monetary policy essay 2023

Over the past 11 months, the Federal Reserve has raised the federal funds rate (FFR) at the fastest pace since the 1980s. This tightening of monetary policy was to combat inflation that surged in 2021 to levels not seen in 40 years and remained high throughout 2022.

In this Chicago Fed Letter , we use a quantitative macroeconomic model to tackle the question of whether the response of the Federal Reserve (the Fed) to recent high inflation is consistent with its historical behavior. This is an important question because systematic deviations from past behavior could lead the private sector to revise its expectations about how the Fed will respond to inflation going forward, which, according to macroeconomic theory, could affect its ability to stabilize inflation in the future.

We find that the fast tightening of 2022 was broadly in line with the Fed’s historical behavior. However, to evaluate the overall stance of monetary policy, it is also important to consider the market path of the FFR, i.e., the path expected by market participants. This path affects the longer-term interest rates that individuals and businesses face when making their consumption and investment decisions. The market path expected in 2022:Q4 has the FFR peaking 75 basis points lower than is consistent with past tightening cycles. It stays flat until 2023:Q4 and then declines at a gradual pace that is consistent with past Fed behavior, but at a lower level. Our model explains this gradual pace with the persistently high levels of inflation in 2022 and the Fed’s historical tendency to spread out its response to inflation over time. Despite the market path being more dovish overall compared to the Fed’s historical behavior, the model’s forecast of inflation has it falling to near the Fed’s 2% target by the end of 2025.

There is an important lesson to learn from the gradual pace of interest rate reductions in the market path. According to the model, what matters for stabilizing inflation is not so much the response of the interest rate to current inflation at the beginning of a tightening cycle but the expectations that the cumulative increase in the interest rate over the full cycle is sufficiently strong. Consequently, even if interest rates are raised more slowly than inflation rises, a central bank can still effectively stabilize inflation if financial markets expect that rates will be cut slowly when inflation is on the way down. This lesson is of particular importance when prices rise so rapidly that raising interest rates faster than inflation in the short run could destabilize financial markets.

Comparing tightening cycles

In panel A of figure 1, we compare the path of the FFR in 2022 to the past four tightening cycles (1994–95, 1999–2000, 2004–06, and 2015–18). In panel B, we show core PCE inflation during each of these tightening cycles. As one can notice from panel A, in 2022 the Fed raised the FFR faster than in any of the previous tightening cycles. While informative, these comparisons are insufficient to gauge the current stance of monetary policy.

First, in the previous tightening cycles the Fed was dealing with considerably lower inflation, as shown in panel B of figure 1. Therefore, it is possible that the current tightening actually entails a weaker response to inflation than before. Adjusting the rise in interest rates for the increase in inflation is critical to assess the effects of a monetary tightening on aggregate demand. It is the real cost of funds to a borrower and the real yield to a lender or to an investor that matters for households’ and firms’ decisions.

1. Federal funds rate and inflation during the five most recent tightening cycles

A. cumulative increase in federal funds rate.

B. Year-over-year core PCE inflation

Second, the FFR in and of itself provides only an incomplete characterization of the stance of monetary policy. A more comprehensive characterization includes the path of the FFR expected by financial markets. The market path influences the longer-term interest rates that govern choices to consume and invest. Thus, changes in the expected path of interest rates are likely to influence economic conditions today.

We consider a model that takes these considerations into account. The next section describes monetary policy in the model and our empirical strategy. More details about the model and how we estimate it can be found in Ferroni, Fisher, and Melosi (2022) . 1

Analytical framework

In the model, the central bank sets the short-term nominal interest rate (the equivalent of the FFR) according to a mathematical rule. This rule posits that the interest rate responds to deviations of inflation from the central bank’s target (the inflation gap) and deviations of output from its long-run time-varying trend (the output gap), as well as the previous quarter’s interest rate (the inertial component). 2 The first two components reflect the Fed’s commitment to pursuing its dual mandate of maximum employment and price stability. 3 The inertial component of the rule captures central banks’ inclination to spread out their policy responses to inflation and output over time. The inertial component is essential for the rule to fit the dynamics of the FFR in the historical data and arguably reflects policymakers’ concern that abrupt changes in interest rates may disrupt financial markets.

In the model, monetary shocks capture deviations of the FFR from the estimated policy rule. When the deviations from the rule are negative, the central bank is more accommodative relative to its historical behavior. And when the deviations are positive, the central bank is more restrictive. If the FFR and the market path are always consistent with the estimated rule, our model would not detect any deviations from the rule—the monetary shocks would all be equal to zero.

We estimate the model using a large set of macroeconomic and financial data, including the market path. 4 We assume that agents in the model expect the market path. The estimated rule is interpreted as capturing the historical behavior of the Fed in our estimation sample period, 1993–2016. This is a period in which U.S. monetary policy has been successful at stabilizing inflation, validating the use of the estimated rule as a benchmark.

Model-based comparison of tightening cycles

We assess the stance of monetary policy by comparing the current and expected FFR predicted by the estimated policy rule to the current FFR and the market path. 5 Figure 2 displays our main findings. This figure compares the FFR in 2022 (gray line) and the market path from 2022:Q4 (blue line) with the path consistent with the estimated policy rule (orange line). The path consistent with the historical rule to the left of the vertical line is based on data up to 2022:Q4. To the right of the vertical line, this path is based on the model’s forecast of the inflation and output gaps conditioned on 2022:Q4 data.

2. Comparing the path of the federal funds rate (FFR) with the Fed’s historical behavior

The figure shows that the quick and robust tightening of monetary policy in 2022 (gray line) is roughly consistent with the Fed’s historical behavior as it is only slightly more contractionary (positive yellow bars) than the historical response (orange squares), just 40 basis points above what the historical response would have called for. However, going forward from 2022:Q4, the market path has the FFR becoming more accommodative than the historical rule (negative yellow bars). The market path in 2022:Q4 peaks at about 5% in 2023, while the historical rule peaks 75 basis points higher. The market path stays flat until 2023:Q4 and then declines at a gradual pace similar to the historical rule, but at a lower level.

We can use the model to understand why the Fed was expected to lower its policy rate slowly. To do this, we decompose the difference between the actual FFR (gray line) or the market path (blue line) and the market path as of 2021:Q4 (dashed blue line) into the parts contributed by the output (pink bars) and inflation (green bars) gaps and the inertial component (red bars).

At the end of 2021, the Fed was expected to lift off the FFR from its effective lower bound in 2022:Q2 and to keep raising rates at a gradual pace. At the end of 2022, after inflation had been high for a year and a half, the market path was revised up substantially and was hump-shaped.

The model explains this revision through a combination of shocks that hit the economy in 2022, which have persistent effects on the output and inflation gaps. Shocks in the model unexpectedly change the economic environment in which agents make their decisions. Examples of these shocks include persistent productivity shocks that affect potential output, transitory supply shocks that directly impact inflation, and the monetary shocks. The monetary shocks allow our model to account for revisions in the market path that are not accounted for by the nonmonetary shocks. Their contribution is shown by the yellow bars. 6

By affecting agents’ decisions, the nonmonetary shocks lead to changes in the current and expected future path of the output and inflation gaps. This prompts the central bank to respond by adjusting the current interest rate and changes the path of interest rates expected by the model’s economic agents through their understanding of the policy rule. The pink and green bars capture the central bank’s immediate response to the revised paths of the output and inflation gaps, respectively, due to the nonmonetary shocks that occurred in 2022. The large inflation gap in 2022 explains a substantial share of the difference between the FFR and the market path as of 2021:Q4.

In the forecasting period, which lies on the right of the vertical line, the inertial component (red bars) accounts for the lion’s share of the revision in the market path at the end of 2022. This large role played by the inertial component mostly stems from the combination of the extraordinarily fast increase in inflation in 2022 and the central bank’s historical tendency to spread out its response to inflation over time.

The market path that is expected by agents in our model coincides with relatively benign inflation, which as of 2022:Q4 is forecast to be 2.2% by the end of 2025 (not shown). From a shock-accounting point of view, the benign outlook arises from the effects on inflation of the model’s nonmonetary shocks from 2022:Q4 and earlier waning over time. But this does not mean that monetary policy—specifically the historical rule—does not play a role in shaping the inflation outlook.

First, in the model, the interest rate path expected by agents after the ten quarters of the market path is determined by the historical rule. After ten quarters, the rule has the FFR jumping up and staying higher for some time. This offsets the accommodation from the dovish market path and therefore contributes to the benign outlook for inflation.

Second, the market path being systematically lower than the historical rule may lead market participants to expect a weaker response of monetary policy to inflation going forward. In the model this would make it more difficult for the central bank to stabilize inflation (see, for example, Clarida, Galí, and Gertler, 2000 .)

In this Chicago Fed Letter , we have presented some model-based evidence that the robust monetary tightening carried out by the Fed in 2022 is broadly in line with its historical behavior. We have also shown that in 2022:Q4, the market path peaks 75 basis points lower than the historical rule. The market path stays flat until 2023:Q4 and then declines at a gradual pace similar to the historical rule, but at a lower level. According to the model, this gradual pace does not decrease the central bank’s ability to pursue price stability.

Our analysis is subject to a number of caveats. It is based on the assumption that U.S. monetary policy can be approximated by a fixed rule and that estimating this rule adequately captures the historical behavior of the Federal Reserve. This assumption is convenient because it allows us to interpret the observed deviations of the market path from the estimated rule. Yet this is only one way to interpret these deviations. They could also reflect combinations of changes in how the Fed responds to economic shocks, risk management that is not captured in our estimated rule, and markets pricing in macroeconomic risks. 7 While our approach is a useful benchmark to evaluate the stance of monetary policy, it is not the only valid approach, and our results should not be interpreted as a direct measure of that stance.

Moreover, our model’s forecasts for GDP and inflation may differ from the markets’ forecasts. This difference may contribute to explaining why the model’s estimated historical rule prescribes a higher path for the FFR than markets expect. For instance, the market path could be lower than the historically consistent path because markets forecast softer economic growth and inflation than our model. We try to mitigate this issue by incorporating one- to four-quarter ahead expectations for GDP growth and inflation from the Survey of Professional Forecasters to inform the model’s forecasts. This addition renders our model’s forecasts for GDP growth and inflation very similar to those in that survey. To the extent that its forecasts accord well with the views of financial markets, this issue of the discrepancy between the model’s and the markets’ forecasts becomes less relevant.

Another caveat is related to the unprecedented nature of the ongoing inflationary pressures, which to some extent reflects supply disruptions due to the pandemic and the mitigation policies implemented by governments all over the world. In our analysis, we do not explicitly model the health and economic consequences of the pandemic, nor does our model feature these supply disruptions. We address this issue by modeling the outbreak of Covid-19 using a flexible econometric methodology that we developed in a recent paper ( Ferroni, Fisher, and Melosi, 2022 ). In that paper, we show that this methodology can help economic models account for the unusual nature of the Covid-19 recession and recovery. However, this approach might only partially capture the extraordinary mix of economic and policy shocks set off by the onset of the pandemic.

1 The model belongs to the broad class of medium-scale dynamic stochastic general equilibrium models, which are shown to be well-suited to account for U.S. business cycle dynamics and to forecast economic aggregates, such as gross domestic product (GDP) and inflation. See, for example, Christiano, Eichenbaum, and Evans (2005) , Smets and Wouters (2007) , and Del Negro, Giannoni, and Schorfheide (2015) .

