance, since the end of June conditions in both secured and unshort-term funding markets have clittle, with many money market ratremaining near the bottom of the have occupied since the federal funfirst reached its zero lower bound. offshore dollar funding markets gedid not exhibit any signs of stress. asset-backed commercial paper anfinancial commercial paper for the

also stayed low. In the repo markegeneral collateral Treasury repos aconsistent with reduced financing of dealers. These rates declined noyear-end, leading to increased parin the Federal Reserves overnight repurchase agreement operations (of this report). Overall, year-end p

short-term funding markets were mroughly in line with experiences duyears since the financial crisis.

Broad equity price indexes incfurther and risk spreads on cordebt declined . . .

Boosted by improved market senti

regarding the economic outlook anFOMCs sustained highly accommmonetary policy, broad measures oprices continued posting substantithrough the end of 2013. Around of the year, however, investor sent100

120

140

December 31, 2007 = 100

33. Equity prices

Daily

Dow Jonesbank index


26/58


Treasury securities of comparable maturities

have narrowed, on net, since the middle of2013. Spreads on syndicated loans have alsonarrowed some, and issuance of leveragedloans, boosted by strong demand fromcollateralized loan obligations, was generallystrong in the second half of 2013.

While some broad equity price indexestouched all-time highs in nominal terms sincethe middle of 2013 and valuation metricsin some sectors appear stretched, valuationmeasures for the overall market are nowgenerally at levels not far above their historicalaverage levels, suggesting that, in aggregate,investors are not excessively optimistic in theirattitudes toward equities. Implied volatility forthe S&P 500 index, as calculated from option

prices, generally remained low over the period;it has risen since early January but remainsbelow the recent high reached during the debtceiling standoff in the fall.

. . . and market sentiment towardfinancial institutions continued tostrengthen as their capital and liquidity

profiles improvedMarket sentiment toward the financial sectorcontinued to strengthen in the second halfof 2013, reportedly driven in large part byimprovements in banks capital and liquidityprofiles, as well as further improvements inasset quality. On average, equity prices of largedomestic banks and insurance companies

performed roughly in line with broader equityindexes (figure 33). The spreads on the creditdefault swap (CDS) contracts written onthe debt of these firms generally narrowed.Among nonbank financial institutions, manyhedge funds significantly underperformed

34. Change in use of financial leverage

Quarterly


27/58


continued to see strong inflows, ho

bringing its assets under managemall-time high by the end of 2013.

Standard measures of profitabilityholding companies (BHCs) were lichanged in the third quarter of 20large reductions in income from moriginations and revenue from fixetrading, as well as a sharp increaseexpenses, were offset primarily by in provisions for loan losses and incompensation. Asset quality contiimprove for BHCs, with delinquendeclining across a range of asset clthe industrys net charge-off rate nto pre-crisis levels (figure 35). Net margins remained about unchange

the same period. (For further discuof the financial condition of BHCbox Developments Related to FinStability.) Meanwhile, aggregate cprovided by commercial banks incin the second half of 2013 followinrise in longer-term interest rates (fiStrong growth in loan categories th

more likely to have floating interesshorter maturitiesincluding C&Iand auto loanswas partly offset in assets that have longer durationmore sensitive to increases in interincluding residential mortgages ansecurities.

Financial conditions in the mubond market generally remaine

Yields on 20-year general obligatiobonds rose since June 2013. Howevspreads of municipal bond yields oof comparable-maturity Treasury

Net charge-offs, all loans

0

1

2

3

4

5

6

7

8

Percent

20132010200720042001199819951992

35. Delinquency and charge-off rates for commercial banks

Quarterly

Delinquencies, all loans

NOTE: The data extend through 2013:Q3. The delinquency rates are thepercent of loans 30 days or more past due or not accruing interest. The netcharge-off rates are the percent of loans charged off net of recoveries. Theshaded bars indicate a period of business recession as defined by the NationalBureau of Economic Research.

SOURCE: Federal Financial Institutions Examination Council, FFIEC031/041, Consolidation Reports of Condition and Income for Commerical

Banks (Call Reports).

10

5

+

_0

5

10

15


20132010200720042001199819951992

36. Change in total bank credit

Quarterly

NOTE: The data are seasonally adjusted.SOURCE: Federal Reserve Board, Statistical Release H.8, Assets and

Liabilities of Commercial Banks in the United States.


