Summary

The labor market improved further during the second half of 2013 and into early 2014 as the economic recovery strengthened: Employment has increased at an average monthly pace of about 175,000 since June, and the unemployment rate fell from 7.5 percent in June to 6.6 percent in January. With these gains, payrolls have risen a cumulative 3-1/4 million and the unemployment rate has declined 1-1/2 percentage points since August 2012, the month before the Federal Open Market Committee (FOMC) began its current asset purchase program. Nevertheless, even with these improvements, the unemployment rate remains well above levels that FOMC participants judge to be sustainable in the longer run.

Consumer price inflation remained low. The price index for personal consumption expenditures rose at an annual rate of only 1 percent in the second half of last year, noticeably below the FOMC's longer-run objective of 2 percent. However, some of the recent softness reflects factors that seem likely to prove transitory, and survey- and market-based measures of longer-term inflation expectations have remained in the ranges seen over the past several years.

Economic growth picked up in the second half of last year. Real gross domestic product is estimated to have increased at an annual rate of 3-3/4 percent, up from a 1-3/4 percent gain in the first half. Fiscal policy--which was unusually restrictive in 2013 as a whole--likely began to impose somewhat less restraint on the pace of expansion in the latter part of the year. Moreover, financial markets remained supportive of economic growth--as household net worth rose further, credit became more readily available, and interest rates remained relatively low--and economic conditions in the rest of the world improved overall despite recent turbulence in some emerging financial markets. As a result, growth in consumer spending, business investment, and exports all increased in the second half of last year.

On the whole, the U.S. financial system continued to strengthen. Capital and liquidity profiles at large bank holding companies improved further. In addition, the Federal Reserve and other agencies took further steps to enhance the resilience of the financial system, including strengthening capital regulations for large financial institutions and issuing a final rule implementing the Volcker rule, which restricts such firms' proprietary trading activities. Use of financial leverage was relatively restrained, and valuations in most asset markets were broadly in line with historical norms. Overall, the vulnerability of the system to adverse shocks remained at a moderate level.

With the economic recovery continuing, most Committee members judged by the time of the December 2013 FOMC meeting that they had seen meaningful, sustainable improvement in economic and labor market conditions since the beginning of the current asset purchase program, even while recognizing that the unemployment rate remained elevated and that inflation was running noticeably below the Committee's 2 percent longer-run objective. Accordingly, the FOMC concluded that a highly accommodative policy stance remained appropriate, but that in light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee could begin to trim the pace of its asset purchases. Specifically, the Committee decided that, beginning in January, it would add to its holdings of longer-term securities at a pace of $75 billion per month rather than $85 billion per month as it had done previously. At its January meeting, the Committee continued to see improvements in economic conditions and the outlook and reduced the pace of its asset purchases by an additional $10 billion per month, to $65 billion. The FOMC indicated that if incoming information continues to broadly support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. Nonetheless, the Committee reiterated that asset purchases are not on a preset course, and that its decisions about their pace will remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. The FOMC also noted that its sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help make broader financial conditions more accommodative.

At the same time, to emphasize its commitment to provide a high level of monetary accommodation for as long as needed to support continued progress toward maximum employment and price stability, the Committee enhanced its forward guidance regarding the federal funds rate. Over the year prior to December 2013, the FOMC had reaffirmed its view that a highly accommodative stance of monetary policy would remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee indicated its intention to maintain the current low target range for the federal funds rate at least as long as the unemployment rate remained above 6-1/2 percent, inflation between one and two years ahead was projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continued to be well anchored. At the December 2013 FOMC meeting, with the unemployment rate moving down toward the 6-1/2 percent threshold, the Committee decided to provide additional information about how it expects its policies to evolve after the threshold is crossed. Specifically, the Committee indicated its anticipation that it will likely maintain the current federal funds rate target well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below its 2 percent goal.

At the time of the most recent FOMC meeting in late January, Committee participants saw the economic outlook as little changed from the time of their December meeting, when the most recent Summary of Economic Projections (SEP) was compiled. (The December SEP is included as Part 3 of this report.) Participants viewed labor market indicators as showing further improvement on balance--notwithstanding recent mixed readings--and overall economic activity as consistent with growing underlying strength in the broader economy. Even taking into account the recent volatility in global financial markets, participants regarded the risks to the outlook for the economy and the labor market as having become more nearly balanced in recent months. FOMC participants expected that, with appropriate policy accommodation, economic activity would expand at a moderate pace, and that the unemployment rate would gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee recognized that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.