2 The inflation gap is defined as the average of the two-period lagged, one-period lagged, current, and expected one-quarter-ahead inflation gaps. The output gap is defined similarly.

3 The output gap is a proxy for the employment gap (i.e., employment minus full employment). The link between these two gaps is regulated by Okun’s law .

4 Our measure of the market path is the median path taken from the Survey of Market Participants conducted by the Federal Reserve Bank of New York before regular meetings of the Federal Open Market Committee, the Fed’s monetary policymaking body.

5 One complication is that the market path might incorporate asymmetric risks to the economic outlook perceived by market participants. We abstract from this issue, but it is an important one. For instance, if market participants view risks to the outlook for economic activity as tilted toward the downside, then the market path will be lower than otherwise. This would be interpreted by our model as a dovish deviation from the historical rule.

6 As the market path would correspond to the historical rule without the monetary shocks, the yellow bars are equal to deviations of the market path from the historical rule.

7 Evans, Fisher, Gourio, and Krane (2015) discuss how empirically risk-management considerations have played a significant role in guiding monetary policy and show theoretically that risk management affects the optimal timing of liftoff from the zero lower bound.

Opinions expressed in this article are those of the author(s) and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.

• Download Entire Publication

Subscribe Now

Register to receive email alerts when new issues are published.

Related Topics

• The Evolution of Disagreement About Long-Run Inflation, 2007–24
• How Do Recent Financial Conditions Compare to Previous Episodes of Monetary Tightening?
• Seventh District Midyear Review: Economic Growth Continued to Be Solid in the First Half of 2024
• Balance Sheet Policy Uncertainty and Its Aggregate Implications
• Region & Community
• Style Guide

Federal Reserve Bank of Chicago, 230 South LaSalle Street, Chicago, Illinois 60604-1413, USA. Tel. (312) 322-5322

Copyright © 2024. All rights reserved.

Please review our Privacy Policy | Legal Notices

• Federal Reserve Facebook Page
• Federal Reserve Instagram Page
• Federal Reserve YouTube Page
• Federal Reserve Flickr Page
• Federal Reserve LinkedIn Page
• Federal Reserve Threads Page
• Federal Reserve Twitter Page
• Subscribe to RSS
• Subscribe to Email
• Recent Postings
• Publications

Board of Governors of the Federal Reserve System

The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system.

• Monetary Policy
• Monetary Policy Report

Monetary Policy Report – March 2023

Part 1: recent economic and financial developments, monetary policy report submitted to the congress on march 3, 2023, pursuant to section 2b of the federal reserve act, domestic developments, inflation has declined in recent months but remains elevated....

Inflation, as measured by the 12-month change in the price index for personal consumption expenditures (PCE), stepped down from its peak of 7.0 percent in June of last year to 5.4 percent in January, still notably above the Federal Open Market Committee's (FOMC) longer-run objective of 2 percent ( figure 1 ). Core PCE prices—which exclude volatile food and energy prices and are generally considered a better guide to the direction of future inflation—rose 4.7 percent over the 12 months to January, down from the above 5 percent pace that prevailed last spring. 2

Accessible Version  |  Return to text

...in part because energy prices declined in the second half of last year, while food price inflation slowed but remains high

After rising sharply in the first half of last year, oil prices peaked and have since declined. This decline comes mainly on global growth concerns and despite a European Union embargo on Russian crude oil and petroleum products ( figure 2 ). As a result of these movements, gasoline prices declined over the second half of last year following their earlier large increases. On net, the PCE energy price index in January stood 10 percent above its level 12 months earlier ( figure 3 ).

Food price increases slowed in recent months, but, given earlier sizable increases, grocery store prices are up 11 percent over the 12 months ending in January. After having spiked at the start of the war in Ukraine, prices of most food commodities (agricultural products and livestock) have stabilized in recent months, likely contributing to the recent slowing of food price increases ( figure 4 ).

Prices of both energy and food are of particular importance for lower-income households, for which such necessities are a large share of expenditures.

Softer core goods prices reflect easing supply bottlenecks and declines in import prices...

Recent inflation performance has varied markedly across spending categories. Price increases for goods (outside of food and energy) slowed considerably in the latter part of 2022. Demand for these goods appears to have stabilized, and supply chain issues and other capacity constraints have waned. For example, transportation costs have fallen, and supplier delivery times have improved notably ( figure 5 ). In addition, nonfuel import prices have declined, on net, since last spring, bringing the 12-month change down to around 1 percent from a peak of almost 8 percent early last year ( figure 6 ). This moderation occurred following both the appreciation of the dollar that occurred earlier in the year and declines in commodity prices such as those for industrial metals.

The easing of inflation pressures in goods has been especially pronounced for durable goods, where prices have declined, on net, since June of last year. In particular, used motor vehicle prices, which skyrocketed in 2021 amid reduced production of new cars and trucks, have fallen more than 9 percent over that period.

...while core services price inflation remains elevated

In contrast, core services price inflation remains elevated ( figure 3 ). Housing services prices have risen especially rapidly, up 8 percent over the 12 months ending in January. However, market rents on new housing leases to new tenants, which had risen strongly over the past two years, have decelerated sharply and flattened out since autumn ( figure 7 ). Because prices for housing services measure the rents paid by all tenants (and the equivalent rent implicitly paid by all homeowners)—including those whose leases have not yet come up for renewal—they tend to adjust slowly to changes in rental market conditions and should therefore be expected to decelerate over the year ahead. In contrast, prices for other core services—a broad group that includes services such as travel and dining, financial services, and car repair—rose 4.7 percent over the 12 months ending in January and have not yet shown clear signs of slowing. Some softening of labor market conditions will likely be required for core services price inflation to abate.

Measures of longer-term inflation expectations have remained contained, while shorter-term expectations have partially reversed their earlier increases

Inflation expectations likely influence actual inflation by affecting wage- and price-setting decisions. Over the past year, survey-based measures of expected inflation over a longer horizon remained within the range of values seen in the years before the pandemic and appear broadly consistent with the FOMC's longer-run 2 percent inflation objective. That is evident for the median value for expected inflation over the next 5 to 10 years from the University of Michigan Surveys of Consumers ( figure 8 ). And while expected inflation over the next 10 years in the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, has moved up somewhat, that increase is driven by expectations for the next few years: The median forecaster in the survey expects PCE price inflation to average 2 percent over the five years beginning five years from now.

Furthermore, inflation expectations over a shorter horizon—which tend to follow observed inflation and rose when inflation turned up—moved lower in the second half of 2022 and into 2023, accompanying the softer inflation readings over this period. In the Michigan survey, the median value for inflation expectations over the next year was 4.1 percent in February, a step-down from the values in the middle of 2022. Expected inflation for the next year from the Survey of Consumer Expectations, conducted by the Federal Reserve Bank of New York, has also moved lower in recent months.

Market-based measures of longer-term inflation compensation, which are based on financial instruments linked to inflation, are also broadly in line with readings seen in the years before the pandemic. A measure of inflation compensation over the next 5 years implied by Treasury Inflation-Protected Securities moved notably lower last year, and inflation compensation 5 to 10 years ahead still appears consistent with inflation returning to 2 percent ( figure 9 ).

The labor market has continued to strengthen

Payroll employment gains averaged 380,000 per month since the middle of 2022, down from the 445,000 per month pace in the first half but still quite robust ( figure 10 ). Employment in the leisure and hospitality sector continued its steady recovery from the pandemic, and payrolls also increased robustly in health services and in state and local governments. 3 Alternative indicators of employment—the Bureau of Labor Statistics' household survey, the Federal Reserve Board staff's measure of private employment using data from the payroll processing firm ADP, and the Quarterly Census of Employment and Wages—suggest a slower pace of job gains last year, particularly in the first half. However, these other indicators suggest continued job gains in recent months, roughly in line with published payroll data.

The unemployment rate has remained at historically low levels ( figure 11 ). At 3.4 percent in January, the jobless rate was a touch below its level right before the pandemic. Unemployment rates among various age, educational attainment, gender, and ethnic and racial groups are also near their respective historical lows ( figure 12 ). (The box " Developments in Employment and Earnings across Demographic Groups " provides further details.)

Developments in Employment and Earnings across Demographic Groups

As the labor market has recovered from the depths of the pandemic, conditions have become extremely tight. Tight labor markets, characterized by low unemployment and plentiful job openings, have historically proven especially beneficial to minorities and less educated workers. 1 These disproportionate benefits can help make up for disproportionate losses experienced by the same groups during recessions.

Tight labor market conditions have largely erased the pandemic-induced widening of the gaps in employment across different groups. As shown in the left panel of figure A , both men and women aged 25 to 54 with a high school degree or less saw much larger employment declines in early 2020 than workers with at least some college education, but by the end of 2022, this gap had almost entirely closed. 2 The same story is true among both Black or African American and Hispanic or Latino workers aged 25 to 54, as shown in the right panel. From mid-2021 through 2022, as labor market conditions became extremely tight, employment rose faster for the groups that saw larger initial declines. However, while disparities in employment have largely returned to pre-pandemic levels, these disparities are significant in absolute levels of employment across groups.

Differences in employment dynamics between groups during the pandemic stem from a mixture of demand and supply factors. On the labor demand side, for example, the leisure and hospitality sector experienced severe losses in 2020 but has seen a strong rebound in employment growth in the past two years. Since workers with a high school degree or less are historically more than twice as likely as workers with a college degree to be employed in leisure and hospitality, part of this group's unusually large employment decline and rebound is likely attributable to the fluctuations in labor demand from this sector. 3 On the labor supply side, many parents left work during the pandemic period when schools and childcare facilities were closed. This phenomenon appears to have been particularly acute for women, especially Black and Hispanic mothers, as well as those with less education. 4 (For more discussion of recent labor supply developments, see the box " Why Has the Labor Force Recovery Been So Slow? ")

As labor market conditions have tightened, wage growth has risen sharply, especially for the least advantaged groups. As shown in the upper panels of figure B , growth of nominal hourly wages jumped in 2022, but growth was higher for non-college-educated workers than for college-educated workers and higher for nonwhite workers than for white workers. This largely reflects that wage growth has been consistently stronger at the lower end of the income distribution (see the lower-right panel). 5 Importantly, these higher rates of wage growth for less advantaged groups coincided with the faster increase in employment, indicating that labor supply could not keep up with the growth in labor demand.

1. See Arthur M. Okun (1973), "Upward Mobility in a High-Pressure Economy," Brookings Papers on Economic Activity, no. 1, pp. 207–61, https://www.brookings.edu/wp-content/uploads/1973/01/1973a_bpea_okun_fellner_greenspan.pdf ; and Stephanie R. Aaronson, Mary C. Daly, William L. Wascher, and David W. Wilcox (2019), "Okun Revisited: Who Benefits Most from a Strong Economy?" Brookings Papers on Economic Activity, Spring, pp. 333–75, https://www.brookings.edu/wp-content/uploads/2019/03/aaronson_web.pdf . Return to text

2. Women saw slightly greater employment losses relative to men with a similar educational background at the beginning of the pandemic but also experienced a slightly more rapid recovery. The disproportionate effect of the pandemic on women contrasts with previous recessions, when employment has historically fallen more among men than women. Return to text

3. Similarly, Black or African American, Hispanic or Latino, and Asian workers are also overrepresented in the leisure and hospitality industry relative to white workers, although these differences are smaller than differences by education. See Guido Matias Cortes and Eliza Forsythe (2022), "Heterogeneous Labor Market Impacts of the COVID-19 Pandemic," ILR Review, vol. 76 (January), pp. 30–55. Return to text

4. See Joshua Montes, Christopher Smith, and Isabel Leigh (2021), "Caregiving for Children and Parental Labor Force Participation during the Pandemic," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, November 5), https://www.federalreserve.gov/econres/notes/feds-notes/caregiving-for-children-and-parental-labor-force-participation-during-the-pandemic-20211105.htm . Return to text

5. Wage growth for the bottom quartile was a bit stronger than for other groups even before the pandemic, as labor market conditions tightened at the end of the previous expansion. Return to text

Labor demand has remained very strong, showing only tentative signs of easing...

