The Federal Reserve's semi-annual monetary policy report: Still highly vigilant about inflation risks, warning of fragility in financial stability.

On Friday, the Federal Reserve's semi-annual monetary policy report showed that officials remain highly vigilant about inflation risks, with future data, outlook, and risks guiding interest rate decisions.

The Fed stated in the report that the banking system is sound and resilient, but several risk areas should still be monitored. There are significant vulnerabilities in financial stability, although the pressures faced by the banking industry last spring have subsided:

• The Fed linked these vulnerabilities to the level of borrowing and pointed out that for some banks, the fair value decline of their fixed-rate assets is quite significant relative to regulatory capital.
• The Fed also mentioned that the severe stress on the banking system has eased since last spring, and banks' regulatory risk-based capital ratios have remained stable and generally increased as banks have strong profits and reduced capital distributions.

According to the minutes of the Fed's meeting released last week, at the Fed's most recent policy meeting in January, Fed staff briefed policymakers on their assessment of the stability of the U.S. financial system, describing the financial vulnerabilities of the system as significant.

Economically, the Fed reiterated its commitment to lowering inflation to 2% and stated that the Federal Open Market Committee (FOMC) does not expect to take further rate-cutting actions until they have greater confidence in "sustainably lowering inflation to 2%." The report noted that inflation has slowed significantly but remains above the 2% target. Despite some easing in labor demand, the labor market remains "relatively tight."

The Fed's report also indicated that due to high demand for workers, employment and income gaps across different genders, races, ethnicities, and education levels have narrowed, although the Fed pointed out that significant differences still exist among different groups.

The Fed's semi-annual report to Congress was released ahead of the two-day testimony by Fed Chairman Powell next Wednesday and Thursday. The report typically reviews economic developments and actions taken by the Fed since its last report to U.S. lawmakers and can offer new perspectives on some of the latest economic data and topics such as financial stability. At next week's hearing, Powell is likely to face a series of questions from lawmakers about the Fed's tightening policy stance and expectations for future easing policies.

Summary of the Federal Reserve's Semi-Annual Monetary Policy Report

Although the inflation rate remains above the FOMC's 2% target, it has slowed significantly over the past year, and unemployment has not risen significantly as inflation has slowed. The labor market remains relatively tight, with unemployment near historic lows and job vacancies still high. Supported by steady growth in consumer spending, real GDP growth is also robust.

Since the July 2023 meeting, the FOMC has maintained the target range for the federal funds rate at 5.25%-5.5%. The committee believes that in the tightening cycle that began in early 2022, policy rates may reach their peak. The Fed continues to reduce its holdings of U.S. Treasury securities and agency mortgage-backed securities.

As the tightness in the labor market eases and inflation continues to make progress, the risks of achieving the Fed's employment and inflation goals have become better balanced. Nevertheless, the FOMC remains highly attentive to inflation risks and keenly aware of the significant difficulties that high inflation brings, especially for those least able to afford higher costs of essential goods. The FOMC is firmly committed to restoring the inflation rate to the 2% target. When considering any adjustments to the target range for the federal funds rate, a careful assessment will be made of the latest data, evolving outlook, and risk balance. The FOMC expects not to lower the target range for interest rates until there is more confidence in the continuous progress towards 2% inflation.

Recent Economic and Financial Developments

Inflation. Consumer price inflation has significantly slowed down but remains above 2%. In January, the Personal Consumption Expenditures (PCE) price index rose by 2.4% year-on-year, lower than the peak of 7.1% in 2022. The Core PCE price index (excluding volatile food and energy prices), considered a better guide for future inflation direction, increased by 2.8% year-on-year in January. Inflation slowdown is widespread in goods and services. The Core PCE prices grew at an annual rate of 2.5% in the six months leading up to January, although measuring inflation over relatively short periods may exaggerate the impact of specific or temporary factors. Long-term inflation expectations are within the range of the pre-COVID-19 decade and continue to align roughly with the FOMC's 2% long-term target.

Labor Market. The labor market remains relatively tight, with an average of 239,000 new jobs added monthly since June and the unemployment rate nearing historic lows. As vacancies in many economic sectors decrease, labor demand has eased but still exceeds the available supply of workers. Over the past year, labor supply has been increasing, reflecting a strong pace of immigration and rising labor force participation rates, especially among prime-age workers. Nominal wage growth slowed in 2023, reflecting an improvement in the balance of labor supply and demand. However, considering the general trend of productivity growth, wage growth remains above 2% in the long run.