28/58


the City of Detroit filed for bankruptcy in

July 2013, making it the largest municipalbankruptcy filing in U.S. history. In addition,the prices of bonds issued by Puerto Ricocontinued to reflect the substantial financialpressures facing the territory and the spreadsfor five-year CDS contracts written on thedebt issued by the territory soared. In earlyFebruary, some of the territorys bonds weredowngraded to below investment grade.

M2 rose briskly

M2 has increased at an annual rate of about7 percent since June, faster than the paceregistered in the first half of 2013. Flows intoM2 picked up amid the selloff in fixed-incomemarkets in the summer, which prompted

large outflows from bond funds, as well as theuncertainty about the passage of debt limitlegislation in the fall, which appeared to haveled some institutional investors to shift frommoney fund shares to bank deposits. Followingthe resolution of the fiscal standoff, M2 growthslowed significantly as investors reallocated outof cash positions.

International Developments

Bond yields rose sharply in some emergingmarket economies, but were flat to downin most advanced foreign economies

Foreign long-term bond yields rose significantly

from May of last year through most of thesummer, as expectations of an imminentreduction in the pace of large-scale assetpurchases by the Federal Reserve intensified(figure 37). In many EMEs, yields stabilizedafter the September FOMC meeting However

United Kingdom

Daily

. -year nom na enc mar y e s


29/58


Developments Related to Financial Stability

Since the previous Monetary Policy Report, theFederal Reserve and other agencies took furtherregulatory steps to improve the safety of the financialsystem, including strengthening capital regulations,proposing new quantitative liquidity requirementsfor large financial institutions, and issuing a final

rule implementing the Volcker rule, which restrictsthe proprietary trading activities of such firms.Moreover, the Federal Reserve added to the numberof large bank holding companies (BHCs) evaluatedby annual stress tests and has begun to supervise thenonbank financial companies Prudential; AmericanInternational Group, Inc., or AIG; and GE Capital asa result of their designation by the Financial StabilityOversight Council as systemically important financialinstitutions. The vulnerability of the financial system

to adverse shocks remained at a moderate level, ascapital profiles at large BHCs improved further, useof financial leverage was relatively restrained, andvaluations in most asset markets were broadly inline with historical norms. The Federal Reserve willcontinue its comprehensive monitoring of financialvulnerabilities.

The financial strength of the banking sectorimproved last year. BHCs have stabilized their capitalratios at levels significantly higher than prior to the

financial crisis and roughly in line with new, tougherregulatory standards. For example, the ratio of Tier 1common equity to risk-weighted assets at all BHCshas been around 13 percent, on average, over thepast two years, 4 percentage points higher than theaverage prior to 2009. Moreover, the aggregate rateof charge-offs and delinquent loans continued tofall, reflecting improvement in the quality of loansoriginated and the strengthening in household andbusiness balance sheets that has accompanied theeconomic recovery. Thirty large BHCs are currentlyundergoing the stress tests mandated by the Dodd-Frank Wall Street Reform and Consumer ProtectionAct of 2010 (Dodd-Frank Act), the summary resultsof which will be released in March. These stresstests are supervisory tools that the Federal Reserve

t h l th t fi i l i tit ti h

of adverse macroeconomic conditions. Lastress tests found that large BHCs had conto increase their resilience to adverse ecoconditions since the financial crisis, and ttesting regimen encourages BHCs effortsimprove their capital-planning processes

large BHCs dependence on short-term fuwhich proved highly unreliable during thcontinued to decrease last year.

At the same time, litigation expenses aBHCs increased. During 2013, several BHentered into various consent orders and rsettlements that stemmed from their actioto the financial crisis. Some, but not all, olitigation was due to offerings of mortgagsecurities (MBS). Civil and criminal pena

in significant increases to noninterest expthat diminished net profits for the year. Osaw its net profit turn negative in the third2013 as a result of litigation expenses of $10 billion, or 18 percent of total expensperiod. Although the analyst community that litigation expenses should decrease, profitability remains.

Market-based measures indicate that bseen by investors as stronger. Bank stock

continued to rise, on net, and premiums ocredit default swaps (CDS) remain relativeSimilarly, systemic risk measures for thesewhich also are based on the correlations their stock prices and the broader marketto decline.