Demand for labor continued to be very strong in the second half of 2022. The Job Openings and Labor Turnover Survey indicated that there were 11 million job openings at the end of December—down about 850,000 from the all-time high recorded last March but still more than 50 percent above pre-pandemic levels. An alternative measure of job vacancies constructed by Federal Reserve Board staff using job postings data from the large online job board Indeed also shows that vacancies moved gradually lower throughout 2022 but remain well above pre-pandemic levels. Many employers report having scaled back their hiring plans somewhat, though levels of anticipated hiring remain high by historical standards. 4 Also consistent with strong labor demand, initial claims for unemployment insurance have remained at historically low levels.

...while labor supply has increased only modestly...

Meanwhile, the supply of labor increased only modestly last year. The labor force participation rate, which measures the share of people either working or actively seeking work, was essentially flat last year and remains roughly 1-1/4 percentage points below its February 2020 level ( figure 13 ). 5 (See the box " Why Has the Labor Force Recovery Been So Slow ?")

Why Has the Labor Force Recovery Been So Slow?

By many measures, the labor market has recovered strongly. Unemployment is low, job growth has been robust, and job opportunities are abundant. However, the labor market has underperformed in one key dimension: The labor force, or the number of people working or looking for work, is well below levels projected by most observers before the pandemic. This shortfall has contributed to a widening gap between labor demand and labor supply and to widespread labor shortages.

One estimate of the shortfall compares the labor force that the nation has now to the labor force that might have been expected given past economic and demographic trends. One way to make such a comparison is to look at what professional forecasters at some point in the past expected the labor force to be now. For example, comparing the current level of the labor force with the Congressional Budget Office's January 2020 projection of its current level suggests a shortfall of about 3-1/2 million ( figure A ). 1 That figure is likely an upper bound on the true shortfall, in light of new data not yet incorporated into the Census Bureau's publicly available population estimates and so not in these calculations. 2 Even so, the shortfall appears large and economically significant, and it reflects both a lower labor force participation rate and slower population growth than was expected without the pandemic ( figure B ).

B. Decomposition of the current labor force shortfall

Millions of people

Note: The labor force shortfall is calculated over the period from 2019:Q4 to 2022:Q4.

Source: Current Population Survey; CDC mortality statistics; staff calculations.

Lower labor force participation

The labor force participation rate dropped sharply at the onset of the pandemic and has remained persistently below pre-pandemic levels ever since then ( figure 13 , main text). Earlier in the pandemic, the low level of participation reflected several pandemic-related influences ( figure C ). Many people left the labor force to care for sick relatives or for children learning remotely. Others withdrew because they were sick with COVID-19 or feared getting COVID-19 at work. Many others retired early. As COVID concerns have waned, the influence of caregiving and fears of contracting COVID at work have diminished, whereas the contribution of retirements has increased. As a result, essentially all of the current participation rate shortfall can be accounted for by the higher percentage of the population that is retired.

The retired share of the population jumped sharply at the onset of the pandemic ( figure D , blue line). Some of this increase was to be expected. In the decade leading up to the pandemic, retirements increased steadily as the baby-boom cohort aged. If the pandemic had not occurred, this trend of rising retirements would have likely continued ( figure D , black line). Currently, however, the total number of people retired is well above that expected level. Excess retirements (the difference between total and expected) number roughly 2.2 million and are concentrated among older Americans, particularly among people aged 65 and over. 3

Several factors have led to people retiring before they otherwise would have. Health concerns likely contributed to a portion of the excess retirements, as COVID poses a particularly large risk to the health of older people. In addition, many older workers lost their jobs early in the pandemic when layoffs were historically high, and finding new employment may have been particularly difficult for those workers given pandemic-related disruptions to the work environment and health concerns. Indeed, workers aged 65 and over who lost their job during the pandemic had much lower reemployment rates and much higher rates of labor force exit than did similarly aged displaced workers in the years just before the pandemic. 4 Further, increases in wealth, fueled by gains in the stock market and rising house prices in the first two years of the pandemic, may have allowed some people to retire early, and research suggests that excess retirements have been largest among college-educated and white workers—the groups that likely benefited most from the stock market and house price gains earlier in the pandemic. There is little sign yet of a reduction in excess retirements. Instead, older workers are still retiring at higher rates than before the pandemic, and retirees are not returning to the labor force in sufficient numbers to reduce the total number of retirees.

In contrast, participation for those aged 25 to 54 (prime age) has mostly returned to pre-COVID levels ( figure E ). This recovery likely reflects the abundance of job opportunities and strong wage growth as well as the waning influence of COVID-related factors. However, the prime-age participation rate did move somewhat lower the last few months of 2022. Although the drag on participation from caregiving has diminished since the first year of the pandemic, it remains elevated relative to its pre-pandemic level and, in fact, moved higher over the second half of 2022—perhaps because many caretakers have been unable to participate in the labor force because of flu, COVID, or other respiratory illness among their children and other family members. 5 Further, many workers are still out of work because they are sick with COVID or continue to suffer lingering symptoms from previous COVID infections ("long COVID"), and their illness is likely depressing participation to some extent. 6

Lower population growth

The second contributor to the labor force shortfall is slower population growth. Over the decade before the pandemic, the population increased about 1 percent per year. Since the start of 2020, annual population growth has slowed to about 1/2 percent per year, on average, resulting in slower labor force growth for a given participation rate. That slowdown reflects two factors. First, primarily because of COVID, mortality over the past few years has far exceeded what was expected before the pandemic; even though the mortality was concentrated among older Americans who are less likely to be working, it still has contributed about 500,000 to the labor force shortfall. Second, pandemic-related restrictions on entry into the U.S. substantially slowed total immigration in the first two years of the pandemic. Although net migration rebounded considerably in 2022, lower net international migration since the start of the pandemic has lowered the labor force by as much as 900,000 people relative to pre-pandemic trends. 7

Looking ahead

Due to the aging of the population, a meaningful reversal of the run-up in the retired share of the population seems unlikely, and the labor force participation rate is likely to remain well below its level from before the pandemic. It is possible that some of those who retired during the pandemic will reenter the labor force, but the persistently high level of excess retirements suggests this reentry is not yet happening. In contrast, some further gains in labor force participation among younger people may be possible. Over the five years before the pandemic, the participation rate for 25-to-54-year-olds increased significantly, partially reversing a multidecade decline in their labor force participation, and the participation rate for this group seemed poised for further gains had the pandemic not occurred. However, even if further increases in participation among younger people occur, those increases would likely only gradually reduce the overall labor force shortfall.

Regarding population growth, as pandemic-related restrictions on immigration have eased, immigration has started to rebound. If net migration continues to move higher, it may help alleviate labor shortages, as immigrant workers have tended to work in industries and jobs where labor shortages appear particularly acute, such as childcare, health care, and accommodation and food services. 8

1. All analysis in this discussion is through the end of 2022 and based on data from the Current Population Survey that are adjusted for the January 2022 updated population controls as described in the main text. To account for the effect of those population controls on the level of the labor force, the shortfall is calculated by appending the Congressional Budget Office's (CBO) January 2020 projected labor force growth from the start of the pandemic through the end of 2022 onto the level of the labor force just before the start of the pandemic that is adjusted for population controls. The CBO projected the labor force participation rate (LFPR) to decline about 1/4 percentage point per year from 2020 onward, consistent with the downward pressure on the LFPR from the aging of the baby boomers into retirement ages. The CBO also projected the population to increase at an average annual rate of 2.1 million from 2020 onward. See Congressional Budget Office (2020), The Budget and Economic Outlook: 2020 to 2030 (Washington: CBO, January), https://www.cbo.gov/publication/56073 . Return to text

2. This analysis does not adjust for the updated January 2023 population controls. The January 2023 updated population controls revised up the level of the labor force in December 2022 by 871,000 people, which suggests that the labor force shortfall may be materially smaller. However, as the detailed population estimates are not yet available, it is not possible to precisely estimate the level of the labor force before the pandemic that reflects the January 2023 updated population controls. Return to text

3. For more on pandemic retirements, see Joshua Montes, Christopher Smith, and Juliana Dajon (2022), " ‘The Great Retirement Boom': The Pandemic-Era Surge in Retirements and Implications for Future Labor Force Participation," Finance and Economics Discussion Series 2022-081 (Washington: Board of Governors of the Federal Reserve System, November), https://doi.org/10.17016/FEDS.2022.081 . Return to text

4. See Bureau of Labor Statistics (2022), "Displaced Workers Summary," Economic News Release, August 26, https://www.bls.gov/news.release/disp.nr0.htm . Return to text

5. For more on how caregiving burdens affected labor force participation in the first year and a half of the pandemic, see, for example, Joshua Montes, Christopher Smith, and Isabel Leigh (2021), "Caregiving for Children and Parental Labor Force Participation during the Pandemic," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, November 5), https://doi.org/10.17016/2380-7172.3013 . Return to text

6. See, for example, Gopi Shah Goda and Evan J. Soltas (2022), "The Impacts of COVID-19 Illnesses on Workers," NBER Working Paper Series 30435 (Cambridge, Mass.: National Bureau of Economic Research, September), https://doi.org/10.3386/w30435 ; Louise Sheiner and Nasiha Salwati (2022), "How Much Is Long COVID Reducing Labor Force Participation? Not Much (So Far)," Hutchins Center Working Paper Series 80 (Washington: Brookings Institution, October), https://www.brookings.edu/wp-content/uploads/2022/10/WP80-Sheiner-Salwati_10.27.pdf ; and Brendan M. Price (2022), "Long COVID, Cognitive Impairment, and the Stalled Decline in Disability Rates," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, August 5), https://doi.org/10.17016/2380-7172.3189 . Return to text

7. There is considerable uncertainty about the contribution of changes in immigration since the start of the pandemic to the labor force shortfall, especially in light of the revisions to the historical level of the labor force due to the January 2023 updated population controls and because of the pickup in immigration over 2022, which lowered its contribution to the labor force shortfall. The 900,000-person contribution of lower immigration to the labor force shortfall is likely an upper-bound estimate. Return to text

8. Immigration had slowed markedly in the few years before the pandemic. If immigration rises only to the relatively low levels prevailing before the pandemic, the population will grow at a historically low rate. Return to text

...resulting in an extremely tight labor market

As a result, the labor market remains extremely tight despite some tentative signs of modest easing. The number of total available jobs (measured by total employment plus posted job openings) continues to far exceed the number of available workers (measured by the size of the labor force). This jobs–workers gap was 5.3 million at the end of the year, down about 600,000 from the peak recorded last March but still very elevated by historical standards ( figure 14 ). 6 The share of workers quitting jobs each month, an indicator of the availability of attractive job prospects, was 2.7 percent at the end of the year, somewhat below the all-time high of 3 percent reported a year earlier but still elevated. Similarly, households' and small businesses' perceptions of labor market tightness have come down from their recent peaks but remain high. And many employers across Federal Reserve Districts reported some easing of hiring and retention difficulties but continued to view labor market conditions as tight. 7

Wage growth has slowed but remains elevated

Wage growth slowed in the second half of 2022 but was still elevated ( figure 15 ). Total hourly compensation as measured by the employment cost index increased at an annual rate of 4.1 percent in the second half of last year, a strong gain but a step-down from the 6.0 percent increase observed during the first half. Increases in average hourly earnings (a less comprehensive measure of compensation) have slowed as well, rising 4.4 percent over the 12 months to January, down from 5.7 percent over the preceding 12 months. Wage growth as computed by the Federal Reserve Bank of Atlanta, which tracks the median 12-month wage growth of individuals responding to the Current Population Survey, was 6.1 percent in January, down from its peak last summer but well above the 3 to 4 percent pace reported over the previous few years.

