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FRBSF WEEKLY LETTER February 7, 1986 Base Drift The narrow measure of the money supply, M1, consisting of coin and currency in the public's hands and deposits with unlimited checking privileges, grew rapidly in 1985. By june, M1 had greatly exceeded the 4-7 percent 1985 target range set in February, havi ng grown at an 11 percent annual rate to that point. In july, the Federal Reserve's Federal Open Market Committee, or FOMC, announced a new target range of 3-8 percent growth for the second half of 1985 and a new base - the actual level of M1 in the second quartet - from which to calculate growth. Since second quarter M1 was well above the original target range, the decision to use actual M1 as the new base in essence impounded the overshoot into the level of M1. As shown in Chart 1, the practice of using the actual level of M1 as the base from which new target ranges are calcuated shifts the level of the target path. For example, if M1 had grown at 5112 percent (the midpoint of the 3-8 percent range) after july, it would have remained permanently above the path implied by a 5112 percent growth rate starting from the base at the fourth quarter of 1984. In this Letter, the factors that determine the appropriate adjustment in the base from which to calculate target ranges are discussed. It is argued that eliminating all base adjustments is likely to lead to inappropriate monetary policy, and that, even if M1 always grew at the midpoint of its target range, adjustments in the target base would often be necessary. Definition and criticism The difference between the base used to calculate a new monetary target range and the value of the monetary aggregate M1 implied by the midpoint of the old target is commonly called "base drift." If the midpoint were always used as the new base no matter what actual M1 turned out to be, no base drift would occur. In the past, however, the FOMC has used the actual level of M1 as its base - a procedure that results in complete base drift. From 1975 through 1978, the FOMC rebased its target ranges every quarter using actual M1. Since 1979, rebasing has occurred only at the start of each year with two exceptions: in both 1983 and 1985 the target ranges for M1 were rebased in july. Monetarists have long criticized the FOMC for allowing base drift to occur. Milton Friedman has likened the Fed's practice to that of a marksman who always hits the bulls-eye by painting the target after taking his shot (Wall Street Journal, August 20,1985). Base drift has been called a major impediment to achieving price stability since it essentially ratifies, and makes permanent, deviations of money growth from target. Federal Reserve officials have taken the view that frequent shifts in the demand for money often have required adjustments in the base of target ranges. In this view, deviations from the target growth path due to money demand shifts in anyone year should be accommodated in order to prevent monetary policy from automatically becoming "too tight" or "too easy." If deviations from the midpoint of the Fed's M1 target growth path were small and as likely to be positive as negative, average drift would be close to zero even under a policy that allowed complete base drift. However, as shown in Chart 2, base drift was positive in every year between 1976 and 1985 except two. Furthermore, it ranged from negative $8.8 billion in 1981 to a high of $20.9 billion in 1982. The respective roles of base drift and the target growth ranges can be seen in Chart 3. The solid lines plot successive actual fourth quarter to fourth quarter target ranges as established by the FOMe. These target cones originate from the actual level of M1 (M1-A prior to 1980) at the start of each target period under the FOMC's policy of allowing complete base drift. The dashed set of target cones are drawn under a hypothetical pol icy of zero base drift - each cone originates from the midpoint of the previous cone. As Chart 3 shows, the cumulative effect of base drift accounts for a substantial part of the total rise in M1 over the period plotted. In FRBSF fact, base drift accounts for almost 25 percent of the total increase in M1 since 1975. Base drift and price stability The effect of base drift on price stability can be understood by using the simple quantity equation of exchange. In this equation, GNP, a measure oftotaUinaLspendingby households, businesses and government, is equal to the volume of money available for spending (M) times the average number of times in the period each dollar is spent (its velocity, or V). At the same time, GNP reflects the total volume of goods and services purchased (Q) times its average price (P). Thus, MV = PQ. Since this "equation of exchange" holds by definition at each point in time, a change in M must result in changes in V, P, or Q. Most economists agree that the effect of an autonomous change in the money supply (M) eventually falls almost entirely on the price level (P). Hence, the practiceof complete base drift would appear eventually to lead to a parallel drift in the price level if Vand Q are unaffected. If price stability is a goal of monetary policy, it would seem that all base drift should be eliminated. This conclusion is valid, however, only if velocity and real GNP are not subject to persistent shifts. For example, suppose innovation in the finan.cial market leads to a permanent increase in velocity as individuals and businesses find they can manage the same volume of transactions while holding, on average, smaller M1 balances. This appears to have happened in the mid-1970s as corporations developed more efficient methods for managing their money balances. If, in these circumstances, the velocity of money rises above trend and the growth path of M1is kept fixed, either P or Q must also rise above trend. A policy that aims for price and outputstability should, in this case, reduce the level of the growth path of M enough to counteract the upward shift in velocity. Similarly; a technological innovation that permanently affected the long-run, or full employment, path of real GNP \Yould lead to price level adjustments if the growth path of M remained unchanged. Price stability will therefore require that the base of the target range for M be adjusted in response to' some output and velocity movements. However, such adjustments would not be