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RECENT MONETARY POLICY Paper presented a t the 19o9 Money and Banking Workshop, Federal Reserve Bank of M i n n e a p o l i s , May 9 , 1 9 6 9 . Sherman J . M a i s e l , Governor Federal Reserve System Washington, D. C . ^ want today to comment informally on two issues of m o n e t a r y and Federal Reserve policy which seem to me to be mistreated in much of the economic literature. I don't think that the traditional view is necessarily Wrong, but it does I believe lead to a misinterpretation of both what Federal Reserve does and secondly of the time period within which we should expect to measure the results of alteration in monetary policy. M y first point is'that I believe that most p e o p l e , including, unfortunately, ma n y in the Federal Reserve S y s t e m , have an incorrect idea of how m o n e t a r y Policy w o r k s , and of how the Federal Reserve controls monetary policy. all know the elementary textbook case in which the Federal Reserve cr e a t e s reserves and thereby bank d e p o s i t s . l s In the one-bank case, money created based upon the amount of new reserves and the reserve ratio. the next more complicated textbook case, we show five or six banks an d show that it takes a little while for the new reserves to be multi- Plied into a given amount of m o n e y . 0 u t When we are sophisticated, we point in modern terminology that banks are profit making organizations and therefore don't create m o n e y a u t o m a t i c a l l y . Banks m u s t want assets b e f o r e they create liabilities. b a n k s don't automatically create liabilities, but sometimes t h e i r excess reserves. Since these are not always available, increase (Although in the last ten y e a r s , this complication ^°esn't add m u c h because the amount of change in excess reserves has not been great.) ^ you teach according to these cases you might conclude, as do m a n y People, that last month the Federal Reserve by creating y reserves lr t *creased the m o n e y supply by x % . O r , you might point out that in April he Federal Reserve increased the m o n e y supply by 117 and then decreased lt Ca l n by 2% in M a y . These figures trigger lots of articles stating how n the Federal Reserve be so foolish. W h y do they create so much money one month and then decrease it the next? Wouldn't it be much better they would just create reserves at a given rate and call it quits? ^•he a n s w e r , I b e l i e v e , is that the textbooks do not paint an accurate Picture of how the Federal Reserve influences the m o n e y supply even though l t is suggested in the more advanced literature such as in articles by Tiegan or G u t e n t o g . The point that I want to stress is this--under present p o l i c i e s , reserves and the m o n e y supply are endogenous not exogenous v a r i a b l e s . The Fed influences them, but Federal Reserve policy variables are only some among many forces impinging on their g r o w t h . What the Federal Reserve does is to influence the m a r g i n a l cost of m o n e y to b a n k s . c o s t s change, banks alter their a s s e t s . When their m a r g i n a l It becomes more or less worth- while for a bank to sell or purchase investments. Depending upon changes in market conditions, the bank w i l l change their asset h o l d i n g s . As a result, banks w i l l also change their liabilities to the same e x t e n t . Depending upon what form their liabilities take, the narrowly defined money supply or time deposits or demand deposits or government deposits Will a l t e r . As a result, the bank's required reserves two weeks from now w i l l change. The F e d e r a l Reserve under its present operating Will furnish most of those required reserves. system, Reserves are furnished after the fact, after the m o n e y supply has increased or the amount of hank liabilities and assets have increased. Reserves are furnished as v i r t u a l l y an automatic p r o c e s s . s o when you teach about the Federal Reserve, you should say that the Federal Reserve changes its policies in order to change the m a r g i n a l c o s t of m o n e y to the b a n k s . As a result of altered cost-price ships, the growth of monetary aggregates or, in the assets and banks is a l t e r e d . relationliabilities Under this strategy, the operational directives °f the open market committee to the manager of the open market account say, "Change the rate at which you are purchasing bills in the open market in order to influence those short-term rates upon which you have ^ e greatest impact." These rates are those for Federal Funds and dealer borrowing rates. Such rates plus m a n y other factors influence the treasury bill rate. For e x a m p l e ^ ^ u r r e n t l y , because the Treasury has gotten to the point where it is paying off debt on a seasonal basis instead of b o r r o w i n g , it probably has m o r e impact on the three month hill rate than the Federal -Reserve does in any given w e e k . - 2 - There are other important influences such as state funds, corporation etc. F offerings, Assume that you are at a given level of short-term rates, the e d open market operations may move the Fed Fund rate by 10, 15, or 20 basis points and their pressure on the bill rate in the same w a y . At the same time, h o w e v e r , other market pressures m a y have a greater impact in the opposite d i r e c t i o n . All of these conflicting movements take place with some relationship to the discount rate. So that if the discount rate, is m o v e d , there is a new peg around which these other