More broadly, aggregate measures of fileverage, including the use of short-term debt, have remained subdued. The provisof dealer-intermediated leverage to fund appear moderate. In addition, while issuaprivate securitization markets has continurebound, it is far below the peak reachedthe crisis. Of particular note was the growcollateralized loan obligations that securiof leveraged loans. Regulators have addre

i k d b h d b ki fi


30/58


to recognize exposures to off-balance-sheet vehiclesand to hold liquidity buffers when they providecredit or liquidity facilities. Still, it is important tomake progress on other ongoing reform efforts tofix remaining structural vulnerabilities in short-termfunding markets.

While the extended period of low interest rateshas contributed to improved economic conditions,it could also lead investors to reach for yieldthrough, for example, excessive leverage, durationrisk, or credit risk. Prices for corporate equitieshave risen and spreads for corporate bonds havenarrowed, but valuations for broad indexes forthese markets do not appear stretched by historicalstandards. Some reach-for-yield behavior is evidentin the lower-rated corporate debt markets. Over the

past year, issuance of syndicated leveraged loansand high-yield bonds has surged and underwritingstandards have deteriorated. Federal bankingregulators issued supervisory guidance on leveragedlending practices, and followed up with banks inthe fall, in order to mitigate the buildup of risky debtat banks.

The rise in interest rates and volatility since lastspring may have led investors to adjust their riskpositions. For example, estimated term premiums

on longer-term Treasury securities rose, andintermediate and long-term bond mutual funds haveexperienced sizable outflows since the spring, afterreceiving strong inflows for the past several years.Increasing interest rates caused losses for real estateinvestment trusts specializing in agency MBS(agency REITs), which fund purchases of agencyMBS mostly using relatively short-term repurchaseagreements, implying extensive maturitytransformation. The rise in interest rates prompted

agency REITs to sell assets, reducing the overallamount of leverage used in the agency MBS market.At the largest banking firms, supervisors have beenevaluating interest rate risk and are working withinstitutions to improve their risk-managementpractices so that they are prepared for unexpectedh i i t t t

highlighted here. First, together with oagencies, the Federal Reserve issued aimplementing the Volcker rule designereduce moral hazard in the financial sVolcker rule prohibits banking entitiesin short-term proprietary trading in sec

derivatives, commodity futures, and oinstruments. The rule also imposes limentities investments in hedge funds anequity funds. Exemptions are providedactivities, including market making, uhedging, trading in government obligainsurance company activities, and orgoffering hedge funds or private equity clients.

Furthermore, the Federal Reserve B

proposed a rule that would strengthenpositions of large and internationally ainstitutions by enforcing a quantitativerequirement, called the liquidity covefor the first time. Liquidity is essential tviability and the smooth functioning osystem. In conjunction with other reforule would foster a more resilient and system.

In addition, the Federal Reserve Bo

completing the regulations to implemand Dodd-Frank Act regulatory capita

July, is working to finalize the remainiprudential standards mandated by secthe Dodd-Frank Act, with stricter regusupervisory requirements for large BHbanking organizations with a U.S. presrules include requirements for risk-basleverage, liquidity, and stress tests. TheReserve also is working to propose a r

to implement the Basel Committee onSupervision risk-based capital surcharfor global systemically important bank

Finally, the Federal Reserve and othregulatory agencies are working to moearlier proposals to address risks from t ti th t l b l f


31/58


stresses (see the box Financial Str

Vulnerabilities in the Emerging MEconomies). Rates in the advanceeconomies (AFEs) rose slightly onduring the second half of 2013, wieconomic conditions generally supyields. In particular, bond yields inthe United Kingdom as unemploymore quickly than anticipated. In area, yields were little changed, as target inflation led the European CBank (ECB) to cut its main refinana further 25 basis points in Novemcontrast, Japanese government bowere down modestly, on net, since in part as market participants antithat the Bank of Japan (BOJ) wouthe size of its asset purchase progr

the past two weeks, however, AFEyields in general declined somewhaparticipants pulled back from risky

The dollar has appreciated a li

The broad nominal value of the doa little, on net, since last summer (The dollar depreciated against botand the British pound in the seconyear, as macroeconomic conditionin Europe and as financial stressesassociated flight to safety continueHowever, the dollar has appreciateagainst the Japanese yen since Octreflecting anticipations of an expathe BOJs asset purchase program

it retraced somewhat in recent weethe recent turbulence in emerging markets. The U.S. dollar also appragainst the currencies of some vulEMEs amid higher long-term yieldUnited States and more recently

Euro

Yen

90

95

100

105

110

115

120

125

130

135

140

January 4, 2012 = 100

201420132012

38. U.S. dollar exchange rate against broad indexand selected major currencies

Daily

Broad

NOTE: The data are in foreign currency units per dollar.SOURCE: Federal Reserve Board, Statistical Release H.10, Foreign

Exchange Rates.