appropriate in response to all velocity and output disturbances. An important distinction must be made between permanent and temporary movements in output and velocity. Permanent and temporary disturbances When output temporarily rises above trend during the upswing of a business cycle, the appropriate monetary policy would be to avoid base drift - that is, to prevent a rise in the growth path of M. Such a policy would result in a rise in interest rates which, in turn, would moderate spending and help to stabilize real output. Temporary fluctuations in real GNP should not be completely accommodated by adjusting the level of the money supply's growth path since this would eventually affect prices. Similarly, if M1 rose during the year in response to a temporary velocity decl ine, or if technical factors prevented the Fed from controlling M1 exactly and caused a target to be missed, any base drift would be inappropriate. There is an increasing body of empirical evidence suggesting that disturbances to velocity and real output on an annual basis are predominately permanent in nature. For example, the work of Charles Nelson of the University of Washington and Charles Plosser of the University of Rochester has shown that both real GNP and velocity can be thought of as growing at an average, or trend rate, while subject to unpredictable shifts up or down in their levels - shifts that, in the absence of further shocks, are permanent. Thus, if M1 velocity rises 4 percent during a year, rather than its average rate of 3 percent, the extra 1 percent growth is likely to represent a shift upward in its level that in itself is permanent. Similar results have been found to apply to deviations from the trend growth of real GNP. This suggests that, more often than not, the monetary target base should be adjusted to offset velocity or output disturbance almost completely. For example, in late 1982, velocity declined relative to its trend, and M1 was allowed to overshoot its target range. In setting the new base for the 1983 target range, the FOMC explicitly allowed base drift to occur by using the abovetarget actual value of M1 as the new base, since $ Billions Chart 1 M1 Chart 2 Base Drift 1976-1985 630 620 610 Chart 3 Actual Target Ranges and Alternative Zero-Base-Drift Ranges $ Billions $ Billions 25 650 600 20 600 590 15 550 580 10 500 5 450 Of---J'LilLLLLLllLdLLL"v-7~'-LLL'-"'-r:,-rL..1 400 570 560 550 540 ·5 530 ·10 520 350 300 250 l..L.LLLl..LLl--l...L.l..L.LLLl..LLl...J...J...w...LJ...LLJ ONDJFMAMJJASONDJFMAMJJASOND 19831964 1976 1977 1976 1979 1960 1961 1982 1983 1984 1985:6 '-'-.l....-.l....-.l....-.l....-.l....-~~~~~~ 1975 1976 1977 1978 1979 1960 1981 1982 1963 1984 1985 1986 1985 the decline in velocity appeared to be permanent. The subsequent behavior of the economy, which showed no acceleration of inflation, confirmed the appropriateness of base drift in this case. More recently, the rebasing of the M1 target ranges in July 1985 followed the approximately 5 percent decline in M1 velocity during the first six months of 1985. In its July meeting, the FaMC reviewed whether the fall in velocity was a one-time. shift or was likely to reverse itself. By rebasing the target path, the FaMC chose a policy that was consistent with a belief that the velocity decline was permanent. If M1 had not been allowed to rise sufficiently in the face of a permanent velocity decline, monetary policy would have become overly tight, and the new base for subsequent target ranges would need to be above the actual value of M1 to offset the lack of policy response. rule of zero drift nor one of complete drift will always provide a superior guideline for policy. However, because both velocity and output disturbances tend to persist, price level stability will generally require some year-to-year adjustment in the base from which target ranges are calculated. The policy records of the FaMC reveal that the Committee has attempted to distinguish between shifts in velocity that are viewed to be permanent and those viewed as transitory. However, by automatically using actual M1 as the base for new target ranges, it is likely that some temporary disturbances have led to permanent changes in the price level. The most appropriate adjustment of the target base in any particular period can only be determined by analyzing the sources of velocity and output movements in that period. Carl E. Walsh, Senior Economist Conclusion Because the nature of velocity and output movements can differ in different episodes, neither a Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor (Gregory Tong) or to the author ..•. Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246. uo~6U!4S0m 040PI 4o~n uo6l?iJO !!omoH O!UJOj!l0) ouoz!J~ 0POl\l?iU 0>tsol~ O)SI)UOJj UOS JO aAJaSa~ ~U08 IOJapaj ~uaw~Jodaa lpJOaSa~ BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities large Commercial Banks Loans, Leases and Investments 1 2 Loans and Leases 1 6 Commercial and Industrial Real estate Loans to Individuals Leases U. S. Treasu ry and Agency Secu rities 2 Other Secu rities 2 Total Deposits Demand Deposits Demand Deposits Adjusted 3 Other Transaction Balances 4 Total Non-Transaction Balances 6 Money Market Deposit Accounts-Total Time Deposits in Amounts of $100,000 or more Other Liabilities for Borrowed MoneyS Two Week Averages of Daily Figures Amount Outstanding Change from 1/15/86 202,908 183,591 52,574 65,987 38,618 5,694 10,761 8,555 203,987 50,934 33,072 15,239 137,813 118/86 676 1,043 - 141 7 95 151 - 400 31 223 790 -1,177 - 249 - 319 46,013 - 33 38,134 26,086 - 143 1,403 Period ended Change from 1/16/85 Dollar Percent 7 14,913 13,555 325 4,081 6,260 428 266 1,623 8,615 4,837 4,178 2,173 1,604 - 3,062 7.1 1,900 5,486 - 4.7 Period ended 1113/86 12/30/85 107 3 104 97 84 14 Reserve Position, All Reporting Banks Excess Reserves (+ l/Deficiency (- l Borrowings Net free reserves (+ l/Net borrowed( -) 1 Includes loss reserves, unearned income, excludes interbank loans 2 Excludes trading account securities 3 Excludes U.S. government and depository institution deposits and cash items 4 ATS, NOW, Super NOW and savings accounts with telephone transfers s Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources 6 Includes items not shown separately 7 Annualized percent change - 7.9 7.9 .6 6.5 19.3 8.1 2.4 23.4 4.4 10.4 14.4 16.6 1.1 26.6
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