r ates are a l i g n e d . Let me write this strategy as a set of relationships. How does the Fed influence what I call the intermediate m o n e t a r y variable? The IMV (intermediate m o n e t a r y variable) can be a m o n e t a r y aggregate. People m i g h t define it as interest rates. Some Many would probably think of it as either bank assets or liabilities, or they might think of it as °ne type of bank asset or bank liability. ^his picture of operations can be expressed Whe re: IMV *b R f Q r, c GNP = Intermediate moruTtra^y variable = Borrowed = Free reserves = Q ceiling = Treasury bill rate = Federal funds rate = Call money rate to dealers = Economic activity = L i q u i d i t y preference of corporations, b a n k s , financial institutions, e t c . = Treasury cash management = Discount rate = Required = Open market operations d RR Then: IMV V symbolically: V reserves reserves = M (R^ r c " r Rp, Q , r b , r f , r c > G N P , L , T) V - V 3 - G N P > L * T ) % (1.0) ( 2 *0) The change in the intermediate m o n e t a r y v a r i a b l e , however d e f i n e d , is determined by the interaction of the Federal Reserve controlled varia b l e s ; certain m o n e y market rates strongly influenced by the Federal Reserve; changes in output and prices; m o v e m e n t s in the financial sector liquidity functions; and the Treasury as in (1.0). The Federal Reserve action m a y influence directly the I M V . It also w i l l influence m o n e y m a r k e t rates as in (2.0). RRt+2 Rb; Rf - IMV (3.0) - R ( RR, S) (4.0) T^e change in the intermediate m o n e t a r y variable approximately determines t he change in required reserves two weeks later (3.0). Given the change required reserves, the manager of the Open M a r k e t Account can (within limits of his operating m i s s e s ) determine exactly the level of net free reserves (4.0). r The banking system, given a level of net free e s e r v e s , determines its own level of borrowings and excess reserves simultaneously. other w o r d s , this IMV then is a function of such things as: a the mount of net borrowed reserves in the System; regulations such as Q . the past three months the relationship of market rates to Q has had a u major impact upon bank assets and bank liabilities.) It also depends Pon short-term rates--say the short-term rate on the Treasury b i l l , ^ e short-term rate on Federal F u n d s , the short-term rate on dealer ^°ans. It- It also obviously depends on what is happening to the e c o n o m y . W i l l depend upon the liquidity preference function of the e c o n o m y , in the short run will depend very greatly on treasury operations-If the treasury borrows and how the treasury handles its cash b a l a n c e s . * you look at banks you'll note that the treasury balances in banks fluctuate from three to eight billion or w i l l fluctuate by five ^^llion over rather short-term p e r i o d s . as The amount of change in bank s e t s and bank liabilities results from an interplay of all these °rces. It does not result from the fact that the Federal Reserve says that to a next month we're going to create $22,000.00 of reserves in order lter bank assets and liabilities by $ 1 0 0 , 0 0 0 . 0 0 . That is m y first Point. As a related item to this first p o i n t , let me call attention to the need f °r more careful definition and use of the concept of the m o n e y supply. If you look at the rates of growth in the monetary a g g r e g a t e s , everybody tnUst be impressed by the tremendous differences in period-to-period d e m e n t s of the different definitions of the m o n e y supply. Currently you would expect to happen would vary greatly depending which ^ e t a r y aggregates you believe in. diff gr 6 We now are at a period when the e r e n c e s among the rates of change in these variables have been very eat. if y Q U believe that short-run m o v e m e n t s are important you would *Pect the economy to react in a very different m a n n e r , depending on definition you trusted. g0in For e x a m p l e , I have here a breakdown 8 back approximately 16 m o n t h s . It is divided into three periods. first period the bank credit proxy (roughly equivalent to the ld ° Friedman M 0 ) rose at an annual rate of 3 1/27. at the same time th e Perl narrowly defined m o n e y supply grew at a rate of 87. M^ In the next °d they changed at annual rates of 14.1 and 3 . 4 , respectively. in the last period M 2 declined at a rate of - 3 . 2 7 while M x w a s tislr *g at 37. t0 a As you can s e e , these are rather large differences. This means that we need some w a y of deciding which among these m o n e t a r y &gregates to use. It also m a y mean that we need some way of deciding are logical periods when we talk about the monetary aggregates. 