Following a period of strong growth, labor productivity weakened last year

The extent to which wage gains raise firms' costs and act as a source of inflation pressure depends importantly on the pace of productivity growth. Productivity rose at a rapid average pace of 3-1/4 percent over 2020 and 2021, but it declined last year as output growth slowed and employment growth held up ( figure 16 ). In retrospect, much of the strong productivity growth in 2020 and 2021 seems to have been the result of temporary pandemic-related factors such that the decline in 2022 may reflect a normalization as productivity moves back toward its trend. In 2021, as the economy reopened, firms struggled to hire workers, and many firms temporarily operated with overstretched workforces. 8 Subsequently, the slowdown in aggregate demand last year allowed many firms to catch up in their hiring. 9

The pace of productivity growth going forward remains very uncertain. Productivity growth averaged only about 1 percent per year during the expansion that preceded the pandemic recession, and it is possible that the economy will return to a similar low-productivity growth regime. However, it also seems possible that the high rate of new business formation, widespread adoption of remote-work technology, and the wave of labor-saving investments that the pandemic brought about could boost productivity growth above that pace in coming years.

Momentum in gross domestic product has slowed

After the strong rebound in 2021 from the pandemic-induced recession, economic activity lost momentum last year. Although real gross domestic product (GDP) is reported to have risen at a solid 3.0 percent pace in the second half of 2022, growth in real private domestic final purchases—consumer spending plus residential and business fixed investment, a measure of output that often better reflects the underlying momentum of economic activity—slowed to just a 0.6 percent pace ( figure 17 ). Consumer spending growth held up last year, but the fundamentals that underpin household spending have deteriorated. Business investment rose moderately in the second half of 2022, although new orders indexes, business sentiment, and profit expectations suggest that spending growth may slow. And activity in the housing sector contracted sharply last year in response to elevated mortgage rates. Finally, manufacturing output moved lower, on net, over the past few months, with surveys of manufacturing pointing to continued weakness in coming months. Diffusion indexes of new orders from various manufacturing surveys are well into contractionary territory, and backlogs of existing orders have declined sharply.

Consumer spending grew moderately last year...

Consumer spending adjusted for inflation grew at a 1.8 percent rate in the second half of 2022, about the same pace as in the first half of the year. And, averaging through some recent volatility, consumer spending has continued to look solid in the most recent data. Spending increases over the past year have been concentrated in services, whereas spending on goods has remained roughly flat since mid-2021 following its surge during 2020 and early 2021, suggesting that consumers' spending habits have been returning toward their pre-pandemic patterns ( figure 18 ).

...even as real disposable income fell and consumer confidence was low

The fundamentals for household spending, however, appear to be somewhat less supportive of spending growth. Despite the sizable increases in jobs and wages last year, after factoring in the rise in prices, higher tax payments, and reduced transfers, real disposable income fell 1.4 percent in 2022. And the University of Michigan index of consumer sentiment remains very low by historical standards despite a move higher in the second half of 2022 ( figure 19 ).

As real incomes fell, households likely relied on the savings that had been accumulated during the pandemic as well as higher wealth—reflecting, in part, house price gains over the past few years that outweighed the drag from recent equity price declines—to fund continued consumption. As a result, the personal saving rate fell to its lowest levels since the Great Recession ( figure 20 ).

Consumer financing conditions have tightened somewhat

Interest rates on credit cards and auto loans continued to increase last year and are now higher than the levels observed in 2018 at the peak of the previous monetary policy tightening cycle. In addition, banks reported tighter lending standards across consumer credit products in the second half of 2022, in part reflecting increases in delinquency rates and concerns about further future deterioration in credit performance. After reaching record lows in 2021, delinquency rates for credit cards and auto loans rose last year. That said, the share of delinquent balances for credit cards remained low, while that for auto loans is just a little above its pre-pandemic level. Despite these tighter financial conditions, financing has been generally available to support consumer spending, and consumer credit continued to expand in the past several months ( figure 21 ). Total credit card balances have increased across the credit score distribution, and auto loans continued to rise at a robust pace.

Housing market activity has declined sharply

After rising further over the summer, mortgage rates have fallen back some but remain roughly 3 percentage points higher than their levels a year ago ( figure 22 ). Although mortgage credit broadly remains available, the move up in mortgage rates (along with the earlier large home price increases) has greatly reduced affordability and further depressed homebuying sentiment, leading to a sharp decline in demand to purchase homes. Home sales fell precipitously last year and are now at levels seen during the financial crisis, while house prices have ceased their sharp increases ( figures 23 and 24 ).

The drop in housing demand, combined with a larger-than-normal backlog of homes already in the construction pipeline, has led builders to sharply cut back the number of new housing starts. Single-family starts collapsed from their 2021 highs, though multifamily starts have held up, likely supported by a shift in demand toward rentals given the decline in purchase affordability ( figure 25 ).

Capital spending grew at a solid pace in the second half last year but has been slowing

Business investment in equipment and intangible capital grew at a solid 5 percent pace in the second half of 2022 ( figure 26 ). The increase in part reflects a jump in spending on transportation equipment, as supply bottlenecks in the motor vehicles sector eased and aircraft shipments stepped up. Excluding the volatile transportation category, investment in equipment and intangibles declined in the fourth quarter, likely reflecting tighter financial conditions for businesses as well as tepid growth in demand. In contrast, investment in nonresidential structures—which tends to respond with a lag to economic conditions—has shown signs of turning up of late, after falling further last year amid ongoing pandemic-related weakness in demand for categories such as office buildings.

While business sentiment has declined significantly and financial conditions have tightened, survey indicators of capital spending plans have continued to hold up and remain above levels that would normally be associated with a sharp downturn in capital spending.

Business financing conditions tightened, but credit generally remained available

Credit remained available to most nonfinancial corporations but at generally higher interest rates and under tighter financial conditions more broadly. Issuance of leveraged loans and speculative-grade corporate bonds slowed substantially in the second half of the year, while investment-grade bond issuance declined modestly. Banks tightened lending standards on commercial and industrial loans and commercial real estate loans over the third and fourth quarters of 2022. Credit remained tight for lower-rated borrowers and tightened further for bank-dependent borrowers. Business loans at banks continued to grow in the second half of 2022 but started to decelerate in the fourth quarter, thus moderating the robust pace of growth observed earlier in the year. Despite the increase in borrowing costs, credit quality has remained strong for most nonfinancial firms. However, some predictors of future business defaults suggest that defaults are more likely.

Meanwhile, financing conditions for small businesses have remained stable over the past year. While credit supply appears to have tightened slightly and interest rates on small business loans have risen notably in recent months, credit availability is broadly in line with pre-pandemic levels. Loan performance remains strong but shows signs of weakening, as default and delinquency rates remain below their pre-pandemic levels but have risen moderately since last spring.

Trade softened amid slowing goods demand

After growing at a notable pace during the first half of the year, real imports declined in the second half, reflecting softening domestic demand for goods ( figure 27 ). Real exports increased modestly, restrained by the past appreciation of the dollar and weak foreign demand. Real exports of services, especially travel services, continue to slowly recover but remain subdued. The current account deficit as a share of GDP narrowed over the second half of last year but remains wider than before the pandemic.

The support to economic activity from federal fiscal actions has largely phased out

The federal government enacted a historic set of fiscal policies to alleviate hardship caused by the pandemic and to support the economic recovery. Policies such as stimulus checks, supplemental unemployment insurance, and child tax credit payments aided households; grants-in-aid supported state and local governments; and business support programs such as the Paycheck Protection Program helped support firms. The support to the level of GDP from these temporary policies has been diminishing, and their unwinding likely imposed a drag on GDP growth in 2022 as the effects on spending waned.

The budget deficit fell sharply from pandemic highs, causing growth in federal debt to moderate

Fiscal policies enacted since the start of the pandemic, combined with the effects of automatic stabilizers—the reduction in tax receipts and the increase in transfers that occur because of subdued economic activity—caused the federal deficit to surge to 15 percent of GDP in fiscal 2020 and to more than 12 percent in fiscal 2021 ( figure 28 ). 10 However, with pandemic-related fiscal support fading and receipts on the rise, the deficit fell to 5.5 percent of GDP in 2022.

As a result of the unprecedented fiscal support enacted early in the pandemic, federal debt held by the public jumped roughly 20 percentage points to 100 percent of GDP in fiscal 2020—the highest debt-to-GDP ratio since 1947 ( figure 29 ). With deficits falling and economic growth rebounding since fiscal 2020, the debt-to-GDP ratio has since leveled off but is expected to remain elevated compared with the years before the pandemic. With interest rates on the rise, net interest outlays have recently picked up and are expected to continue to grow over the next few years.

State and local government budget positions remain strong...

Federal policymakers provided a historical level of fiscal support to state and local governments during the pandemic, leaving the sector in a strong budget position overall. In addition, total state tax collections rose appreciably in 2021 and 2022, pushed up by the economic recovery ( figure 30 ). In response to their strong budget positions, lawmakers cut state taxes by roughly $16 billion in state fiscal year 2023 according to the National Association of State Budget Officers.

At the local level, property taxes have continued to rise, and the typically long lags between changes in the market value of real estate and changes in taxable assessments suggest that property tax revenues will continue to grow despite the recent sharp deceleration in house prices.

...yet employment and construction outlays are still below their pre-pandemic levels

Despite the strong fiscal position of state and local governments, the sector's payrolls have regained approximately three-fourths of their sizable pandemic losses, and real infrastructure spending by these governments is 10 percent below pre-pandemic levels. Nevertheless, both infrastructure outlays and employment showed signs of a recovery in the second half of 2022 ( figure 31 ).

Financial Developments

The expected level of the federal funds rate over the next year shifted up notably.