32/58


central banks in some EMEs, such as Brazil

and Turkey, intervened in currency markets.

During the second half of 2013, equity indexes

in the AFEs added considerably to earlier

gains, likely reflecting the improved economic

outlook (figure 39). Over the year as a whole,

equity markets in Japan outperformed

other foreign indexes, increasing more than

50 percent. Since the end of last year, however,

AFE equity indexes have reversed part of their

earlier gains, with the decrease coinciding

with heightened financial volatility in the

EMEs. Equity markets in the EMEs, after

underperforming those in the AFEs during the

second half of last year, have also fallen more

recently.

Activity in the advanced foreigneconomies continued to recover . . .

Indicators suggest that economic growth in

the AFEs edged higher in the second half of

2013, supported by diminished fiscal drag

and further easing of European financial

stresses (figure 40). The euro area continued

to pull slowly out of recession in the third

quarter, with some of the most vulnerableeconomies returning to positive growth, but

unemployment remained at record levels.

Real GDP growth in the United Kingdom

picked up to a robust 3 percent pace in the

second half of last year, driven in part by

improving household and business sentiment,

and Canadian growth rebounded in the third

quarter after being restrained by floods thatimpeded economic activity in the second

quarter. Japanese GDP growth stepped down

in the third quarter from the rapid 4 percent

pace registered in the first half, as exports

dipped and household spending moderated,

Japan

UnitedKingdom

201220112010

40. Real gross domestic product growthadvanced foreign economies

Quarterly

Canada

NOTE: The Canada, Japan, and euro area data extSOURCE: For Canada, Statistics Canada; for the

Japan, Cabinet Office of Japan; for the United KingStatistics.

Quarterly

Euro area

Japan

Un

Emergingmarkets

20132012

39. Equity indexes for selected foreign e

Daily

SOURCE: For emerging markets, Morgan Stanley Capital Index; for the euro area, Dow Jones Euro STokyo Stock Exchange (TOPIX); all via Bloomberg.

28 A C N CONOM C AN NANC A O M N S


33/58


India Turke

Brazil

Mexico

Korea

J

A. Exchange rates of selected emerging marketagainst the U.S. dollar

Daily

Taiwan

Many emerging market economies (EMEs) haveexperienced heightened financial stresses since Aprilof last year. EMEdedicated international bond andequity funds sustained substantial outflows, and

many EME currencies depreciated sharply against thedollar (figure A). At the same time, EME governmentbond yields rose abruptly and by much more thanU.S. Treasury bond yields. Financial conditions inthe EMEs generally stabilized after September, butfinancial stresses have flared up again in recentweeks, with many currencies experiencing anotherbout of depreciation.

The stresses that arose in the middle of last yearappeared to be triggered to a significant degree by

Federal Reserve communications indicating thatthe Federal Reserve would likely start reducing itslarge-scale asset purchases later in the year. Someof the selloff in EME assets may have been due tothe unwinding of carry trades that investors hadentered into earlier to take advantage of higher EMEinterest rates than those prevailing in the advancedeconomies. These trades appeared profitable so longas EME currencies remained stable or were expectedto appreciate. But when anticipations of a slowing

in the pace of Federal Reserve asset purchases ledto higher U.S. interest rates as well as higher marketvolatility, these trades may have been quicklyreversed, engendering sharper declines in EMEcurrencies and asset prices.

In December, when the Federal Reserve actuallyannounced a reduction in asset purchases, thereaction of financial markets in the EMEs wasrelatively muted. Then, in late January, volatilityin these markets returned. Unlike last summer,there was little change in expectations regardingU.S. monetary policy during this time. Rather, afew adverse developmentsincluding a weaker-than-expected reading on Chinese manufacturing,a devaluation of the Argentine peso, and Turkeysintervention to support its currencytriggered the

Financial Stress and Vulnerabilities in the EmergingMarket Economies

suggesting that, even as the selloff of EMEwas in part driven by common factors, innonetheless were also responding to diffethese economies situations. Brazil, India

South Africa, and Turkey are among the ethat appear to have been the most affecteexample, the currencies of Brazil, India, adropped sharply in the middle of last yeathe currencies of Korea and Taiwan were resilient (as shown in figure A). And in realthough EME currencies sold off broadlyyields tended to increase the most in ecosaw the largest rises during 2013.