6 know that over five years differences aren't great'. But in a year ^ o y e a r s , particularly with the sorts of policies we have been / S V i n 8 , their movements vary a good d e a l . Mv . . second point is to call attention to a problem in relating monetary P ° l i c y and monetary theory. ' Currently^w^jreally have two or three types of m o n e t a r y theories. tQ T h e s e , h o w e v e r , have to be broadened Set explanations as to how and when monetary policy w i l l alter price, put » and e m p l o y m e n t . ' , " 5 - " As e c o n o m i s t s , we normally list five ways in w h i c h m o n e t a r y policy influences the level of spending. (If w e are pure quantity don't have to be concerned with the level of spending. ^ a t monetary policy is going to affect prices directly.) U s a theorists, We can say But m o s t of are probably not pure quantity theorists and we're not willing to g r e e that in M V = P O , "V" and "0" are constants, and that therefore is a direct function of "M". assume that all four of these factors are v a r i a b l e s . We must explain how m o n e t a r y policy influences spending rather than velocity a l o n e . W a y is through the stock of m o n e y - - t h i s is the simplest and most direct view. Changes in the amount of m o n e y are directly transmitted changes in spending. into Questions do arise as to what constitutes m o n e y . They have been very important in recent p e r i o d s . a s One There are also questions to w h e t h e r changes in m o n e y and^spending are or are not p r o p o r t i o n a l . other w o r d s , what is the degree to which "V" varies and the degree t o which you can predict changes in "V"? ^hat time lags exist? ^regular? 1 3 What variables influence "V"? • Are these long or short? Are they regular or - But the general point of those who stress the stock of m o n e y a belief that people w i l l spend less when they hold less m o n e y . A decrease in the rate of m o n e y creation will be followed by a fall in the rate of new spending. second path from changes in monetary policy to changes in spending is through the cost of c a p i t a l . This is a good Keynesian approach. The level of interest rates is an important factor determining the amount purchasers w i l l spend on real estate and other long-lived a s s e t s . If interest rates rise ceteris p a r i b u s , less should be spent on plant a n d e q u i p m e n t , on h o u s i n g , probably also on consumer durables and on governmental investment. Third we have the wealth e f f e c t . e n c e d by their net w o r t h . v o r t h falls. This says consumer spending is influ- Consumers w i l l demand less when their net T h e r e f o r e , m o n e t a r y policy has a deflationary impact inso- . 6 . far as it tends to lover the prices of stocks and b o n d s . lovers the assets of h o u s e h o l d s , they spend less. The fourth path is through the availability of credit. monetary p o l i c y , you make credit less a v a i l a b l e . rationing in particular a r e a s . make credit more a v a i l a b l e . W h e n it If you tighten This leads to credit On the other hand when you e x p a n d , you Banks can increase their intermediation or banks create credit which goes into the hands of spenders. The spenders then p u r c h a s e , and you get a m u l t i p l i e r effect as a result of the new spending. Finally, spending might be influenced by psychology or expectations. This raises the question of how much people do or do not change their spending policy as a result of psychology or e x p e c t a t i o n s . These are the five channels between m o n e t a r y policy and spending. What concerns me is that when I look at most monetary theory, whether it stresses portfolio adjustment or the wealth impact, or the cost of c a p i t a l - - a n d to a certain e x t e n t , the m o n e y stock--all are theories under which we would expect v e r y long lags between policy changes and movements in prices and e m p l o y m e n t . In fact, if you look at the Brookings or the FRB-MIT econometric m o d e l s , or similar o n e s , you find only a little monetary impact on p r i c e s , for three years or so. You Probably don't get even half your price impact until w e l l after the third y e a r . The price impact of any change in monetary policy this year in fact w i l l still be felt four or more years from n o w . In contrast, some have taken the m o n e y stock theory and have run regressions which seem to say, w e ' l l get a spending impact in an average of about nine m o n t h s . If you put your trust in those m o d e l s , you Probably get about 50% of your spending impact between the 8th and 13th month. You still, h o w e v e r , have to move from that spending impact and ask when w i l l prices be changed. into the future. Again this puts you out a long time I won't argue about the validity of those regressions or the v a l i d i t y of those theories. In any c a s e , I think one m i g h t agree ^ a t w h i c h e v e r basic theory we teach t h e m , they don't give you much short-run impact for m o n e t a r y p o l i c y . 1 would g u e s s , h o w e v e r , that if we go beyond the simplified theories, can find a basis for believing in a shorter run impact. What m u s t he done is to add to the theories as they now stand a credit availability and expectations factor. 1 W h i l e I don't give m u c h weight to e x p e c t a t i o n s , would note that some of m y colleagues put a great deal of weight on them. I personally would put m o s t of m y stress on availability and the impact on spending of the creation of c r e d i t . h I think these do explain o w m o n e t a r y policy has a shorter run impact by limiting or increasing the amount of credit banks and financial institutions can create and thereby shifting directly spending functions. But it seems to me that if you stick with the m o r e traditional m o n e t a r y theories, you really d °n't find m u c h reason for using monetary policy--certainly not for c ountercyclical purposes. You would have to conclude from these theories that m o n e t a r y policy ought just to do its thing by remaining almost constant along some line and sticking close to it. H o w e v e r , if you look at availability and e x p e c t a t i o n s , then I believe you can find some reason for shifts in p o l i c y .
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