The FOMC raised the target range for the federal funds rate a further 3 percentage points since June. Market-based measures of the path of the federal funds rate expected to prevail through the first half of 2024 also shifted up notably over the same period ( figure 32 ). 11 According to these market-based measures, investors anticipate that the federal funds rate will peak at more than 5 percent in mid-2023, which is about 2 percentage points higher than the peak rate that had been expected in June. The market path implies that market participants believe that the federal funds rate will fall gradually starting around the fourth quarter of 2023 and will reach about 3.3 percent by the end of 2025. The results of the Survey of Primary Dealers and the Survey of Market Participants, both conducted by the Federal Reserve Bank of New York in January, similarly indicate that respondents' projections of the most likely path of the federal funds rate over 2023 and 2024 shifted up significantly since June. 12

Yields on U.S. nominal Treasury securities also rose considerably

Short-term yields have increased substantially further since June, reflecting expectations for a higher path for the federal funds rate, while long-term yields have risen notably further, following a considerable rise in yields across maturities over the first half of 2022 ( figure 33 ). The increases in nominal yields since June were primarily accounted for by higher real yields, consistent with expectations for more restrictive monetary policy.

Yields on other long-term debt increased modestly

After increasing substantially over the first half of 2022, corporate bond yields for investment-grade borrowers and yields for municipal borrowers have increased moderately further since June, while yields for speculative-grade corporate borrowers are about unchanged ( figure 34 ). Corporate and municipal bond spreads over comparable-maturity Treasury securities have declined somewhat since June, particularly so for speculative-grade corporate bonds, and are now near levels prevailing shortly before the pandemic. Corporate and municipal credit quality remains strong, and defaults have been low in 2022 and thus far in 2023. However, an indicator of future business defaults is elevated.

Yields on agency mortgage-backed securities (MBS)—an important pricing factor for home mortgage rates—generally moved in line with longer-dated Treasury yields since June and have increased notably on net ( figure 35 ). The MBS spread remains elevated relative to pre-pandemic levels, at least partly resulting from the large amount of interest rate volatility, which reduces the value of holding MBS.

Broad equity price indexes increased moderately, on net, amid substantial volatility

After declining sharply over the first half of 2022, broad equity price indexes have been volatile and have increased moderately since June, on net, as inflation pressures showed some signs of easing and earnings remained resilient ( figure 36 ). One-month option-implied volatility on the S&P 500 index—the VIX—has declined notably but remains moderately above the median of its historical distribution ( figure 37 ). (For a discussion of financial stability issues, see the box " Developments Related to Financial Stability .")

Developments Related to Financial Stability

This discussion reviews vulnerabilities in the U.S. financial system. 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, business and household debt, leverage in the financial sector, and funding risks. Against the backdrop of a weaker economic outlook, higher interest rates, and elevated uncertainty over the second half of the year, financial vulnerabilities remain moderate overall. Valuation pressures in equity markets increased modestly, and real estate prices continued to be high relative to fundamentals, such as rents, despite a marked slowing in price increases. Nonfinancial business and household debt grew in line with gross domestic product (GDP), leaving vulnerabilities associated with borrowing by businesses and households unchanged at moderate levels, and vulnerabilities from financial-sector leverage remained well within their historical range. Funding risks at domestic banks are low, but structural vulnerabilities persist at some money market funds, bond funds, and stablecoins.

Broad equity prices increased moderately since the middle of last year even as earning expectations fell as the economic outlook weakened. As a result, overall valuation pressures, as measured by the ratio of prices to expected earnings, ticked up. Spreads on corporate bonds declined moderately over the past six months and remain roughly in line with their historical median. The prices of several crypto-assets fell substantially after a widely publicized bankruptcy filing in November, but spillovers from crypto markets to the broader financial system were limited. Residential real estate valuations remain elevated despite the rise in mortgage rates and sharply decelerating real estate prices, as the increase in house prices over the past two years has substantially exceeded the increase in rents. Similarly, commercial real estate prices relative to the income associated with such properties remain high by historical standards. Indicators for market liquidity such as market depth, a measure of the availability of contracts to trade at best quoted prices, and price impact, a measure of how much prices move in response to large directional orders, remain low in several important markets—including the Treasury market—relative to pre-pandemic levels. However, market functioning remained orderly.

The total combined debt of households and nonfinancial businesses grew roughly in line with GDP, leaving the credit-to-GDP ratio roughly flat and close to its pre-pandemic level ( figure A ). Household balance sheets remained strong, with continued buffers of excess savings built up over 2020 and 2021 and sizable home equity cushions. Most of the increases in real household debt were accounted for by borrowers with prime credit scores, for whom delinquency rates remain low and stable. In contrast, some signs of increased stress have become apparent for households at the lower end of the income distribution as delinquency rates for near-prime and subprime borrowers have risen. Business leverage continues to be elevated by historical standards, but indicators of credit quality have remained solid and, thus far, the increase in interest rates has not weighted materially on the ability of businesses to service their debt.

Vulnerabilities from financial-sector leverage are roughly in line with historically average levels. Risk-based capital ratios at domestic bank holding companies declined last year, in part due to strong loan growth, but remain well above regulatory requirements. Moreover, even as rising interest rates have led to declines in the value of available-for-sale securities held on bank balance sheets, earnings and credit quality remain strong for banks. Leverage at certain nonbank financial institutions, including life insurers and hedge funds, has remained near historical highs. While data limitations and the complexity of hedge fund strategies can obscure the true nature of leverage in that sector, one common measure of hedge fund leverage, the ratio of gross notional exposure to equity capital, remained elevated in the third quarter of 2022—the most recent data available.

Funding risks at domestic banks and broker-dealers remain low. Liquidity coverage ratios indicate that large banks continue to have ample liquidity to meet severe deposit outflows. However, prime and tax-exempt money market funds, as well as certain other cash-investment vehicles, remain susceptible to runs. Many bond and bank-loan mutual funds continue to be vulnerable to large redemptions, because they hold assets that can become illiquid amid stress.

Near-term risks to financial stability are little changed. A recession would likely limit the ability of some households and firms to service their debt, potentially increasing delinquency rates. If a recession were to coincide with higher-than-expected inflation and interest rates, the strains on households, businesses, and the financial sector would be exacerbated. Moreover, low liquidity in some financial markets may amplify the volatility of asset prices, impair market functioning, and cause funding pressures at financial intermediaries. International developments such as Russia's continuing war against Ukraine or stresses in China could cause some strains in parts of the U.S. financial system. Finally, cyber risk in the financial system, defined as the risk of loss or operational disruptions relating to dependence on computer systems and digital technology, has increased over time and could impair the U.S. financial system.

Major asset markets functioned in an orderly way, but some measures suggest persistence of low liquidity

Consistent with ongoing higher interest rate volatility, liquidity conditions in the Treasury cash market continue to remain low relative to pre-pandemic levels. Market depth—a measure of the availability of contracts to trade at best quoted prices—for Treasury securities remains near historically low levels, particularly for short-term Treasury securities, and bid-ask spreads remain elevated relative to pre-pandemic levels. However, trading volumes in Treasury securities markets have remained about in line with historical levels, and market functioning has not been materially impaired. Equity market liquidity has improved somewhat since the summer but is still strained compared with pre-COVID levels. Corporate and municipal secondary bond markets continue to function well; transaction costs in these markets remained fairly low by historical standards.

Short-term funding market conditions remained stable

Conditions in short-term funding markets have remained stable. Increases in the FOMC's target range for the federal funds rate were transmitted effectively to other overnight rates. The effective federal funds rate and other unsecured overnight rates have been a few basis points below the interest rate on reserve balances since June. Secured overnight rates have been somewhat lower than unsecured rates but have shown some signs of firming more recently.

Prime money market funds (MMFs) have seen a notable increase in assets under management (AUM) since June, but government MMF AUM have remained relatively flat. Both prime and government MMFs have shortened their portfolios' weighted average maturities to near historical lows, likely in response to the continued increase in short-term rates and fund managers' uncertainty about the future path of interest rates. Both elevated AUM and short weighted average maturities at MMFs, as well as a limited supply of Treasury bills, have contributed to continuing elevated take-up at the Federal Reserve's overnight reverse repurchase agreement facility.

Bank credit continued to expand, but growth decelerated in the fourth quarter

Total loans and leases outstanding at commercial banks have continued to expand since June, although the pace of growth has moderated in recent months ( figure 38 ). Banks reported tighter standards and weaker demand for most loan categories over the third and fourth quarters of 2022 in the October and January Senior Loan Officer Opinion Surveys on Bank Lending Practices. Interest rates on bank loans increased through the second half of 2022, in line with the current tightening cycle. Bank profitability in the second half of 2022 remained robust overall, driven by strong net interest income, but revenues and earnings in the fourth quarter were generally weaker, particularly among banks with a greater share of income derived from investment banking activities ( figure 39 ). Bank equity prices increased moderately, on net, in line with broader equity price indexes ( figure 36 ). Delinquency rates on bank loans remained low in the fourth quarter of 2022 relative to historical averages. However, loan loss provisions have increased in recent quarters, consistent with banks' expectations for credit losses to increase in the future, and delinquency rates rose slightly last year for some loan types such as credit cards and auto loans.

International Developments

Economic activity abroad has softened....

Following solid growth early last year, foreign economic growth slowed, especially at the end of the year, weighed down by a COVID-related slowdown in China, the economic fallout of Russia's war against Ukraine, and tighter financial conditions. A stringent clampdown on COVID cases in the fall brought a marked deceleration in Chinese economic activity. In Europe, GDP growth stepped down notably in the second half of the year as high energy prices compressed real incomes and depressed confidence of households and businesses. In addition to tighter financial conditions, weaker global demand also damped activity in emerging market economies (EMEs), where exports have fallen notably.

More recently, however, economic indicators suggest that a recovery has started to take hold in China following the rapid abandonment of its zero-COVID policy. In Europe, economic activity, although still subdued, is proving more resilient than expected and is being supported by a sharp fall in natural gas prices to below their levels preceding the Russian invasion of Ukraine in 2022 ( figure 40 ).

Despite softer activity in the second half of last year, labor markets remained strong in most advanced foreign economies (AFEs), with unemployment rates at or near decades lows ( figure 41 ). As in the U.S., low jobless rates in part reflect continued high labor demand. Job vacancy rates in AFEs eased slightly in recent months but remain near historically high levels, pointing to continued difficulties in hiring. In addition, labor supply challenges in some foreign economies have contributed to tight labor market conditions. For example, the labor force participation rate in the U.K. has not risen back to its pre-pandemic level, reflecting the slow ongoing recovery from a broad range of pandemic-related factors, including long-term sickness and early retirements. In Canada, reduced immigration flows at the onset of the pandemic and an aging population have contributed to slower labor force growth in recent years.

Global supply chains continued to normalize over the latter half of 2022, helped by the slowdown in foreign economic growth. Transportation and production bottlenecks continued to abate amid weakening demand for goods. Recent data suggest that congestion at U.S. ports has broadly decreased. Container spot prices have declined sharply, especially for shipping from China to the West Coast. Both air cargo and ocean cargo transit times from Asia to North America have declined from their early 2022 peaks.

...and foreign inflationary pressures have broadened...

Foreign headline inflation abroad has started falling as effects of earlier commodity price increases have waned, though the decline so far has been less pronounced than in the U.S. ( figure 42 ). Energy inflation has moderated in foreign economies, but food inflation remained strong through year-end ( figure 43 ).

While headline inflation has begun easing, core inflation has been running firmly above its pre-COVID average in the second half of 2022. Pass-through from past energy price increases into other prices, robust wage growth stemming from tight labor markets, and past exchange rate depreciation in some economies have all contributed to elevated core inflation abroad. Core goods inflation has begun moderating, helped by fewer supply bottlenecks and a rebalancing of consumption away from goods. Services inflation, however, remains persistent.