Economic Activity. Despite tightening financial conditions, including rising long-term interest rates, real GDP grew by 3.1% last year, significantly faster than in 2022. Consumer spending has been steadily increasing, and real estate market activity started to rebound in the second half of last year after a decline that began in early 2021. However, actual business fixed investment growth slowed, possibly reflecting tightening financial conditions and subdued business sentiment. Manufacturing output showed little net change compared to GDP, with a slight decline after two strong years of growth following the pandemic.

Financial Conditions. Financial market conditions tightened further in the summer and early fall, then reversed towards the end of the year. The FOMC raised the federal funds rate target range by an additional 25 basis points at its meeting in July last year, bringing the overall increase in the target range for this tightening cycle to 525 basis points. Since mid-2023, the implied path of the federal funds rate by the market has been generally upward, and long-term nominal Treasury yields are significantly higher overall. Most households and businesses can still generally access credit, but at higher rates, putting pressure on financing activities. Bank lending to households and businesses has slowed significantly since June as banks continue to tighten standards and loan demand remains weak.

Financial Stability. Overall, the banking system remains sound and resilient; although severe pressures on the banking system have eased since March last year, some risk areas still require ongoing monitoring. The upward pressure on asset valuation continues to exist, with real estate prices rising relative to rents and stock market price-earnings ratios also relatively high. Borrowing from non-financial corporations and households continues to grow at a pace lower than the nominal GDP growth rate, with the debt-to-GDP ratio currently at its lowest level in nearly 20 years. The vulnerability brought by leverage in the financial sector remains significant. Although banks' regulatory risk-based capital ratios have remained stable and generally increased, for some banks, the fair value of their fixed-rate assets has decreased significantly relative to regulatory capital. Meanwhile, hedge funds' leverage has stabilized at a high level, life insurance companies' leverage has risen to near historical average levels, but the composition of liabilities has become more reliant on non-traditional funding sources. Most banks maintain high levels of liquidity and stable funding, but bank financing costs continue to rise.

International Developments. Following a rebound in early 2023, growth in external economic activity slowed in the second half of last year. Economic growth in advanced foreign economies (AFE) was particularly weak, as tight monetary policy suppressed economic activity and high inflation eroded real household incomes. Structural adjustments in Europe due to rising energy prices continued to hinder economic performance. Overall foreign inflation rates further declined, reflecting decreases in core inflation rates and food inflation rates. However, the speed of disinflation varies across countries and sectors, with the slowdown in commodity inflation generally outpacing the slowdown in service sector inflation.

Most foreign central banks paused policy rate hikes in the second half of last year and have since maintained stable interest rates. The policy rate paths implied by financial market pricing suggest that many AFE central banks are expected to begin lowering policy rates in 2024. Some central banks in emerging market economies have already started easing monetary policy. Since mid-last year, the net value of the US dollar's trade-weighted exchange rate has slightly increased.

Monetary Policy

Interest Rate Policy. Since significantly tightening its monetary policy stance in early 2022, the FOMC has maintained the policy rate target range at 5.25% to 5.5% since its July meeting last year. While the Federal Open Market Committee believes that the risks to achieving its employment and inflation goals are moving towards a better balance, the committee remains highly concerned about inflation risks. The committee stated that it is not appropriate to lower the target range until it is more confident that the inflation rate is steadily moving towards 2%. When considering any adjustments to the federal funds rate target range, the committee will carefully assess the latest data, evolving outlook, and risk balance.

Balance Sheet Policy. The Federal Reserve continues to significantly reduce its holdings of Treasury securities and agency securities in a predictable manner, tightening financial conditions. Starting from June 2022, principal repayments on securities held in the System Open Market Account will only be reinvested if they exceed the monthly caps. Under this policy, since mid-June 2023, the Fed has reduced its holdings of securities by around $640 billion, leading to a total reduction of about $1.4 trillion in securities holdings since the balance sheet reduction began. The FOMC stated its intention to maintain securities holdings consistent with the efficient and effective implementation of monetary policy under the ample reserves regime. To ensure a smooth transition, the FOMC plans to slow down and eventually stop reducing its securities holdings when the level of reserve balances is slightly above what the FOMC considers to be consistent with ample reserves.