To a considerable extent, investors ap

have been differentiating among EMEs batheir economic vulnerabilities. The scattefigure B shows the link between the degrrelative vulnerability across EMEs as implsimple index (plotted on the horizontal aone measure of financial market stress, thchange in the value of EME currencies agdollar since the end of April (plotted on taxis). The index is constructed for a samp15 EMEs and is based on six indicators: (

of the current account balance to gross dproduct (GDP), (2) the ratio of gross govedebt to GDP, (3) average annual inflation

MONETARY POLICY REPORT FEB


34/58


Exchange

B. Exchange rate appreciation versus emereconomy vulnerability index

Vulnerability index3 4 5 6 7 8 9 10

Regression line; R-squared = 0.7

CH

CL

CO

ID

IN

KO

MA MXPH

TA

THRU

SA

past three years, (4) the change over the past fiveyears of bank credit to the private sector as a share ofGDP, (5) the ratio of total external debt to annualizedexports, and (6) the ratio of foreign exchange

reserves to GDP.1

By construction, higher values ofthe index indicate a greater degree of vulnerability.The figure indicates that those economies that appearrelatively more vulnerable according to the indexalso experienced larger currency depreciations.Moreover, the more vulnerable EMEs have alsosuffered larger increases in government bondyields since late April (not shown). This evidence isconsistent with the view that reducing the extent ofeconomic vulnerabilities is important if EMEs are to

become more resilient to external shocks, includingthose emanating from financial developments in theadvanced economies.

Indeed, policymakers in many EMEs madesustained efforts, following the crises of the 1990s,to improve their policy frameworks and reducetheir vulnerabilities to external funding shocks.These efforts included taming rampant inflation,allowing greater exchange rate flexibility, reducingexternal indebtedness, and building holdings of

foreign exchange reserves. As a result, the degreeof vulnerability across economies appears to bematerially lower compared with past episodes ofwidespread EME crisis, even for those economiesthat currently appear relatively more vulnerable.These improvements should leave many EMEs betterpositioned than in the past to manage volatility infinancial markets.

That said, a number of EMEs continue to harborsignificant economic and financial vulnerabilities,and even economies in somewhat stronger positionsface the challenge of bolstering investor confidencein a jittery environment. To be sure, in response tobouts of turbulence since last summer, authoritiesin EMEs have taken steps to stabilize their marketsand enhance their resilience. For example, some

easing in the middle of last year, fearioutflows of capital and additional disrdepreciations that could exacerbate inpressures. Brazil, India, and Turkey, am

EMEs, have raised their policy rates sinaddition, some EME central banks havforeign exchange markets to support tTo help stabilize financial markets, BrIndonesia relaxed some of the restrictinflows that they imposed during the rthe global financial crisis, when inflowIndia and Indonesia also imposed meas import restrictions, to curb their cudeficits.

Nevertheless, beyond these stopgacontinued progress implementing monand structural reforms will be needed to help remedy fundamental vulnerabthe EMEs on a firmer footing, and makresilient to a range of economic shockwill take time, and global investors witheir progress closely.



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some other AFEs, with much of this decline

reflecting falling retail energy and food pricesas well as continued economic slack. Withinflation low and economic activity stillsluggish, monetary policy in the AFEs remainsvery accommodative. In addition to the ECBscut of its main refinancing rate in November,the Bank of England issued forward guidancein August that it intends to maintain a highlystimulative policy stance until economic slackhas been substantially reduced, while the BOJcontinued its aggressive program of assetpurchases.

. . . while growth in the emerging marketeconomies moved back up from itssoftness earlier last year

After slowing earlier last year, economicgrowth in the EMEs moved back up in thethird quarter, reflecting a rebound of Mexicanactivity from its second-quarter contractionand a pickup in emerging Asia. Recent datasuggest that activity in EMEs continued tostrengthen in the fourth quarter.

In China, economic growth picked up in

the second half of 2013, supported in partby relatively accommodative policies andrapid credit growth earlier in the year. Sincethe middle of last year, the pace of creditcreation has slowed, interbank interest rateshave trended up, and the interbank markethas experienced bouts of volatility duringwhich interest rates spiked. In mid-November,

Chinese leaders unveiled an ambitious reformagenda that aims to enhance the role of

markets in the economy, address w

imbalances, and improve the prospsustainable economic growth.