...leading many foreign central banks to continue tightening monetary policy

In response to persistent inflationary pressures, foreign central banks—especially those in AFEs—raised policy rates expeditiously. Some also started reducing, or laid out plans to reduce, the size of their balance sheets. In light of the cumulative increase in policy rates and signs that inflation is easing, many foreign central banks have in recent months slowed the pace of their policy rate increases, signaled that such a slowing is coming, or paused policy rate hikes to take stock of the effects of policy tightening thus far on their economies. Even so, most foreign central banks have communicated that they would maintain sufficiently restrictive policy stances to lower inflation to target.

The European Central Bank has communicated its intention to continue raising its policy rate, citing strong underlying price pressures, while the Bank of England has signaled additional tightening will be warranted if inflationary pressures, especially from the labor market, prove more persistent than anticipated. Both these central banks have indicated that future policy decisions depend on realized progress toward their inflation goals. In January, the Bank of Canada conveyed that it was pausing policy rate hikes to assess the effect of the cumulative rise in interest rates on inflation and the economy. That said, the Bank of Canada also warned that it stood ready to raise its policy rate further if needed to lower inflation to its 2 percent target. In contrast to other foreign central banks, and notwithstanding a widening of the trading band on 10-year Japanese government bond yields, the Bank of Japan reaffirmed that it intends to maintain accommodative monetary conditions "as long as it is necessary" to achieve its 2 percent inflation target, including by conducting further asset purchases.

Within EMEs, the Central Bank of Brazil has left its policy rate unchanged since the middle of 2022 but recently indicated that it will resume tightening the stance of policy if reductions in inflation do not progress as expected. Other EME central banks, including the Bank of Mexico and Reserve Bank of India, have conveyed the possibility of further rate increases given still-elevated core inflation.

The synchronous nature of the recent increases in global interest rates has raised concerns about possible adverse international spillovers of tighter monetary policy. Simulations from global macroeconomic models suggest that U.S. monetary policy actions can produce notable spillovers abroad, especially given the dollar's dominant role in international trade and finance. Spillovers from foreign economies' policy actions to the U.S. can be sizable as well, particularly when many central banks tighten policy simultaneously. 13

Financial conditions abroad have tightened

Since the middle of last year, market-based measures of monetary policy expectations and sovereign bond yields have moved significantly higher in many AFEs ( figure 44 ). The rise in sovereign bond yields reflects rapid tightening in monetary policy and spillovers from higher U.S. yields. Fiscal announcements in the U.K. in late September drove significant global bond market volatility and yield increases, although these moves largely retraced following changes in government policy plans. The Bank of Japan widened the trading band of its yield curve control policy framework, allowing Japanese 10-year interest rates to rise and leading Japanese yields across the curve to rise. Euro-area yields rose amid communications from the European Central Bank that were perceived as more restrictive than expected.

After declining over the first half of last year, prices of foreign risky assets turned higher toward the end of the year. Foreign equity indexes increased across major economies, buoyed by moderation in U.S. and European inflation readings and by recent economic developments that suggest improved growth prospects in China and Europe ( figure 45 ). In addition, equities abroad were supported by China's shift away from its zero-COVID policy, which led to improved sentiment regarding China's medium-term growth prospects. Financial conditions in EMEs have improved since year-end. Outflows from EME-focused investment funds, which had been slowing toward the end of last year, turned to inflows this year, while EME sovereign spreads are little changed.

The broad dollar index—a measure of the trade-weighted value of the dollar against foreign currencies—continued to rise over the summer and through the beginning of the fourth quarter but, more recently, has largely reversed those increases ( figure 46 ). Widening yield differentials between the U.S. and the rest of the world and concerns around foreign growth pushed the dollar higher through October of last year, prompting several central banks, especially in Asia, to intervene in foreign exchange markets to support their currencies. Since peaking in October, the dollar has largely retraced those gains, reflecting softer inflation data in the U.S., tighter monetary policy abroad, and better prospects for foreign economic growth. Still, the broad dollar index remains stronger than it was in early 2021. After reaching multidecade lows against the dollar in October, the Japanese yen rebounded following the adjustment of the Bank of Japan's yield curve control policy.

 2. The latest 12-month changes in PCE prices are likely overstated at present (and will remain so until the annual revisions of the national income and product accounts in September) because they only incompletely incorporate new seasonally adjusted consumer price index data. The current overstatement in headline and core PCE inflation appears to be roughly 0.2 percentage point and 0.1 percentage point, respectively.  Return to text

 3. Two sectors where employment growth slowed notably in the second half were transportation and warehousing—where employment had expanded robustly since the onset of the pandemic—and retail trade.  Return to text

 4. For example, the (net) share of employers planning to increase payrolls in coming months, as reported by both the staffing firm ManpowerGroup and the National Federation of Independent Business, has come down in recent months but remains elevated.  Return to text

 5. This labor force participation rate (LFPR) estimate and figure 13 adjust the historical data to account for the updated population estimates produced by the Census Bureau and incorporated by the Bureau of Labor Statistics in their January 2022 Employment Situation report. Without making an adjustment for these updated population estimates, the LFPR would erroneously appear to have improved more since the onset of the pandemic and to be only about 1 percentage point below its pre-pandemic level.  Return to text

 6. The ratio of job openings to unemployment shows that there were 1.9 job openings per unemployed person in December 2022. For comparison, this ratio averaged 1.2 in 2019 and 0.6 over the 10-year period from 2010 to 2019.  Return to text

 7. See the January 2023 Beige Book, available on the Board's website at https://www.federalreserve.gov/monetarypolicy/publications/beige-book-default.htm .  Return to text

 8. In 2020, there were also significant composition effects boosting labor productivity, as pandemic-induced employment losses were largest in lower-productivity services sectors. Employment composition looks to have largely normalized by 2021.  Return to text

 9. Consistent with this view, the November 2022 Beige Book reported that many employers cited concerns that their workforce was being overworked as an important reason for hiring; see that publication, which can be found on the Board's website at https://www.federalreserve.gov/monetarypolicy/files/BeigeBook_20221130.pdf.   Return to text

 10. For more information, see Congressional Budget Office (2020), "The Budgetary Effects of Laws Enacted in Response to the 2020 Coronavirus Pandemic, March and April 2020," June, https://www.cbo.gov/system/files/2020-06/56403-CBO-covid-legislation.pdf ; Congressional Budget Office (2021), "The Budgetary Effects of Major Laws Enacted in Response to the 2020–21 Coronavirus Pandemic, December 2020 and March 2021," September, https://www.cbo.gov/system/files/2021-09/57343-Pandemic.pdf ; and Congressional Budget Office (2021), "Senate Amendment 2137 to H.R. 3684, the Infrastructure Investment and Jobs Act, as Proposed on August 1, 2021," August 9, https://www.cbo.gov/system/files/2021-08/hr3684_infrastructure.pdf .  Return to text

 11. These measures are based on market prices for effective federal funds overnight interest rate swaps and are not adjusted for term premiums.  Return to text

 12. The results of the Survey of Primary Dealers and the Survey of Market Participants are available on the Federal Reserve Bank of New York's website at https://www.newyorkfed.org/markets/primarydealer_survey_questions.html and https://www.newyorkfed.org/markets/survey_market_participants , respectively.  Return to text

 13. For a discussion of these spillovers, their channels of transmission, and their likely effects on growth, see Dario Caldara, Francesco Ferrante, and Albert Queralto (2022), "International Spillovers of Tighter Monetary Policy," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, December 22), https://doi.org/10.17016/2380-7172.3238 .  Return to text

This website uses cookies.

By clicking the "Accept" button or continuing to browse our site, you agree to first-party and session-only cookies being stored on your device to enhance site navigation and analyze site performance and traffic. For more information on our use of cookies, please see our Privacy Policy .

Journal of Economic Literature

• December 2023

A Fed for Our Times: A Review Essay on 21st Century Monetary Policy by Ben Bernanke

ISSN 0022-0515 (Print) | ISSN 2328-8175 (Online)

• Editorial Policy
• Annual Report of the Editor
• Research Highlights
• Contact Information
• Current Issue
• Forthcoming Articles
• Guidelines for Proposals
• Accepted Article Guidelines
• Style Guide
• Coverage of New Books
• Lucrezia Reichlin
• Article Information

Additional Materials

• Author Disclosure Statement(s) (47.36 KB)

JEL Classification

• N22 Economic History: Financial Markets and Institutions: U.S.; Canada: 1913-

The Monetary Policy Essay Prize .

The monetary policy essay prize 2024-5, the submission and style requirements, how to enter, about the iea, about the iimr, about the vinson centre, the iea is an educational charity and free market think tank ..

Our mission is to improve understanding of the fundamental institutions of a free society by analysing and expounding the role of markets in solving economic and social problems.

Privacy Overview

Necessary cookies are absolutely essential for the website to function properly. This category only includes cookies that ensures basic functionalities and security features of the website. These cookies do not store any personal information.

Advertisement cookies are used to provide visitors with relevant ads and marketing campaigns. These cookies track visitors across websites and collect information to provide customized ads.

Performance cookies are used to understand and analyze the key performance indexes of the website which helps in delivering a better user experience for the visitors.

Analytical cookies are used to understand how visitors interact with the website. These cookies help provide information on metrics the number of visitors, bounce rate, traffic source, etc.

Functional cookies help to perform certain functionalities like sharing the content of the website on social media platforms, collect feedbacks, and other third-party features.

Undefined cookies are those that are being analyzed and have not been classified into a category as yet.

• About the New York Fed
• Bank Leadership
• Diversity and Inclusion
• Communities We Serve
• Board of Directors
• Disclosures
• Ethics and Conflicts of Interest
• Annual Financial Statements
• News & Events
• Advisory Groups
• Vendor Information
• Holiday Schedule

At the New York Fed, our mission is to make the U.S. economy stronger and the financial system more stable for all segments of society. We do this by executing monetary policy, providing financial services, supervising banks and conducting research and providing expertise on issues that impact the nation and communities we serve.

The New York Innovation Center bridges the worlds of finance, technology, and innovation and generates insights into high-value central bank-related opportunities.

Do you have a request for information and records? Learn how to submit it.

Learn about the history of the New York Fed and central banking in the United States through articles, speeches, photos and video.

• Markets & Policy Implementation
• Reference Rates
• Effective Federal Funds Rate
• Overnight Bank Funding Rate
• Secured Overnight Financing Rate
• SOFR Averages & Index
• Broad General Collateral Rate
• Tri-Party General Collateral Rate
• Desk Operations
• Treasury Securities
• Agency Mortgage-Backed Securities
• Reverse Repos
• Securities Lending
• Central Bank Liquidity Swaps
• System Open Market Account Holdings
• Primary Dealer Statistics
• Historical Transaction Data
• Monetary Policy Implementation
• Agency Commercial Mortgage-Backed Securities
• Agency Debt Securities
• Repos & Reverse Repos
• Discount Window
• Treasury Debt Auctions & Buybacks as Fiscal Agent
• INTERNATIONAL MARKET OPERATIONS
• Foreign Exchange
• Foreign Reserves Management
• Central Bank Swap Arrangements
• Statements & Operating Policies
• Survey of Primary Dealers
• Survey of Market Participants
• Annual Reports
• Primary Dealers
• Standing Repo Facility Counterparties
• Reverse Repo Counterparties
• Foreign Exchange Counterparties
• Foreign Reserves Management Counterparties
• Operational Readiness
• Central Bank & International Account Services
• Programs Archive
• Economic Research
• Consumer Expectations & Behavior
• Survey of Consumer Expectations
• Household Debt & Credit Report
• Home Price Changes
• Growth & Inflation
• Equitable Growth Indicators
• Multivariate Core Trend Inflation
• New York Fed DSGE Model
• New York Fed Staff Nowcast
• R-star: Natural Rate of Interest
• Labor Market
• Labor Market for Recent College Graduates
• Financial Stability
• Corporate Bond Market Distress Index
• Outlook-at-Risk
• Treasury Term Premia
• Yield Curve as a Leading Indicator
• Banking Research Data Sets
• Quarterly Trends for Consolidated U.S. Banking Organizations
• Empire State Manufacturing Survey
• Business Leaders Survey
• Regional Business Surveys: Special Topics
• Regional Employment Trends
• Early Benchmarked Employment Data
• INTERNATIONAL ECONOMY
• Global Supply Chain Pressure Index
• Staff Economists
• Visiting Scholars
• Resident Scholars
• PUBLICATIONS
• Liberty Street Economics
• Staff Reports
• Economic Policy Review
• RESEARCH CENTERS
• Applied Macroeconomics & Econometrics Center (AMEC)
• Center for Microeconomic Data (CMD)
• Economic Indicators Calendar
• Financial Institution Supervision
• Regulations
• Reporting Forms
• Correspondence
• Bank Applications
• Community Reinvestment Act Exams
• Frauds and Scams

As part of our core mission, we supervise and regulate financial institutions in the Second District. Our primary objective is to maintain a safe and competitive U.S. and global banking system.

The Governance & Culture Reform hub is designed to foster discussion about corporate governance and the reform of culture and behavior in the financial services industry.

Need to file a report with the New York Fed? Here are all of the forms, instructions and other information related to regulatory and statistical reporting in one spot.

The New York Fed works to protect consumers as well as provides information and resources on how to avoid and report specific scams.

• Financial Services & Infrastructure
• Services For Financial Institutions
• Payment Services
• Payment System Oversight
• International Services, Seminars & Training
• Tri-Party Repo Infrastructure Reform
• Managing Foreign Exchange
• Money Market Funds
• Over-The-Counter Derivatives

The Federal Reserve Bank of New York works to promote sound and well-functioning financial systems and markets through its provision of industry and payment services, advancement of infrastructure reform in key markets and training and educational support to international institutions.

The growing role of nonbank financial institutions, or NBFIs, in U.S. financial markets is a transformational trend with implications for monetary policy and financial stability.

The New York Fed offers the Central Banking Seminar and several specialized courses for central bankers and financial supervisors.

• Community Development & Education
• Household Financial Well-being
• Fed Communities
• Fed Listens
• Fed Small Business
• Workforce Development
• Other Community Development Work
• High School Fed Challenge
• College Fed Challenge
• Teacher Professional Development
• Classroom Visits
• Museum & Learning Center Visits
• Educational Comic Books
• Economist Spotlight Series
• Lesson Plans and Resources
• Economic Education Calendar

We are connecting emerging solutions with funding in three areas—health, household financial stability, and climate—to improve life for underserved communities. Learn more by reading our strategy.

The Economic Inequality & Equitable Growth hub is a collection of research, analysis and convenings to help better understand economic inequality.

Implementing Monetary Policy: What’s Working and Where We’re Headed

Thank you for the introduction and thank you to NABE for the invitation to speak today. 1  As Manager of the Federal Reserve’s System Open Market Account, I am excited to share some perspectives from the New York Fed’s Open Market Trading Desk (the Desk) at this unique moment.  The Desk plays a central role in implementing monetary policy.  Looking at just the past few years, in 2020, the Desk was instrumental in carrying out the Federal Reserve’s response to the pandemic.  More recently, it has played a key role in implementing the sizable increase in the federal funds rate and the reduction in the Federal Reserve’s securities holdings directed by the Federal Open Market Committee (FOMC).

In my remarks today, I want to draw some lessons on monetary policy implementation from recent experience and discuss my perspective on money markets and reserve conditions going forward.

Before going further, I would like to mention the typical disclaimer that these remarks reflect my views and not necessarily those of the New York Fed or the Federal Reserve System.

The Ample Reserves Framework

I will start off by briefly reviewing our current operating framework.  In January 2019, the FOMC communicated its intention to maintain an ample supply of reserves. 2   When reserves are ample, interest rate control is achieved primarily through administered rates rather than active management of the supply of reserves.  This approach is typically described as a “floor system.” 3   In their discussion of implementation frameworks, policymakers noted that maintaining an ample reserves operating framework provides for good control of the policy rate under a variety of conditions as well as good transmission to other money market rates and broader financial markets. 4   A floor system is an alternative to the “scarce reserves” system used before the global financial crisis, which involved controlling the policy rate through the active management of reserves.  Maintaining a scarce reserves operating framework was seen as having some notable disadvantages, particularly considering the likely much larger levels and variability in reserve demand and supply since the crisis. 5

Obviously, the supply of reserves since the global financial crisis greatly increased due to the necessity of easing policy by conducting asset purchases when the target range was at the effective lower bound.  Two important structural changes in reserves markets since the crisis supported the decision to maintain an ample reserves operating framework instead of the prior framework.

First, whereas reserve demand by banks prior to 2008 was primarily driven by reserve requirements, since that time a more diverse and variable set of factors—including regulatory and supervisory considerations, statutory changes, and shifts in intraday liquidity management strategies—have taken on a more prominent role. 6   That has increased the baseline level of reserves demanded by banks and has rendered shifts in that demand harder to forecast on a day-to-day basis. 7  Maintaining an ample supply of reserves is a simple and efficient way of accommodating that variability.  Ample reserves have the added advantage of more straightforwardly accommodating large shifts in non-reserve liabilities, such as the Treasury General Account, for example.

The second important structural change has been the expansion of the Federal Reserve’s balance sheet after 2008, which also made it less likely that individual depository institutions found themselves short of their target holdings of reserves on any given day.  As a result, trading in the federal funds market has become much more subdued.  In recent years, activity has been driven largely by overnight borrowing patterns among a narrow set of banks.  Lending is provided almost exclusively by the Federal Home Loan Banks (FHLBs), which by statute do not earn interest on their deposits with the Federal Reserve. 8 The borrowers are instead predominantly branches of foreign banking organizations (FBOs), which are not eligible for federal deposit insurance and thus do not owe insurance premiums.  Further, FBOs often view federal funds as an attractive source of liquidity for regulatory requirements.  These incentives allow FBOs to monetize the spread between the effective federal funds rate (EFFR) and the interest rate on reserve balances, or IORB, to the extent that the former is lower than the latter. 

Despite the decline in fed funds trading volumes, there is still a strong link between the EFFR—the targeted rate for monetary policy implementation—and other money market rates; other mechanisms such as repurchase agreements (repo) and FHLB advances have emerged to facilitate the redistribution of liquidity across the system as needed.

In this environment, rate control is achieved via two administered rates that work together to maintain the EFFR within the target range indicated by the FOMC.  The IORB sets a benchmark against which banks evaluate their lending and borrowing opportunities.  The interest rate on the overnight reverse repo facility (ON RRP) provides a soft floor for overnight money market rates for a broader set of market participants.  It supports control of the federal funds rate, particularly when the supply of reserves is abundant, and the availability of alternative investments is relatively limited.  Currently, the IORB is set 10 basis points below the top of the target range, while the ON RRP rate is set five basis points above the bottom of the target range. 9

When reserves are abundant, as is currently the case, overnight rates may fall somewhat below IORB.  That so-called leakage reflects limits on how many reserves banks may want to borrow, even when overnight unsecured rates are below IORB.  Under those circumstances, the ON RRP offering rate has a direct influence on the distribution of rates in the federal funds market and provides a strong floor.  For instance, when market interest rates are above the ON RRP rate, money market funds (MMFs) are incentivized to pull funds from the ON RRP facility to lend in private markets, which pressures all front-end market rates lower.  Conversely, when rates are below the ON RRP rate, MMFs are incentivized to reduce their lending in private markets in favor of the facility, pressuring market rates higher. 10   We can say that, while both IORB and the ON RRP work together to steer the rates at which money market participants are willing to lend federal funds overnight, the IORB has a greater influence over the median rate while the ON RRP rate has a greater influence over the left tail of the effective fed funds rate distribution. 11

So, it is clear that both the IORB and the ON RRP rate play important and complementary roles in maintaining rate control.  Usage of the ON RRP facility has been very large for a time, but that should not be surprising.  In fact, the facility worked as expected, responding strongly to changes in private market conditions.  When market rates were below the ON RRP rate, take-up at the facility was elevated.  As the supply of alternative investments increased and money market rates moved up, even marginally, ON RRP usage has diminished notably, as we have seen recently.  Over time, as these dynamics continue, we should see ON RRP usage decline even more, possibly to low levels, and, everything else equal, the liquidity previously absorbed by the ON RRP should be released into the banking system in the form of reserves.

At the same time, the runoff of the Federal Reserve’s securities holdings continues to reduce the size of the Federal Reserve’s balance sheet; at some point, reserves will gradually transition from abundant, where they are today, to ample.  In an abundant reserves regime, reserves are so plentiful that market prices are largely unresponsive to changes in supply—in other words, the system is operating in the flat portion of the demand curve, as shown in Panel 1 .  In a regime in which reserves are ample, instead, banks in the aggregate will need to more actively manage a smaller quantity of reserves.  As that occurs, money market rates will drift somewhat higher—that is, the system would be operating in the “gently” upward-sloping portion of the demand curve. 12   Under those circumstances, usage of the ON RRP facility should be very small, and the IORB alone will play a direct role in anchoring the federal funds rate and other money market rates.

What Can Recent Events Tell Us?

Recently, our implementation framework has confronted a number of stress tests and performed quite well.  The past three years have seen a once-in-a-century pandemic, inflationary pressures necessitating a rapid increase in policy rates, significant demand for precautionary liquidity from some banks, investor uncertainty ahead of the recent suspension of the federal debt limit, and a subsequent rapid increase in short-term government debt.  Despite all this, the Federal Reserve has maintained strong rate control, even though the size and composition of its balance sheet has varied a lot ( Panels 2 and 3 ).  Indeed, not only has the EFFR remained well within the target range since the start of the pandemic and subsequent events, but its volatility relative to administered rates has been historically low ( Panel 4 ).

I would like to say a few words about two recent episodes in particular.

First, this past spring some banks reported significant deposit outflows which, in turn, reduced the reserve holdings and overall liquidity position of the affected institutions.  These outgoing funds were primarily transferred to larger banks at first and eventually migrated to money market funds.  Most of the affected banks turned to private markets, particularly advances from the FHLB system, to replace outflowing deposit funding.  Many used the same instruments to source precautionary liquidity as well.  In total, private markets supplied around $250 billion to domestic commercial banks over just a one-week period, a significant portion of which appeared to be provided by the FHLB system ( Panel 5 ). 13 FHLBs funded that credit expansion primarily by issuing short-term debt, including discount notes, at a modest premium to the ON RRP rate.