The step-up in Chinese growth, alofirmer activity in the advanced ecogenerally helped support economiin other parts of Asia. In Mexico, appears to have rebounded in the sof the year, supported by higher gspending and a pickup in U.S. manactivity. In recent months, Mexicoto make progress on the governmeagenda, with its Congress approvinenergy, and financial sector reformcontrast, in some EMEs, such as Band Indonesia, shifts in market exabout the path of U.S. monetary p

appear to have resulted in tighteneconditions, which weighed on growsecond half of last year.

Inflation remained subdued in moand their central banks generally krates on hold or, as in Chile, MexicThailand, cut them to further supp

In contrast, inflation remained elevfew EMEs, such as Brazil, India, Iand Turkey, due to currency deprewell as country-specific factors, incsupply bottlenecks and tight laborconditions in some sectors. In respto higher inflation, central banks icountries raised rates and, in some

intervened in foreign exchange masupport their currencies.


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PART2MONETARYPOLICY

In light of the cumulative progress toward maximum employment and the improvemenoutlook for labor market conditions, the Federal Open Market Committee (FOMC) demodestly reduce the pace of its asset purchases at its December 2013 and January 20Nonetheless, with unemployment still well above its longer-run normal level and inflatiCommittees 2 percent objective, the stance of monetary policy remains highly accomthe Federal Reserve continuing to increase the size of its balance sheet, albeit at a redu

having enhanced its forward guidance with regard to the future path of the federal fun

Through most of last year, the FOMCmaintained the current pace of large-scale asset purchases while awaitingmore evidence that progress towardits economic objectives would besustained . . .

Since the onset of the financial crisis andensuing deep recession, the unemployment ratehas remained well above its normal levels andthe inflation rate has tended to run at or belowthe FOMCs 2 percent objective despite thetarget range for the federal funds rate remainingat its effective lower bound. Accordingly, thestrategy of the FOMC during the past several

years has been to employ alternative methods ofproviding additional monetary accommodationand promoting the more rapid achievementof its mandated objectives of maximumemployment and price stability. In particular,the FOMC has used large-scale asset purchasesand forward guidance regarding the futurepath of the federal funds rate to put downwardpressure on longer-term interest rates.

During most of the second half of 2013,with unemployment still elevated (thoughdeclining), and with inflation remainingnoticeably below the Committees 2 percent

govern the winding-down of theof large-scale asset purchases. Inconference following the June 20meeting, Chairman Bernanke inif the economy were to evolve brwith the expectations that the Co

held at that time, the FOMC wothe pace of purchases later in 20economic developments remaineconsistent with the Committees subsequently reduce them in furtsteps. However, the Chairman emthat the Committees purchases wway predetermined, and that a dreducing the pace of purchases won how economic conditions evo

At each of its subsequent meetinDecember 2013, the Committee outlook for the economy and thehad improved, on net, since the the current asset purchase prograit was appropriate to await more

the progress would be sustained Committee began adjusting the purchases. In addition, at the JulCommittee recognized that inflabelow its 2 percent objective couto economic performance 9 At th

32 PART 2: MONETARY POLICY


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FOMC meeting, Committee members also

expressed concern about near-term fiscaluncertainties and the rapid tightening offinancial conditions observed over the summer,which, if sustained, could have slowedimprovements in the economy and the labormarket.10The Committee therefore decided toawait more evidence that progress toward itsgoals would be maintained before adjusting thepace of asset purchases and, in the meantime,

continued adding to its holdings of agencymortgage-backed securities (MBS) and longer-term Treasury securities at a pace of $40 billionand $45 billion per month, respectively.

. . . before modestly reducing the pace ofasset purchases in light of the cumulativeprogress toward maximum employment

and the improvement in the outlook forlabor market conditions

By the time of the December 2013 meeting,most Committee members viewed thecumulative improvement in labor marketconditions as meaningful and likely to besustained. Participants also anticipatedthat inflation would move back toward

2 percent over time as the economic recoverystrengthened and longer-run inflationexpectations remained steady. Therefore, mostmembers agreed that the Committee couldappropriately begin to slow the pace of itsasset purchases. Nonetheless, some membersexpressed concern about the potential for anunintended tightening of financial conditions if

a reduction in the pace of asset purchases wasmisinterpreted as signaling that the Committeewas likely to withdraw policy accommodationmore quickly than had been anticipated. Manymembers therefore judged that the Committeeshould proceed cautiously in taking its first

stressed the need to underscore tha

asset purchases was not on a presetwould remain contingent on the Cooutlook for the labor market and inwell as its assessment of the efficacyof purchases.