Over those critical days, private funding markets were able to achieve significant redistribution of liquidity while continuing to function smoothly.  Rate control remained flawless throughout this episode.  Moreover, the ON RRP worked as intended, with usage declining in response to higher private market rates, even as total money market fund assets increased due to bank deposit outflows.  MMFs were responsive to relatively small price incentives, reallocating their activity away from the ON RRP and toward FHLB debt, thereby channeling much needed liquidity back into the banking system at a reasonable cost relative to other wholesale alternatives.  At the peak of the stress period, roughly half of that liquidity came out of the ON RRP ( Panel 6 ).

Second, consider the recent debt limit episode and its aftermath.  Ahead of the suspension of the debt limit in early June, there was notable volatility in short-dated Treasury bill yields as certain cash investors shied away from some bills perceived to be at risk of payment delays.  After the debt limit was suspended, the Treasury issued new bills at a very fast pace to rebuild the Treasury General Account (TGA) balance ( Panel 7 ).  Since June 3, the TGA has increased by over $600 billion.  Once again, money market fund reallocations out of the ON RRP were important in allowing markets to accommodate the rapid increase in Treasury debt. Money funds continued to be responsive to small price incentives, purchasing Treasury bills trading at only a modest premium to other market rates ( Panel 8 ).  Rate control remained flawless throughout this episode as well.

These two examples show that our monetary policy implementation framework operates as intended even at times of stress, with ON RRP and IORB rates anchoring money market rates.  It also shows that price incentives for nonbank intermediaries facilitate efficient movement between different Federal Reserve liabilities.  These characteristics have helped us maintain strong rate control despite clear and significant variation in reserve demand and other forms of liquidity.  That is a critical feature of any monetary policy implementation framework designed to operate in an uncertain and dynamic market environment.  Our system works well.

From Abundant Liquidity to a Future State

I’d now like to turn in more detail to the topic of balance sheet runoff and our monitoring of reserve conditions.

In May 2022, policymakers noted their desire to ensure a smooth transition from abundant to ample reserves. 14  Importantly, that transition entails slowing and ultimately stopping balance sheet runoff somewhat above the level believed to be consistent with ample reserves.  Since the start of runoff in June 2022, SOMA securities holdings have declined by over $1.0 trillion, with the reduction in Federal Reserve assets partly offset by a rise in lending after the March bank stress, as shown in Panel 9 . On net, the overall balance sheet has shrunk by around $950 billion.  Notably, on the liabilities side of the Fed balance sheet, this has been concentrated in non-reserve liabilities, with reserve balances experiencing only a modest decline. 

Consistent with the Committee’s objectives, the implementation of balance sheet runoff has been proceeding smoothly.  We have seen no significant disruptions to financial or funding markets.  The principles and plans for runoff were based in part on lessons from the previous experience of 2017-19.  In particular, the use of passive redemptions subject to caps ( Panels 10 and 11 ) enables a smooth and predictable process.

At some yet unknown point in the future, reserves will approach a level beyond which the FOMC would prefer to not allow further declines.  We are cognizant of the challenges that transition can present, and the experience of September 2019 exemplifies them well.  At that time, a confluence of factors contributed to a scarcity of reserves that put considerable pressure on short-term interest rates.  That episode has been the subject of extensive discussion and analysis which I will not review here. 15   But, although the current situation is different in several ways, it is worth reflecting on the policy implementation lessons that can be drawn from that experience. First, as noted earlier, demand for reserves is not static.  Indeed, it can be highly variable and difficult to observe in real time, and even more difficult to forecast. 

Second, demand for reserves is not only time-varying but also non-linear.  That means that under some circumstances, small changes in the quantity of reserves can generate a large change in federal funds rates relative to administered rates.

These two considerations argue strongly in favor of a floor system and are also the reason why the FOMC has indicated its intention to slow and stop balance sheet runoff when reserve balances are somewhat above the ample region.  We know that the transition from abundant to ample will occur at some point, but we don’t know when.  For now, that moment does not seem to be on the horizon.

There is a third consideration that is important to keep in mind and that should mitigate the associated uncertainty.  In July 2021, the FOMC established the Standing Repo Facility (SRF) for primary dealers and eligible banks to act as a backstop in money markets and support the effective implementation and transmission of monetary policy. 16  The SRF underscores the FOMC’s commitment to the smooth functioning of money markets and is available to provide reserves should there be a sudden and unexpected shortage. 17

And of course, the Desk also has other tools to provide reserves, such as standard open market operations.  These were used effectively in the fall of 2019, when key money market rates came under considerable pressures—it’s worth noting that, thanks to those tools, the EFFR was outside the target range for only one day during that stressful episode.

Both the introduction of additional tools like the SRF and the Desk’s demonstrated ability to use its tools to quickly relieve stress episodes support market participants’ confidence in the ability and willingness of the Federal Reserve to respond as conditions warrant, thereby promoting the smooth transmission of monetary policy to the real economy.

I will turn now to the last point I want to make today.  As I mentioned, the FOMC has communicated its intention to slow and stop balance sheet runoff before reserve supply clearly transitions from abundant to ample.  What information can we rely on to tell us when that point is approaching? 

How Will We Know?

Of course, elements of this question are difficult to answer, and we are well aware of the significant uncertainty involved.  A key issue is that the reserve demand curve, as illustrated by the historical observations in Panel 12 , may have changed over recent years, and maybe even recently following the spring bank stress episode.  The current point of transition between abundant and ample reserves is uncertain.  Consequently, early warning signals will be important.

While reserves currently are clearly abundant, the Desk will continue to carefully monitor market conditions.  We have complementary information sources at our disposal that should act as warning signs of when reserves are approaching a point at which banks start actively competing for them ( Panel 13 ).  These include quantitative readings on money market conditions (that is, the realized slope of the demand curve for reserves) as well as Fed balance sheet usage, survey-based information on reserve demand from the Senior Financial Officer Survey, and ongoing market intelligence-gathering from the Desk’s many contacts. 

From my perspective, the pricing and composition of money market activity will offer particularly important signals.

Some of the quantitative market indicators that the Desk will follow to inform an assessment of reserve conditions include:

• Spreads of private overnight market rates relative to administered rates;
• The relationship between those spreads and changes in reserve balances;
• The composition of borrowers in fed funds and other money markets;
• Changes in advance demand from FHLB member banks;
• The distribution of reserve balances.

This is certainly not an exhaustive list.  We will also rely on other broad types of qualitative information we can gather from markets, market participants, and other contacts.  However, we believe that these objective and quantitative indicators cover a broad range of possible sources and manifestations of demand for reserves.

Where does this leave us? 

First and foremost, all indications are that reserves today remain abundant.  We see no clear evidence of stress in either the pricing of overnight interest rates or the usage of backstop facilities. 

Second, our operating framework has proven its capacity of redistributing liquidity as needed and at a relatively low cost.  This is clear from the ability of private markets to draw funds out of the ON RRP at just a modest premium over the offering rate for that facility. 

Third, we can maintain rate control and the smooth functioning of money markets under a wide range of conditions and through material stress.  Although activity in the federal funds market has not been particularly elevated throughout a couple of stress episodes this year, our implementation framework in conjunction with private markets has demonstrated an ability to redistribute reserves quickly to alleviate acute demand for precautionary liquidity in response to broader stress in the banking system. 

This is all encouraging, but we remain cognizant of the risks and uncertainties ahead.  The FOMC intends to slow and then stop runoff when reserve balances will be somewhat above levels consistent with ample reserves.  The Committee will make that judgment based on careful analysis and market monitoring that incorporates price signals from money markets as well as extensive market outreach and intelligence.  Experience has also given us confidence in the efficacy of our tools should short-term stress arise. 

The combination of a resilient and flexible operating framework and the constant vigilance of the extraordinarily talented and dedicated professionals on the Desk gives me confidence that balance sheet normalization can be accomplished without significant disruptions to short-term funding markets.

1 I would like to thank Eric LeSueur and Josh Younger for their assistance in preparing these remarks, Fina Bertolotti and Manisha Ratakonda for their assistance with data and charts, and my colleagues from across the Federal Reserve System for their many helpful suggestions.

2 Board of Governors of the Federal Reserve System, Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization , January 30, 2019.

3 Todd Keister, Antoine Martin, and James McAndrews, Divorcing Money from Monetary Policy , September 2008.

4 Board of Governors of the Federal Reserve System, Minutes of the Federal Open Market Committee, January 29-30, 2019 .

5 The decreased predictability of reserve demand and supply is discussed in Gara Afonso, Kyungmin Kim, Antoine Martin, Ed Nosal, Simon Potter, and Sam Schulhofer-Wohl, Monetary Policy Implementation with an Ample Supply of Reserves , January 2020, Revised July 2023.

6 The mix of factors supporting reserve demand, despite the elimination of reserve requirements, is evidenced in responses to the Federal Reserve’s Senior Financial Officer Survey. See, for example, questions on preferred reserve levels in the May 2023 survey .

7 Lorie Logan, Operational Perspectives on Monetary Policy Implementation: Panel Remarks on "The Future of the Central Bank Balance Sheet ,” May 4, 2018.

8 The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve, effective October 1, 2011, to pay interest on balances held by or for depository institutions at a Federal Reserve Bank.  The Emergency Economic Stabilization Act of 2008 accelerated the effective date of this change to October 1, 2008.

9 The relative settings of the IORB and ON RRP rate versus the federal funds target range are intended to keep the EFFR well within the target range. They can be adjusted as market conditions evolve.  In fact, there were a series of technical adjustments in years past to support effective rate control.  See Gara Afonso, Lorie Logan, Antoine Martin, William Riordan, and Patricia Zobel, How the Fed Adjusts the Fed Funds Rate within Its Target Range , January 12, 2022. 

10 Gara Afonso, Lorie Logan, Antoine Martin, William Riordan, and Patricia Zobel, How the Fed’s Overnight Reverse Repo Facility Works , January 11, 2022.  

11 Gara Afonso, Marco Cipriani, Gabriele La Spada, and Peter Prastakos, The Federal Reserve’s Two Key Rates: Similar but Not the Same? , August 14, 2023.  

12 See, for example, Gara Afonso, Domenico Giannone, Gabriele La Spada, and John C. Williams, Scarce, Abundant, or Ample? A Time-Varying Model of the Reserve Demand Curve , May 2022, Revised June 2023.

13 See Stephan Luck, Matthew Plosser, and Josh Younger, Bank Funding during the Current Monetary Policy Tightening Cycle , May 11, 2023.

14 Board of Governors of the Federal Reserve System, Plans for Reducing the Size of the Federal Reserve's Balance Sheet , May 4, 2022.

15 See, for example, John C. Williams, Money Markets and the Federal Funds Rate: The Path Forward , October 17, 2019, and Lorie Logan, Money Market Developments: Views from the Desk , November 4, 2019.

16 See Board of Governors of the Federal Reserve System, Statement Regarding Repurchase Agreement Arrangements , July 28, 2021, and Gara Afonso, Lorie Logan, Antoine Martin, William Riordan, and Patricia Zobel,   The Fed’s Latest Tool: A Standing Repo Facility , January 13, 2022.

17 In addition to the 24 primary dealers, there are currently 20 depository institutions that have access to the SRF. The New York Fed continues to accept expressions of interest for becoming a SRF counterparty .

• Request a Speaker
• International Seminars & Training
• Governance & Culture Reform
• Data Visualization
• Economic Research Tracker
• Markets Data APIs
• Terms of Use