Consistent with this approach, the announced at the December meetinwould reduce the pace of its purch

agency MBS from $40 billion to $3month and reduce the pace of its plonger-term Treasury securities fromto $40 billion per month. The Comcontinued to see improvements in econditions and the labor market ouJanuary meeting and further reducof its asset purchases to $30 billion

for agency MBS and $35 billion perlonger-term Treasury securities.

While deciding to modestly reduce of purchases, the Committee emphthat its holdings of longer-term secwere sizable and would still be increwhich would promote a stronger ec

recovery by maintaining downwardon longer-term interest rates, suppomortgage markets, and helping to mfinancial conditions more accommoCommittee reiterated that it will coasset purchases and employ its othetools as appropriate until the outlolabor market has improved substana context of price stability. The FOmaintained its practices of reinvestpayments it receives on agency debguaranteed MBS in new agency Mrolling over maturing Treasury secuauction.



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remain appropriate for a considerable timeafter the asset purchase program ends and theeconomic recovery strengthens. In particular,the Committee stated that the currentexceptionally low target range for the federalfunds rate of 0 to percent will be appropriateat least as long as the unemployment rateremains above 6 percent, inflation betweenone and two years ahead is projected to be nomore than a half percentage point above the

Committees 2 percent longer-run goal, andlonger-term inflation expectations continue tobe well anchored (figure 41). The Committeeemphasized that these criteria are thresholds,not triggers, meaning that crossing a thresholdwill not lead automatically to an increase in thefederal funds rate but will indicate only that itis appropriate for the Committee to consider

whether the broader economic outlook justifiessuch an increase.

In December, with the unemployment ratehaving moved closer to the 6 percentthreshold, the FOMC decided to providequalitative guidance to clarify its likely actionsduring the time after the unemployment

threshold is crossed and, in particular, toemphasize its commitment to providing a highlevel of monetary accommodation for as longas needed to foster its objectives. Specifically,

the Committee indicated that in how long to maintain a highly acstance of monetary policy, it wilonly the unemployment rate butindicators, including additional mlabor market conditions, indicatpressures and inflation expectatireadings on financial developmenthe Committee stated that, basedfactors, it continues to anticipate

likely be appropriate to maintainfederal funds rate target well pasthat the unemployment rate decl6 percent, especially if projectecontinues to run below the Com2 percent longer-run goal. The Ccontinued to indicate that when begin to remove policy accommo

take a balanced approach consislonger-run goals of maximum eminflation of 2 percent.

The Committees large-scale purchases led to a significantthe size of the Federal Reservsheet

As a result of the Committees lapurchase program, Federal Reseincreased significantly since the m

41. Selected interest rates

Daily

10-year Treasury rate

34 PART 2: MONETARY POLICY


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year (figure 42). The par value of the holdingsof U.S. Treasury securities in the SystemOpen Market Account (SOMA) increased$315 billion to $2.2 trillion, and the par value ofits holdings of agency debt and MBS increased$308 billion, on net, to $1.5 trillion.11As ofthe end of January 2014, the SOMAs holdingsof Treasury and agency securities constituted55 percent and 39 percent, respectively, of the$4 trillion in total Federal Reserve assets. As a

result of these purchases, the size of the overallFederal Reserve balance sheet increased brisklyover the second half of the year; on the liabilityside of the balance sheet, the rise resulted in afurther increase in reserve balances.

Reflecting the continued improvement inoffshore U.S. dollar funding markets, the

outstanding amount of dollars providedthrough the temporary U.S. dollar liquidityswap arrangements with foreign centralbanks decreased $1 billion, bringing the level

11. The difference between changes in the par value

of SOMA holdings and the amount of purchases of

securities since the middle of 2013 reflects, in part, lags in

settlements.

close to zero. To reduce uncertaintimarket participants as to whether athese arrangements would be renewthe October FOMC meeting the Coagreed to convert the existing tempcentral bank liquidity swap arrangeto standing arrangements with no pexpiration dates, with the in

monetary policy report

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